Fred's Inc. Annual Report 2009

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FY2009 Annual Report · Fred's Inc.

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Freds AR 09_CVR_Narr:Freds 07_final 5/24/10 9:59 AM Page 1

A n n u a l R e p o r t

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Company Profile

Founded in 1947, FRED'S operates 669 discount general merchandise stores, including 24

franchised FRED'S stores, mainly in the southeastern states. FRED'S stores stock more than

12,000 frequently purchased items that address the everyday needs of its customers, including

nationally recognized brand name products, proprietary FRED'S label products, and lower-

priced, off-brand products. The Company is headquartered in Memphis, Tennessee.

Number of Company-owned and Franchised Stores by State

120

110

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Financial Highlights ($ in thousands, except per share amounts)

Operating Data
Net sales
Net sales, excluding stores closed in 2008
Operating income
Net income
Net income per share - diluted
Weighted average shares outstanding - diluted
Cash dividends declared per share

Balance Sheet Data
Working capital
Total assets
Long-term debt (including capital leases)
Shareholders' equity
Long-term debt to equity

Net Sales
(in millions)

8
8
7
,
1
$

9
9
7
,
1
$

1
8
7
,
1
$

7
6
7
,
1
$

9
8
5
,
1
$

Years Ended

January 30, 2010

January 31, 2009

$ 1,788,136
1,788,136
38,494
23,615
0.59
39,889
0.11

266,692
571,441
4,179
400,939

$ 1,798,840
1,758,522
26,318
16,642
0.42
39,851
0.08

255,549
544,775
4,866
387,081

1.0%

1.3%

Comparable
Store Sales

Net Income
Per Share-Diluted

%
8
.
1

%
4
.
2

%
2
.
1

%
4
.
0

%
3
.
0

7
6
.
0
$

6
6
.
0
$

9
5
.
0
$

2
4
.
0
$

7
2
.
0
$

Number of
Company-Owned
Stores (end of period)

2
9
9 6
3
6

7
7
6

5
4
6

1
2
6

7
0
3

6
9
2

4
8
2

9
8
2

5
7
2

Sales Per
Square Foot

8
8
1
$

4
8
1
$

5
8
1
$

3
8
1
$

7
7
1
$

Selling Space
(Square Footage)
(in thousands)

5
1
2
,
0
1

6
4
9
,
9

0
6
3
,
9

3
2
3
,
9

1
9
0
,
9

Stores
Pharmacies

Letter to Shareholders

In this annual report, my first to you since assuming the
position of Chief Executive Officer in February 2009, I
welcome the opportunity to update you on our recent
achievements and our future plans. In 2009, our team
made considerable headway in implementing current
initiatives and formulating new ones, all designed to
improve FRED'S performance now and over the longer
term. This hard work produced tangible results in the
form of higher earnings for the year and a continued
strengthening of our balance sheet – positioning us to
sustain and build on this momentum in the years ahead.

As 2008 was coming to an end and the growing impact
of the recession began to have a more pronounced effect
on the economy and our business, we anticipated that
2009 would be a difficult year. As suspected, these
concerns were confirmed as the year played out, with
consumers steadily pulling back on spending as job losses
mounted. Separate from these external pressures, research
we commissioned in 2009 revealed that while FRED'S
offers several key points of differentiation to the discount
shopping experience, we have not taken full advantage of
these distinctions. These missed opportunities
to
capitalize fully on FRED'S key points of differentiation
occupied much of our strategic planning in the past year.

Update on Current Initiatives
in
Despite these headwinds, we were successful
implementing a number of
initiatives in 2009 that
strengthen FRED'S in both the near and long term.
These included a continued focus on the fundamentals
in areas like customer service scores; actions to test, refine
and validate our new pilot store; and improvements in
inventory quality, productivity and shrinkage. Our team
also made progress in technology improvements and
greater expense leverage in our stores, distribution centers
and logistics. Regarding the ongoing expansion of our
Own-Brand initiative, our private label sales exceeded
17% penetration as a percentage of total consumable
sales in 2009, reflecting a 350 basis point increase year
over year. These improvements strategically position us to
capitalize on future growth opportunities.

We also accelerated pharmacy acquisitions, utilizing our
improved capital position to acquire 20 pharmacies in
2009. The growth in new pharmacies enabled us to
increase pharmacy department sales 5% last year despite

the continuing shift
from branded prescriptions to
generics. Pharmacy expansion not only helps margins, it
also serves as a proven sales-driver for our other
departments. Our pharmacy Prescription-Plus Program
also grew to more than 160,000 customers enrolled by
the end of the year.

Financial and Operational Review
Net income for 2009 increased to $23.6 million or $0.59
per diluted share from $16.6 million or $0.42 per diluted
share for 2008, which included certain special charges.
On an operational basis, excluding special items, net
income for fiscal 2008 would have been $26.9 million or
$0.68 per diluted share. The year-over-year decline in
operating earnings reflected the competitive environment
and the cost of our efforts to improve customer traffic.

Although earnings growth in 2009 did not achieve
expected results, we remained on track to meet many of
the financial objectives of our strategic plan. Free cash
flow in 2009 was $24 million, bringing the cumulative
two-year total to more than $82 million and positioning
us to reach $100 million for the three-year period from
2008 through 2010. Inventory turnover also improved to
4.1 turns from 3.9 turns in 2008.

Additionally, our balance sheet is now significantly
stronger, as FRED'S has moved from a net debt position
of $26 million at the end of fiscal 2007 to no operating
debt at all and a cash surplus of $50 million by year-end
2009. All of this places FRED'S on a stronger financial
foundation and positions us to undertake new product
initiatives, new store openings and pharmacy acquisitions,
increased dividend payments, as well as share repurchases
that resumed in the second half of 2009.

A final point on FRED'S financial performance should
be made. Again this year, and for the fourth consecutive
year, Audit Integrity named FRED'S to its 2010 list of
the Top 100 Most Trustworthy Companies in the U.S.
This year's Top 100 companies were selected from more
than 12,000 U.S. public corporations using statistical
analysis of over 100 metrics that historically have been
associated with transparent
financial reporting and
corporate governance. Congratulations to our team for
this impressive award and the hard work, responsibility
and accountability that stand behind it.

Tribute
This year's letter to our shareholders would not be
complete without acknowledging the tremendous
contribution Michael Hayes made to FRED'S for a
period of 20 years. Mike served as the Company's Chief
Executive Officer from 1989 through fiscal 2008 and
now is the Chairman of our Board of Directors. He was
the driving force behind FRED'S reinvigoration in the
early 1990s and its tremendous growth over the past two
decades. In doing this, Mike built an excellent financial
foundation for FRED'S, enabling the Company to
compete in the discount retail sector with some of the
best companies in the world. We are indeed fortunate to
retain his strong interest in and engagement with our
planning for FRED'S future and his wisdom and insight
to our company's mission and capabilities. As we
approached the transition at the CEO position this past
year, FRED'S was perhaps in the strongest financial
position of its history, and we are grateful to him for the
solid legacy he has passed on to us.

Closing
While 2009 was not all we had hoped for from an
earnings standpoint, we did make solid headway in many
areas that remain key to our future growth, success and
value creation. As we enter 2010, we know that
challenges lay ahead for FRED'S and the retail industry.
However, because of the ongoing success of the initiatives
we have in place and the new programs we have
underway in the coming year, we are confident that
FRED'S can create new excitement and enthusiasm
among our customers, improve the shopping experience
and give customers many more reasons to look to
FRED'S for value and selection.

Thank you for your continued support.

Bruce A. Efird
Chief Executive Officer

New Initiatives
Our internal and external research and tests confirmed
opportunities to improve sales and margin productivity
by emphasizing certain trip-driving departments to take
advantage of our existing strengths. Our strategies for
2010 evolve around these opportunities to build traffic
and create a more pleasing and rewarding shopping
experience for our customers. One of the most important
elements of our new strategic plan is the development of
our Core 5 Program.

Core 5 is designed to drive comparable sales by focusing
on departments in which FRED'S has a clear and
marketable advantage versus small-box competitors. It
will leverage and build on our current strengths and
competitive differentiation by emphasizing departments
that have strong trip-driving potential like pharmacy,
celebration and party, pet products, paper and chemical
and products for the home.

Another key element of our strategic plan, and one that
links closely with our Core 5 Program,
the
introduction of new major national brand product lines.
Expanding in this area will help us capture traffic that
might go elsewhere when these items are on the shopping
list. We are now selling Coca Cola, Purina and Energizer
products – three of the strongest and most recognizable
brands in America – in all of our stores. Early results of
these key brand products are encouraging.

One of the most significant elements of our plan for
2010 involves the rollout of an exciting new pilot store
format with the remodeling and refurbishing of more
than 200 stores in the coming year. This new layout
includes new signage and décor and highlights our Core
5 trip-driving and differentiating departments. It is
designed to attract new customers and improve the
overall customer experience at FRED'S, giving greater
emphasis and exposure to our pharmacy department and
providing increased focus on higher margin departments.
From a strategic standpoint, it better positions FRED'S
for future sales growth as the economy improves. With
continued implementation at another 250 to 300 stores
in 2011, this new format will extend to between 70%
and 75% of our fleet of stores by 2012 and will move us
significantly toward a more consistent look and layout.

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Selected Financial Data

Our selected financial data set forth below should be read in connection with Management’s Discussion and Analysis of Financial
Condition and Results of Operations, Consolidated Financial Statements and Notes, and the Forward-Looking Statement/Risk Factors
disclosures contained in our Form 10-K for the year ended January 30, 2010.

(Dollars in thousands, except per share amounts)
Statement of Income Data:
Net sales
Operating income
Income before income taxes
Provision for income taxes
Net income

Net income per share:

Basic
Diluted

Cash dividends declared per share

Selected Operating Data:
Operating income as a percentage of sales
Increase in comparable store sales 1
Stores open at end of period

Balance Sheet Data (at period end):
Total assets
Short-term debt (including capital leases)
Long-term debt (including capital leases)
Shareholders' equity

2009

20085

20075

20062, 4

2005

$ 1,788,136
38,494
38,201
14,586
23,615

$ 1,798,840
26,318
25,910
9,268
16,642

$ 1,780,923
16,457
15,664
4,946
10,718

$ 1,767,239 $ 1,589,342
40,081
39,255
13,161
26,094

40,949
40,213
13,467
26,746

0.59
0.59
0.11

2.2%
0.4%
645

0.42
0.42
0.08

1.5%
1.8%
639

0.27
0.27
0.08

0.9%
0.3%
692

0.67
0.67
0.08

2.3%
2.4% 3
677

0.66
0.66
0.08

2.5%
1.2%
621

571,441
718
4,179
400,940

544,775
243
4,866
387,081

550,572
285
35,653
372,059

515,709 $
737
2,331
369,268

498,141
1,053
6,815
339,595

1 A store is first included in the comparable store sales calculation after the end of the 12th month following the store's grand opening month (see additional information

regarding calculation of comparable store sales in "Results of Operations" section).

2 Results for 2006 include 53 weeks.
3 The increase in comparable store sales for 2006 is computed on the same 53-week period for 2005.
4 Results for 2006 include the implementation of ASC 718.
5 Results include certain charges for the non-routine closing of 75 stores in 2008 and 17 in 2007, (see "Exit and Disposal Activities" section) and implementation of

ASC 740.

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Management’s Discussion and Analysis of Financial Condition and Results of Operations

General Accounting Periods

The following information contains references to years 2009, 2008, and 2007, which represent fiscal years ended January 30, 2010,
January 31, 2009 and February 2, 2008 (which were 52-week accounting periods). Amounts are in thousands unless otherwise noted.
This discussion and analysis should be read with, and is qualified in its entirety by, the Consolidated Financial Statements and the notes
thereto. Additionally, our discussion and analysis should be read in conjunction with the Forward-Looking Statements/Risk Factors
disclosures included herein.

Executive Summary

Recognizing our pharmacy department as a key factor differentiating us from other small-box discount retailers, we have accelerated
our growth strategy in this area and are aggressively pursuing opportunities to acquire independent pharmacies within our targeted
markets. Our emphasis will continue to be on acquisitions and buying prescription files, but cold starts will be employed where it makes
sense to do so. As we have mentioned previously, we began offering our Prescription Plus $4 generic program in all pharmacies in the
chain. We piloted this program on a limited basis last year and found it to be a traffic driver, and thus rolled it out to all pharmacies in
the first quarter. We are pleased with this deployment and its effect on our prescription count.

Our Own Brand initiative continues to be a key strategy for the Company in terms of building customer loyalty and increasing gross
margin. We have reached an Own Brand penetration rate of approximately 8.2% of total sales, and that number will continue to grow
in the future as new Own Brand products are introduced. Our commitment to quality in our Own Brand products is resonating with
our customers and they continue to make the switch to our “FRED’S Brand”. We are continuing to add new products to our Own
Brand line on an ongoing basis, with new items in paper and chemicals, food and hardware introduced during 2009.

Expense reduction and containment continues to be a key focus of the Company, especially in light of current economic conditions.
We are aggressively pursuing cost reductions in all functional areas and are also continuously reviewing internal processes to find
efficiencies and/or redundancies and drive unnecessary costs and expenses out of the business. These efforts are being coordinated at the
Executive Level and close attention is being paid not to sacrifice service to our customers. These efforts resulted in a 70 basis point
reduction in expenses as a percentage of sales or $16.0 million in 2009 compared to the same period last year.

Improving inventory productivity has been a key focus throughout 2009. Initiatives set in motion in 2008, such as reducing the store
fixture profile to remove inventory displayed above eye level, improvement in seasonal buying to reduce pack away inventory and
continuous improvement in the line review process, have resulted in a 2.5% reduction in total company inventory from the same period
last year. This reduction in inventory was accomplished without jeopardizing our in-stock positions or the merchandise selection
available to our customers.

During 2009, we continued refining our real estate site selection and store layout programs. We continue to improve the interior
layout of our stores so that our customers experience more open customer spaces, more logical product flow and a more consistent and
meaningful price message, all of which are intended to provide a more pleasurable shopping trip. We also continue to hone our real
estate strategy so that the proper site is selected to support our targeted demographics, thus driving traffic and sales. Many of these efforts
culminated in the third quarter with the grand opening of our “Pilot Store of the Future”.

Throughout 2009, we have continued with capital improvements in infrastructure, including new stores as well as existing store
expansion and remodels, distribution center upgrades and further development of our information technology capabilities. Technology
upgrades have been made in the areas of direct store delivery systems, in-store systems, and pharmacy systems.

During 2010, the Company will continue to implement its strategic plan to improve profitability and operating margin. A significant
number of stores will be refreshed in 2010 to highlight our Core 5 program, which spotlights differentiated, traffic driving departments
within our store. Additionally, a number of these departments have higher than average margin and increased focus and sales will affect
our overall product mix and margin. Also, a number of our stores will be remodeled to reflect our new “Pilot Store” format, which
delivers higher sales per square foot and higher contribution margin per square foot.

While our private label or FRED’S Brand products will continue to be a focus in 2010, we will implement several national brands in
our stores. National brands that resonate with our customers will be implemented to provide our customers with a more complete
shopping trip. Throughout the year, we will be evaluating which name brands are the most popular with our customers and will be
adding those that complement our current product mix.

Key factors that will be critical to the Company’s future success include managing the strategy for opening new stores and pharmacies,
including the ability to open and operate efficiently, maintaining high standards of customer service, maximizing efficiencies in the
supply chain, controlling working capital needs through improved inventory turnover, managing the effects of inflation or deflation,
controlling product mix, increasing operating margin through improved gross margin and leveraging operating costs, and generating
adequate cash flow to fund the Company’s future needs.

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Management’s Discussion and Analysis of Financial Condition and Results of Operations

Other factors that will affect Company performance in 2010 include the continuing management of the impacts of the changing
regulatory environment in which our pharmacy department operates, especially in regards to the health care legislation recently passed
by the United States Congress and related regulations currently being developed. Additionally, we believe that the prolonged recession
and elevated unemployment rate continue to place tremendous economic pressure on the consumer. However, we also continue to
believe that our affordable pricing and value proposition make us an attractive destination to wary consumers.

Critical Accounting Policies

The preparation of FRED’S financial statements requires management to make estimates and judgments in the reporting of assets,
liabilities, revenues, expenses and related disclosures of contingent assets and liabilities. Our estimates are based on historical experience
and on other assumptions that we believe are applicable under the circumstances, the results of which form the basis for making
judgments about the values of assets and liabilities that are not readily apparent from other sources. While we believe that the historical
experience and other factors considered provide a meaningful basis for the accounting policies applied in the Consolidated Financial
Statements, the Company cannot guarantee that the estimates and assumptions will be accurate under different conditions and/or
assumptions. A summary of our critical accounting policies and related estimates and judgments can be found in Note 1 to the
Consolidated Financial Statements. Our most critical accounting policies are as follows:

Revenue recognition. The Company markets goods and services through Company owned stores and 24 franchised stores as of
January 30, 2010. Net sales include sales of merchandise from Company owned stores, net of returns and exclusive of sales taxes. Sales
to franchised stores are recorded when the merchandise is shipped from the Company’s warehouse. Revenues resulting from layaway sales
are recorded upon delivery of the merchandise to the customer.

The Company also sells gift cards for which the revenue is recognized at time of redemption. The Company records a gift card liability
on the date the gift card is issued to the customer. Revenue is recognized and the gift card liability is reduced as the customer redeems
the gift card. The Company will recognize aged liabilities as revenue when the likelihood of the gift card being redeemed is remote (gift
card breakage). The Company has not recognized any revenue from gift card breakage since the inception of the program in May 2004
and does not expect to record any gift card breakage revenue until there is more certainty regarding our ability to retain such amounts
in light of current consumer protection and state escheatment laws.

In addition, the Company charges the franchised stores a fee based on a percentage of their purchases from the Company. These fees
represent a reimbursement for use of the FRED’S name and other administrative costs incurred on behalf of the franchised stores and
are therefore netted against selling, general and administrative expenses. Total franchise income for 2009, 2008, and 2007 was $2,087
$2,145 and $2,008, respectively.

In order to assure valuation at the lower of cost or market, the retail value of our inventory is adjusted on a consistent basis to reflect
current market conditions. These adjustments include increases to the retail value of inventory for initial markups to set the selling price
of goods or additional markups to adjust pricing for inflation and decreases to the retail value of inventory for markdowns associated
with promotional, seasonal or other declines in the market value. Because these adjustments are made on a consistent basis and are based
on current prevailing market conditions, they approximate the carrying value of the inventory at net realizable value (market value).
Therefore, after applying the cost to retail ratio, the cost value of our inventory is stated at the lower of cost or market as is prescribed
by Generally Accepted Accounting Principles in the U.S. (GAAP).

Because the approximation of net realizable value (market value) under the retail inventory method is based on estimates such as
markups, markdowns and inventory losses (shrink), there exists an inherent uncertainty in the final determination of inventory cost and
gross margin. In order to mitigate that uncertainty, the Company has a formal review by product class which considers such variables as
current market trends, seasonality, weather patterns and age of merchandise to ensure that markdowns are taken currently, or a markdown
reserve is established to cover future anticipated markdowns. This review also considers current pricing trends and inflation to ensure
that markups are taken if necessary. The estimation of inventory losses (shrink) is a significant element in approximating the carrying
value of inventory at net realizable value, and as such the following paragraph describes our estimation method as well as the steps we
take to mitigate the risk of this estimate in the determination of the cost value of inventory.

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Management’s Discussion and Analysis of Financial Condition and Results of Operations

occurring in the interim period between physical counts is calculated on a store-specific basis and is based on history, as well as
performance on the most recent physical count. It is calculated by multiplying each store’s shrink rate, which is based on the previously
mentioned factors, by the interim period’s sales for each store. Additionally, the overall estimate for shrink is adjusted at the corporate
level to a three-year historical average to ensure that the overall shrink estimate is the most accurate approximation of shrink based on
the Company’s overall history of shrink. The three-year historical estimate is calculated by dividing the “book to physical” inventory
adjustments for the trailing 36 months by the related sales for the same period. In order to reduce the uncertainty inherent in the shrink
calculation, the Company first performs the calculation at the lowest practical level (by store) using the most current performance
indicators. This ensures a more reliable number, as opposed to using a higher level aggregation or percentage method. The second portion
of the calculation ensures that the extreme negative or positive performance of any particular store or group of stores does not skew the
overall estimation of shrink. This portion of the calculation removes additional uncertainty by eliminating short-term peaks and valleys
that could otherwise cause the underlying carrying cost of inventory to fluctuate unnecessarily. The Company has not experienced any
significant change in shrink as a percentage of sales from year to year during the subject reporting periods.

Management believes that the Company’s Retail Inventory Method provides an inventory valuation which reasonably approximates
cost and results in carrying inventory at the lower of cost or market. For pharmacy inventories, which were approximately $30.2 million,
and $30.8 million at January 30, 2010 and January 31, 2009, respectively, cost was determined using the retail LIFO (last-in, first-out)
method in which inventory cost is maintained using the Retail Inventory Method, then adjusted by application of the Producer Price
Index published by the U.S. Department of Labor for the cumulative annual periods. The current cost of inventories exceeded the LIFO
cost by approximately $21.5 million at January 30, 2010 and $19.1 million at January 31, 2009. The LIFO reserve increased by
approximately $2.4 million and $3.7 million during 2009 and 2008, respectively.

The Company has historically included an estimate of inbound freight and certain general and administrative costs in merchandise
inventory as prescribed by GAAP. These costs include activities surrounding the procurement and storage of merchandise inventory such
as merchandise planning and buying, warehousing, accounting, information technology and human resources, as well as inbound freight.
The total amount of procurement and storage costs and inbound freight included in merchandise inventory at January 30, 2010 is $17.4
million, with the corresponding amount of $19.0 million at January 31, 2009.

Impairment. The Company’s policy is to review the carrying value of all long-lived assets for impairment whenever events or changes
in circumstances indicate that the carrying value of an asset may not be recoverable. In accordance with FASB ASC 360, “Impairment
or Disposal of Long-Lived Assets,” we review for impairment all stores open at least 3 years or remodeled more than 2 years. Impairment
results when the carrying value of the assets exceeds the undiscounted future cash flows over the life of the lease or 10 years for owned
stores. Our estimate of undiscounted future cash flows over the lease term is based upon historical operations of the stores and estimates
of future store profitability which encompasses many factors that are subject to management’s judgment and are difficult to predict. If a
long-lived asset is found to be impaired, the amount recognized for impairment is equal to the difference between the carrying value and
the asset’s fair value. The fair value is based on estimated market values for similar assets or other reasonable estimates of fair market value
based upon management’s judgment.

Exit and Disposal Activities. During fiscal 2007, the Company closed 17 underperforming stores.
During fiscal 2008, the Company closed 74 underperforming stores and 23 underperforming pharmacies. The closures took place
during the first three quarters of 2008 pursuant to our restructuring plan announced February 6, 2008 and were the result of an in-depth
study conducted by the Company of its operations over the previous 10 quarters. The study revealed that FRED’S has a strong and
healthy store base, and that by closing these underperforming stores the Company would improve its cash flow and operating margin,
both of which are core goals of the Company’s overall strategic plan. As a result of the successful execution of this plan, the Company is
stronger and is in a better position to respond to fluctuations in the economy and to take advantage of opportunities to further improve
our business.

During fiscal 2009, the Company closed 9 underperforming stores, which is consistent with our anticipated amount of annual

store closures.

Inventory Impairment
During fiscal 2007, we recorded a below-cost inventory adjustment of approximately $10.0 million to reduce the value of inventory
to lower of cost or market in stores that were planned for closure as part of the Company’s strategic plan to improve profitability and
operating margin. The adjustment was recorded in cost of goods sold in the consolidated statement of income for the year ended
February 2, 2008.

In fiscal 2008, we recorded an additional below-cost inventory adjustment of $0.3 million to reduce the value of inventory to lower

of cost or market associated with stores closed in the third quarter and utilized the entire $10.3 million impairment.

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Management’s Discussion and Analysis of Financial Condition and Results of Operations

Lease Termination
For store closures where a lease obligation still exists, we record the estimated future liability associated with the rental obligation on
the cease use date (when the store is closed) in accordance with FASB ASC 420, “Exit or Disposal Cost Obligations.” Liabilities are
established at the cease use date for the present value of any remaining operating lease obligations, net of estimated sublease income, and
at the communication date for severance and other exit costs, as prescribed by FASB ASC 420. Key assumptions in calculating the
liability include the timeframe expected to terminate lease agreements, estimates related to the sublease potential of closed locations, and
estimation of other related exit costs. If actual timing and potential termination costs or realization of sublease income differ from our
estimates, the resulting liabilities could vary from recorded amounts. These liabilities are reviewed periodically and adjusted when
necessary.

During fiscal 2007, we closed 17 under performing stores and recorded lease contract termination costs of $1.6 million in rent
expense in conjunction with those closings, of which $1.0 million was utilized during fiscal 2007, leaving $.6 million in the reserve at
the beginning of fiscal year 2008.

During fiscal 2008, we closed 74 under performing stores and recorded lease contract termination costs of $10.5 million, of which
$9.6 million was charged to rent expense and $.9 million reduced the liability for deferred rent. We utilized $7.7 million during the
period, leaving $3.4 million in the reserve at January 31, 2009.

During fiscal 2009, we utilized $2.4 million, leaving $1.0 million in the reserve at January 30, 2010.
The following table illustrates the exit and disposal activity related to the store closures discussed in the previous paragraphs

(in millions):

Lease contract termination liability

Beginning Balance
January 31, 2009

3.4

Additions
FY09
–

Utilized
FY09

(2.4)

Ending Balance
January 30, 2010

1.0

Fixed Asset Impairment
During the fourth quarter of 2007, the Company recorded a charge of $4.6 million in selling, general and administrative expense for
the impairment of fixed assets and leasehold improvements associated with the planned closure of 75 stores in 2008. During the second
quarter of fiscal 2008, the Company recorded an additional charge of $.1 million associated with store closures that occurred in the third
quarter. Impairment of $0.2 million for the planned store closures was recorded in fiscal 2009.

Property and equipment and intangibles. Property and equipment are carried at cost. Depreciation is calculated using the straight-
line method over the estimated useful lives of the assets and recorded in selling, general and administrative expenses. Improvements to
leased premises are depreciated using the straight-line method over the shorter of the initial term of the lease or the useful life of the
improvement. Leasehold improvements added late in the lease term are depreciated over the shorter of the remaining term of the lease
(including the upcoming renewal option, if the renewal is reasonably assured) or the useful life of the improvement, whichever is lesser.
Gains or losses on the sale of assets are recorded at disposal as a component of operating income. The following average estimated useful
lives are generally applied:

Building and building improvements
Furniture, fixtures and equipment
Leasehold improvements
Automobiles and vehicles
Airplane

Estimated Useful Lives
8 - 31.5 years
3 - 10 years
3 - 10 years or term of lease, if shorter
3 - 6 years
9 years

Assets under capital lease are depreciated in accordance with the Company’s normal depreciation policy for owned assets or over the
lease term (regardless of renewal options), if shorter, and the charge to earnings is included in depreciation expense in the Consolidated
Financial Statements.

Other identifiable intangible assets, which are included in other noncurrent assets, primarily represent customer lists associated with

acquired pharmacies and are being amortized on a straight-line basis over five years.

Vendor Rebates and Allowances. The Company receives rebates for a variety of merchandising activities, such as volume
commitment rebates, relief for temporary and permanent price reductions, cooperative advertising programs, and for the introduction
of new products in our stores. In accordance with FASB ASC 605-50 “Customer Payments and Incentives”, rebates received from a
vendor are recorded as a reduction of cost of sales when the product is sold or a reduction to selling, general and administrative expenses
if the reimbursement represents a specific incremental and identifiable cost. Should the allowance received exceed the incremental cost,

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Management’s Discussion and Analysis of Financial Condition and Results of Operations

then the excess is recorded as a reduction of cost of sales when the product is sold. Any excess amounts for the periods reported are
immaterial. Any rebates received subsequent to merchandise being sold are recorded as a reduction to cost of goods sold when received.
As of January 30, 2010, the Company had approximately 750 vendors who participate in vendor rebate programs and the terms of
the agreements with those vendors vary in length from short-term arrangements to be completed within a month to longer-term
arrangements that could last up to three years.

In accordance with FASB ASC 720-35 “Advertising Costs”, the Company charges advertising, including production costs, to selling,
general and administrative expense on the first day of the advertising period. Gross advertising expenses for 2009, 2008 and 2007, were
$24.0 million, $24.1 million and $27.6 million, respectively. Gross advertising expenses were reduced by vendor cooperative advertising
allowances of $2.6 million, $2.3 million and $1.5 million, for 2009, 2008 and 2007, respectively. It would be the Company’s intention
to incur a similar amount of advertising expense as in prior years and in support of our stores even if we did not receive support from
our vendors in the form of cooperative adverting programs.

Insurance Reserves. The Company is largely self-insured for workers compensation, general liability and employee medical
insurance. The Company’s liability for self-insurance is determined based on claims known at the time of determination of the reserve
and estimates for future payments against incurred losses and claims that have been incurred but not reported. Estimates for future claims
costs include uncertainty because of the variability of the factors involved, such as the type of injury or claim, required services by the
providers, healing time, age of claimant, case management costs, location of the claimant, and governmental regulations. These
uncertainties or a deviation in future claims trends from recent historical patterns could result in the Company recording additional
expenses or expense reductions that might be material to the Company’s results of operations. The Company carries additional coverage
for excessive or catastrophic claims with stop loss limits of $500,000 for property and general liability and $200,000 for employee
medical. The Company’s insurance reserve was $9.0 million and $8.6 million on January 30, 2010 and January 31, 2009, respectively.
Changes in the reserve over that time period were attributable to additional reserve requirements of $44.6 million netted with reserve
utilization of $44.2 million.

Income Taxes. The Company reports income taxes in accordance with FASB ASC 740, “Income Taxes.” Under FASB ASC 740, the
asset and liability method is used for computing future income tax consequences of events, which have been recognized in the Company’s
Consolidated Financial Statements or income tax returns. Deferred income tax expense or benefit is the net change during the year in
the Company’s deferred income tax assets and liabilities (see Note 4 – Income Taxes).

In June 2006, the Financial Accounting Standards Board issued FASB Interpretation No. 48 (“FASB ASC 740”), Accounting for
Uncertainty in Income Taxes — an Interpretation of FASB Statement No.109 that is codified in FASB ASC 740. We adopted FASB ASC
740 as of February 4, 2007, the first day of fiscal 2007. This interpretation clarifies the accounting for uncertainty in income taxes
recognized in an enterprise’s financial statements in accordance with FASB ASC 740 and prescribes a minimum recognition threshold of
more-likely-than-not to be sustained upon examination that a tax position must meet before being recognized in the financial statements.
Under FASB ASC 740, the impact of an uncertain income tax position on the income tax return must be recognized at the largest amount
that is more-likely-than-not to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be
recognized if it has less than a 50% likelihood of being sustained. Additionally, FASB ASC 740 provides guidance on de-recognition,
measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition (see Note 4 – Income Taxes).
FASB ASC 740 further requires that interest and penalties required to be paid by the tax law on the underpayment of taxes should
be accrued on the difference between the amount claimed or expected to be claimed on the tax return and the tax benefit recognized in
the financial statements. The Company includes potential interest and penalties recognized in accordance with FASB ASC 740 in the
financial statements as a component of income tax expense. As of January 30, 2010, accrued interest and penalties related to our
unrecognized tax benefits totaled $1.4 million and $0.3 million, respectively, and are both recorded in the consolidated balance sheet
within “Other non-current liabilities.”

Stock-Based Compensation. Effective January 29, 2006, the Company adopted the fair value recognition provisions of FASB ASC
718, “Compensation – Stock Compensation”, using the modified prospective transition method. Under this method, compensation
expense recognized post adoption includes: (1) compensation expense for all share-based payments granted prior to, but not yet vested
as of January 29, 2006, based on the grant date fair value estimated in accordance with the FASB ASC 718, and (2) compensation cost
for all share-based payments granted subsequent to January 29, 2006, based on the grant date fair value estimated in accordance with
the provisions of FASB ASC 718. Results for prior periods have not been restated.

Effective January 29, 2006, the Company elected to adopt the alternative transition method provided in FASB ASC 718 for
calculating the income tax effects of stock-based compensation. The alternative transition method includes simplified methods to
establish the beginning balance of the additional paid-in-capital pool (“APIC Pool”) related to the income tax effects of stock based
compensation, and for determining the subsequent impact on the APIC pool and consolidated statements of cash flows of the income
tax effects of stock-based compensation awards that are outstanding upon adoption of FASB ASC 718.

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Management’s Discussion and Analysis of Financial Condition and Results of Operations

FASB ASC 718 also requires the benefits of income tax deductions in excess of recognized compensation cost to be reported as a
financing cash flow, rather than as an operating cash flow. The impact of adopting FASB ASC 718 on future results will depend on,
among other things, levels of share-based payments granted in the future, actual forfeiture rates and the timing of option exercises.

Stock-based compensation expense, post adoption of FASB ASC 718, is based on awards ultimately expected to vest, and therefore
has been reduced for estimated forfeitures. Forfeitures are estimated at the time of grant based on the Company’s historical forfeiture
experience and will be revised in subsequent periods if actual forfeitures differ from those estimates.

Equity Incentive Plans. See Note 7 to the Consolidated Financial Statements for additional information regarding equity incentive plans.

Results of Operations

The following table provides a comparison of FRED’S financial results for the past three years. In this table, categories of income and

expense are expressed as a percentage of sales.

Net sales
Cost of good sold 1
Gross profit
Selling, general and administrative expenses 2
Operating income
Interest expense, net
Income before taxes
Income taxes
Net income

January 30,
2010
100.0%
72.1
27.9
25.8
2.1
–
2.1
0.8
1.3%

For the Year Ended
January 31,
20093
100.0%
72.0
28.0
26.5
1.5
0.1
1.4
0.5
0.9%

February 2,
20083
100.0%
72.5
27.5
26.6
0.9
–
0.9
0.3
0.6%

1 Cost of goods sold includes the cost of product sold, along with all costs associated with inbound freight.
2 Selling, general and administrative expenses include the costs associated with purchasing, receiving, handling, securing and storing

product. These costs are associated with products that have been sold and no longer remain in ending inventory.

3 Results include certain charges for the non-routine closing of 75 stores in 2008 and the 17 stores closed in 2007 (see Item 7, "Exit

and Disposal Activities" section).

Comparable Sales. Our policy regarding the calculation of comparable store sales represents the increase or decrease in net sales for
stores that have been opened after the end of the 12th month following the store’s grand opening month, including stores that have been
remodeled or relocated during the reporting period. The majority of our remodels and relocations do not include expansion. The purpose
of the remodel or the relocation is to change the store’s layout, refresh the store with new fixtures, interiors or signage or to locate the
store in a more desirable area. This type of change to the store does not necessarily change the product mix or product departments;
therefore, on a comparable store sales basis, the store is the same before and after the remodel or relocation. In relation to remodels and
relocations, expansions have been much more infrequent and consequently, any increase in the selling square footage is immaterial to the
overall calculation of comparable store sales.

Additionally, we do not exclude newly added hardline, softline or pharmacy departments from our comparable store sales calculation
because we believe that all departments within a FRED’S store create a synergy supporting our overall goals for managing the store,
servicing our customer and promoting traffic and sales growth. Therefore, the introduction of all new departments is included in same
store sales in the year in which the department is introduced. Likewise, our same store sales calculation is not adjusted for the removal
of a department from a location.

Fiscal 2009 Compared to Fiscal 2008

Sales

Net sales for 2009 decreased to $1,788.1 million from $1,798.8 million in 2008, a year-over-year decrease of $10.7 million or .6%.
Excluding sales from stores closed in 2008 ($40.3 million), total sales were up $29.6 million or 1.7% over the prior year. On a comparable
store basis, sales for 2009 increased .4% ($6.2 million) compared with a 1.8% ($29.1 million) increase in the same period last year.

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Management’s Discussion and Analysis of Financial Condition and Results of Operations

The Company’s 2009 front store (non-pharmacy) sales decreased 3.2% over 2008 front store sales. Excluding the front store sales
from stores closed in 2008 ($40.3 million), sales increased .2% over prior year. We experienced sales increases in categories such as
tobacco, food and small appliances partially offset by decreases in home furnishings, health and beauty aids and housewares.

The Company’s pharmacy sales were 33.5% of total sales in 2009 compared to 31.5% of total sales in the prior year and continue to
rank as the largest sales category within the Company. The total sales in this department, including the Company’s mail order operation
which we closed during the first quarter of 2009, increased 5.0% over 2008, with third party prescription sales representing
approximately 93% of total pharmacy sales, the same as in the prior year. The Company’s pharmacy department continues to benefit
from an ongoing program of purchasing prescription files from independent pharmacies as well as the addition of pharmacy departments
in existing store locations.

Sales to FRED’S 24 franchised locations during 2009 decreased to $38.4 million (2.2% of sales) from $39.6 million (2.2% of sales)
in 2008. The decrease in year-over-year franchise sales continues to be impacted by the ongoing economic challenges affecting our
customers’ disposable income. The Company does not intend to expand its franchise network.

The sales mix for the period, unadjusted for deferred layaway sales, was 33.5% Pharmaceuticals, 23.4% Household Goods, 16.2%
Food and Tobacco, 9.2% Paper and Cleaning Supplies, 7.9% Apparel and Linens, 7.6% Health and Beauty Aids, and 2.2% Franchise.
The sales mix for the same period last year was 31.7% Pharmaceuticals, 24.8% Household Goods, 15.5% Food and Tobacco, 9.2% Paper
and Cleaning Supplies, 8.6% Apparel and Linens, 8.0% Health and Beauty Aids, and 2.2% Franchise.

For the year, comparable store customer traffic decreased .1% over last year while the average customer ticket increased 1.0% to $19.29.

Gross Profit

Gross profit for the year decreased to $499.2 million in 2009 from $503.0 million in 2008, a year-over-year decline of $3.8 million
or .8%. Gross margin, measured as a percentage of sales, declined to 27.9% in 2009 from 28.0% in 2008. Gross margin was unfavorably
impacted by continued competitive pressures, higher promotional markdowns, and an unfavorable shift in the product mix toward lower
margin basic and consumable products. Gross profit was also favorably impacted, primarily in the third and fourth quarter, by purchase
price variances related to those and previous quarters. These purchase price variances resulted from reduced product costs obtained from
vendors. The impact on prior quarters was immaterial. This unfavorability was partially offset by an increase in vendor dollar
consideration and higher general merchandise department markup and improved shrink experience.

Selling, General and Administrative Expenses

Selling, general and administrative expenses, including depreciation and amortization, decreased to $460.7 million in 2009 (25.8%
of sales) from $476.7 million in 2008 (26.5% of sales). This 70 basis point expense leverage resulted primarily from the effect of our
store closures in fiscal 2008 ($9.6 million), a reduction in professional fees primarily due to the legal costs related to the settlement of
the Atchinson and Ziegler cases recorded in fiscal 2008 ($6.6 million) (see Item 3. Legal Proceedings from our 10-K filed April 16, 2009).
In addition, we continued to manage costs in our stores by reducing labor expense ($2.8 million) and lowering utilities expense ($2.2
million) with the installation of Energy Management Systems. This favorability was partially offset by deleveraging in our pharmacy
labor and depreciation expense related to new pharmacy openings during the fiscal year.

Operating Income

Operating income increased to $38.5 million in 2009 (2.1% of sales) from $26.3 million in 2008 (1.5% of sales) due primarily to a
decrease in selling, general and administrative expenses as the Company did not incur expenses related to store closures in 2009 and did
not experience the one-time legal costs as in 2008, referenced in the Selling, General and Administrative Expenses section above. This
favorability was partially offset by a decrease in gross profit of $3.8 million, a year-over-year decline of .8%, as described in the Gross
Profit section above.

Interest Expense, Net

Net interest expense for 2009 totaled $.3 million or less than .1% of sales compared to $.4 million which was also less than .1% of

sales in 2008.

Income Taxes

The effective income tax rate was 38.2% in 2009 compared to 35.8% in 2008. The increase in the effective tax rate was primarily
due to an increase in the valuation allowance associated with deferred state tax benefits which management has determined are more
likely than not to expire unused.

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Management’s Discussion and Analysis of Financial Condition and Results of Operations

The Company’s estimates of income taxes and the significant items resulting in the recognition of deferred tax assets and liabilities
are described in Note 4 to the Consolidated Financial Statements and reflect the Company’s assessment of future tax consequences of
transactions that have been reflected in the Company’s financial statements or tax returns for each taxing authority in which it operates.
Actual income taxes to be paid could vary from these estimates due to future changes in income tax law or the outcome of audits
completed by federal and state taxing authorities. The reserves are determined based upon the Company’s judgment of the probable
outcome of the tax contingencies and are adjusted, from time to time, based upon changing facts and circumstances.

State net operating loss carry-forwards are available to reduce state income taxes in future years. These carry-forwards total
approximately $135.7 million for state income tax purposes and expire at various times during 2010 through 2029. If certain substantial
changes in the Company’s ownership should occur, there would be an annual limitation on the amount of carry-forwards that can be
utilized. We have provided a reserve for the portion believed to be more likely than not to expire unused.

We expect our effective tax rate to decrease in fiscal 2010 to 35% — 36% from fiscal 2009 due mainly to the settlement of the Internal

Revenue Service Examination ($8.6 million) during 2009.

Net Income

Net income increased to $23.6 million ($.59 per diluted share) in 2009 from $16.6 million ($.42 per diluted share) in 2008. The
increase in net income is primarily attributable to the decrease in selling, general and administrative expenses of 3.3% resulting from the
effect of our store closures in fiscal 2008 ($9.6 million) and the legal costs related to the settlement of the Atchinson case also in 2008
($5.0 million) (see Item 3. Legal Proceedings from our 10-K filed April 16, 2009). This favorability was partially offset by the $3.8
million reduction in gross profit as described within the caption Gross Profit above, as well as increased income taxes due to a $12.3
million increase in pretax income and an increased tax rate resulting from the final settlement of the IRS audit.

Fiscal 2008 Compared to Fiscal 2007

Sales

Net sales increased 1.0% ($17.9 million) in 2008. Approximately $24.9 million of the increase was attributable to a net addition of
21 new stores, and a net addition of 6 pharmacies during 2008, together with the sales of 15 store locations and 7 pharmacies that were
opened or upgraded during 2007 and contributed a full year of sales in 2008. Comparable store sales, consisting of sales from stores that
have been open for more than one year, increased 1.8% in 2008, which accounted for $32.9 million in sales. This increase was partially
offset by the closure of 74 stores and 22 pharmacy locations during 2008. Those stores represent a reduction in year-over-year sales of
$39.9 million.

The Company’s 2008 front store (non-pharmacy) sales increased approximately 1.7% over 2007 front store sales. Front store sales
growth benefited from the above mentioned store additions and improvements, and sales increases in certain categories such as pets,
tobacco, paper and chemical, food, prepaid products, beverage and lawn and garden.

FRED’S pharmacy sales were 31.7% of total sales in 2008 and 32.2% of total sales in 2007 and continue to rank as the largest sales
category within the Company. The total sales in this department, including the Company’s mail order operation, decreased 0.4% over
2007, with third party prescription sales representing approximately 92% of total pharmacy sales, the same as in the prior year. The
Company’s pharmacy department continued to benefit from an ongoing program of purchasing prescription files from independent
pharmacies and the addition of pharmacy departments in existing store locations, however overall pharmacy department sales declined
due to the closing of 23 pharmacies in 2008, the sales mix shift from branded to generic and a significant decline in the Company’s mail
order operation caused by a lack of competitive sourcing for its primary product, contraceptives.

Sales to FRED’S 24 franchised locations increased approximately $2.3 million in 2008 and represented 2.2% of the Company’s total
sales, compared to 2.1% of the Company’s total sales in 2007. The increase in sales to franchised locations results primarily from the sales
volume increases experienced by the franchise locations during the year. The Company does not intend to expand its franchise network
in the future.

Gross Margin

Gross margin as a percentage of sales increased to 28.0% in 2008 compared to 27.5% in 2007. Excluding the costs associated with
closing underperforming stores in both years ($0.3 million in 2008 and $10.0 million in 2007, see Note 11 Exit and Disposal Activities),
gross margin was 28.0% in 2008 compared with 28.1% in 2007. This decline resulted from continued pricing pressures, an unfavorable
shift in the product mix toward lower margin, basic and consumable products, and higher inbound freight costs. These negative factors
were partially offset by the favorable margin effect of a positive mix shift in the pharmacy department from branded to generic drugs.

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Management’s Discussion and Analysis of Financial Condition and Results of Operations

Selling, General and Administrative Expenses

Selling, general and administrative expenses were $450.2 million (25.0% of net sales) in 2008 compared to $445.2 million (25.0%
of net sales) in 2007. The increase in selling, general and administrative expenses was due primarily to an increase in insurance costs of
$2.5 million (0.1%) related to increasing medical costs and higher claims, additional legal costs of $5.9 million (0.3%) related to the
settlement of the Ziegler and Atchinson cases (see Item 3. Legal Proceedings) as well as an additional $4.3 million (0.2%) in impairment
charges from lease write-offs and liquidation fees for stores closed in 2008. These increases were partially offset by decreases in labor costs
of $2.1 million (0.1%), occupancy costs of $3.5 million (0.2%) and advertising costs of $4.2 million (0.2%) all resulting from the store
closures completed in the current year.

Operating Income

Operating income increased to $26.3 million in 2008 (1.5% of sales) from $16.5 million in 2007 (0.9% of sales) due to increased
sales primarily from comparable stores and new stores in 2008 and a gross margin increase which was driven by a reduction in year-over-
year costs associated with closing underperforming stores ($0.3 million in 2008 versus $10.0 million in 2007). These increases were
reduced by an increase in selling, general and administrative expenses due primarily to higher insurance costs of $2.5 million (0.1%)
related to increasing medical costs and higher claims, additional legal costs of $5.9 million (0.3%) related to the settlement of the Ziegler
and Atchinson cases (see Item 3. Legal Proceedings) as well as an additional $4.3 million (0.2%) in impairment charges from lease write-
offs and liquidations fees for stores closed in 2008. These increases were partially offset by decreases in labor costs of $2.1 million (0.1%),
occupancy costs of $3.5 million (0.2%) and advertising costs of $4.2 million (0.2%) all resulting from the store closures completed in
the current year.

Interest Expense, Net

Net interest expense for 2008 totaled $.4 million or less than .1% of sales compared to $.8 million which was also less than .1% of

sales in 2007.

Income Taxes

The effective income tax rate was 35.8% in 2008 compared to 31.6% in 2007, primarily as a result of various jobs tax credits available

in 2007.

State net operating loss carry-forwards are available to reduce state income taxes in future years. These carry-forwards total
approximately $118.5 million for state income tax purposes and expire at various times during 2009 through 2028. If certain substantial
changes in the Company’s ownership should occur, there would be an annual limitation on the amount of carry-forwards that can be
utilized. We have provided a reserve for the portion believed to be more likely than not to expire unused.

We expect our effective tax rate to increase in fiscal 2009 to 36% — 37% from fiscal 2008 and fiscal 2007 levels due to the expiration
of federal credits for jobs in the 2005 hurricane impact zone and the mid year end expiration of state tax incentives offered by Georgia.

Net Income

Net income increased to $16.6 million ($.42 per diluted share) in 2008 from $10.7 million ($.27 per diluted share) in 2007. The
increase in net income is attributable to sales increases of 1.0% and gross margin increases of 0.5% driven by a reduction in year-over
year costs associated with closing underperforming stores ($0.3 million in 2008 versus $10.0 million in 2007). The gross margin increase
was partially offset by increased selling, general and administrative costs of $5.0 million as described within the caption Selling, General
and Administrative Expenses above, as well as increased income taxes of 0.5% due to a $10.2 million increase in pretax income and an
increased tax rate resulting from less tax credits being available in 2008 when compared to 2007.

Liquidity and Capital Resources

The Company’s principal capital requirements include funding new stores and pharmacies, remodeling existing stores and
pharmacies, maintenance of stores and distribution centers, and the ongoing investment in information systems. FRED’S primary
sources of working capital have traditionally been cash flow from operations and borrowings under its credit facility. The Company had

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Management’s Discussion and Analysis of Financial Condition and Results of Operations

working capital of $266.7 million, $255.5 million and $270.5 million at year-end 2009, 2008 and 2007, respectively. Working capital
fluctuates in relation to profitability, seasonal inventory levels, and the level of store openings and closings. Working capital at year-end
2009 increased by approximately $11.1 million from 2008. The increase was primarily due to increased cash and cash equivalents of
$19.6 million due to improved cash management and a $7.7 million reduction in accrued expenses related to the settlement of two legal
cases (see Item 3. Legal Proceedings in our 10-K filed April 16, 2009). The increase described above was offset by a year-over-year
increase in account payable of $17.4 million, a result of our focus on improving our terms with vendors. In 2010, the Company intends
to open approximately 20 - 25 stores and pharmacies and close an estimated 10 stores and 5 pharmacies.

During 2005, 2006, 2007 and 2009, we incurred losses caused by fire, tornado and flood damage, which consisted primarily of losses
of inventory and fixed assets. We reached settlements on some of our insurance claims related to inventory and fixed assets in 2006, 2007
and 2008. Insurance proceeds related to fixed assets are included in cash flows from investing activities and proceeds related to inventory
losses and business interruption are included in cash flows from operating activities.

Net cash flow provided by operating activities totaled $64.2 million in 2009, $78.3 million in 2008 and $19.3 million in 2007.
In fiscal 2009, inventory, net of the LIFO reserve, decreased by approximately $7.5 million due to higher inventory turn rates in our
stores, the average of which has increased to 4.1 in fiscal 2009 from 3.8 in fiscal 2008. Accounts receivable increased by approximately
$1.6 million due primarily to an increase in vendor related allowances. Accounts payable and accrued expenses increased by
approximately $11.4 million primarily as a result of the focus on improving our terms with our vendors. Income taxes payable decreased
by $8.0 million while deferred income tax expense increased by $5.9 million. Other non-current liabilities decreased by $3.4 million due
to a reduction in the Company FASB ASC 740 reserves.

In fiscal 2008, inventory, net of the LIFO reserve, decreased by approximately $18.5 million due to the store and pharmacy closing
throughout the year, as well as reductions in discretionary product classes where sales decreased in 2008. Accounts receivable decreased
by approximately $5.4 million due primarily to a decrease of an income tax receivable that was created in the prior year. Accrued expenses
increased by approximately $5.5 million primarily as a result of the $6.6 million legal accrual related to the settlement of the Ziegler and
Atchinson cases in the fourth quarter of 2008. Other non-current liabilities increased by $8.7 million due to an increase in the Company
FASB ASC 740 reserves.

In fiscal 2007, inventory, net of the LIFO reserve, increased by approximately $25.3 million due to improving in-stock positions in
the basic and consumable product categories as well as slower sales than projected during the 2007 Holiday season. This increase was
offset by a $10.0 million non-cash reduction in inventory resulting from the below-cost inventory adjustment related to the planned
store closures in the upcoming year. Accounts receivable increased by approximately $8.1 million due an increase in income tax receivable
which reflects overpayment of estimated taxes due to lower than anticipated sales.

Capital expenditures in 2009 totaled $22.7 million compared to $17.0 million in 2008 and $31.4 million in 2007. The capital
expenditures during 2009 consisted primarily of the store and pharmacy expansion program ($15.7 million), technology enhancements
($3.3 million), transportation and distribution center expenditures ($2.1 million) and other corporate expenditures ($1.6 million).
Capital expenditures during 2008 consisted primarily of the store and pharmacy expansion program ($13.7 million), technology and
other corporate expenditures ($2.2 million) and improvements at our two distribution centers ($1.1 million). The capital expenditures
during 2007 consisted primarily of the store and pharmacy expansion program ($15.3 million), acquisition of previously leased land and
buildings ($11.7 million), expenditures related to the Store Refresher Program ($7.5 million) and technology and other corporate
expenditures ($4.2 million). Also during fiscal 2007, the Company assumed debt of $6.1 million and issued $1.2 million in common
stock for the acquisition of store real estate. Cash used for investing activities also includes $10.7 million in 2009, $5.7 million in 2008
and $1.7 million in 2007 for the acquisition of prescription lists and other pharmacy related items and $0.6 million in 2008 and $1.1
million in 2007 from insurance proceeds related to fixed assets reimbursements.

In 2010, the Company is planning capital expenditures totaling approximately $26.6 million. Expenditures are planned totaling
$19.3 million for new and existing stores and pharmacies. Planned expenditures also include approximately $4.3 million for technology
upgrades and approximately $2.4 million for distribution center equipment and other capital maintenance. Technology upgrades in 2010
will be made in the areas of business intelligence software and POS systems and equipment for the stores. In addition, the Company
plans expenditures of approximately $10.0 million in 2010 for the acquisition of prescription lists and other pharmacy related items.

Cash and cash equivalents were $54.7 million at the end of 2009 compared to $35.1 million at the end of 2008 and $10.3 million
at the end of 2007. Short-term investment objectives are to maximize yields while minimizing company risk and maintaining liquidity.
Accordingly, limitations are placed on the amounts and types of investments the Company can select.

On August 27, 2007, the Board of Directors approved a plan that authorized stock repurchases of up to 4.0 million shares of the
Company’s common stock. Under the plan, the Company may repurchase its common stock in open market or privately negotiated
transactions at such times and at such prices as determined to be in the Company’s best interest. These purchases may be commenced
or suspended without prior notice depending on then-existing business or market conditions and other factors. In fiscal 2009, the
Company repurchased 742,663 shares for $7.2 million. There were no share repurchases in fiscal 2008.

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Management’s Discussion and Analysis of Financial Condition and Results of Operations

On September 16, 2008, the Company and Regions Bank entered into a Ninth Loan Modification of the Revolving Loan and Credit
Agreement which decreased the credit line from $75 million to $60 million and extended the term until July 31, 2011. All other terms,
conditions and covenants remained in place after the amendment, with only a slight modification to one of the financial covenants
required by the Agreement. Under the most restrictive covenants of the Agreement, the Company is required to maintain specified
shareholders’ equity (which was $300.6 million at January 31, 2009) and net income levels. Borrowings and the unused fees under the
agreement bear interest at a tiered rate based on the Company’s previous four quarter average of the Fixed Charge Coverage Ratio.
Currently the Company is at 125 basis points over LIBOR for borrowings and 25 basis points over LIBOR for the unused fee. There
were no borrowings outstanding under the Agreement at January 31, 2009 and $30.6 million outstanding at February 2, 2008. The
weighted-average interest rate on borrowings under the Agreement was 3.67% and 5.76% at January 31, 2009 and February 2, 2008,
respectively.

On October 30, 2007, the Company and Regions Bank entered into an Eighth Modification Agreement of the Revolving Loan and
Credit Agreement (“Agreement”) to provide an increase in the credit line from $50 million to $75 million and to extend the term until
July 31, 2009. All other terms, conditions and covenants remained in place after the amendment. Borrowings under the Agreement bore
interest at 1.5% below the prime rate or a LIBOR-based rate. Under the most restrictive covenants of the Agreement, the Company was
required to maintain specified shareholders’ equity (which was $292.3 million at February 2, 2008) and net income levels. The Company
was required to pay a commitment fee to the bank at a rate per annum equal to 0.15% on the unutilized portion of the revolving line
commitment over the term of the Agreement. There were $30.6 million and $2.2 million of borrowings outstanding under the
Agreement at February 2, 2008 and February 3, 2007, respectively. The increase in debt was due to an increase in inventory to improve
in-stock positions and capital expenditures to acquire the land and building occupied by thirteen FRED’S stores that we had previously
leased. The weighted average interest rate on borrowings under Agreement was 5.76% and 5.93% at February 2, 2008 and February 3,
2007, respectively.

The Company believes that sufficient capital resources are available in both the short-term and long-term through currently available

cash, cash generated from future operations and, if necessary, the ability to obtain additional financing.

Off-Balance Sheet Arrangements

The Company has no off-balance sheet financing arrangements.
Effects of Inflation and Changing Prices. The Company believes that inflation and/or deflation had a minimal impact on its overall

operations during fiscal years 2009, 2008 and 2007.

Contractual Obligations and Commercial Commitments

As discussed in Note 5 to the Consolidated Financial Statements, the Company leases certain of its store locations under
noncancelable operating leases expiring at various dates through 2029. Many of these leases contain renewal options and require the
Company to pay contingent rent based upon a percentage of sales, taxes, maintenance, insurance and certain other operating expenses
applicable to the leased properties. In addition, the Company leases various equipment under noncancelable operating leases.

The following table summarizes the Company’s significant contractual obligations as of January 30, 2010, which excludes the effect

of imputed interest:

(Dollars in thousands)
Operating leases 1
Inventory purchase obligations 2
Equipment leases 3
Mortgage loans on land & buildings

and other 4

Postretirement benefits 5
Total contractual obligations

2010
$ 45,274
154,241
1,808

718
29
$ 202,070

2011
$ 40,440

2012
$ 33,851

2013
$ 23,558

2014
$ 15,148

Thereafter
$ 26,724

1,438

457

161
33
$ 42,072

170
36
$ 34,514

1,109
40
$ 24,765

525
46
$ 15,725

2,214
271
$ 29,209

Total
$ 184,995
154,241
3,767

4,897
455
$ 348,355

1 Operating leases are described in Note 5 to the Consolidated Financial Statements.
2

Inventory purchase obligations represent open purchase orders and any outstanding purchase commitments as of January 30, 2010.

3 Equipment leases represent the cooler program and other equipment operating leases.
4 Mortgage loans for purchased land and buildings and other debt.
5 Postretirement benefits are described in Note 9 to the Consolidated Financial Statements.

Freds AR 09 Fin_Fixes:Freds AR 2007 fin-final 5/24/10 1:45 PM Page 16

Management’s Discussion and Analysis of Financial Condition and Results of Operations

The Company had commitments approximating $8.8 million at January 30, 2010 and $9.7 million at January 31, 2009 on issued
letters of credit, which support purchase orders for merchandise. Additionally, the Company had outstanding letters of credit
aggregating approximately $11.1 million at January 30, 2010 and $12.0 million at January 31, 2009 utilized as collateral for its risk
management programs.

The Company financed the construction of its Dublin, Georgia distribution center with taxable industrial development revenue
bonds issued by the City of Dublin and County of Laurens development authority. The Company purchased 100% of the bonds and
intends to hold them to maturity, effectively financing the construction with internal cash flow. The Company has offset the investment
in the bonds ($34.6 million) against the related liability and neither is reflected in the consolidated balance sheet.

Related Party Transactions

During the year ended February 2, 2008, Atlantic Retail Investors, LLC, which is partially owned by Michael J. Hayes, Chairman of
the Board of Directors, purchased the land and buildings occupied by thirteen FRED’S stores. The stores were purchased by Atlantic
Retail Investors, LLC from an independent landlord/developer. Prior to the purchase by Atlantic Retail Investors, LLC the Company
was offered the right to purchase the same stores and declined the offer. The terms and conditions regarding the leases on these locations
are consistent in all material respects with other stores leases of the Company. The total rental payments related to these leases was $1.3
million for the year ended January 30, 2010. Total future commitments under related party leases are $9.7 million.

Recent Accounting Pronouncements

In June 2009, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No.
168, “The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles – a replacement of
SFAS No. 162” (“FASB ASC 105”). FASB ASC 105 modifies the GAAP hierarchy by establishing only two levels of GAAP, authoritative
and nonauthoritative accounting literature. Effective July 2009, the FASB Accounting Standards Codification (“ASC”), also known
collectively as the “Codification”, is considered the single source of authoritative U.S. accounting and reporting standards, except for
additional authoritative rules and interpretive releases issued by the SEC. The Codification was developed to organize GAAP
pronouncements by topic so that users can more easily access authoritative accounting guidance. FASB ASC 105 became effective for
the third quarter of fiscal year 2009. All other accounting standards references have been updated in this report with ASC references.

In May 2009, the FASB issued FASB ASC 855, “Subsequent Events”, which establishes general standards of accounting for and
disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. FASB
ASC 855 requires issuers to reflect in their financial statements and disclosures the effects of subsequent events that provide additional
evidence about conditions at the balance sheet date. Disclosures should include the nature of the event and either an estimate of its
financial effect or a statement that an estimate cannot be made. This standard also requires issuers to disclose the date through which
they have evaluated subsequent events and whether the date corresponds with the release of their financial statements. The Company
adopted FASB ASC 855 as of the interim period ended August 1, 2009. As the requirements under FASB ASC 855 are consistent with
its current practice, the implementation of this standard did not have an impact on the Company’s consolidated financial statements.

In December 2008, the FASB issued FASB ASC 715, “Compensation-Retirement Benefits”, which is effective for fiscal years ending
after December 15, 2009. FASB ASC 715 provides additional guidance on required disclosures about postretirement benefit plan assets
of a defined benefit pension or other postretirement benefit plan. The Company adopted FASB ASC 715 as of the year ending January
30, 2010 and concluded the implementation of this standard did not have an impact on the Company’s consolidated financial statements
or disclosures.

In June 2008, the FASB issued FASB ASC 260, which addresses whether instruments granted in share-based payment transactions
are participating securities prior to vesting and therefore need to be included in the earnings allocation in computing earnings per share
(EPS) under the two-class method described in FASB ASC 260, “Earnings Per Share”. This FASB ASC is effective for fiscal periods
beginning after December 15, 2008. The Company adopted FASB ASC 260 in the quarter ended May 2, 2009 and determined that it
had no significant impact on its results of operations or financial position.

Freds AR 09 Fin_Fixes:Freds AR 2007 fin-final 5/24/10 1:45 PM Page 17

Management’s Discussion and Analysis of Financial Condition and Results of Operations

disclosed at fair value in the financial statements on a recurring basis, to fiscal years beginning after November 15, 2008, and interim
periods within those fiscal years. The Company adopted FASB ASC 820 effective February 3, 2008, and its adoption did not have a
material effect on its results of operations or financial position. The Company has also evaluated FASB ASC 820-10-65-1 and
determined that it will have no impact on its results of operations or financial position. In October 2008, the FASB issued ASC 820-
10-65-2, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active”. FASB ASC 820-10-65-2
clarifies the application of FASB ASC 820 when the market for a financial asset is inactive. The guidance in FASB ASC 820-10-65-2 is
effective immediately and has no effect on our financial statements. In April 2009, the FASB issued ASC 820-10-65-4, “Determining
Fair Value When the Level and Volume of Activity for the Asset or Liability have Significantly Decreased and Identifying Transactions
That Are Not Orderly” which further clarifies the principles established by FASB ASC 820. The guidance is effective for the periods
ending after June 15, 2009 with early adoption permitted for the periods ending after March 15, 2009. The Company has evaluated
FASB ASC 820-10-65-4 and determined that it had no impact on its results of operations or financial position.

Freds AR 09 Fin_Fixes:Freds AR 2007 fin-final 5/24/10 1:45 PM Page 18

Consolidated Statements of Income and Comprehensive Income

(In thousands, except per share data)
Net sales
Cost of goods sold
Gross profit

Depreciation and amortization
Selling, general and administrative expenses

Operating income

Interest income
Interest expense

Income before income taxes

Provision for income taxes

Net income

Net income per share

Basic
Diluted

Weighted average shares outstanding

Basic
Effect of dilutive stock options

Diluted

Comprehensive income:
Net income
Other comprehensive income (expense), net of tax

postretirement plan adjustment

Comprehensive income

January 30,
2010
$ 1,788,136
1,288,899
499,237

For the Years Ended
January 31,
2009
1,798,840
1,295,822
503,018

February 2,
2008
1,780,923
1,290,680
490,243

26,387
434,356
38,494

(189)
482
38,201

14,586
23,615

0.59
0.59

39,822
67
39,889

23,615

(159)
23,456

$
$

26,425
450,275
26,318

(308)
716
25,910

9,268
16,642

0.42
0.42

39,282
569
39,851

16,642

23
16,665

28,614
445,172
16,457

(567)
1,360
15,664

4,946
10,718

0.27
0.27

39,771
111
39,882

$
$

$10,718

(43)
10,675

See accompanying notes to consolidated financial statements.

Freds AR 09 Fin_Fixes:Freds AR 2007 fin-final 5/24/10 1:45 PM Page 19

Consolidated Balance Sheets

(In thousands, except for number of shares)
ASSETS
Current assets:

Cash and cash equivalents
Receivables, less allowance for doubtful accounts of $764 and $885, respectively
Inventories
Other non-trade receivables
Prepaid expenses and other current assets

Total current assets

Property and equipment, at depreciated cost
Equipment under capital leases, less accumulated amortization of

$4,967 and $4,928, respectively

Intangibles
Other noncurrent assets, net

Total assets

LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:

Accounts payable
Current portion of indebtedness
Accrued expenses and other
Deferred income taxes
Other current liabilities

Total current liabilities

Long-term portion of indebtedness
Deferred income taxes
Other noncurrent liabilities

Total liabilities

Commitments and contingencies

Shareholders’ equity:

Preferred stock, nonvoting, no par value, 10,000,000 shares authorized,

none outstanding

Preferred stock, Series A junior participating nonvoting, no par value,

224,594 shares authorized, none outstanding

Common stock, Class A voting, no par value, 60,000,000 shares authorized,
39,363,462 and 40,028,484 shares issued and outstanding, respectively

Common stock, Class B nonvoting, no par value, 11,500,000 shares authorized,

none outstanding

Retained earnings
Accumulated other comprehensive income

Total shareholders’ equity
Total liabilities and shareholders’ equity

January 30,
2010

January 31,
2009

54,742
28,893
294,024
25,193
10,945
413,797
137,569

–
16,035
4,040
571,441

87,393
718
39,621
19,373
–
147,105
4,179
2,009
17,209
170,502

35,128
28,857
301,537
15,782
11,912
393,216
138,036

39
9,042
4,442
544,775

69,955
243
46,659
13,061
7,749
137,667
4,866
1,328
13,833
157,694

–

131,685

136,877

–
268,350
904
400,939
571,441

–
249,141
1,063
387,081
544,775

See accompanying notes to consolidated financial statements.

Freds AR 09 Fin_Fixes:Freds AR 2007 fin-final 5/24/10 1:45 PM Page 20

Consolidated Statements of Changes in Shareholders’ Equity

(In thousands, except share and per share amounts)
Balance, February 3, 2007
Adjustment to initially apply

FASB ASC 740 as of February 4, 2007

Cash dividends paid ($.08 per share)
Restricted stock grants, cancellations

and withholdings, net

Issuance of shares under employee

stock purchase plan

Repurchased and cancelled shares
Stock-based compensation
Issuance of shares for real estate purchase
Income tax benefit on exercise

of stock options

Adjustment for postretirement benefits

(net of tax)

Net income
Balance, February 2, 2008
Cash dividends paid ($.08 per share)
Restricted stock grants, cancellations

and withholdings, net

Issuance of shares under employee

stock purchase plan
Stock-based compensation
Exercises of stock options
Income tax benefit on exercise

of stock options

Adjustment for postretirement benefits

(net of tax)

Net income
Balance, January 31, 2009
Cash dividends paid ($.11per share)
Restricted stock grants, cancellations

and withholdings, net

Issuance of shares under employee

stock purchase plan

Repurchased and cancelled shares
Stock-based compensation
Exercises of stock options
Income tax benefit on exercise

of stock options

Adjustment for postretirement benefits

(net of tax)

Net income
Balance, January 30, 2010

Common Stock

Shares
40,068,953

Amount
$ 135,803

Retained
Earnings
$ 232,382

Unearned
Compensation

–

Accumulated
Other
Comprehensive
Income
$ 1,083

Total
$ 369,268

(4,212)
(3,204)

64,036

71,294
(426,500)

103,053

(43)

667
(4,371)
2,116
1,173

(10)

39,880,836

135,335

10,718
235,684
(3,196)

(43)

–

1,040

73,364

73,084

1,200

(35)

584
990
17

(14)

40,028,484

136,877

16,691

(142)

60,350
(742,663)

600

542
(7,152)
1,595
8

(43)

11
16,642
249,141
(4,406)

–

1,063

(4,212)
(3,204)

(43)

667
(4,371)
2,116
1,173

(10)

(43)
10,718
372,059
(3,196)

(35)

584
990
17

(14)

34
16,642
387,081
(4,406)

(142)

542
(7,152)
1,595
8

(43)

39,363,462

$ 131,685

23,615
$ 268,350

–

904

(159)

(159)
23,615
$ 400,939

See accompanying notes to consolidated financial statements.

Freds AR 09 Fin_Fixes:Freds AR 2007 fin-final 5/24/10 1:45 PM Page 21

Consolidated Statements of Cash Flows

(In thousands, except per share data)
Cash flows from operating activities:

Net income
Adjustments to reconcile net income to net cash flows

from operating activities:
Depreciation and amortization
Net (gain) loss on asset disposition
Provision for store closures and asset impairment
Stock-based compensation
(Recovery) provision for uncollectible receivables
LIFO reserve increase
Deferred income tax expense (benefit)
Income tax benefit (charge) upon exercise of stock options
Provision for postretirement medical
(Increase) decrease in operating assets:

Trade receivables
Insurance receivables
Inventories
Other assets

Increase (decrease) in operating liabilities:
Accounts payable and accrued expenses
Income taxes payable
Other noncurrent liabilities

Net cash provided by operating activities

Cash flows from investing activities:

Capital expenditures
Proceeds from asset dispositions
Insurance recoveries for replacement assets
Asset acquisition, net (primarily intangibles)
Net cash used in investing activities

Cash flows from financing activities:

Payments of indebtedness and capital lease obligations
Proceeds from revolving line of credit
Payments on revolving line of credit
Excess tax benefits (charges) from stock-based compensation
Proceeds from exercise of stock options and employee stock purchase plan
Repurchase of shares
Cash dividends paid

Net cash provided by (used in) financing activities

Increase in cash and cash equivalents
Cash and cash equivalents:

Beginning of year
End of year

Supplemental disclosures of cash flow information:

Interest paid
Income taxes paid

Non-cash investing and financial activities:

Assets acquired through term loan
Common stock issued for purchase of capital assets

January 30,
2010

For the Years Ended
January 31,
2009

February 2,
2008

23,615

16,642

10,718

26,387
356
–
1,595
636
2,411
5,932
43
(74)

(2,569)
(780)
5,101
1,369

11,593
(7,925)
(3,441)
64,249

(22,692)
125
–
(10,663)
(33,230)

(212)
–
–
(43)
408
(7,152)
(4,406)
(11,405)

19,614

35,128
54,742

293
22,999

–
–

$
$

26,425
(831)
419
990
486
3,700
(4,080)
14
34

4,925
902
14,751
(169)

5,537
1,178
7,362
78,285

(16,727)
2,182
556
(5,686)
(19,675)

(469)
205,996
(236,631)
(14)
566
–
(3,196)
(33,748)

24,862

10,266
35,128

408
2,559

274
–

28,614
(335)
14,559
2,116
255
1,657
(6,604)
10
(43)

(8,162)
1,537
(26,981)
432

3,377
(3,508)
1,699
19,341

(31,289)
463
1,094
(1,663)
(31,395)

(1,656)
344,755
(316,293)
(10)
624
(4,371)
(3,204)
19,845

7,791

2,475
10,266

1,269
18,200

6,065
1,173

$
$

See accompanying notes to consolidated financial statements.

Freds AR 09 Fin_Fixes:Freds AR 2007 fin-final 5/24/10 1:45 PM Page 22

Notes to Consolidated Financial Statements

Note 1 – Description Of Business And Summary Of Significant Accounting Policies

Description of business. The primary business of FRED’S, Inc. and subsidiaries (the “Company”) is the sale of general merchandise
through its retail discount stores and full service pharmacies. In addition, the Company sells general merchandise to its 24 franchisees. As
of January 30, 2010, the Company had 645 retail stores and 307 pharmacies located in 15 states mainly in the Southeastern United States.
Consolidated Financial Statements. The Consolidated Financial Statements include the accounts of the Company and its
subsidiaries. All significant intercompany accounts and transactions are eliminated. Amounts are in thousands unless otherwise noted.
Fiscal year. The Company utilizes a 52 — 53 week accounting period which ends on the Saturday closest to January 31. Fiscal years
2009, 2008 and 2007, as used herein, refer to the years ended January 30, 2010, January 31, 2009 and February 2, 2008, respectively.
The fiscal years 2009, 2008 and 2007 each had 52 weeks.

Use of estimates. The preparation of financial statements in accordance with accounting principles generally accepted in the United
States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities
and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and
expenses during the reported period. Actual results could differ from those estimates and such differences could be material to the
financial statements.

Cash and cash equivalents. Cash on hand and in banks, together with other highly liquid investments which are subject to market

fluctuations and having original maturities of three months or less, are classified as cash and cash equivalents.

Allowance for doubtful accounts. The Company is reimbursed for drugs sold by its pharmacies by many different payors including
insurance companies, Medicare and various state Medicaid programs. The Company estimates the allowance for doubtful accounts on a
payor-specific basis, given its interpretation of the contract terms or applicable regulations. However, the reimbursement rates are often
subject to interpretations that could result in payments that differ from the Company’s estimates. Additionally, updated regulations and
contract negotiations occur frequently, necessitating the Company’s continual review and assessment of the estimation process. Senior
management reviews accounts receivable on a quarterly basis to determine if any receivables are potentially uncollectible. The Company
includes any accounts receivable balances that are determined to be uncollectible in our overall allowance for doubtful accounts. After
all attempts to collect a receivable have failed, the receivable is written off against the allowance account.

Inventories. Merchandise inventories are valued at the lower of cost or market using the retail first-in, first-out (FIFO) method for
goods in our stores and the cost first-in, first-out (FIFO) method for goods in our distribution centers. The retail inventory method is a
reverse mark-up, averaging method which has been widely used in the retail industry for many years. This method calculates a cost-to-
retail ratio that is applied to the retail value of inventory to determine the cost value of inventory and the resulting cost of goods sold
and gross margin. The assumption that the retail inventory method provides for valuation at lower of cost or market and the inherent
uncertainties therein are discussed in the following paragraphs. In order to assure valuation at the lower of cost or market, the retail value
of our inventory is adjusted on a consistent basis to reflect current market conditions. These adjustments include increases to the retail
value of inventory for initial markups to set the selling price of goods or additional markups to adjust pricing for inflation and decreases
to the retail value of inventory for markdowns associated with promotional, seasonal or other declines in the market value. Because these
adjustments are made on a consistent basis and are based on current prevailing market conditions, they approximate the carrying value
of the inventory at net realizable value (market value). Therefore, after applying the cost to retail ratio, the cost value of our inventory is
stated at the lower of cost or market as is prescribed by U.S. GAAP.

Because the approximation of net realizable value (market value) under the retail inventory method is based on estimates such as
markups, markdowns and inventory losses (shrink), there exists an inherent uncertainty in the final determination of inventory cost and
gross margin. In order to mitigate that uncertainty, the Company has a formal review by product class which considers such variables as
current market trends, seasonality, weather patterns and age of merchandise to ensure that markdowns are taken currently, or a markdown
reserve is established to cover future anticipated markdowns. This review also considers current pricing trends and inflation to ensure
that markups are taken if necessary. The estimation of inventory losses (shrink) is a significant element in approximating the carrying
value of inventory at net realizable value, and as such the following paragraph describes our estimation method as well as the steps we
take to mitigate the risk that this estimate in the determination of the cost value of inventory.

The Company calculates inventory losses (shrink) based on actual inventory losses occurring as a result of physical inventory counts
during each fiscal period and estimated inventory losses occurring between yearly physical inventory counts. The estimate for shrink
occurring in the interim period between physical counts is calculated on a store-specific basis and is based on history, as well as
performance on the most recent physical count. It is calculated by multiplying each store’s shrink rate, which is based on the previously
mentioned factors, by the interim period’s sales for each store. Additionally, the overall estimate for shrink is adjusted at the corporate
level to a three-year historical average to ensure that the overall shrink estimate is the most accurate approximation of shrink based on
the Company’s overall history of shrink. The three-year historical estimate is calculated by dividing the “book to physical” inventory
adjustments for the trailing 36 months by the related sales for the same period. In order to reduce the uncertainty inherent in the shrink

Freds AR 09 Fin_Fixes:Freds AR 2007 fin-final 5/24/10 1:45 PM Page 23

Notes to Consolidated Financial Statements

calculation, the Company first performs the calculation at the lowest practical level (by store) using the most current performance
indicators. This ensures a more reliable number, as opposed to using a higher level aggregation or percentage method. The second portion
of the calculation ensures that the extreme negative or positive performance of any particular store or group of stores does not skew the
overall estimation of shrink. This portion of the calculation removes additional uncertainty by eliminating short-term peaks and valleys
that could otherwise cause the underlying carrying cost of inventory to fluctuate unnecessarily. The Company has not experienced any
significant change in shrink as a percentage of sales from year to year during the subject reporting periods.

Management believes that the Company’s Retail Inventory Method provides an inventory valuation which reasonably approximates
cost and results in carrying inventory at the lower of cost or market. For pharmacy inventories, which were approximately $30.2 million
and $30.8 million at January 30, 2010 and January 31, 2009, respectively, cost was determined using the retail LIFO (last-in, first-out)
method in which inventory cost is maintained using the Retail Inventory Method, then adjusted by application of the Producer Price
Index published by the U.S. Department of Labor for the cumulative annual periods. The current cost of inventories exceeded the LIFO
cost by approximately $21.5 million at January 30, 2010 and $19.1 million at January 31, 2009. The LIFO reserve increased by
approximately $2.4 million during 2009, $3.7 million during 2008 and $1.6 million during 2007.

The Company recorded a year end below-cost inventory adjustment of approximately $10.0 million in cost of goods sold in the
consolidated statements of income for the year ended February 2, 2008 to value inventory at the lower of cost or market in the stores
impacted by the Company’s plan to close approximately 75 stores in fiscal 2008. During the year ended January 31, 2009, we recorded
an additional below-cost inventory adjustment of $0.3 million to reduce the value of inventory to lower of cost or market associated with
stores that closed in the third quarter and utilized the entire $10.3 million. No below-cost inventory adjustment was recorded during the
year ended January 30, 2010 (see Note 11 Exit and Disposal Activity).

Property and equipment. Property and equipment are carried at cost. Depreciation is recorded using the straight-line method over
the estimated useful lives of the assets. Improvements to leased premises are depreciated using the straight-line method over the shorter
of the initial term of the lease or the useful life of the improvement. Leasehold improvements added late in the lease term are depreciated
over the shorter of the remaining term of the lease (including the upcoming renewal option, if the renewal is reasonably assured) or the
useful life of the improvement, whichever is lesser. Gains or losses on the sale of assets are recorded at disposal. The following average
estimated useful lives are generally applied:

Building and building improvements
Furniture, fixtures and equipment
Leasehold improvements
Automobiles and vehicles
Airplane

Estimated Useful Lives
8 - 31.5 years
3 - 10 years
3 - 10 years or term of lease, if shorter
3 - 6 years
9 years

Leases. Certain operating leases include rent increases during the initial lease term. For these leases, the Company recognizes the
related rental expense on a straight-line basis over the term of the lease (which includes the pre-opening period of construction,
renovation, fixturing and merchandise placement) and records the difference between the amounts charged to operations and amounts
paid as a rent liability. Rent is recognized on a straight-line basis over the lease term, which includes any rent holiday period.

The Company recognizes contingent rental expense when the achievement of specified sales targets are considered probable in
accordance with FASB ASC 840 “Leases”. The amount expensed but not paid was $1.1 million at both January 30, 2010 and January
31, 2009, and is included in “Accrued expenses and other” in the consolidated balance sheet (See Note 2).

The Company occasionally receives reimbursements from landlords to be used towards construction of the store the Company
intends to lease. The reimbursement is primarily for the purpose of performing work required to divide a much larger location into
smaller segments, one of which the Company will use for its store. This work could include the addition or demolition of walls,
separation of plumbing, utilities, electrical work, entrances (front and back) and other work as required. Leasehold improvements are

Freds AR 09 Fin_Fixes:Freds AR 2007 fin-final 5/24/10 1:45 PM Page 24

Notes to Consolidated Financial Statements

recorded at their gross costs including items reimbursed by landlords. The reimbursements are initially recorded as a deferred credit and
then amortized as a reduction of rent expense over the initial lease term.

Based upon an overall analysis of store performance and expected trends, we periodically evaluate the need to close underperforming
stores. When we determine that an underperforming store should be closed and a lease obligation still exists, we record the estimated
future liability associated with the rental obligation on the date the store is closed in accordance with FASB ASC 420, “Exit or Disposal
Cost Obligations.” Liabilities are computed based at the point of closure for the present value of any remaining operating lease
obligations, net of estimated sublease income, and at the communication date for severance and other exit costs, as prescribed by FASB
ASC 420. The assumptions in calculating the liability include the timeframe expected to terminate the lease agreement, estimates related
to the sublease of potential closed locations, and estimation of other related exit costs. If the actual timing and the potential termination
costs or realization of sublease income differ from our estimates, the resulting liabilities could vary from recorded amounts. We
periodically review the liability for closed stores and make adjustments when necessary.

Impairment of Long-lived assets. The Company’s policy is to review the carrying value of all long-lived assets for impairment
whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. In accordance with FASB
ASC 360, “Impairment or Disposal of Long-Lived Assets,” we review for impairment all stores open at least 3 years or remodeled for
more than two years. Impairment results when the carrying value of the assets exceeds the undiscounted future cash flows over the life
of the lease. Our estimate of undiscounted future cash flows over the lease term is based upon historical operations of the stores and
estimates of future store profitability which encompasses many factors that are subject to management’s judgment and are difficult to
predict. If a long-lived asset is found to be impaired, the amount recognized for impairment is equal to the difference between the
carrying value and the asset’s fair value. The fair value is based on estimated market values for similar assets or other reasonable estimates
of fair market value based upon management’s judgment.

In the fourth quarter of 2007, the Company recorded approximately $4.6 million in selling, general and administrative expense in
the consolidated statements of income to reflect impairment charges for furniture and fixtures and leasehold improvements relating to
planned fiscal 2008 store closures. During 2008, the Company recorded an additional charge of $0.1 million associated with stores
closures that occurred in the third quarter. Impairment of $0.2 million for the planned store closures was recorded in fiscal 2009.

Vendor rebates and allowances. The Company receives rebates for a variety of merchandising activities, such as volume commitment
rebates, relief for temporary and permanent price reductions, cooperative advertising programs, and for the introduction of new products
in our stores. FASB ASC 605-50 “Customer Payments and Incentives” addresses the accounting and income statement classification for
consideration given by a vendor to a retailer in connection with the sale of the vendor’s products or for the promotion of sales of the
vendor’s products. Such consideration received from vendors is reflected as a decrease in prices paid for inventory and recognized in cost
of sales as the related inventory is sold, unless specific criteria are met qualifying the consideration for treatment as reimbursement of
specific, identifiable incremental costs.

Selling, general and administrative expenses. The Company includes buying, warehousing, distribution, advertising, depreciation

and amortization and occupancy costs in selling, general and administrative expenses.

Advertising. In accordance with FASB ASC 720-35 “Advertising Costs”, the Company charges advertising, including production
costs, to selling, general and administrative expense on the first day of the advertising period. Gross advertising expenses for 2009, 2008
and 2007, were $24.0 million, $24.1 million and $27.6 million, respectively. Gross advertising expenses were reduced by vendor
cooperative advertising allowances of $2.6 million, $2.3 million and $1.5 million for 2009, 2008 and 2007, respectively. It would be the
Company’s intention to incur a similar amount of advertising expense as in prior years and in support of our stores even if we did not
receive support from our vendors in the form of cooperative adverting allowances.

Preopening costs. The Company charges to expense the preopening costs of new stores as incurred. These costs are primarily labor

to stock the store, rent, preopening advertising, store supplies and other expendable items.

Revenue Recognition. The Company markets goods and services through Company owned stores and 24 franchised stores as of
January 30, 2010. Net sales includes sales of merchandise from Company owned stores, net of returns and exclusive of sales taxes. Sales
to franchised stores are recorded when the merchandise is shipped from the Company’s warehouse. Revenues resulting from layaway sales
are recorded upon delivery of the merchandise to the customer.

Freds AR 09 Fin_Fixes:Freds AR 2007 fin-final 5/24/10 1:45 PM Page 25

Notes to Consolidated Financial Statements

In addition, the Company charges the franchised stores a fee based on a percentage of their purchases from the Company. These fees
represent a reimbursement for use of the FRED’S name and other administrative costs incurred on behalf of the franchised stores and
are therefore netted against selling, general and administrative expenses. Total franchise income for 2009, 2008 and 2007 was $2.1
million, $2.1 million and $2.0 million, respectively.

Other intangible assets. Other identifiable intangible assets, which are included in other noncurrent assets, primarily represent
customer lists associated with acquired pharmacies and are being amortized on a straight-line basis over five years. Intangibles, net of
accumulated amortization, totaled $15.9 million at January 30, 2010, and $9.0 million at January 31, 2009. Accumulated amortization
at January 30, 2010 and January 31, 2009 totaled $19.3 million and $15.6 million, respectively. Amortization expense for 2009, 2008
and 2007, was $3.7 million, $2.6 million and $2.4 million, respectively. Estimated amortization expense in millions for each of the next
5 years is as follows: 2010 - $4.2, 2011 - $3.6, 2012 - $3.2, 2013 - $2.7 and 2014 - $1.2.

Financial instruments. At January 30, 2010, the Company did not have any outstanding derivative instruments. The recorded value
of the Company’s financial instruments, which include cash and cash equivalents, receivables, accounts payable and indebtedness,
approximates fair value. The following methods and assumptions were used to estimate fair value of each class of financial instrument:
(1) the carrying amounts of current assets and liabilities approximate fair value because of the short maturity of those instruments and
(2) the fair value of the Company’s indebtedness is estimated based on the current borrowing rates available to the Company for bank
loans with similar terms and average maturities. Most of our indebtedness is under variable interest rates.

Insurance reserves. The Company is largely self-insured for workers compensation, general liability and employee medical insurance.
The Company’s liability for self-insurance is determined based on claims known at the time of determination of the reserve and estimates
for future payments against incurred losses and claims that have been incurred but not reported. Estimates for future claims costs include
uncertainty because of the variability of the factors involved, such as the type of injury or claim, required services by the providers, healing
time, age of claimant, case management costs, location of the claimant, and governmental regulations. These uncertainties or a deviation
in future claims trends from recent historical patterns could result in the Company recording additional expenses or expense reductions
that might be material to the Company’s results of operations. The Company carries additional coverage for excessive or catastrophic claims
with stop loss limits of $250,000 to $500,000 for property and general liability and $200,000 for employee medical. The Company’s
insurance reserve was $9.0 million and $8.6 million on January 30, 2010 and January 31, 2009, respectively. Changes in the reserve during
fiscal 2009 were attributable to additional reserve requirements of $44.6 million netted with reserve utilization of $44.2 million.

Stock-based compensation. Effective January 29, 2006, the Company adopted the fair value recognition provisions of FASB ASC
718, “Compensation – Stock Compensation”, using the modified prospective transition method. Under this method, compensation
expense recognized post adoption includes: (1) compensation expense for all share-based payments granted prior to, but not yet vested
as of January 29, 2006, based on the grant date fair value estimated in accordance with the original provisions of FASB ASC 718, and
(2) compensation cost for all share-based payments granted subsequent to January 29, 2006, based on the grant date fair value estimated
in accordance with the provisions of FASB ASC 718. Results for prior periods have not been restated.

Income taxes. The Company reports income taxes in accordance with FASB ASC 740, “Income Taxes.” Under FASB ASC 740, the
asset and liability method is used for computing future income tax consequences of events, which have been recognized in the Company’s
Consolidated Financial Statements or income tax returns. Deferred income tax expense or benefit is the net change during the year in
the Company’s deferred income tax assets and liabilities (see Note 4 – Income Taxes).

In June 2006, the Financial Accounting Standards Board issued FASB Interpretation No. 48 (“FASB ASC 740”), Accounting for
Uncertainty in Income Taxes – An Interpretation of FASB Statement 109. Effective February 4, 2007, we adopted FASB ASC 740, which
clarifies the accounting for uncertainties in income taxes recognized in the Company’s financial statements in accordance with FASB ASC
740 by defining the criterion that an individual tax position must meet in order to be recognized in the financial statements. FASB ASC

Freds AR 09 Fin_Fixes:Freds AR 2007 fin-final 5/24/10 1:45 PM Page 26

Notes to Consolidated Financial Statements

740 requires that the tax effects of a position be recognized only if it is “more-likely-than-not” to be sustained based solely on the technical
merits as of the reporting date (see Note 4 – Income Taxes).

Business segments. The Company operates in a single reportable operating segment.
Comprehensive income. Comprehensive income consists of two components, net income and other comprehensive income (loss).
Other comprehensive income (loss) refers to gains and losses that under generally accepted accounting principles are recorded as an
element of stockholders’ equity but are excluded from net income. The Company’s accumulated other comprehensive income includes
the effect of adopting SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an
amendment of FASB Statements No. 87, 88, 106, and 132(R)(“SFAS No. 158”) codified in FASB ASC 715 “Compensation –
Retirement Benefits”. See Note 9, Commitments and Contingencies, in the Notes to Consolidated Financial Statements for further
discussion.

Reclassifications. Certain prior year amounts have been reclassified to conform to the 2009 presentation.
Recent Accounting Pronouncements. In June 2009, the Financial Accounting Standards Board (“FASB”) issued Statement of
Financial Accounting Standards (“SFAS”) No. 168, “The FASB Accounting Standards Codification and the Hierarchy of Generally
Accepted Accounting Principles – a replacement of SFAS No. 162” (“FASB ASC 105”). FASB ASC 105 modifies the GAAP hierarchy
by establishing only two levels of GAAP, authoritative and nonauthoritative accounting literature. Effective July 2009, the FASB
Accounting Standards Codification (“ASC”), also known collectively as the “Codification”, is considered the single source of authoritative
U.S. accounting and reporting standards, except for additional authoritative rules and interpretive releases issued by the SEC. The
Codification was developed to organize GAAP pronouncements by topic so that users can more easily access authoritative accounting
guidance. FASB ASC 105 became effective for the third quarter of fiscal year 2009. All other accounting standards references have been
updated in this report with ASC references.

In September 2006, the FASB issued FASB ASC 820, “Fair Value Measurements and Disclosures”. FASB ASC 820 provides a single
definition of fair value, together with a framework for measuring it, and requires additional disclosure about the use of fair value to
measure assets and liabilities. FASB ASC 820 also emphasizes that fair value is a market-based measurement, not an entity-specific
measurement, and sets out a fair value hierarchy with the highest priority being quoted prices in active markets. Under FASB ASC 820,
fair value measurements are required to be disclosed by level within that hierarchy. FASB ASC 820 is effective for fiscal years beginning
after November 15, 2007, and interim periods within those fiscal years. However, FASB ASC 820-10-65-1, issued in February 2008,
delays the effective date of FASB ASC 820 for all nonfinancial assets and nonfinancial liabilities, except for items that are recognized or
disclosed at fair value in the financial statements on a recurring basis, to fiscal years beginning after November 15, 2008, and interim
periods within those fiscal years. The Company adopted FASB ASC 820 effective February 3, 2008, and its adoption did not have a
material effect on its results of operations or financial position. The Company has also evaluated FASB ASC 820-10-65-1 and
determined that it had no impact on its results of operations or financial position. In October 2008, the FASB issued ASC 820-10-65-
2, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active”. FASB ASC 820-10-65-2 clarifies
the application of FASB ASC 820 when the market for a financial asset is inactive. The guidance in FASB ASC 820-10-65-2 is effective
immediately and has no effect on our financial statements. In April 2009, the FASB issued ASC 820-10-65-4, “Determining Fair Value
When the Level and Volume of Activity for the Asset or Liability have Significantly Decreased and Identifying Transactions That Are
Not Orderly” which further clarifies the principles established by FASB ASC 820. The guidance is effective for the periods ending after
June 15, 2009 with early adoption permitted for the periods ending after March 15, 2009. The Company has evaluated FASB ASC
820-10-65-4 and determined that it had no impact on its results of operations or financial position.

Freds AR 09 Fin_Fixes:Freds AR 2007 fin-final 5/24/10 1:45 PM Page 27

Notes to Consolidated Financial Statements

Note 2 – Detail of Certain Balance Sheet Accounts

(In thousands)
Property and equipment, at cost:
Buildings and building improvements
Leasehold improvements
Automobiles and vehicles
Airplane
Furniture, fixtures and equipment

Less: Accumulated depreciation and amortization

Construction in progress
Land

Total Property and equipment, at depreciated cost

2009

2008

95,844 $
55,078
5,273
4,697
240,883
401,775
(271,185)
130,590
446
6,533
137,569 $

91,826
49,775
5,223
4,697
230,272
381,793
(251,002)
130,791
912
6,333
138,036

Depreciation expense totaled $22.7 million, $23.9 million and $26.2 million for 2009, 2008 and 2007, respectively.

(In thousands)
Other non-trade receivables:
Vendor receivables
Income tax receivable
Franchise stores receivable
Insurance claims receivable
Landlord receivables
Other

Total non trade receivable

(In thousands)
Prepaid expenses and other current assets:
Prepaid rent
Supplies
Prepaid insurance
Prepaid advertising
Other

Total prepaid expenses and other current assets

(In thousands)
Accrued expenses and other:
Payroll and benefits
Insurance reserves
Sales and use tax
Deferred / contingent rent
Legal settlement and related fees
Lease liability
Other

Total accrued expenses and other

2009

2008

14,814 $
6,762
1,334
892
–
1,391
25,193 $

12,381
220
1,026
112
109
1,934
15,782

2009

2008

4,059 $
3,904
1,447
590
945
10,945 $

4,045
5,002
1,351
434
1,080
11,912

2009

2008

10,454 $
8,994
5,627
2,507
1,521
1,421
9,097
39,621 $

9,738
8,633
5,090
3,150
6,600
4,341
9,107
46,659

Freds AR 09 Fin_Fixes:Freds AR 2007 fin-final 5/24/10 1:45 PM Page 28

Notes to Consolidated Financial Statements

(In thousands)
Other current liabilities:
Unrecognized tax benefit related to IRS exam (see Note 4 - Income Taxes)

(In thousands)
Other noncurrent liabilities:
ASC 740 liability
Deferred income (see Note 1 - Vendor Rebates and Allowances)
Other

2009

2008

– $

7,749

2009

2008

9,193 $
7,474
542
17,209 $

8,760
4,677
396
13,833

Note 3 – Indebtedness

On September 16, 2008, the Company and Regions Bank entered into a Ninth Loan Modification of the Revolving Loan and Credit
Agreement which decreased the credit line from $75 million to $60 million and extended the term until July 31, 2011. All other terms,
conditions and covenants remained in place after the amendment, with only a slight modification to one of the financial covenants
required by the Agreement. Under the most restrictive covenants of the Agreement, the Company is required to maintain specified
shareholders’ equity (which was $312.4 million at January 30, 2010) and net income levels. Borrowings and the unused fees under the
agreement bear interest at a tiered rate based on the Company’s previous four quarter average of the Fixed Charge Coverage Ratio.
Currently the Company is at 125 basis points over LIBOR for borrowings and 25 basis points over LIBOR for the unused fee. There
were no borrowings outstanding under the Agreement at January 30, 2010 and January 31, 2009.

During the second and third quarter of fiscal 2007, the Company acquired the land and buildings, occupied by 7 FRED’S stores
which we had previously leased. In consideration for the 7 properties, the Company assumed debt that has fixed interest rates from
6.31% to 7.40%. The debt is collateralized by the land and building. The table below shows the long term debt related to these properties
due for the next five years as of January 30, 2010:

(Dollars in thousands)
Mortgage loans on land & buildings

2010

2011

2012

718

161

170

2013
$ 1,109

2014

525

Thereafter
$ 2,214

Total

4,897

The Company financed the construction of its Dublin, Georgia distribution center with taxable industrial development revenue
bonds issued by the City of Dublin and County of Laurens Development Authority. The Company purchased 100% of the issued bonds
and intends to hold them to maturity, effectively financing the construction with internal cash flow. Because a legal right of offset exists,
the Company has offset the investment in the bonds ($34.6 million) against the related liability and neither is reflected on the
consolidated balance sheet.

Note 4 – Income Taxes

The provision for income taxes consists of the following:

(Dollars in thousands)
Current

Federal
State

Deferred
Federal
State

2009

2008

2007

7,782
872
8,654

4,985
947
5,932
14,586

12,677 $
671
13,348

10,886
664
11,550

(3,478)
(602)
(4,080)
9,268 $

(5,354)
(1,250)
(6,604)
4,946

Freds AR 09 Fin_Fixes:Freds AR 2007 fin-final 5/24/10 1:45 PM Page 29

Notes to Consolidated Financial Statements

The income tax effects of temporary differences that give rise to significant portions of the deferred income tax assets and deferred

income tax liabilities are presented below:

Deferred income tax assets:

Accrual for incentive compensation
Allowance for doubtful accounts
Insurance accruals
Other accruals
Net operating loss carryforwards
Postretirement benefits other than pensions
Reserve for below cost inventory adjustment
Legal reserve
Deferred revenue
Federal benefit on state reserves
Amortization of intangibles
Total deferred income tax assets
Less: Valuation allowance

Deferred income tax assets, net of valuation allowance

Deferred income tax liabilities:

Property, plant and equipment
Inventory valuation
Prepaid expenses

Total deferred income tax liabilities

Net deferred income tax liabilities

2009

2008

–
392
2,365
496
5,778
279
–
–
994
2,985
5,608
18,897
2,123
16,774

614
479
2,411
133
5,033
238
110
2,581
730
4,064
4,969
21,362
1,609
19,753

(15,056)
(21,664)
(1,436)
(38,156)

(14,446)
(18,888)
(808)
(34,142)

(21,382) $

(14,389)

The net operating loss carryforwards are available to reduce state income taxes in future years. These carryforwards total approximately

$135.7 million for state income tax purposes and expire at various times during the period 2010 through 2029.

During 2009, the valuation allowance increased $.5 million, and during 2008, the valuation allowance decreased $.1 million. Based
upon expected future income, management believes that it is more likely than not that the results of operations will generate sufficient
taxable income to realize the deferred income tax asset after giving consideration to the valuation allowance.
A reconciliation of the statutory federal income tax rate to the effective income tax rate is as follows:

Income tax provision at statutory rate
Tax credits, principally jobs
State income taxes, net of federal benefit
Permanent differences
Uncertain tax provisions
Change in valuation allowance
Other
Effective income tax rate

2009
35.0%
(3.6)
1.9
1.2
3.1
1.4
(0.8)
38.2%

2008
35.0%
(3.8)
1.3
0.2
3.4
(0.3)
–
35.8%

2007
35.0%
(9.9)
(0.7)
2.2
5.1
(0.1)
–
31.6%

Freds AR 09 Fin_Fixes:Freds AR 2007 fin-final 5/24/10 1:45 PM Page 30

Notes to Consolidated Financial Statements

In June 2006, the Financial Accounting Standards Board issued FASB Interpretation No. 48, Accounting for Uncertainty in Income
Taxes – an Interpretation of FASB Statement No.109 which is codified in FASB ASC 740, “Income Taxes”. We adopted FASB ASC 740
as of February 4, 2007, the first day of fiscal 2007. This interpretation clarifies the accounting for uncertainty in income taxes recognized
in an enterprise’s financial statements and prescribes a minimum recognition threshold of more-likely-than-not to be sustained upon
examination that a tax position must meet before being recognized in the financial statements. Under FASB ASC 740, the impact of an
uncertain income tax position on the income tax return must be recognized at the largest amount that is more-likely-than-not to be
sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized if it has less than a 50%
likelihood of being sustained. Additionally, FASB ASC 740 provides guidance on de-recognition, measurement, classification, interest
and penalties, accounting in interim periods, disclosure and transition.

As a result of the adoption of FASB ASC 740, we recognized a cumulative effect adjustment of a $4.2 million decrease to beginning
retained earnings and a reclassification of certain amounts between deferred income tax liabilities ($2.3 million decrease) and other non-
current liabilities ($6.5 million increase, including $1.0 million of interest and penalties) to conform to the balance sheet presentation
requirements of FASB ASC 740. The Company increased the gross reserve for uncertain tax positions from $6.5 million to $7.3 million,
a change of $0.8 million to disclose the gross liability rather than reflect the liability net of federal income tax benefit.

A reconciliation of the beginning and ending amount of the unrecognized tax benefits is as follows:

(In millions)
Beginning balance

Additions for tax position during the current year
Additions for tax positions of prior years
Reductions for tax positions of prior years from lapse of statue
Reductions for settlements of prior year tax positions

Ending balance

2009

2008

16.5
1.0
1.0
(0.7)
(8.6)
9.2

8.4
1.1
7.7
(0.7)
–
16.5

2007
$

7.3
1.5
0.4
(0.8)
–
8.4

As of January 31, 2009, our liability for unrecognized tax benefits totaled $16.5 million, of which $0.6 million and $0.1 million were
recognized as income tax benefit during the quarterly periods ending October 31, 2009 and January 31, 2010, respectively, as a result of
a lapse in applicable statute of limitations. We had additions of $2.0 million during fiscal 2009, $1.0 million of which resulted from
state tax positions during the current year and $1.0 million resulted from the Internal Revenue Service finalizing an exam of the
Company during 2009 covering fiscal years 2004 through 2007. The Company recorded a reduction to unrecognized tax benefits for
settlement of the IRS exam which included tax and interest in the amount of $8.6 million. The adjustments resulted from the IRS exam
related primarily to timing differences. As of January 30, 2010, our liability for unrecognized tax benefits totaled $9.2 million and is
recorded in our consolidated balance sheet within “Other noncurrent liabilities,” all of which, if recognized, would affect our effective
tax rate. The Company is under examination by state jurisdictions which are expected to be completed within the next 12 months.

FASB ASC 740 further requires that interest and penalties required to be paid by the tax law on the underpayment of taxes should
be accrued on the difference between the amount claimed or expected to be claimed on the tax return and the tax benefit recognized in
the financial statements. The Company includes potential interest and penalties recognized in accordance with FASB ASC 740 in the
financial statements as a component of income tax expense. As of January 30, 2010, accrued interest and penalties related to our
unrecognized tax benefits totaled $1.4 million and $0.3 million, respectively. As of January 31, 2009, accrued interest and penalties
related to our unrecognized tax benefits totaled $2.4 million and $0.4 million, respectively. Both accrued interest and penalties are
recorded in the consolidated balance sheet within “Other non-current liabilities.”

The Company files numerous consolidated and separate company income tax returns in the U.S. federal jurisdiction and in many
U.S. state jurisdictions. With few exceptions, we are subject to U.S. federal, state, and local income tax examinations by tax authorities
for years 2006-2008. However, tax authorities have the ability to review years prior to these to the extent we utilized tax attributes carried
forward from those prior years.

Freds AR 09 Fin_Fixes:Freds AR 2007 fin-final 5/24/10 1:45 PM Page 31

Notes to Consolidated Financial Statements

Note 5 – Long-Term Leases

The Company leases certain of its store locations under noncancelable operating leases that require monthly rental payments primarily
at fixed rates (although a number of the leases provide for additional rent based upon sales) expiring at various dates through 2029. None
of our operating leases contain residual value guarantees. Many of these leases contain renewal options and require the Company to pay
taxes, maintenance, insurance and certain other operating expenses applicable to the leased properties. In addition, the Company leases
various equipment and transportation equipment under noncancelable operating leases and certain transportation equipment under
capital leases. There were no capital lease payments remaining as of January 30, 2010. Total rent expense under operating leases was
$53.2 million, $54.1 million and $54.5 million, for 2009, 2008 and 2007, respectively. Total contingent rentals included in operating
leases above was $1.1 million for 2009, 2008 and 2007.

Future minimum rental payments under all operating leases as of January 30, 2010 are as follows:

(In thousands)
2010
2011
2012
2013
2014
Thereafter
Total minimum lease payments

Operating
Leases

45,273
40,440
33,851
23,558
15,148
26,724
$ 184,994

The gross amount of property and equipment under capital leases was $5.0 million at January 30, 2010 and January 31, 2009.
Accumulated depreciation on property and equipment under capital leases was $5.0 million and $4.9 million at January 30, 2010 and
January 31, 2009, respectively. Depreciation expense on assets under capital lease for 2009, 2008 and 2007, was $39 thousand, $92
thousand and $258 thousand, respectively.

Related Party Transactions. During the year ended February 2, 2008, Atlantic Retail Investors, LLC, which is partially owned by
Michael J. Hayes, Chairman of the Board of Directors, purchased the land and buildings occupied by thirteen FRED’S stores. The stores
were purchased by Atlantic Retail Investors, LLC from an independent landlord/developer. Prior to the purchase by Atlantic Retail
Investors, LLC the Company was offered the right to purchase the same stores and declined the offer. The terms and conditions regarding
the leases on these locations are consistent in all material respects with other store leases of the Company. The total rental payments
related to these leases were $1.3 million and $1.4 million for the years ended January 30, 2010 and January 31, 2009, respectively. Total
future commitments under related party leases are $9.7 million.

Note 6 – Shareholders’ Equity

In 1998, the Company adopted a Shareholders Rights Plan which granted a dividend of one preferred share purchase right (a “Right”)
for each common share outstanding at that date. Each Right represents the right to purchase one-hundredth of a preferred share of stock
at a preset price to be exercised when any one individual, firm, corporation or other entity acquires 15% or more of the Company’s
common stock. The Rights become dilutive at the time of exercise. The Shareholders Rights Plan was renewed in October 2008 and if
unexercised, the Rights will expire in October 2018.

On March 6, 2002, the Company filed a Registration Statement on Form S-3 registering 750,000 shares of Class A common stock.
The common stock may be used from time to time as consideration in the acquisition of assets, goods, or services for use or sale in the
conduct of our business. As of February 2, 2008, the Company had 198,813 shares of Class A common stock available to be issued from
the March 6, 2002 Registration Statement. On December 31, 2008, the Registration Statement expired and the Company has not
elected to renew the statement.

Freds AR 09 Fin_Fixes:Freds AR 2007 fin-final 5/24/10 1:45 PM Page 32

Notes to Consolidated Financial Statements

Purchases of Equity Securities by the Issuer and Affiliated Purchasers. On August 27, 2007, the Board of Directors approved a
plan that authorized stock repurchases of up to 4.0 million shares of the Company’s common stock. Under the plan, the Company may
repurchase its common stock in open market or privately negotiated transactions at such times and at such prices as determined to be in
the Company’s best interest. These purchases may be commenced or suspended without prior notice depending on then-existing business
or market conditions and other factors. The following table sets forth the amounts of our common stock purchased by the Company
during the fiscal year ended January 30, 2010 (amounts in thousands, except price data). The repurchased shares have been cancelled
and returned to authorized but un-issued shares.

Total Number of
Shares Purchased

Average Price
Paid Per Share

–
742.7

$
$

–
9.61

Total Number of Shares Maximum Number

Purchased as Part of
Publicly Announced
Plan or Programs

–
742.7

of Shares That May Yet
Be Purchased Under
the Plans or Programs
3,573.5
2,830.8

February 3, 2008 - January 31, 2009
February 1, 2009 - January 31, 2010

Note 7 – Equity Incentive Plans

Incentive stock option plan. The Company has a long-term incentive plan, which was approved by FRED’S stockholders, under
which an aggregate of 1,631,758 shares as of January 30, 2010 (2,023,079 shares as of January 31, 2009) are available to be granted.
These options expire five years to seven and one-half years from the date of grant. Options outstanding at January 30, 2010 expire in
fiscal 2010 through fiscal 2016.

The Company grants stock options to key employees including executive officers, as well as other employees, as prescribed by the
Compensation Committee (the “Committee”) of the Board of Directors. The number of options granted is directly linked to the
employee’s job classification. Options, which include non-qualified stock options and incentive stock options, are rights to purchase a
specified number of shares of FRED’S common stock at a price fixed by the Committee. Stock options granted have an exercise price
equal to the market price of FRED’S common stock on the date of grant. The exercise price for stock options issued under the plan that
qualify as incentive stock options within the meaning of Section 422(b) of the Code shall not be less than 100% of the fair value as of
the date of grant. The option exercise price may be satisfied in cash or by exchanging shares of FRED’S common stock owned by the
optionee for at least six months, or a combination of cash and shares. Options have a maximum term of five to seven and one-half years
from the date of grant. Options granted under the plan generally become exercisable ratably over five years or ten percent during each
of the first four years on the anniversary date and sixty percent on the fifth anniversary date. The rest vest ratably over the requisite service
period. Stock option expense is generally recognized using the graded vesting attribution method. The plan contains a non-compete
provision and a provision that if the Company meets or exceeds a specified operating income margin during the most recently completed
fiscal year that the annual vesting percentage will accelerate from ten to twenty percent during that vesting period. The plan also provides
for annual stock grants at the fair value of the stock on the grant date to non-employee directors according to a non-discretionary
formula. The number of shares granted is dependent upon current director compensation levels.

Employee Stock Purchase Plan. The 2004 Employee Stock Purchase Plan (the “2004 Plan”), which was approved by FRED’S
stockholders, permits eligible employees to purchase shares of our common stock through payroll deductions at the lower of 85% of the
fair market value of the stock at the time of grant or 85% of the fair market value at the time of exercise. There were 60,350, 73,084 and
71,294 shares issued during fiscal years 2009, 2008 and 2007, respectively. There are 1,410,928 shares approved to be issued under the
2004 Plan and as of January 30, 2010 there were 1,090,513 shares available.

The following represents total stock based compensation expense (a component of selling, general and administrative expenses)

recognized in the consolidated financial statements (in thousands):

(Dollars in thousands)
Stock option expense
Restricted stock expense
ESPP expense

Total stock-based compensation

Income tax benefit on stock-based compensation

2009

789
573
233
1,595
364

2008

526
282
182
990
228

2007
$ 1,312
591
213
2,116
340

Freds AR 09 Fin_Fixes:Freds AR 2007 fin-final 5/24/10 1:45 PM Page 33

Notes to Consolidated Financial Statements

The Company uses the Modified Black-Scholes Option Valuation Model (“BSM”) to measure the fair value of stock options granted
to employees. The BSM option valuation model was developed for use in estimating the fair value of traded options, which have no vesting
restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including
the expected stock volatility and option life. Because the Company’s employee stock options have characteristics significantly different from
those of traded options, and because changes in the subjective assumptions can materially affect the fair value estimate, in management’s
opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.

The fair value of each option granted is estimated on the date of grant using the BSM with the following weighted average assumptions:

Stock Options

Expected volatility
Risk-free interest rate
Expected option life (in years)
Expected dividend yield
Weighted average fair value at grant date

Employee Stock Purchase Plan

Expected volatility
Risk-free interest rate
Expected option life (in years)
Expected dividend yield
Weighted average fair value at grant date

2009

2008

2007

42.5%
2.6%
5.84
0.6%
4.66

73.2%
0.1%
0.63
0.4%
3.85

40.1%
3.3%
5.84
0.5%
4.53

36.8%
3.1%
0.63
0.4%
2.48

42.8%
4.1%
5.84
0.4%
4.68

37.2%
4.7%
0.63
0.4%
3.31

The following is a summary of the methodology applied to develop each assumption:
Expected Volatility — This is a measure of the amount by which a price has fluctuated or is expected to fluctuate. The Company uses actual
historical changes in the market value of our stock to calculate expected price volatility because management believes that this is the best
indicator of future volatility. The Company calculates weekly market value changes from the date of grant over a past period representative
of the expected life of the options to determine volatility. An increase in the expected volatility will increase compensation expense.

Risk-free Interest Rate — This is the yield of a U.S. Treasury zero-coupon bond issue effective at the grant date with a remaining term

equal to the expected life of the option. An increase in the risk-free interest rate will increase compensation expense.

Expected Lives — This is the period of time over which the options granted are expected to remain outstanding and is based on
historical experience. Options granted have a maximum term of seven and one-half years. An increase in the expected life will increase
compensation expense.

Dividend Yield — This is based on the historical yield for a period equivalent to the expected life of the option. An increase in the

dividend yield will decrease compensation expense.

Forfeiture Rate — This is the estimated percentage of options granted that are expected to be forfeited or cancelled before becoming

fully vested. This estimate is based on historical experience. An increase in the forfeiture rate will decrease compensation expense.

Freds AR 09 Fin_Fixes:Freds AR 2007 fin-final 5/24/10 1:45 PM Page 34

Notes to Consolidated Financial Statements

Stock Options. The following table summarizes stock option activity from February 3, 2007 through January 30, 2010:

Outstanding at February 3, 2007

Granted
Forfeited / Cancelled
Exercised

Outstanding at February 2, 2008

Granted
Forfeited / Cancelled
Exercised

Outstanding at January 31, 2009

Granted
Forfeited / Cancelled
Exercised

Outstanding at January 30, 2010
Exercisable at January 30, 2010

Weighted
Average
Exercise
Price
$ 16.74
10.97
17.19
–
$ 15.40
10.97
16.57
13.86
$ 15.13
11.26
15.06
13.25
$ 13.91
$ 15.57

Weighted
Average
Remaining
Contractual
Life (Years)
4.2

Aggregate
Intrinsic
Value
(Thousands)
298

4.6

3.9

3.1
1.9

$
$

–

73
4

Options
1,103,064
270,552
(157,165)
–
1,216,451
37,500
(114,640)
(1,200)
1,138,111
404,891
(281,072)
(600)
1,261,330
793,003

The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the excess of FRED’S closing stock price
on the last trading day of the fiscal year end and the exercise price of the option multiplied by the number of in-the-money options) that
would have been received by the option holders had all option holders exercised their options on that date. This amount changes based
on changes in the market value of FRED’S stock. As of January 30, 2010, total unrecognized stock-based compensation expense net of
estimated forfeitures related to non-vested stock options was approximately $.88 million, which is expected to be recognized over a
weighted average period of approximately 3.5 years.

Other information relative to option activity during 2009, 2008 and 2007 is as follows:

(Dollars in thousands)
Total fair value of stock options vested
Total pretax intrinsic value of stock options exercised

2009
1,249
–

$
$

2008
2,240
1

$
$

2007
$ 1,008
–
$

The following table summarizes information about stock options outstanding at January 30, 2010:

Range of
Exercise Prices
$ 8.93 - $14.60
$14.68 - $18.40
$20.60 - $32.35

Options Outstanding
Weighted
Average
Remaining
Contractual
Life (Years)
4.1
0.8
0.7

Weighted
Average
Exercise
Price
$ 11.86
$ 17.38
$ 21.47

Options Exercisable

Weighted
Average
Exercise
Price
$ 12.83
$ 17.43
$ 21.47

Shares
403,813
295,120
94,070
793,003

Shares
862,380
304,880
94,070
1,261,330

Freds AR 09 Fin_Fixes:Freds AR 2007 fin-final 5/24/10 1:45 PM Page 35

Notes to Consolidated Financial Statements

Restricted Stock. The Company’s equity incentive plans also allow for granting of restricted stock having a fixed number of shares
at a purchase price that is set by the Compensation Committee of the Company’s Board of Directors, which purchase price may be set
at zero, to certain executive officers, directors and key employees. The Company calculates compensation expense as the difference
between the market price of the underlying stock on the date of grant and the purchase price if any. Restricted shares granted under the
plan have various vesting types, which include cliff vesting and graded vesting with a requisite service period of three to ten years.
Restricted stock has a maximum term of five to ten years from grant date. Compensation expense is recorded on a straight-line basis for
shares that cliff vest and under the graded vesting attribution method for those that have graded vesting.
The following table summarizes restricted stock from February 3, 2007 through January 30, 2010:

Non-vested Restricted Stock at February 3, 2007

Granted
Forfeited / Cancelled
Exercised

Non-vested Restricted Stock at February 2, 2008

Granted
Forfeited / Cancelled
Exercised

Non-vested Restricted Stock at January 31, 2009

Granted
Forfeited / Cancelled
Exercised

Non-vested Restricted Stock at January 30, 2010

Weighted
Average
Grant Date
Fair Value
$ 15.03
10.47
13.48
16.59
$ 13.83
9.84
14.15
13.31
$ 12.39
12.38
13.88
14.90
$ 12.01

Options
229,851
81,176
(15,713)
(9,679)
285,635
124,653
(45,876)
(11,628)
352,784
58,993
(29,909)
(35,358)
346,510

The aggregate pre-tax intrinsic value of restricted stock outstanding as of January 30, 2010 is $3.5 million with a weighted average
remaining contractual life of 5.6 years. The unrecognized compensation expense net of estimated forfeitures, related to the outstanding
restricted stock is approximately $2.3 million, which is expected to be recognized over a weighted average period of approximately 5.2
years. The total fair value of restricted stock awards that vested for the years ended January 30, 2010, January 31, 2009 and February 2,
2008 was $.5 million, $.2 million and $.2 million, respectively.

There were no significant modifications to the Company’s share-based compensation plans during fiscal 2009.

Note 8 – Net Income Per Share

Basic earnings per share excludes dilution and is computed by dividing income available to common stockholders by the weighted-
average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur
if options to issue common stock were exercised into common stock or resulted in the issuance of common stock that then shared in the
earnings of the entity. Restricted stock is a participating security and is therefore included in the computation of basic earnings per share.
Options to purchase shares of common stock that were outstanding at the end of the respective fiscal year were not included in
the computation of diluted earnings per share when the options’ exercise prices were greater than the average market price of the
common shares. There were 1,396,549, 1,138,111, and 1,216,451 such options outstanding at January 30, 2010, January 31, 2009
and February 2, 2008.

Note 9 – Commitments and Contingencies

Commitments. The Company had commitments approximating $8.8 million at January 30, 2010 and $9.7 million at January 31,
2009 on issued letters of credit, which support purchase orders for merchandise. Additionally, the Company had outstanding letters of
credit aggregating approximately $11.1 million at January 30, 2010 and $12.0 million at January 31, 2009 utilized as collateral for its risk
management programs.

Freds AR 09 Fin_Fixes:Freds AR 2007 fin-final 5/24/10 1:45 PM Page 36

Notes to Consolidated Financial Statements

Salary reduction profit sharing plan. The Company has a defined contribution profit sharing plans for the benefit of qualifying
employees who have completed three months of service and attained the age of 21. Participants may elect to make contributions to the
plan up to a maximum of 15% of their compensation. Company contributions are made at the discretion of the Company’s Board of
Directors. Participants are 100% vested in their contributions and earnings thereon. Contributions by the Company and earnings thereon
are fully vested upon completion of six years of service. The Company’s contributions for 2009, 2008, and 2007, were $.4 million,
$.3 million, and $.3 million, respectively.

Postretirement benefits. The Company provides certain health care benefits to its full-time employees that retire between the ages of
62 and 65 with certain specified levels of credited service. Health care coverage options for retirees under the plan are the same as those
available to active employees.

Effective February 3, 2007, the Company began recognizing the funded status of its postretirement benefits plan in accordance with
SFAS No. 158 codified in FASB ASC 715. In accordance with FASB ASC 715 the Company is required to display the net over-or–under
funded position of a defined benefit postretirement plan as an asset or liability, with any unrecognized prior service costs, transition
obligations or actuarial gains/losses reported as a component of accumulated other comprehensive income in shareholders’ equity.

During 2008, the Company changed its measurement date from November 30 to January 31. In accordance with FASB ASC 715, we
used the “14-month method” to transition to the new measurement date and calculate the net periodic postretirement benefit cost for the
year ended January 31, 2009. As part of the transition, an adjustment to retained earnings was recorded for the two month period
December 2, 2008 through January 31, 2009.

The Company’s change in benefit obligation based upon an actuarial valuation is as follows:

(In thousands)
Benefit obligation at beginning of year

Service cost
Interest cost
Actuarial loss (gain)
Benefits paid
Adjustments due to adoption of FASB ASC 715 measurement date provisions

Benefit obligation at end of year

January 30,
2010

January 31,
2009

February 2,
2008

396
33
30
111
(28)
–
542

539 $
25
24
(172)
(28)
8
396 $

591
33
30
(82)
(33)
–
539

The medical care cost trend used in determining this obligation is 8.0% at January 30, 2010, decreasing annually throughout the
actuarial projection period. The below table illustrates a one-percentage-point increase or decrease in the healthcare cost trend rate
assumed for postretirement benefits:

(In thousands)
Effect of health care trend rate
1% increase effect of accumulated benefit obligations
1% increase effect on periodic cost
1% decrease effect on accumulated benefit obligations
1% decrease effect on periodic cost

For the Year Ended

January 30,
2009

January 31,
2009

52 $
7
(47)
(6)

34
6
(30)
(5)

Freds AR 09 Fin_Fixes:Freds AR 2007 fin-final 5/24/10 1:45 PM Page 37

Notes to Consolidated Financial Statements

The discount rate used in calculating the obligation was 5.6% in 2009 and 6.25% in 2008.
The annual net postretirement cost is as follows:

Service cost
Interest cost
Amorization of prior service cost
Amorization of unrecognized prior service costs
Net periodic postretirement benefit cost

January 30,
2010

33
30
(14)
(94)
(45)

For the Year Ended
January 31,
2009

25
24
(14)
(102)
(67)

February 2,
2008

33
30
(14)
(97)
(48)

The Company’s policy is to fund claims as incurred.
Information about the expected cash flows for the postretirement medical plan follows:

(In thousands)
Expected Benefit Payments net of retiree contributions

2010
2011
2012
2013
2014
Next 5 years

Postretirement
Medical Plan

29
33
36
40
46
271

Litigation. In July 2008, a lawsuit styled Jessica Chapman, on behalf of herself and others similarly situated, v. FRED’S Stores of
Tennessee, Inc. was filed in the United States District Court for the Northern District of Alabama, Southern Division, in which the
plaintiff alleges that she and other female assistant store managers are paid less than comparable males and seek compensable damages,
liquidated damages, attorney fees and court costs. The plaintiff filed a motion seeking collective action. Briefs have been filed, but the
court has not ruled. The Company believes that all assistant managers have been properly paid and that the matter is not appropriate
for collective action treatment. Discovery has not yet begun. The Company is and will continue to vigorously defend this matter. In
accordance with FASB ASC 450, “Contingencies”, the Company does not feel that a loss in this matter is probable or can be reasonably
estimated. Therefore, we have not recorded a liability for this case.

In August 2007, a lawsuit entitled Julia Atchinson, et al. v. FRED’S Stores of Tennessee, Inc., et al, was filed in the United States
District Court for the Northern District of Alabama, Southern Division in which the plaintiff alleges that she and other current and
former FRED’S Discount assistant store managers were improperly classified as exempt executive employees under the Fair Labor
Standards Act (FLSA) and seeks to recover overtime pay, liquidated damages, attorney’s fees and court costs. The plaintiffs filed a motion
seeking a collective action which the Judge has not ruled on. The Company believes that its assistant store managers are and have been
properly classified as exempt employees under FLSA and that the matter is not appropriate for collective action treatment. The parties
also agreed to mediate this case in January 2009 and did so successfully, reaching a settlement of $1.5 million (including attorneys’ fees
and costs). Again, based on the substantial costs of continuing litigation, unfavorably high jury verdicts against other retailers and the
constant distraction to management of a possible protracted jury trial, this is a favorable settlement for FRED’S. FRED’S has admitted
no liability or wrongdoing, and no liability has been found against the Company. The parties are finalizing settlement documents and
will jointly present the settlement to the court, which must approve the settlement.

Freds AR 09 Fin_Fixes:Freds AR 2007 fin-final 5/24/10 1:45 PM Page 38

Notes to Consolidated Financial Statements

In June 2006, a lawsuit entitled Sarah Ziegler, et al. v. FRED’S Discount Store was filed in the United States District Court for the
Northern District of Alabama in which the plaintiff alleges that she and other current and former FRED’S Discount assistant store
managers were improperly classified as exempt executive employees under the Fair Labor Standards Act (“FLSA”) and sought to recover
overtime pay, liquidated damages, and attorneys’ fees and court cost. In July 2006, the plaintiffs filed an emergency motion to facilitate
notice pursuant to the FLSA that would give current and former assistant managers information about their rights to opt-in to the
lawsuit. After initially denying the motion, in October 2006, the judge granted plaintiffs motion to facilitate notice pursuant to the
FLSA. Notice was sent to some 2,055 current and former assistant store managers and approximately 450 persons opted into the case.
The cutoff date for individuals to advise of their interest in becoming part of this lawsuit was February 2, 2007.

The Company believes that its assistant store managers are and have been properly classified as exempt employees under the FLSA
and that the actions described above are not appropriate for collective action treatment. The parties agreed to mediate this case and did
so successfully in January 2009. The total settlement amount, (including attorneys’ fees and costs) was $5.0 million. FRED’S believes
this was a favorable settlement in consideration of the substantial costs of continuing litigation, high jury verdicts against other retailers
who were sued for practices similar to the claims alleged in this case as well as the constant distraction to management of a possible
protracted jury trial. FRED’S has admitted no liability or wrongdoing and no liability was found against FRED’S. The parties finalized
settlement documents, which the court approved and the Company paid in 2009.

In addition to the matters disclosed above, the Company is party to several pending legal proceedings and claims arising in the normal
course of business. Although the outcome of the proceedings and claims cannot be determined with certainty, management of the
Company is of the opinion that it is unlikely that these proceedings and claims will have a material adverse effect on the financial
statements as a whole. However, litigation involves an element of uncertainty. There can be no assurance that pending lawsuits will not
consume the time and energy of our management or that future developments will not cause these actions or claims, individually or in
aggregate, to have a material adverse effect on the financial statements as a whole. We intend to vigorously defend or prosecute each
pending lawsuit.

Note 10 – Sales Mix

The Company manages its business on the basis of one reportable segment. See Note 1 for a brief description of the Company’s
business. As of January 30, 2010, all of the Company’s operations were located within the United States. The following data is presented
in accordance with FASB ASC 280, “Segment Reporting.”

The Company’s sales mix by major category during the last 3 years was as follows:

Pharmaceuticals
Household Goods
Food and Tobacco Products
Paper and Cleaning Supplies
Apparel and Linens
Health and Beauty Aids
Sales to Franchised FRED'S Stores
Total Sales Mix

January 30,
2010
33.5%
23.4%
16.2%
9.2%
7.9%
7.6%
2.2%
100.0%

For the Year Ended
January 31,
2009
31.7%
24.8%
15.5%
9.2%
8.6%
8.0%
2.2%
100.0%

February 2,
2008
32.2%
24.8%
14.2%
8.8%
9.9%
8.0%
2.1%
100.0%

Note 11 – Exit and Disposal Activity

During fiscal 2007, the Company closed 17 underperforming stores.
During fiscal 2008, the Company closed 74 underperforming stores and 23 underperforming pharmacies. The closures took place
during the first three quarters of 2008 pursuant to our restructuring plan announced February 6, 2008 and were the result of an in-depth
study conducted by the Company of its operations over the previous 10 quarters. The study revealed that FRED’S has a strong and
healthy store base, and that by closing these underperforming stores the Company would improve its cash flow and operating margin,
both of which are core goals of the Company’s overall strategic plan. As a result of the successful execution of this plan, the Company is
stronger and is in a better position to respond to fluctuations in the economy and to take advantage of opportunities to further improve
our business.

Freds AR 09 Fin_Fixes:Freds AR 2007 fin-final 5/24/10 1:45 PM Page 39

Notes to Consolidated Financial Statements

During fiscal 2009, the Company closed 9 underperforming stores, which is consistent with our anticipated amount of annual

store closures.

In fiscal 2008, we recorded an additional below-cost inventory adjustment of $0.3 million to reduce the value of inventory to lower

of cost or market associated with stores closed in the third quarter and utilized the entire $10.3 million impairment.

Lease Termination
For store closures where a lease obligation still exists, we record the estimated future liability associated with the rental obligation on
the cease use date (when the store is closed) in accordance with FASB ASC 420, “Exit and Disposal Cost Obligations.” Liabilities are
established at the cease use date for the present value of any remaining operating lease obligations, net of estimated sublease income,
and at the communication date for severance and other exit costs, as prescribed by FASB ASC 420. Key assumptions in calculating
the liability include the timeframe expected to terminate lease agreements, estimates related to the sublease potential of closed locations,
and estimation of other related exit costs. If actual timing and potential termination costs or realization of sublease income differ
from our estimates, the resulting liabilities could vary from recorded amounts. These liabilities are reviewed periodically and adjusted
when necessary.

(in millions):

(In millions)
Inventory markdowns for planned store closings
Lease contract termination liability

Beginning
Balance
January 31, 2009

–
3.4
3.4

Additions
FY09
–
–
–

Utilized
FY09
–
2.4
2.4

Ending
Balance
January 30, 2010

–
1.0
1.0

Fixed Asset Impairment
During the fourth quarter of 2007, the Company recorded a charge of $4.6 million in selling, general and administrative expense for
the impairment of fixed assets and leasehold improvements associated with the planned closure of 75 stores in 2008. During the second
quarter of fiscal 2008, the Company recorded an additional charge of $.1 million associated with store closures that occurred in the third
quarter 2008. Impairment of $0.2 million for the planned store closures was recorded in fiscal 2009.

Freds AR 09 Fin_Fixes:Freds AR 2007 fin-final 5/24/10 1:45 PM Page 40

Notes to Consolidated Financial Statements

Note 12 – Quarterly Financial Data (Unaudited)

The Company’s unaudited quarterly financial information for the fiscal years ended January 30, 2010 and January 31, 2009 is

reported below:

(In thousands)
Year ended January 30, 2010
Net sales
Gross profit
Net income

Net income per share

Basic
Diluted

Cash dividends paid per share

Year ended January 31, 2009
Net sales
Gross profit
Net income

Net income per share

Basic
Diluted

Cash dividends paid per share

First
Quarter

Second
Quarter

Third
Quarter

Fourth
Quarter

$ 458,380
128,977
8,550

$ 434,214
120,742
4,240

$ 422,438
122,869
5,032

$ 473,104
126,649
5,793

$
$
$

0.21
0.21
0.02

$
$
$

0.11
0.11
0.03

$
$
$

0.13
0.13
0.03

$
$
$

0.15
0.15
0.03

464,292
132,481
7,250

$ 447,127
123,851
1,033 1

$ 418,036
124,186
6,089

$ 469,385
122,500
2,270

0.18
0.18
0.02

$
$
$

0.03 1
0.03 1
0.02

$
$
$

0.15
0.15
0.02

$
$
$

0.06
0.06
0.02

1 Results include certain charges for the non-routine closing of 75 stores in 2008 and the 17 stores closed in 2007 (see Note 11 - Exit

and Disposal Activities).

Freds AR 09 Fin_Fixes:Freds AR 2007 fin-final 5/24/10 1:45 PM Page 41

Reports of Independent Registered Public Accounting Firm

Board of Directors and Stockholders
FRED’S, Inc.
Memphis, Tennessee

We have audited the accompanying consolidated balance sheets of FRED’S, Inc. (the “Company”) as of January 30, 2010 and January
31, 2009 and the related consolidated statements of income and comprehensive income, changes in shareholders’ equity, and cash flows
for each of the three years in the period ended January 30, 2010. These financial statements are the responsibility of the Company’s
management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).
Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are
free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the
financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of
FRED’S, Inc. at January 30, 2010 and January 31, 2009, and the results of its operations and its cash flows for each of the three years
in the period ended January 30, 2010, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 1 to the Consolidated Financial Statements, the Company has changed its method for accounting for uncertainty
in income taxes in the year ended February 2, 2008 due to the adoption of revised accounting standards FASB ASC 740.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States),
FRED’S, Inc.’s internal control over financial reporting as of January 30, 2010, based on criteria established in Internal Control –
Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated
April 15, 2010 expressed an unqualified opinion thereon.

Memphis, Tennessee
April 15, 2010

Freds AR 09 Fin_Fixes:Freds AR 2007 fin-final 5/24/10 1:45 PM Page 42

Management’s Annual Report on Internal Control Over Financial Reporting

The management of FRED’S, Inc. is responsible for establishing and maintaining adequate internal control over financial reporting
as defined in Rule 13a – 15(f ) under the Securities Exchange Act of 1934. FRED’S, Inc. internal control system was designed to provide
reasonable assurance to the Company’s management and board of directors regarding the fair and reliable preparation and presentation
of the Consolidated Financial Statements.

All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be

effective can provide only reasonable assurance with respect to financial statement preparation and presentation.
The management of FRED’S, Inc. assessed the effectiveness of the Company’s internal control over financial reporting as of January 30,
2010. In making its assessment, the Company used criteria set forth by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO) in Internal Control – Integrated Framework. Based on its assessment, management has concluded that the
Company’s internal control over financial reporting is effective as of January 30, 2010.

Our independent registered public accounting firm has issued an audit report on our internal controls over financial reporting,

included herein.

Freds AR 09 Fin_Fixes:Freds AR 2007 fin-final 5/24/10 1:45 PM Page 43

Report of Independent Registered Public Accounting Firm
on Internal Control Over Financial Reporting

Board of Directors and Shareholders
FRED’S, Inc.
Memphis, Tennessee

We have audited FRED’S, Inc.’s (the “Company’s”) internal control over financial reporting as of January 30, 2010, based on criteria
established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission (the COSO criteria). The Company’s management is responsible for maintaining effective internal control over financial
reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying report,
“Item 9A(b), Management’s Annual Report on Internal Control Over Financial Reporting”. Our responsibility is to express an opinion
on the company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those
standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over
financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over
financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of
internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the
circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of
financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting
principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the
maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the
company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in
accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in
accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention
or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the
financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections
of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in
conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of January 30,

2010, based on the COSO criteria.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the
consolidated balance sheets of the Company as of January 30, 2010 and January 31, 2009, and the related consolidated statements of
income and comprehensive income, changes in shareholders’ equity, and cash flows for each of the three years in the period ended January
30, 2010 and our report dated April 15, 2010 expressed an unqualified opinion thereon.

Memphis, Tennessee
April 15, 2010

Freds AR 09 Fin_Fixes:Freds AR 2007 fin-final 5/24/10 1:45 PM Page 44

Directors and Officers

Executive Officers

Michael J. Hayes
Chairman

Bruce A. Efird
President and Chief Executive Officer

Jerry A. Shore
Executive Vice President and Chief Financial Officer

Rick A. Chambers
Executive Vice President – Pharmacy Operations

Reggie E. Jacobs
Executive Vice President – Corporate Services,
Distribution and Transportation

Earl L. Taylor
Executive Vice President – Store Operations

Charles S. Vail
Corporate Secretary, Vice President – Legal Services
and General Counsel

Board of Directors

Michael J. Hayes
Chairman of the Board
FRED’S, Inc.

Bruce A. Efird
President and Chief Executive Officer
FRED’S, Inc.

John R. Eisenman
Real Estate Investments
REMAX Island Realty, Inc.
Former President of Sally's, Inc.
(a restaurant chain)
Former commercial real estate developer

Roger T. Knox
President Emeritus
Memphis Zoological Society
Former Chairman of the Board and
Chief Executive Officer
Goldsmith's Department Stores
(retailing)

Michael T. McMillan
Director of Franchise Development
Pepsi-Cola North America
(consumer products)

B. Mary McNabb
Former Chief Executive Officer
Kid’s Outlet in California
(retailing)

Thomas J. Tashjian
Private Investor

Freds AR 09_CVR_Narr:Freds 07_final 5/24/10 9:59 AM Page 6

Corporate Information

Corporate Offices
FRED’S, Inc.
4300 New Getwell Road
Memphis, Tennessee 38118
(901) 365-8880

Web Address
www.fredsinc.com

SIC 5331

Transfer Agent
American Stock Transfer & Trust Company
59 Maiden Lane
New York, New York 10038
(800) 937-5449

Independent Registered
Public Accounting Firm
BDO Seidman, LLP
Memphis, Tennessee

Securities Counsel
Baker, Donelson, Bearman, Caldwell & Berkowitz, P.C.
Memphis, Tennessee

Annual Report on Form 10-K
Shareholders of record may obtain a copy of the Company's
Annual Report on Form 10-K for the year ended January 30,
2010, as filed with the Securities and Exchange Commission,
to Jerry A. Shore,
without charge upon written request
Executive Vice President and Chief Financial Officer.
In
addition, we make available free of charge through our website
at www.fredsinc.com annual reports on Form 10-K, quarterly
reports on Form 10-Q, current reports on Form 8-K, and all
amendments to those reports filed with or furnished to the
SEC. The reports are available as soon as reasonably practical
after we electronically file such material with the SEC, and may
be found using "Stock Links" under the "Investor Relations"
section of our website.

Annual Meeting of Shareholders
The 2010 annual meeting of shareholders will be held at
5:00 p.m. Eastern Daylight Time on Wednesday, June 16,
2010, at the Holiday Inn Express, 2192 S. Highway 441,
Dublin, Georgia. Shareholders of record as of April 30, 2010,
are invited to attend this meeting.

Market and Dividend Information
The Company's common stock trades on the NASDAQ
Global Select Market under the symbol FRED (CUSIP No.
356108-10-0). At April 30, 2010, the Company had an
estimated 12,200 shareholders,
including beneficial owners
holding shares in nominee or street name.

The table below sets forth the high and low stock prices,
together with cash dividends paid per share, for each fiscal
quarter in the past two fiscal years.

2009
Fourth
Third
Second
First

2008
Fourth
Third
Second
First

High

Low

Dividends
Per Share

$ 12.18
$ 14.00
$ 14.85
$ 14.17

$
9.01
$ 11.68
$ 11.91
8.52
$

$ 12.90
$ 15.91
$ 13.64
$ 11.79

$
$
$
$

8.22
9.17
10.33
8.20

$
$
$
$

0.03
0.03
0.03
0.02

0.02
0.02
0.02
0.02

The following graph shows a comparison of the cumulative
total returns for the past five years. The total cumulative return
on investment assumes that $100 was invested in FRED'S, the
NASDAQ Retail Trade Stocks Index and NASDAQ Stock
Market (U.S.) Index on January 29, 2005, and that all
dividends were reinvested.

COMPARISON OF 5-YEAR CUMULATIVE TOTAL RETURN*
Among FRED'S, Inc., The NASDAQ Composite Index
and The NASDAQ Retail Trade Index

$140 –

$120 –

$100 –

$80 –

$60 –

$40 –

$20 –

$0 –
1/29/05

1/28/06

2/3/07

2/2/08

1/3/09

1/31/10

FRED’S Inc

NASDAQ Composite

NASDAQ Retail Trade

* $100 invested on on 1/29/05 in index, including reinvestment of dividends.

Indexes calculated on month-end basis.

Freds AR 09_CVR_Narr:Freds 07_final 5/24/10 9:59 AM Page 7

4300 New Getwell Road
Memphis, Tennessee 38118