Fred's Inc. Annual Report 2011

FY2011 Annual Report · Fred's Inc.

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2011 ANNUAL REPORT

Freds 11 AR_PROD IFCs_4pg:Freds 07_final 6/26/12 2:29 PM Page 2

COMPANY
PROFILE

Founded in 1947, Fred's operates 700 discount general merchandise stores, including 21 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

(As of January 28, 2012)

133

117

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FINANCIAL
HIGHLIGHTS

($ in thousands, except per share amounts)
Operating Data
Net sales
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

Years Ended

January 28, 2012

January 29, 2011

$ 1,879,059
51,155
33,428
0.87
38,268
0.20

259,008
631,982
6,640
423,612

$ 1,841,755
46,718
29,587
0.75
39,196
0.16

282,097
595,528
3,969
423,888

1.6%

0.9%

NET SALES
(in millions)

9
7
8
,
1
$

2
4
8
,
1
$

8
8
7
,
1
$

9
9
7
,
1
$

1
8
7
,
1
$

COMPARABLE
STORE SALES

NET INCOME
PER SHARE-DILUTED

%
2
.
2

%
8
.
1

7
8
.
0
$

5
7
.
0
$

9
5
.
0
$

2
4
.
0
$

7
2
.
0
$

%
5
.
0

%
4
.
0

%
3
.
0

SALES PER
SQUARE FOOT

9
9
1
$

8
9
1
$

2
9
1
$

4
8
1
$

7
7
1
$

SELLING SPACE
(SQUARE FOOTAGE)
(in thousands)

5
1
2
,
0
1

0
9
5
,
9

0
5
3
,
9

0
6
3
,
9

3
2
3
,
9

NUMBER OF
COMPANY-OWNED
STORES (end of period)

9
7
6

3
5
6

5
4
6

2
9
9 6
3
6

5
2
3

3
1
3

7
0
3

4
8
2

6
9
2

Stores
Pharmacies

Freds 11 AR_PROD IFCs_4pg:Freds 07_final 6/26/12 2:29 PM Page 4

LETTER TO
SHAREHOLDERS

I am pleased to provide a fresh update on your company's
ongoing progress during 2011. It was another good year for
Fred's, and I am extremely proud of the 10,000 team
members who contributed to our growth and rose to the
challenges of a highly competitive environment. Reflecting
their efforts, we continued to execute on our strategic plan,
driving sustainable improvements throughout many areas of
our business, all of which combined to produce another year
of solid earnings growth and generate tangible momentum in
our operations.

Financial Review
Even though the year held some signs of improving economic
conditions, those indications were faint and inconsistent
across most of our markets, thus we continued to face a
generally challenging business climate in 2011. Despite those
headwinds, Fred's net income for 2011 increased 16% to
$0.87 per diluted share from $0.75 per diluted share for 2010
as the Company maintained the upward trajectory that has
characterized our operations over the past several years. Total
sales for 2011 increased 2% to $1.879 billion from $1.842
billion for 2010 and comparable store sales increased 0.5%
for 2011 on top of the 2.2% increase we experienced in the
year-earlier period. Another notable accomplishment for
the year was seen in customer traffic, which again increased
0.7% in 2011.

Gross margin improvement remained a key focus for us in
2011 as we continued to build on our Core 5 program and
Own Brand strategies, create new product
sourcing
opportunities, and reduce costs. These, along with other
initiatives, boosted gross margin 10 basis points in 2011 and
helped push our operating margin for the year up 20 basis
points to 2.7%. As you know, raising our operating margin
has been a central objective in our long-term strategic plan.

Just as in 2010, we finished this past year in a very sound
financial position, free from operating debt and with a strong
cash balance at year's end – a noteworthy feat considering the
accelerating growth we experienced with new store and
pharmacy openings during 2011, as well as our ongoing
investments in store remodels and technology improvements.
Because of our continued balance sheet strength and steadfast
optimism about Fred's future growth prospects, the Board
of Directors again increased the Company's cash dividend
rate 25% in 2011, raising the annual payout to $0.20 per
share. The dividend was increased yet again to $0.24 per
share in February 2012. On top of these efforts to drive
higher shareholder value, the Company also repurchased
almost 2.5 million common shares during 2011 and recently

recharged the stock repurchase program with an additional
authorization for another 3.6 million shares.

Pharmacy
There is no question that our pharmacy department is
strategic to our long-term objectives. It promotes higher
margins and also serves as a proven driver of customer trips
and loyalty. In 2011, despite pressure on third-party
reimbursements, our pharmacy department results exceeded
goals in terms of script growth, unit growth, operating profit,
and customer service metrics.

Considering the steady brand-to-generic shift in prescription
drugs that we have witnessed during the past several years, we
anticipated increased pressure on third-party reimbursements
in 2011 from both public and private payers. The actual
impact of these pressures was in line with our projections, but
the Fred's team managed to overcome these challenges by
improving margins in other areas and controlling expenses.

Against this backdrop, we accelerated pharmacy acquisitions
again during the past year, utilizing our strong capital position
to make 12 pharmacy acquisitions and open 24 new
pharmacy locations. The growth in new pharmacies during
2011 enabled us to increase pharmacy department script
counts more than 3% last year,
successfully expand
membership in our Prescription Plus program, and penetrate
the immunizations market more deeply.

Looking ahead, we will continue to leverage our pharmacies
in 2012. Knowing that third-party margin pressures will
continue, we remain optimistic about the future of pharmacy
based on our experience that indicates customer loyalty and
retention is better in stores with a pharmacy. This stronger
customer bond translates into higher front-end traffic, and
stores with pharmacies consistently perform on average 10%
or more above stores without pharmacies.

We anticipate that the brand-to-generic shift in 2012 will be
the most significant in history, as 22% of branded drugs will
convert to generic over the next 12 months. Countering this
trend, an aging population will drive future script growth and
healthcare reform will foster additional pharmacy growth as
more individuals gain access to pharmacy benefits coverage.
Also, the increasing utilization of home healthcare will benefit
pharmacy operations, while our ability to expand clinical
services within our pharmacies, such as immunizations,
diabetes programs and patient consulting, also will contribute
to our pharmacy growth.

Freds 11 AR_PROD IFCs_4pg:Freds 07_final 6/26/12 2:30 PM Page 5

Merchandising
During 2011, we continued to make solid headway with our
Core 5 program, which focuses on Pharmacy, Celebration
and Party, Pet Products, Household Supplies, and Home
Products. These key areas drive comparable sales
in
departments in which Fred's has a clear and marketable
advantage over our small-box competitors.

When we conceived the Core 5 program, we recognized that
our customers placed great value on both price and selection,
and in our testing, the availability of name-brand national
products emerged as a key determinant of shopping patterns.
After adding important brands to our merchandise line-up in
2010,
like Coca-Cola, Purina, and Energizer, we have
continued to reinforce our offering with other strong brand
including Prestone and Sunbeam. We have been
names,
encouraged by our customers' response to these efforts.

Our Own Brand initiative continues to be a key element in
our strategy for building customer loyalty and increasing gross
margin. The strength of this program responds directly to the
needs of our customers, considering current economic
pressures, and provides an attractive complement to our
national brand sales. Additionally, our commitment to quality
in our Own Brand products has resonated with customers as
we continue to expand our line with new products.

In 2011, we accelerated our growth in store openings by
adding 26 new stores, the most in any year since 2007. Also,
for the second year in a row, we completed the remodeling
and refurbishment of more than 200 stores. At the end of
fiscal 2011, approximately 60% of our chain reflected the new
look and layout of our current prototype.

Concluding Thoughts
In developing our 2012 strategic initiatives, we plan to build
on last year's momentum and break new ground in several
key areas, with a goal to increase market share, comparable
sales, and customer traffic, while driving toward higher
operating margins. Expanded marketing efforts in the coming
year – more customer-specific and utilizing in-store
marketing, direct mailings, and social media – will be a key
driver of these efforts. Also, we intend to maintain our
price leadership as our customers experience continuing
economic pressures.

Based on the improvements we have seen recently in the
performance of our new stores, we will continue to invest in
store expansion during 2012. We plan to open between
22 and 28 new stores and pharmacies in the coming year. We
also will continue to reinvest in our stores with 50 to 75 more
remodels and upgrades in 2012. When this year's scheduled
upgrades are completed, we will have refreshed or refurbished
approximately 70% of our stores over the past three years.

In terms of fundamentals, our team will continue to focus on
process improvements and support those with increased
investments in technology. These investments will enhance
our store operations, provide greater inventory accuracy, and
drive higher in-stock levels. Concurrently, we will work to
further strengthen operating margins through better product
improved inventory quality, and leveraging
sourcing,
operating expenses throughout the organization.

In closing, 2011 was a very solid year for Fred's as our team
made good progress in laying the groundwork for future
success. Beyond operational and financial
improvements,
I was very pleased with the way our team continued to focus
on "winning" with our customers, delivering an ever higher
standard of service, and fulfilling Fred's vision – A Smile on
Every Customer's Face.

In 2012, we mark our 65th anniversary as a company and
celebrate our role in retail across the Southeast. Fred's also will
mark its 20th year as a publicly held company in 2012. Truly,
we've come a long way from humble beginnings in 1947 with
the opening of our first store in Coldwater, Mississippi, and
yet we've never been more excited about the future of Fred's.
We believe that there are significant opportunities ahead
for stable and consistent growth while extending the
improvements in operating performance that we have begun
to realize over the past three years. I am confident in the
opportunities for Fred's to deliver another year of double-digit
earnings growth.

We are grateful
shareholders. We thank all of you for your support.

for our customers, team members and

Bruce A. Efird
Chief Executive Officer

Freds AR 11 Fin:Freds AR 2007 fin-final 6/26/12 2:30 PM Page 4

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 Statements/Risk Factors
disclosures in Item 1 at our Annual Report on Form 10-K for 2011.

(Dollars in thousands, except per share amounts and store data)
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
Company owned 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

2011

2010

2009

20082

20072

$ 1,879,059
51,155
50,758
17,330
33,428

$ 1,841,755
46,718
46,528
16,941
29,587

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

$ 1,798,840 $ 1,780,923
16,457
15,664
4,946
10,718

26,318
25,910
9,268
16,642

0.88
0.87
0.20

0.76
0.75
0.16

0.59
0.59
0.11

0.42 $
0.42
0.08

0.27
0.27
0.08

2.7%
0.5%
679

2.5%
2.2%
653

2.2%
0.4%
645

1.5%
1.8%
639

0.9%
0.3%
692

631,982
658
6,640
423,612

595,528
201
3,969
423,888

571,441
718
4,179
400,939

544,775 $
243
4,866
387,081

550,572
285
35,653
372,059

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 Item 7: "Results of Operations" section).

2 Results include certain charges for the non-routine closing of 75 stores in 2008 and 17 in 2007, (see Item 7: "Exit and Disposal Activities" section) and implementation

of ASC 740.

Freds AR 11 Fin:Freds AR 2007 fin-final 6/26/12 2:30 PM Page 5

MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

GENERAL ACCOUNTING PERIODS

The following information contains references to years 2011, 2010 and 2009, which represent fiscal years ended January 28, 2012,
January 29, 2011 and January 30, 2010 (which were 52-week accounting periods). 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 in our Annual Report on Form
10-K for 2011.

EXECUTIVE SUMMARY

Throughout 2011, we continued the implementation of our key initiatives to differentiate our stores from other small-box discount
retailers. The Core 5 Program is our long-term strategy designed to highlight key categories within our stores that differentiate us from
our competition. The Core 5 categories - Home, Celebration, Pet, Pharmacy and Paper and Chemical – are strong trip driving
departments in which FRED’S has a clear and marketable advantage versus small box competitors. Additionally, these categories have
high household penetration and resonate with customers across multiple demographics. This initiative is also intended to shift our
product mix toward the more discretionary, higher margin categories and away from the lower margin consumable categories, thus
driving higher margin and leading to increased operating profit.

The implementation of the Core 5 Program requires a moderate refresh of the store to address space allocation, product placement
and adjacencies and signage in the Core 5 categories. The implementation is also accompanied by an extensive direct mail marketing
campaign timed to coincide with the refresh of the store and then continuing for six months thereafter. In 2011, we implemented the
Core 5 Program in 205 stores, bringing the total completed stores to 413 over the past two years.

As mentioned previously, our Pharmacy department is one of our Core 5 categories and is a key differentiating factor from other
small-box discount retailers. As such, 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 acquiring prescription files, but cold
starts will be employed where it makes sense to do so. Pharmacy department expansion is a proven driver of customer trips and loyalty.
Our stores which have a pharmacy department continue to perform better in general merchandise department sales by over 10% than
those without.

During the fourth quarter of fiscal year 2011, we opened sixteen new stores and seven express pharmacy locations. Five express
pharmacy locations and one franchise store closed in the quarter. For the fiscal year, there were 26 new stores and ten new express
pharmacy locations. Eight stores and two express pharmacy locations were closed during the year. Additionally, three franchise stores
closed during the year, bringing the net increase in Fred’s locations to 23 for the year.

Another key focus throughout 2011 has been improvement of our store in-stock position. Recognizing in-stock position as one of
the fundamental drivers of our business, we have dedicated significant resources to improving the tools we use to monitor and measure
in-stock position in our stores.
Increased investments in technology played a role in our improvements with implementations in
merchandise allocations, price optimization, ad planning, vendor performance tracking, and several business intelligence applications.
As an extension of this initiative, we have made significant improvements to our freight flow processes to ensure that product is in the
store and available for our customers. Improvements in store in-stock position during the year have been a factor in increasing store sales,
as well as improving customer service scores. Improvements being made in the freight flow process will drive higher store in-stock results
beyond 2011.

Our Own Brand initiative continues to be a key strategy for the Company in terms of building customer loyalty and increasing gross
margin.
In 2011, our Own Brand penetration rate was 19.0% of consumable product sales, which is relatively flat with last year.
Considering the sales mix shift toward basic and consumable products and the strong increase in national brand sales, we see maintaining
our Own Brand penetration rate as a positive during this year. 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 food and health and beauty aids introduced in the last half 2011.

While our private label, or Fred's Brand products, continued to be a focus in 2011, we also carry many national brands in our stores,
including products such as Coke, Purina, Energizer, Prestone, and Sunbeam. Our customers identify with these national brands, which
provide them with a more complete shopping trip. On an ongoing basis, we will continue to evaluate additional national brands that
are the most popular with our customers and will be adding those that complement our current product mix.

Freds AR 11 Fin:Freds AR 2007 fin-final 6/26/12 2:30 PM Page 6

MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Gross margin improvement continues to be a key focus of the Company, as highlighted above with our Core 5 and Own Brand
strategies. We are aggressively pursuing product sourcing improvements and cost reductions across all product lines in order to drive
overall product costs down and in turn raise our gross margin. Additionally, we have implemented new processes intended to control
both promotional and clearance markdowns. We also continue to make improvements in our loss prevention processes and procedures
to control shrinkage in our stores and consequently increase gross margin.

During 2011, we used $66.0 million for capital expenditures and pharmacy acquisitions, a 71% increase over the prior year, with
most of the expenditures being used to open new stores and pharmacies, as well as continuing the upgrades of our existing stores.
Included in the total is $3.5 million for technology upgrades such as computer software and hardware, and distribution equipment.

Looking to 2012 and beyond, we expect continuous improvement as we adapt our strategic initiatives to the retail environment for
the long-term. We have developed our 2012 strategic initiatives to build on our momentum and break new ground in key areas, with
the goal to increase market share, comparable sales, and customer traffic while driving toward higher operating margins. Our Core 5
Program will be an ongoing catalyst for sales growth. Two of our major sales and marketing initiatives going forward are to help the
economically challenged customer and attract the younger mother. We will accomplish these initiatives through greater value in basic
products, continued expansion of own-brand or private label products, and evolving our Fred’s Kids line of products. We will continue
to leverage our pharmacy products and service in 2012 as we still view pharmacy growth as a solid use of invested capital. Finally, we
will continue to focus on fundamentals and increase investments in technology to drive process improvement and customer satisfaction.
Key factors that will be critical to the Company’s future success include the successful roll-out of our Core 5 program, as well as
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, controlling 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.

Other factors that will affect Company performance in 2012 include the continuing management of the impacts of the changing
regulatory environment in which our pharmacy department operates. Additionally, we believe that the protracted elevation in
commodity and fuel prices, as well as the unemployment rate continues 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 for the price
conscious consumer.

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 679 Company owned stores and 21 franchised stores as
of January 28, 2012. 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 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.

Freds AR 11 Fin:Freds AR 2007 fin-final 6/26/12 2:30 PM Page 7

MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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 2011, 2010 and 2009 was $1.8 million,
$2.0 million and $2.1 million, respectively.

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 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 Generally Accepted Accounting Principles in the U.S. ("U.S. GAAP").

Because the approximation of net realizable 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 is a significant element in approximating the carrying value of
inventory at net realizable value; thus the following paragraph describes our estimation method as well as the steps we take to mitigate
the risk this estimate has in the determination of the cost value of inventory.

The Company calculates inventory losses 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 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 experienced improvement in reducing shrink as
a percentage of sales from year to year due to improved inventory control measures, which includes the chain-wide utilization of the
NEX/DEX technology.

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 $40.4 million,
and $32.5 million at January 28, 2012 and January 29, 2011, 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 $26.8 million at January 28, 2012 and $24.0 million at January 29, 2011. The LIFO reserve increased by
approximately $2.8 million and $2.4 million during 2011 and 2010, respectively.

Freds AR 11 Fin:Freds AR 2007 fin-final 6/26/12 2:30 PM Page 8

MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The Company has historically included an estimate of inbound freight and certain general and administrative costs in merchandise
inventory as prescribed by U.S. 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 28, 2012
is $20.3 million compared to $19.5 million at January 29, 2011.

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 using a discounted cash flow model.

Exit and Disposal Activities.
Lease Termination
Lease obligations still exist for some store closures that occurred in 2008. We record the estimated future liability associated with the
rental obligation on the cease use date (when the stores were closed). The lease obligations 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, “Exit or Disposal Cost Obligations”. Key assumptions in calculating the
liability include the timeframe expected to terminate lease agreements, estimates related to the sublease potential of closed locations, and
estimates 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 2011, we reserved an additional $0.1 million in rent expense related to the revision of the estimated amount of the
remaining lease liability for the fiscal 2008 store closures. We also utilized $0.5 million, leaving $0.3 million in the reserve at January
28, 2012.

Lease contract termination liability

Beginning Balance
January 29, 2011

0.7

Additions
FY11
0.1

Utilized
FY11

Ending Balance
January 28, 2012

(0.5)

0.3

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.
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 - 10 years
9 years

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Assets under capital lease are amortized 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. Based on the Company’s history of intangible asset acquisitions beginning in fiscal 2004, these assets are being
amortized on a straight-line basis over five years until such time as the Company’s internal analysis has sufficient history to indicate
another method is preferable.

Vendor Rebates and Allowances and Advertising Costs. 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, 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 28, 2012, the Company had approximately 1,050 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 2011, 2010 and 2009, were
$21.9 million, $24.5 million and $24.0 million, respectively. Gross advertising expenses were reduced by vendor cooperative advertising
allowances of $2.4 million, $2.4 million and $2.6 million, for 2011, 2010 and 2009, 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’s insurance policy coverage
runs August 1 through July 31 of each fiscal year. On August 1, 2011, the Company increased its stop loss limits for excessive or
catastrophic claims for general liability to $350,000 from $250,000 and for employee medical to $175,000 from $150,000. The stop
loss limit for worker’s compensation remained unchanged at $500,000. The Company’s insurance reserve was $10.3 million and $10.3
million on January 28, 2012 and January 29, 2011, respectively. Changes in the reserve over that time period were attributable to
additional reserve requirements of $49.0 million netted with payments of $49.0 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

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

1 0

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 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 28, 2012, accrued interest and penalties related to our unrecognized
tax benefits totaled $1.3 million and $0.2 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.

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.

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 28,
2012
100.0%
71.3
28.7
26.0
2.7
–
2.7
0.9
1.8%

For the Year Ended
January 29,
2011
100.0%
71.4
28.6
26.1
2.5
–
2.5
0.9
1.6%

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

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.

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

1 1

Comparable Store Sales. Our 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, and includes 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 2011 COMPARED TO FISCAL 2010

Sales

Net sales for 2011 increased to $1,879.1 million from $1,841.8 million in 2010, a year-over-year increase of $37.3 million or 2.0%.
On a comparable store basis, sales for 2011 increased 0.5% ($9.0 million) compared with a 2.2% ($33.3 million) increase in the same
period last year.

The Company’s 2011 front store ("non-pharmacy") sales increased 1.0% over 2010 front store sales We experienced sales increases

in categories such as food, pet, paper and chemical and beverage partially offset by decreases in electronics and home furnishings.

The Company’s pharmacy sales were 34.9% of total sales in 2011 compared to 34.1% 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 increased 4.2% over 2010, with third party
prescription sales representing approximately 91% 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 21 franchised locations during 2011 declined 3.4% to $36.1 million (2.0% of sales) compared to fiscal 2010. The
decrease in year-over-year franchise sales was due to the impact of three franchise stores that closed during the year as well as 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 34.9% Pharmaceuticals, 23.3% Household Goods, 16.8%
Food and Tobacco, 8.7% Paper and Cleaning Supplies, 7.4% Health and Beauty Aids, 6.9% Apparel and Linens, and 2.0% Franchise.
The sales mix for the same period last year was 34.1% Pharmaceuticals, 24.1% Household Goods, 16.2% Food and Tobacco, 8.6% Paper
and Cleaning Supplies, 7.6% Apparel and Linens, 7.4% Health and Beauty Aids, and 2.0% Franchise.

For the year, comparable store customer traffic increased 0.7% over last year while the average customer ticket decreased 0.2%

to $19.96.

Gross Profit

Gross profit for the year increased to $538.5 million in 2011 from $527.0 million in 2010, a year-over-year increase of $11.5 million
or 2.2%. Gross margin, measured as a percentage of sales, increased to 28.7% in 2011 from 28.6% in 2010, a 10 basis point
improvement. Gross margin was favorably impacted by higher pharmacy department rebates.

Selling, General and Administrative Expenses

Selling, general and administrative expenses, including depreciation and amortization, increased to $487.4 million in 2011 (26.0%
of sales) from $480.3 million in 2010 (26.1% of sales). This 10 basis point expense leveraging resulted primarily from the decrease in
advertising costs of $2.5 million (13 basis points) and an increase in proceeds from the sale of pharmacy script files of $1.0 million (21
basis points). This leveraging was partially offset by an increase in incentive compensation (18 basis points).

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

1 2

Operating Income

Operating income increased to $51.2 million in 2011 (2.7% of sales) from $46.7 million in 2010 (2.5% of sales) due primarily to
an increase in gross profit of $11.5 million as a result of higher pharmacy department rebates as described in the Gross Profit section
above. This favorability was partially offset by an increase in selling, general and administrative expenses of $7.1 million as described in
the Selling, General and Administrative Expenses section above.

Interest Expense, Net

Net interest expense for 2011 totaled $0.4 million or less than 0.1% of sales compared to $0.2 million which was also less than 0.1%
of sales in 2010. The increase in interest expense was the result of real estate purchases done throughout 2011 that had existing loans
that were assumed.

Income Taxes

The effective income tax rate was 34.1% in 2011 compared to 36.4% in 2010. The decrease in the effective tax rate was primarily
attributable to the improved utilization of the Work Opportunity Tax Credits, the favorable result of finalized state tax audits and overall
favorable state tax rates when compared to the prior year.

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 $156.6 million for state income tax purposes at January 28, 2012 and expire at various times during 2012 through 2031.
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 be in the range of 36% to 37% in fiscal 2012.

Net Income

Net income increased to $33.4 million ($0.87 per diluted share) in 2011 from $29.6 million ($0.75 per diluted share) in 2010, a
13.0% increase. The increase in net income is primarily attributable to the favorable gross profit of $11.5 million as described in the
Gross Profit section above. This favorability was partially offset by the $7.1 million increase in selling, general and administrative
expenses as described in the Selling, General and Administrative Expenses section above, as well as higher income tax expense due to a
pretax income increase of $4.2 million.

FISCAL 2010 COMPARED TO FISCAL 2009

Sales

Net sales for 2010 increased to $1,841.8 million from $1,788.1 million in 2009, a year-over-year increase of $53.6 million or 3.0%.
On a comparable store basis, sales for 2010 increased 2.2% ($33.3 million) compared with a 0.4% ($6.2 million) increase in the prior year.
The Company’s 2010 front store sales increased 2.1% over 2009 front store sales We experienced sales increases in categories such as

direct beverage, small appliances, greeting cards and tobacco partially offset by decreases in food and electronics.

The Company’s pharmacy sales were 34.2% of total sales in 2010 compared to 33.5% 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 5.2% over 2009, 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.

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

1 3

Sales to Fred's 24 franchised locations during 2010 decreased to $37.4 million (2.0% of sales) from $38.4 million (2.2% of sales) in
2009. 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 34.1% Pharmaceuticals, 24.1% Household Goods, 16.2%
Food and Tobacco, 8.6% Paper and Cleaning Supplies, 7.6% Apparel and Linens, 7.4% Health and Beauty Aids, and 2.0% Franchise.
The sales mix for the same period in 2009 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.

For 2010, comparable store customer traffic increased 0.3% over the prior year while the average customer ticket increased 1.6%

to $19.75.

Gross Profit

Gross profit for the year increased to $527.0 million in 2010 from $499.2 million in 2009, a year-over-year increase of $27.8 million
or 5.6%. Gross margin, measured as a percentage of sales, increased to 28.6% in 2010 from 27.9% in 2009, a 70 basis point
improvement. Gross margin was favorably impacted by the improved product mix shift toward household goods which carry higher
margins, continued management of shrink in our stores,
improved pharmacy department margins and an increase in vendor
consideration. This favorability was partially offset by an increase in store markdowns and pharmacy shrinkage.

Selling, General and Administrative Expenses

Selling, general and administrative expenses, including depreciation and amortization, increased to $480.3 million in 2010 (26.1%
of sales) from $460.7 million in 2009 (25.8% of sales). This 30 basis point expense deleveraging resulted primarily from the increase in
labor of $8.8 million and amortization expense of $2.5 million related mainly to pharmacy acquisitions during the year, as well as an
increase in incentive compensation of $2.6 million.

Operating Income

Operating income increased to $46.7 million in 2010 (2.5% of sales) from $38.5 million in 2009 (2.1% of sales) due primarily to
an increase in gross profit of $27.8 million due to the improved product mix shift toward household goods which carry higher margins,
continued management of shrink in our stores, improved pharmacy department margins and an increase in vendor dollar consideration.
This favorability was partially offset by an increase in selling, general and administrative expenses of $19.6 million as described in the
Selling, General and Administrative Expenses section above.

Interest Expense, Net

Net interest expense for 2010 totaled $0.2 million or less than 0.1% of sales compared to $0.3 million which was also less than 0.1%

of sales in 2009.

Income Taxes

The effective income tax rate was 36.4% in 2010 compared to 38.2% in 2009. The decrease in the effective tax rate was primarily

due to the finalization and settlement of the Internal Revenue Exam which was incurred in 2009.

State net operating loss carry-forwards are available to reduce state income taxes in future years. These carry-forwards total
approximately $142.5 million for state income tax purposes and expire at various times during 2011 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.

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

1 4

Net Income

Net income increased to $29.6 million ($0.75 per diluted share) in 2010 from $23.6 million ($0.59 per diluted share) in 2009, a
25.3% increase. The increase in net income is primarily attributable to the favorable gross profit of $27.8 million as described in the
Gross Profit section above. This favorability was partially offset by the $19.6 million increase in selling, general and administrative
expenses as described in the Selling, General and Administrative Expenses section above, as well as higher income tax expense due to a
pretax income increase of $8.3 million.

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 working
capital of $259.0 million, $282.1 million and $266.7 million at year-end 2011, 2010 and 2009, respectively. Working capital fluctuates
in relation to profitability, seasonal inventory levels, and the level of store openings and closings. Working capital at year-end 2011
decreased by $23.1 million from 2010. The decrease was primarily due to a year-over-year decrease in cash and cash equivalents of $22.1
million as a result of share repurchases totaling $28.5 million and $10.0 million for the acquisition of leased properties. Accounts
payable increased $25.9 million as a result of the increased inventory at year end and improved vendor terms. Partially offsetting the
decreased in working capital, inventory increased by $18.5 million primarily due to inflation and new store growth, and other non-trade
receivables increased $5.7 million primarily from increases in vendor related allowances and income tax receivables. In 2012, the
Company intends to open approximately 22-28 stores and pharmacies and close an estimated 10 stores and 5 pharmacies.

We have incurred losses caused by fire, tornado and flood damage, which consisted primarily of losses of inventory and fixed assets.
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 $76.6 million in 2011, $42.1 million in 2010 and $64.2 million in 2009.
In fiscal 2011, accounts payable and accrued expenses increased by approximately $25.4 million. Deferred income tax expense

increased by $4.6 million and depreciation and amortization increased by $5.0 million.

In fiscal 2010, inventory, net of the LIFO reserve, increased by approximately $19.4 million due to many factors including our drive
to support our in-stock position, additional toy and trim-a-home inventory purchased for the 2010 holiday season and a strategic
decision to purchase import goods earlier in an effort to avoid business interruptions from the Chinese New Year. Accounts receivable
increased by approximately $6.2 million due primarily to an increase in vendor related allowances. Accounts payable and accrued
expenses decreased by approximately $0.6 million. Income taxes payable increased by $3.8 million while deferred income tax liability
increased by $1.9 million. Other non-current liabilities increased by $0.7 million.

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.

Net cash used in investing activities totaled $62.3 million in 2011, $38.2 million in 2010 and $33.2 million in 2009.
Capital expenditures in 2011 totaled $49.2 million compared to $27.0 million in 2010 and $22.7 million in 2009. The capital
expenditures during 2011 consisted primarily of existing store improvements ($19.4 million), the purchase of 17 existing store properties
($14.5 million), the store and pharmacy expansion program ($9.6 million), technology ($3.5 million), and distribution and corporate
expenditures ($2.2 million). Additionally, $16.8 million was expended related to acquisitions of pharmacies during 2011.

Capital expenditures in 2010 totaled $27.0 million compared to $22.7 million in 2009 and $17.0 million in 2008. The capital
expenditures during 2010 consisted primarily of the store and pharmacy expansion program ($22.4 million), technology enhancements
($2.9 million), transportation and distribution center expenditures ($1.0 million) and other corporate expenditures ($.7 million).
Additionally, $11.5 million was expended related to acquisitions of pharmacies during 2010.

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

1 5

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). Additionally, $10.7 million was expended related to acquisitions of pharmacies during 2009.

In 2012, the Company is planning capital expenditures totaling approximately $26.0 million. Expenditures are planned totaling
$18.0 million for new and existing stores and pharmacies. Planned expenditures also include approximately $5.0 million for technology
upgrades and approximately $3.0 million for distribution center equipment and other capital maintenance. In addition, the Company
plans expenditures of approximately $18.0 million in 2012 for the acquisition of prescription lists and other pharmacy related items.

Net cash used in financing activities totaled $36.3 million in 2011, $9.4 million in 2010 and $11.4 million in 2009.
The Board of Directors regularly reviews the Company’s dividend plans to ensure that they are consistent with the Company’s
earnings performance, financial condition, need for capital and other relevant factors. As part of that review and in light of the Company’s
current financial position, the Board of Directors raised the dividend from $0.03 per share to $0.04 per share in the first quarter of 2010.
On March 2, 2011, the Board of Directors increased the dividend to shareholders of record as of March 10, 2011 to $0.05, a 25 %
increase. For the fourth consecutive year, on February 16, 2012, the Board of Directors increased the dividend to shareholders of record
as of March 1, 2012 to $0.06, a 20% increase.

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 2011, the Company
repurchased 2,447,823 shares for $28.5 million compared to 293,000 shares for $3.0 million in 2010, and 742,663 shares for $7.2 million
in 2009. On February 16, 2012, Fred's Board authorized the expansion of the Company's existing stock repurchase program by increasing
the authorization to repurchase an additional 3.6 million shares or approximately 10% of the current outstanding shares.

On September 27, 2010, the Company and Regions Bank entered into the Tenth Loan Modification of the Revolving Loan and
Credit Agreement which decreased the credit line from $60 million to $50 million and extended the term until September 27, 2013.
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 $423.6 million at January 28, 2012) and positive net income levels. The Company was in
compliance with all loan covenants at January 28, 2012. 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’s rates are 100
basis points over LIBOR for borrowings and 20 basis points over LIBOR for the unused portion of the credit line. There were no
borrowings outstanding under the Agreement at January 28, 2012 and January 29, 2011.

Cash and cash equivalents were $27.1 million at the end of 2011 compared to $49.2 million at the end of 2010 and $54.7 million
at the end of 2009. 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.

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 2011, 2010

and 2009.

Freds AR 11 Fin:Freds AR 2007 fin-final 6/26/12 2:30 PM Page 16

1 6

MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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 28, 2012, 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

2012
$ 49,082
110,592
1,689

2013
$ 36,886

2014
$ 27,334

2015
$ 21,527

2016
$ 15,619

Thereafter
$ 44,102

1,062

945

710

707

210

Total
$ 194,550
110,592
5,323

and other 4

Postretirement benefits 5
Total contractual obligations

676
35
$ 162,074

1,307
38
$ 39,293

2,076
40
$ 30,395

998
36
$ 23,271

68
37
$ 16,431

2,195
209
$ 46,716

7,320
395
$ 318,180

Inventory purchase obligations represent open purchase orders and any outstanding purchase commitments as of January 28, 2012.

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

The Company had commitments approximating $10.7 million at January 28, 2012 and $10.5 million at January 29, 2011 on
issued letters of credit, which support purchase orders for merchandise. Additionally, the Company had outstanding standby letters of
credit aggregating approximately $11.2 million at January 28, 2012 and $11.0 million at January 29, 2011 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

Atlantic Retail Investors, LLC, which is partially owned by Michael J. Hayes, a director of the Company, owned the land and
buildings occupied by thirteen Fred’s stores, until March 2011 when, as described below, a portion of these properties were purchased
by the Company. The terms and conditions regarding the leases on these locations were consistent in all material respects with other
stores leases of the Company with unrelated landlords.

On March 30, 2011, Fred’s selected and purchased ten of the thirteen properties leased from Atlantic Retail Investors, LLC, one of
which has an adjacent parcel and building that is leased to an unrelated party for a total of eleven properties, for $7.5 million in cash
and assumed mortgage debt of $3.5 million. The Board of Directors approved these transactions after receiving an evaluation by an
independent real estate broker, who concluded that all were acquired at comparable, and favorable, purchase prices to market value and
were financially beneficial to Fred’s as the depreciation expense for the newly acquired assets will be less than the future value of the lease
payments that would have been due.

Freds AR 11 Fin:Freds AR 2007 fin-final 6/26/12 2:30 PM Page 17

MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

1 7

In May 2011 after approximately 18 months of negotiation, Atlantic Retail Investors, LLC purchased the land and building of four
additional properties that the Company had previously evaluated multiple times and eventually passed for purchase. These stores were
subsequently purchased by Atlantic Retail Investors, LLC, from a lender who had foreclosed on the independent landlord/developer at
terms and conditions favorable to those earlier evaluated by the Company. Upon closing, Atlantic Retail Investors, LLC informed the
Company of the purchase and offered them at substantially the same terms. The terms and conditions regarding the leases on these
locations were consistent or better, in all material respects with other stores leases of the Company with unrelated landlords.

In June 2011, Fred’s purchased these four properties together with an adjacent parcel and building at an existing owned location for
a total consideration of $2.4 million in cash. No mortgage debt was assumed in this transaction. The Board of Directors approved these
transactions based on the financial terms that were more favorable to market value and financially beneficial to Fred’s as a result of the
depreciation expense on the newly acquired assets being less than the future value of lease payments that would have been due.

As of January 28, 2012, Fred’s is leasing three properties from Atlantic Retail Investors, LLC. The total rental payments for related
party leases were $451.2 thousand for the year ended January 28, 2012 and $1.3 million for the years ended January 29, 2011 and
January 30, 2010, respectively.

RECENT ACCOUNTING PRONOUNCEMENTS

In May 2011, the Financial Accounting Standards Board issued Accounting Standards Update (“ASU”) 2011-04, Fair Value
Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U. S. GAAP
and IFRSs, which amends the current fair value measurement and disclosure guidance to include increased transparency around valuation
inputs and investment categorization. This guidance will be effective beginning in fiscal 2012. The adoption of ASU 2011-04 is not
expected to have a material impact on the Company’s consolidated net earnings, cash flows or financial position.

In June 2011, the FASB issued ASI 2011-05, Comprehensive Income (Topic 22): Presentation of Comprehensive Income, which
revises the current practice of including other comprehensive income within the equity section of the statement of financial position and
requires disclosure of other comprehensive income either in a single continuous statement of comprehensive income or in a separate
statement. This guidance will be effective beginning in fiscal 2012. The adoption of ASU 2011-05 is not expected to have an impact on
the Company’s consolidated net earnings, cash flows or financial position, but the adoption will change the current presentation of other
comprehensive income in the Company’s consolidated financial statements.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company has no holdings of derivative financial or commodity instruments as of January 28, 2012. The Company is exposed
to financial market risks, including changes in interest rates. All borrowings under the Company’s Revolving Credit Agreement bear
interest on a sliding scale from 1.00% - 1.625% plus LIBOR. An increase in interest rates of 100 basis points would not significantly
affect the Company’s income. All of the Company’s business is transacted in U.S. dollars and, accordingly, foreign exchange rate
fluctuations have never had a significant impact on the Company, and they are not expected to in the foreseeable future.

Freds AR 11 Fin:Freds AR 2007 fin-final 6/26/12 2:30 PM Page 18

CONSOLIDATED STATEMENTS OF
INCOME AND COMPREHENSIVE INCOME

1 8

(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 28,
2012
$ 1,879,059
1,340,519
538,540

For the Years Ended
January 29,
2011
1,841,755
1,314,737
527,018

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

34,190
453,195
51,155

(156)
553
50,758

17,330
33,428

0.88
0.87

38,176
92
38,268

33,428

(8)
33,420

$
$

29,236
451,064
46,718

(234)
424
46,528

16,941
29,587

0.76
0.75

39,133
63
39,196

29,587

(32)
29,555

$
$

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

See accompanying notes to condensed consolidated financial statements.

Freds AR 11 Fin:Freds AR 2007 fin-final 6/26/12 2:30 PM Page 19

1 9

CONSOLIDATED
BALANCE SHEETS

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

Cash and cash equivalents
Receivables, less allowance for doubtful accounts of $1,595 and $1,218, respectively
Inventories
Other non-trade receivables
Prepaid expenses and other current assets

Total current assets

Property and equipment, less accumulated depreciation
Equipment under capital leases, less accumulated amortization of

$5,043 and $4,967, respectively

Intangible assets, net
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

Total current liabilities

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

Total liabilities

Commitments and contingencies (see Note 3 Indebtedness)
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,
37,203,794 and 39,300,872 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 28,
2012

January 29,
2011

27,130
31,883
331,882
32,090
12,321
435,306
161,112

97
32,191
3,276
631,982

106,886
658
44,876
23,878
176,298
6,640
5,633
19,799
208,370

49,182
28,146
313,384
26,378
12,723
429,813
139,931

–
22,193
3,591
595,528

81,002
201
45,371
21,142
147,716
3,969
2,069
17,886
171,640

–

105,384

131,367

–
317,364
864
423,612
631,982

–
291,649
872
423,888
595,528

See accompanying notes to condensed consolidated financial statements.

Freds AR 11 Fin:Freds AR 2007 fin-final 6/26/12 2:30 PM Page 20

CONSOLIDATED STATEMENTS OF
CHANGES IN SHAREHOLDERS’ EQUITY

(In thousands, except share and per share amounts)
Balance, January 31, 2009
Cash dividends paid ($.11per share)
Restricted stock grants, cancellations and withholdings, net
Issuance of shares under employee stock purchase plan
Repurchased and cancelled shares
Stock-based compensation
Exercises of stock options
Income tax benefit on exercise of stock options
Adjustment for postretirement benefits (net of tax)
Net income
Balance, January 30, 2010
Cash dividends paid ($.16 per 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 29, 2011
Cash dividends paid ($.20 per 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 28, 2012

Accumulated
Other

Retained Comprehensive
Earnings
249,141
(4,406)

Income
1,063

(159)

904

(32)

872

23,615
268,350
(6,288)

29,587
291,649
(7,713)

Common Stock

Shares
40,028,484

Amount
136,877

16,691
60,350
(742,663)

600

(142)
542
(7,152)
1,595
8
(43)

39,363,462

131,685

156,510
63,680
(293,000)

10,220

113
552
(2,989)
1,886
130
(10)

39,300,872

131,367

280,156
52,526
(2,447,823)

18,063

(285)
571
(28,482)
2,075
165
(27)

37,203,794

$ 105,384

(8)

33,428
$ 317,364

864

Total
387,081
(4,406)
(142)
542
(7,152)
1,595
8
(43)
(159)
23,615
400,939
(6,288)
113
552
(2,989)
1,886
130
(10)
(32)
29,587
423,888
(7,713)
(285)
571
(28,482)
2,075
165
(27)
(8)
33,428
$ 423,612

See accompanying notes to condensed consolidated financial statements.

Freds AR 11 Fin:Freds AR 2007 fin-final 6/26/12 2:31 PM Page 21

CONSOLIDATED STATEMENTS OF
CASH FLOWS

2 1

(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 loss on asset disposition
Provision for store closures and asset impairment
Stock-based compensation
Provision for uncollectible receivables
LIFO reserve increase
Deferred income tax expense (benefit)
Income tax benefit upon exercise of stock options
Provision for postretirement medical
(Increase) decrease in operating assets:
Trade and non-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 acquisitions, net (primarily intangibles)

Net cash used in investing activities

Cash flows from financing activities:

Payments of indebtedness and capital lease obligations
Excess tax benefit from stock-based compensation
Proceeds from exercise of stock options and employee stock purchase plan
Repurchase of shares
Cash dividends paid

Net cash used in financing activities

Increase (decrease) 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
Restricted stock issued for the aquistion of intangible assets

$
$

See accompanying notes to condensed consolidated financial statements.

January 28,
2012

For the Years Ended
January 29,
2011

January 30,
2010

33,428

29,587

23,615

34,190
474
112
2,075
377
2,792
6,462
27
(85)

(8,313)
205
(21,402)
607

25,534
(1,719)
1,801
76,565

(45,681)
119
–
(16,770)
(62,332)

(514)
(27)
451
(28,482)
(7,713)
(36,285)

(22,052)

49,182
27,130

397
13,126

3,497
135

$
$

29,236
741
340
1,886
455
2,406
1,898
10
(97)

(6,199)
1,390
(22,106)
(1,330)

(641)
3,813
668
42,057

(27,013)
168
98
(11,451)
(38,198)

(727)
(10)
595
(2,989)
(6,288)
(9,419)

(5,560)

54,742
49,182

190
7,145

–
200

$
$

26,387
356
-
1,595
(121)
2,411
5,932
43
(74)

(1,812)
(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

–
–

Freds AR 11 Fin:Freds AR 2007 fin-final 6/26/12 2:31 PM Page 22

NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS

2 2

NOTE 1 – DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Description of business. The primary business of Fred's, Inc. and subsidiaries is the sale of general merchandise through its retail
discount stores and full service pharmacies. In addition, the Company sells general merchandise to its 21 franchisees. As of January 28,
2012, the Company had 700 retail stores and 325 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
2011, 2010 and 2009, as used herein, refer to the years ended January 28, 2012, January 29, 2011 and January 30, 2010, respectively.
The fiscal years 2011, 2010 and 2009 each had 52 weeks.

Use of estimates. The preparation of financial statements in accordance with U.S. GAAP 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 its 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 method for goods in
our stores and the cost first-in, first-out 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. 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 under the retail inventory method is based on estimates such as markups,
markdowns and inventory losses, 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 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 has in the determination of the cost value of inventory.

Freds AR 11 Fin:Freds AR 2007 fin-final 6/26/12 2:31 PM Page 23

NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS

2 3

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 $40.4 million
and $32.5 million at January 28, 2012 and January 29, 2011, respectively, cost was determined using the retail LIFO 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 $26.8 million at January 28, 2012 and $24.0 million at January 29, 2011. The LIFO reserve increased by approximately
$2.8 million during 2011 and $2.4 million during 2010 and 2009, respectively.

The Company did not record any below-cost inventory adjustments during the years ended January 28, 2012, January 29, 2011 and

January 30, 2010 in connection with planned store closures (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 - 10 years
9 years

Freds AR 11 Fin:Freds AR 2007 fin-final 6/26/12 2:31 PM Page 24

NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS

2 4

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 $1.0 million and $1.0 million at January 28, 2012
and January 29, 2011 respectively, and is included in “Accrued expenses and other” in the consolidated balance sheet (See Note 2 - Detail
of Certain Balance Sheet Accounts).

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
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 property and equipment as well as
purchased intangible assets subject to amortization 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 using a discounted cash
flow model.

Impairment of $0.2 million for the planned store closures was recorded in 2009 with no impairments recognized in 2010 or 2011.
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.

Freds AR 11 Fin:Freds AR 2007 fin-final 6/26/12 2:31 PM Page 25

NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS

2 5

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 2011, 2010
and 2009, were $21.9 million, $24.5 million and $24.0 million, respectively. Gross advertising expenses were reduced by vendor
cooperative advertising allowances of $2.4 million, $2.4 million and $2.6 million, for 2011, 2010 and 2009, 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.

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 679 Company owned stores and 21 franchised stores as of
January 28, 2012. 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.

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. 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.

Intangible assets. Other identifiable intangible 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 $32.1 million at January
28, 2012, and $22.2 million at January 29, 2011. Accumulated amortization at January 28, 2012 and January 29, 2011 totaled $31.7
million and $24.8 million, respectively. Amortization expense for 2011, 2010 and 2009, was $6.9 million, $5.5 million and $3.7 million,
respectively. Estimated amortization expense in millions for each of the next 5 years is as follows: 2012 - $8.7 million, 2013 - $8.1
million, 2014 - $6.7 million, 2015 - $4.6 million and 2016 - $2.4 million.

Financial instruments. At January 28, 2012, 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’s insurance policy coverage runs August 1 through July 31
of each fiscal year. On August 1, 2011, the Company increased its stop loss limits for excessive or catastrophic claims for general liability

Freds AR 11 Fin:Freds AR 2007 fin-final 6/26/12 2:31 PM Page 26

NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS

2 6

to $350,000 from $250,000 and for employee medical to $175,000 from $150,000. The stop loss limit for worker’s compensation
remained unchanged at $500,000. The Company’s insurance reserve was $10.3 million at January 28, 2012 and January 29, 2011,
respectively. Changes in the reserve over that time period were attributable to additional reserve requirements of $49.0 million netted
with payments of $49.0 million.

Stock-based compensation. The Company uses 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.

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 tax assets and liabilities are measured using enacted tax rates expected
to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on
deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. 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
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 shareholders’ 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 2011 presentation.

Freds AR 11 Fin:Freds AR 2007 fin-final 6/26/12 2:31 PM Page 27

NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS

2 7

Recent Accounting Pronouncements. In May 2011, the Financial Accounting Standards Board issued Accounting Standards
Update (“ASU”) 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and
Disclosure Requirements in U. S. GAAP and IFRSs, which amends the current fair value measurement and disclosure guidance to
include increased transparency around valuation inputs and investment categorization. This guidance will be effective beginning in fiscal
2012. The adoption of ASU 2011-04 is not expected to have a material impact on the Company’s consolidated net earnings, cash flows
or financial position.

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

January 28,
2012

January 29,
2011

112,321 $
70,509
5,348
4,697
250,241
443,116
(289,884)
153,232
23
7,857
161,112 $

96,923
62,504
5,198
4,697
234,710
404,032
(271,129)
132,903
198
6,830
139,931

Depreciation expense totaled $27.3 million, $23.7 million and $22.7 million for 2011, 2010 and 2009, respectively.

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

Total non trade receivable

January 28,
2012

January 29,
2011

22,316 $
4,844
950
474
201
3,305
32,090 $

19,384
3,124
1,069
512
26
2,263
26,378

Freds AR 11 Fin:Freds AR 2007 fin-final 6/26/12 2:31 PM Page 28

2 8

NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS

(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
Real estate tax
Personal property tax
Warehouse freight and fuel
Lease liability
Other

Total accrued expenses and other

(In thousands)
Other noncurrent liabilities:
Deferred income (see Note 1 - Vendor Rebates and Allowances)
Uncertain tax positions
Other

January 28,
2012

January 29,
2011

4,288 $
4,344
1,842
413
1,434
12,321 $

4,161
4,266
1,274
1,425
1,597
12,723

January 28,
2012

January 29,
2011

13,561 $
10,291
5,287
3,599
1,612
1,177
564
478
8,307
44,876 $

14,281
10,252
5,323
2,152
1,904
1,118
1,939
1,473
6,929
45,371

January 28,
2012

January 29,
2011

10,209 $
9,590
–
19,799 $

8,110
9,285
491
17,886

NOTE 3 – INDEBTEDNESS

Freds AR 11 Fin:Freds AR 2007 fin-final 6/26/12 2:31 PM Page 29

NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS

2 9

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%. On March 30, 2011, Fred’s purchased ten properties leased from Atlantic Retail Investors, LLC, one of which has an additional
parcel that is leased to an unrelated party, for $7.5 million in cash and assumed mortgage debt of $3.5 million on 6 of these locations
(see Note 5 – Long-Term Leases) with fixed interest rates from 6.65% 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 28, 2012:

(Dollars in thousands)
Mortgage loans on land & buildings

2012

676

2013
$ 1,307

2014
$ 2,076

2015

2016

998

Thereafter
$ 2,195

Total

7,320

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 for the years ended:

(Dollars in thousands)
Current

Federal
State

Deferred
Federal
State

2011

2010

2009

9,953
915
10,868

6,886
(424)
6,462
17,330

13,808 $
1,235
15,043

7,782
872
8,654

2,070
(172)
1,898
16,941 $

4,985
947
5,932
14,586

Freds AR 11 Fin:Freds AR 2007 fin-final 6/26/12 2:31 PM Page 30

NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS

3 0

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

income tax liabilities as of year-end are presented below:

(Dollars in thousands)
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
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

2011

2010

111 $
794
2,802
186
6,722
374
693
3,176
8,489
23,347
2,849
20,498

1,592
638
2,985
415
6,096
293
785
3,044
7,020
22,868
2,441
20,427

(21,945)
(26,972)
(1,091)
(50,008)

(16,700)
(25,027)
(1,911)
(43,638)

(29,510) $

(23,211)

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

approximately $156.6 million for state income tax purposes and expire at various times during the fiscal years 2012 through 2031.

We maintain a valuation allowance for state net operating losses that we do not expect to utilize prior to their expiration. During
2011, the valuation allowance increased $.4 million, and during 2010, the valuation allowance increased $.3 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 state valuation allowance
Other

Effective income tax rate

2011
35.0%
(2.3)
(0.2)
0.5
0.3
0.8
–

34.1%

2010
35.0%
(1.0)
0.8
0.8
0.1
0.7
–
36.4%

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

Freds AR 11 Fin:Freds AR 2007 fin-final 6/26/12 2:31 PM Page 31

NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS

3 1

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

2011

2010

9.3
1.1
0.3
(1.1)
–
9.6

9.2
0.9
0.3
(1.1)
–
9.3

2009
$

16.5
1.0
1.0
(0.7)
(8.6)
9.2

As of January 29, 2011, our liability for unrecognized tax benefits totaled $9.3 million, of which $0.5 million and $0.6 million were
recognized as income tax benefit during the periods ending October 29, 2011 and January 28, 2012, respectively, as a result of a lapse
in applicable statute of limitations. We had additions of $1.4 million during fiscal 2011, $1.1 million of which resulted from state tax
positions during the current year. As of January 28, 2012, our liability for unrecognized tax benefits totaled $9.6 million and is recorded
in our consolidated balance sheet within “Other noncurrent liabilities,” all of which, if recognized, would affect our effective tax rate.
Examinations by the state jurisdictions are expected to be completed within the next 12 months which could result in a change to our
unrecognized tax benefits.

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 28, 2012, accrued interest and penalties related to our
unrecognized tax benefits totaled $1.2 million and $0.02 million, respectively. As of January 29, 2011, accrued interest and penalties
related to our unrecognized tax benefits totaled $1.3 million and $0.3 million, respectively. Both accrued interest and penalties are
recorded in the consolidated balance sheet within “Other noncurrent 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 2007-2009. 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.

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 fiscal 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 under noncancelable operating leases. Total rent expense under operating leases was $53.2 million, $53.4
million and $53.2 million, for 2011, 2010 and 2009, respectively. Total contingent rentals included in operating leases above was $1.0
million for 2011, $1.0 million for 2010 and $1.1 million for 2009. Future minimum rental payments under all operating leases as of
January 28, 2012 are as follows:

(In thousands)
2012
2013
2014
2015
2016
Thereafter

Total minimum lease payments

Operating
Leases

49,082
36,886
27,334
21,527
15,619
44,102
$ 194,550

Freds AR 11 Fin:Freds AR 2007 fin-final 6/26/12 2:31 PM Page 32

NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS

3 2

The gross amount of property and equipment under capital leases was $5.1 million at January 28, 2012 and $5.0 million at January
29, 2011. Accumulated amortization on property and equipment under capital leases was $5.0 million at January 28, 2012 and January
29, 2011, respectively. We did not incur any amortization expense on assets under capital lease for 2010 as the assets were fully
amortized. Amortization expense on assets under capital lease for 2011 was $76 thousand.

Related Party Transactions. Atlantic Retail Investors, LLC, which is partially owned by Michael J. Hayes, a director of the
Company, owned the land and buildings occupied by thirteen Fred’s stores, until March 2011 when, as described below, a portion of
these properties were purchased by the Company. The terms and conditions regarding the leases on these locations were consistent in all
material respects with other stores leases of the Company with unrelated landlords.

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.

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

Freds AR 11 Fin:Freds AR 2007 fin-final 6/26/12 2:31 PM Page 33

NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS

3 3

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 28, 2012 (amounts in thousands, except price data). The repurchased shares have been cancelled
and returned to authorized but un-issued shares.

Total Number of Shares Maximum Number

Total Number of
Shares Purchased

Average Price
Paid Per Share

Purchased as Part of
Publicly Announced
Plans or Program

Balance at January 29, 2011

January 30 - February 26, 2011
February 27 - April 2, 2011
April 3, - April 30, 2011
May 1, - May 28, 2011
May 29, - July 2, 2011
July 3, - July 30, 2011
July 31, - August 27, 2011
August 28, - October 1, 2011
October 2, - October 29, 2011
October 30, - November 26, 2011
November 27, - December 31, 2011
January 1, - January 28, 2012

–
2.0
–
–
256.5
161.5
473.4
1,331.7
222.7
–
–
–

$
$
$
$
$
$
$
$
$
$
$
$

–
12.50
–
–
13.97
13.84
11.00
11.21
11.04
–
–
–

–
2.0
–
–
256.5
161.5
473.4
1,331.7
222.7
–
–
–

of Shares That May Yet
Be Purchased Under
the Plans or Program
2,537.8
2,537.8
2,535.8
2,535.8
2,535.8
2,279.3
2,117.8
1,644.4
312.7
90.0
90.0
90.0
90.0

On February 16, 2012, Fred's Board authorized the expansion of the Company's existing stock re-purchase program by increasing

the authorization to repurchase an additional 3.6 million shares or approximately 10% of the current outstanding shares.

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 1,200,159 shares as of January 28, 2012 (1,446,199 shares as of January 29, 2011) are available to be granted. These
options expire five years to seven from the date of grant. Options outstanding at January 28, 2012 expire in fiscal 2012 through fiscal
2019.

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.

Freds AR 11 Fin:Freds AR 2007 fin-final 6/26/12 2:31 PM Page 34

NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS

3 4

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 52,526, 63,680 and
60,350 shares issued during fiscal years 2011, 2010 and 2009, respectively. There are 1,410,928 shares approved to be issued under the
2004 Plan and as of January 28, 2012 there were 974,307 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

2011

455
1,446
174
2,075
573

$
$

2010

552
1,173
161
1,886
509

$
$

2009

789
573
233
$ 1,595
364
$

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

2011
41.2%
1.8%
5.13
0.9%
4.35

27.6%
0.3%
0.63
0.9%
3.32

2010
42.1%
2.9%
5.84
0.7%
5.18

32.3%
0.6%
0.63
0.6%
2.53

2009
42.5%
2.6%
5.84
0.6%
4.66

73.2%
0.1%
0.63
0.4%
3.85

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.

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NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS

3 5

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.
Stock Options. The following table summarizes stock option activity from January 31, 2009 through January 28, 2012:

Outstanding at January 31, 2009

Granted
Forfeited / Cancelled
Exercised

Outstanding at January 30, 2010

Granted
Forfeited / Cancelled
Exercised

Outstanding at January 29, 2011

Granted
Forfeited / Cancelled
Exercised

Outstanding at January 28, 2012
Exercisable at January 28, 2012

Weighted
Average
Exercise
Price
$ 15.13
11.26
15.06
13.25
$ 13.91
12.55
17.98
12.69
$ 12.15
11.96
14.39
12.12
$ 11.52
$ 11.68

Weighted
Average
Contractual
Life (Years)
3.9

Aggregate
Intrinsic
Value
(Thousands)
11

3.1

3.2

1,524

3.0
2.3

$ 2,831
$ 1,752

Options
1,138,111
404,891
(281,072)
(600)
1,261,330
51,352
(384,000)
(10,220)
918,462
113,821
(218,844)
(18,063)
795,376
514,457

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 28, 2012, total unrecognized stock-based compensation expense net of
estimated forfeitures related to non-vested stock options was approximately $.45 million, which is expected to be recognized over a
weighted average period of approximately 3.2 years.

Other information relative to option activity during 2011, 2010 and 2009 is as follows:

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

2011

642
42

$
$

2010

792
11

$
$

2009
$ 1,249
–
$

Freds AR 11 Fin:Freds AR 2007 fin-final 6/26/12 2:31 PM Page 36

NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS

3 6

The following table summarizes information about stock options outstanding at January 28, 2012:

Range of
Exercise Prices
$ 8.66 - $13.00
$13.02 - $14.02
$14.03 - $17.35

Options Outstanding
Weighted
Average
Contractual
Life (Years)
3.4
2.3
2.4

Weighted
Average
Exercise
Price
$ 10.44
$ 13.28
$ 14.58

Options Exercisable

Weighted
Average
Exercise
Price
$ 10.54
$ 13.27
$ 14.80

Shares
316,797
167,840
29,820
514,457

Shares
514,317
234,957
46,102
795,376

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. If certain performance metrics
are met, vesting may be accelerated and is recognized once achievement of the performance metric is considered probable.

The following table summarizes restricted stock from January 31, 2009 through January 28, 2012:

Non-vested Restricted Stock at January 31, 2009

Granted
Forfeited / Cancelled
Exercised

Non-vested Restricted Stock at January 30, 2010

Granted
Forfeited / Cancelled
Exercised

Non-vested Restricted Stock at January 29, 2011

Granted
Forfeited / Cancelled
Exercised

Non-vested Restricted Stock at January 28, 2012

Weighted
Average
Grant Date
Fair Value
$ 12.39
12.38
13.88
14.90
$12.01
13.44
11.09
11.57
$ 12.55
3.84
9.02
12.17
7.74

Options
352,784
58,993
(29,909)
(35,358)
346,510
168,736
(22,208)
(20,111)
472,927
396,830
(91,375)
(66,782)
711,600

The aggregate pre-tax intrinsic value of restricted stock outstanding as of January 28, 2012 is $10.7 million with a weighted average
remaining contractual life of 5.1 years. The unrecognized compensation expense net of estimated forfeitures, related to the outstanding
restricted stock is approximately $4.4 million, which is expected to be recognized over a weighted average period of approximately 6.4
years. The total fair value of restricted stock awards that vested for the years ended January 28, 2012, January 29, 2011 and January 30,
2010 was $0.9 million, $0.2 million and $0.5 million, respectively.

There were no significant modifications to the Company’s share-based compensation plans during fiscal 2011, 2010 or 2009.

Freds AR 11 Fin:Freds AR 2007 fin-final 6/26/12 2:31 PM Page 37

3 7

NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS

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 2,500, 222,552 and 1,088,845 such options outstanding at January 28, 2012, January 29, 2011 and January 30,
2010.

NOTE 9 – COMMITMENTS AND CONTINGENCIES

Commitments. The Company had commitments approximating $10.7 million at January 28, 2012 and $10.5 million at January
29, 2011 on issued letters of credit, which support purchase orders for merchandise. Additionally, the Company had outstanding letters
of credit aggregating approximately $11.2 million at January 28, 2012 and $11.0 million at January 29, 2011 utilized as collateral for
its risk management programs.

Salary reduction profit sharing plan. The Company has 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
plans up to 60% of their compensation or a maximum of $17,000. 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 2011, 2010 and 2009, were
$0.2 million, $0.2 million and $0.4 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–underfunded 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. The measurement date for the plan in January 31.

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

Benefit obligation at end of year

January 28,
2012

January 29,
2011

January 30,
2010

492
25
20
(33)
(32)
472

542 $
18
25
(54)
(39)
492 $

396
33
30
111
(28)
542

Freds AR 11 Fin:Freds AR 2007 fin-final 6/26/12 2:31 PM Page 38

NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS

3 8

The Company’s components of net accumulated other comprehensive income were as follows:

(In thousands)
Accumulated other comprehensive income
Deferred tax
Accumulated other comprehensive income, net

January 28,
2012

January 29,
2011

January 30,
2010

1,306
(442)
864

1,372 $
(500)
872 $

1,418
(514)
904

The medical care cost trend used in determining this obligation is 7.5% at January 28, 2012, 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

The discount rate used in calculating the obligation was 3.9% in 2011 and 4.8% in 2010.
The annual net postretirement cost is as follows:

For the Year Ended

January 28,
2012

January 29,
2011

40 $
5
(36)
(5)

39
4
(35)
(4)

(In thousands)
Service cost
Interest cost
Amortization of prior service cost
Amortization of unrecognized prior service costs
Net periodic postretirement benefit cost

January 28,
2012

For the Year Ended
January 29,
2011

January 30,
2010

25
20
(13)
(85)
(53) $

18 $
25
(14)
(87)
(58) $

33
30
(14)
(94)
(45)

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

2012
2013
2014
2015
2016
Thereafter

Postretirement
Medical Plan

35
38
40
36
37
209

Freds AR 11 Fin:Freds AR 2007 fin-final 6/26/12 2:31 PM Page 39

NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS

3 9

Litigation. In December 2008, a lawsuit entitled Whiteaker, et al v. FRED’S Stores of Tennessee, Inc., et al, was filed in the United
States District Court in the Northern District of Mississippi, in which the plaintiffs allege past and future damages as a result of a 2006
trip and fall accident at a Fred’s store. The Company denied liability and vigorously defended the case on its merits. In accordance with
FASB ASC 450, “Contingencies”, management concluded a loss in the matter was not probable or could not be reasonably estimated.
However, on November 17, 2010, a jury rendered a $1.1 million verdict and apportioned the Company with 81% fault. This case is
covered by the Company’s General Liability insurance, which has a $250,000 deductible. On or about February 4, 2011, the trial judge
set aside a verdict amount as being excessive but left in effect the percentage of fault and ordered a new trial on damages only. On or
about June 20, 2011, the Company, through its insurance carrier, verbally agreed to settle the lawsuit for $700,000, which was paid in
the second quarter of 2011. As a result, on or about July 28, 2011, the Court issued a judgment of dismissal with prejudice.

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 seeks 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 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 remote 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 – “Description of Business and Summary of
Significant Accounting Policies” for a brief description of the Company’s business. As of January 28, 2012, 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
Health and Beauty Aids
Apparel and Linens
Sales to Franchised Fred's Stores
Total Sales Mix

January 28,
2012
34.9%
23.3%
16.8%
8.7%
7.4%
6.9%
2.0%
100.0%

For the Year Ended
January 29,
2011
34.1%
24.1%
16.2%
8.6%
7.4%
7.6%
2.0%
100.0%

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

Freds AR 11 Fin:Freds AR 2007 fin-final 6/26/12 2:31 PM Page 40

4 0

NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS

Note 11 – Exit and Disposal Activity

Lease Termination
Lease obligations still exist for some store closures that occurred in 2008. We record the estimated future liability associated with the
rental obligation on the cease use date (when the stores were closed). The lease obligations 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, “Exit or Disposal Cost Obligations”. Key assumptions in calculating the liability
include the timeframe expected to terminate lease agreements, estimates related to the sublease potential of closed locations, and estimates
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 2011, we reserved an additional $0.1 million in rent expense related to the revision of the estimated amount of
the remaining lease liability for the fiscal 2008 store closures. We also utilized $0.5 million, leaving $0.3 million in the reserve at
January 28, 2012.

The following table illustrates the exit and disposal activity related to the store closures discussed in the previous paragraphs (in millions):

(In millions)
Lease contract termination liability

Beginning
Balance
January 29, 2011

0.7

Additions
FY11
0.1

Utilized
FY11

(0.5)

Ending
Balance
January 28, 2012

0.3

NOTE 12 – QUARTERLY FINANCIAL DATA (UNAUDITED)

The Company’s unaudited quarterly financial information for the fiscal years ended January 28, 2012 and January 29, 2011 is

reported below:

(In thousands, except per share data)
Year ended January 28, 2012
Net sales
Gross profit
Net income

Net income per share

Basic
Diluted

Cash dividends paid per share

Year ended January 29, 2011
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

$ 484,399
137,942
9,514

$ 452,690
126,931
5,086

$ 444,378
135,966
9,032

$ 497,592
137,701
9,796

$
$
$

0.24
0.24
0.05

471,647
136,949
8,191

0.21
0.21
0.04

$
$
$

0.13
0.13
0.05

449,467
125,936
4,958

0.13
0.13
0.04

$
$
$

0.24
0.24
0.05

$
$
$

0.27
0.26
0.05

435,008
129,747
7,818

$ 485,633
134,386
8,620

0.20
0.20
0.04

$
$
$

0.22
0.22
0.04

Freds AR 11 Fin:Freds AR 2007 fin-final 6/26/12 2:31 PM Page 41

4 1

NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS

Board of Directors and Shareholders
Fred’s, Inc.
Memphis, Tennessee

We have audited the accompanying consolidated balance sheets of FRED’s, Inc. (the “Company”) as of January 28, 2012 and
January 29, 2011 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 28, 2012. 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 28, 2012 and January 29, 2011, and the results of its operations and its cash flows for each of the three years in
the period ended January 28, 2012, in conformity with accounting principles generally accepted in the United States of America.

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 28, 2012, 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 12, 2012 expressed an unqualified opinion thereon.

Memphis, Tennessee
April 12, 2012

Freds AR 11 Fin:Freds AR 2007 fin-final 6/26/12 2:31 PM Page 42

MANAGEMENT’S ANNUAL REPORT ON
INTERNAL CONTROL OVER FINANCIAL REPORTING

4 2

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 Exchange Act. 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 28,
2012. 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 28, 2012.

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

is included in this Form 10-K.

Freds AR 11 Fin:Freds AR 2007 fin-final 6/26/12 2:31 PM Page 43

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
ON INTERNAL CONTROL OVER FINANCIAL REPORTING

4 3

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 28, 2012, 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,
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, Fred’s, Inc. maintained, in all material respects, effective internal control over financial reporting as of January 28,

2012, 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 28, 2012 and January 29, 2011, 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
28, 2012 and our report dated April 12, 2012 expressed an unqualified opinion thereon.

Memphis, Tennessee
April 12, 2012

Freds AR 11 Fin:Freds AR 2007 fin-final 6/26/12 2:31 PM Page 44

DIRECTORS
AND OFFICERS

4 4

BOARD OF DIRECTORS

EXECUTIVE OFFICERS

Michael J. Hayes
Chairman

Bruce A. Efird
President and Chief Executive Officer

Jerry A. Shore
Executive Vice President, Chief Financial Officer and
Chief Administrative Officer

Rick A. Chambers
Executive Vice President – Pharmacy Operations

Alan C. Crockett
Executive Vice President – General Merchandise Manager

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

Kirby M. Salgado
Executive Vice President – General Merchandise Manager

Ricky W. Pruitt
Executive Vice President – Store Operations

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

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
Senior 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 11 AR_PROD IFCs_4pg:Freds 07_final 6/26/12 2:30 PM 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 USA, 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 28,
2012, as filed with the Securities and Exchange Commission,
without charge upon written request to Jerry A. Shore,
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 the "SEC Filings"
link under the "Investor Relations" section of our website.

ANNUAL MEETING OF SHAREHOLDERS
The 2012 annual meeting of shareholders will be held at
5:00 p.m. Eastern Daylight Time on Wednesday, June 19,
2012, at the Holiday Inn Express, 2192 S. Highway 441,
Dublin, Georgia. Shareholders of record as of April 20,
2012, 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 20, 2012, the Company had an
estimated 18,000 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.

Fiscal 2011
Fourth
Third
Second
First

Fiscal 2010
Fourth
Third
Second
First

High

Low

Dividends
Per Share

$ 15.26
$ 13.52
$ 14.74
$ 14.30

$ 14.40
$ 12.98
$ 14.30
$ 14.39

$ 11.54
$ 10.27
$ 13.10
$ 12.02

$ 11.70
$ 10.36
$ 10.16
9.07
$

$ 0.05
$ 0.05
$ 0.05
$ 0.05

$
$
$
$

0.04
0.04
0.04
0.04

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 on February 3, 2007, and $100 was invested in the
NASDAQ Retail Trade Stocks Index and the NASDAQ
Stock Market (U.S.) Index on January 31, 2007, 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

$200 –

$180 –

$160 –

$140 –

$120 –

$100 –

$80 –

$60 –

$40 –

$20 –

$0 –

2/3/07

2/2/08

1/3/09

1/31/10

1/29/11

1/28/12

FRED’S Inc.

NASDAQ Composite

NASDAQ Retail Trade

4300 New Getwell Road
Memphis, TN 38118