F R E D ’ S I N C . 2 0 1 5 A N N U A L R E P O R T
Company Profile
Founded in 1947, Fred’s, Inc. and subsidiaries operate 659 discount general merchandise
stores and three specialty pharmacy-only locations in 15 states in the southeastern United
States. Included in the store count are 18 franchised locations. Also, there are 372 full
service pharmacy departments located within Fred’s stores, including five franchised
locations. 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 30, 2016)
5
1
16
89
138
87
104
7
66
68
18
37
7
2
14
Core Markets
s
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the Fiscal Year Ended January 30, 2016
Or
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
Commission File Number 001-14565
FRED’S, INC.
(Exact Name of Registrant as Specified in its Charter)
TENNESSEE
(State or Other Jurisdiction of
Incorporation or Organization)
62-0634010
(I.R.S. Employer
Identification Number)
4300 NEW GETWELL ROAD
MEMPHIS, TENNESSEE 38118
(Address of Principal Executive Offices)
Registrant’s telephone number, including area code (901) 365-8880
Securities Registered Pursuant to Section 12(b) of the Act:
Title of Class
Class A Common Stock, no par value
Share Purchase Rights
Name of exchange on which registered
The NASDAQ Global Select Market
Securities Registered Pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes No
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes No
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities
Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports),
and (2) has been subject to such filing requirements for the past 90 days. Yes No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every
Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the
preceding 12 months (of for such shorter period that the registrant was required to submit and post such files). Yes No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not
be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III
of this Form 10-K or any amendment to this Form 10-K
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller
reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2
of the Exchange Act. (Check one):
.
Large accelerated filer Accelerated filer
Non-accelerated filer
(Do not check if a smaller reporting company)
Smaller reporting company
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).
Yes No
Aggregate market value of the voting stock held by non-affiliates of the Registrant, based upon the last reported sale price on such
date by the NASDAQ Stock Market, Inc. on August 1, 2015 the last business day of the registrant’s most recently completed second
fiscal quarter, was approximately $478 million. Shares of voting stock held by executive officers, directors and holders of more than
10% of the outstanding voting shares have been excluded from this calculation because such persons may be deemed to be affiliates.
Exclusion of such shares should not be construed to indicate that any of such persons possess the power, direct or indirect, to control
the Registrant, or that such person is controlled by or under common control of the Registrant.
As of April 8, 2016, there were 37,233,632 shares outstanding of the Registrant’s Class A no par value voting common stock.
As of April 8, 2016, there were no shares outstanding of the Registrant’s Class B no par value non-voting common stock.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Company’s Proxy Statement for the 2016 annual stockholders meeting, to be filed within 120 days of the registrant’s
fiscal year end, are incorporated into Part III of this Annual Report on Form 10-K (the “Form 10-K) by reference. With the exception
of those portions that are specifically incorporated herein by reference, the aforesaid document is not to be deemed filed as part of this
Form 10-K.
FRED’S, INC.
FORM 10-K
TABLE OF CONTENTS
PART I
ITEM 1. — Business
ITEM 1A. — Risk Factors
ITEM 1B. — Unresolved Staff Comments
ITEM 2. — Properties
ITEM 3. — Legal Proceedings
ITEM 4. — Mine Safety Disclosures
PART II
ITEM 5. — Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
ITEM 6. — Selected Financial Data
ITEM 7. — Management’s Discussion and Analysis of Financial Condition and Results of Operations
ITEM 7A. — Quantitative and Qualitative Disclosures about Market Risk
ITEM 8. — Financial Statements and Supplementary Data
ITEM 9. — Changes In and Disagreements with Accountants on Accounting and Financial Disclosure
ITEM 9A. — Controls and Procedures
ITEM 9B. — Other Information
PART III
ITEM 10. — Directors, Executive Officers and Corporate Governance
ITEM 11. — Executive Compensation
ITEM 12. — Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
ITEM 13. — Certain Relationships and Related Transactions, and Director Independence
ITEM 14. — Principal Accountant Fees and Services
PART IV
ITEM 15. — Exhibits, Financial Statement Schedules
SIGNATURES
EXHIBIT INDEX
Exhibit 21.1
Exhibit 23.1
Exhibit 31.1
Exhibit 31.2
Exhibit 32
Page No.
4
11
15
15
16
17
17
19
20
33
34
61
61
63
63
65
65
65
65
66
70
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Cautionary Statement Regarding Forward-looking Information
Other than statements based on historical facts, many of the matters discussed in this Form 10-K relate to events which we expect or
anticipate may occur in the future. Such statements are defined as “forward-looking statements” under the Private Securities Litigation
Reform Act of 1995 (the “Reform Act”), 15 U.S.C.A. Sections 77z-2 and 78u-5 (Supp. 1996). The Reform Act created a safe harbor
to protect companies from securities law liability in connection with forward-looking statements. Fred's Inc. (“Fred's” or the
“Company”) intends to qualify both its written and oral forward-looking statements for protection under the Reform Act and any other
similar safe harbor provisions.
The words "outlook", "guidance", "may", "should", "could", “believe”, “anticipate”, “project”, “plan”, “expect”, “estimate”,
“objective”, “forecast”, “goal”, “intend”, “will likely result”, or “will continue” and similar expressions generally identify forward-
looking statements. All forward-looking statements are inherently uncertain, and concern matters that involve risks and other factors
that may cause the actual performance of the Company to differ materially from the performance expressed or implied by these
statements. Therefore, forward-looking statements should be evaluated in the context of these uncertainties and risks, including but
not limited to:
o Economic and weather conditions which affect buying patterns of our customers and supply chain efficiency;
o Changes in consumer spending and our ability to anticipate buying patterns and anticipate and implement appropriate
inventory strategies;
o Continued availability of capital and financing;
o Competitive factors, and the ability to recruit and retain employees;
o Changes in the merchandise supply chain;
o Changes in pharmaceutical inventory costs;
o Changes in reimbursement practices for pharmaceuticals;
o Governmental regulation;
o
o
o Cyber-security risks; and
o Other factors affecting business beyond our control, including (but not limited to) those discussed under Part I, Item 1A
Increases in insurance costs;
Increases in fuel and utility rates;
“Risk Factors” herein.
Consequently, all forward-looking statements are qualified by this cautionary statement. We undertake no obligation to update any
forward-looking statement to reflect events or circumstances arising after the date on which it was made.
- 3 -
ITEM 1: Business
General
PART I
Fred's, Inc. and its subsidiaries ("Fred's", “We”, “Our”, “Us” or “Company”) was founded in 1947 and operates 641 company-owned
stores, including 60 express stores (or “Xpress” stores), as of January 30, 2016 in fifteen states primarily in the southeastern United
States. In addition to the company-owned stores, there were 18 franchised stores operating under the Fred's name, four of which have
pharmacy departments. Fred's stores generally serve low, middle and fixed income families located in small- to medium-sized towns.
There were 372 full-service pharmacies, which are included in the company-owned and Xpress stores. Included in the pharmacy
counts are one retail pharmacy and two specialty pharmacy only locations we acquired on April 10, 2015 when we purchased 100% of
the equity interests in Reeves-Sain Drug Store, Inc. The Company is headquartered in Memphis, Tennessee.
Fred's stores stock over 12,000 items which address the everyday needs of its customers, including nationally recognized brand name
products, proprietary “Fred's” label products and lower priced off-brand products. Fred's management believes its customers shop
Fred's stores as a result of their convenient locations, consumer friendly sizes, consistent availability of products at everyday low
prices, pharmacy department and healthcare services, regularly advertised departmental promotions and seasonal specials. Fred's
company-owned, full-service stores had an average selling space of 14,802 square feet and had average sales of $3,033,000 in fiscal
2015.
The Company utilizes a 52 - 53 week accounting period which ends on the Saturday closest to January 31. Fiscal years 2015, 2014
and 2013, as used herein, refer to the years ended January 30, 2016, January 31, 2015 and February 1, 2014, respectively. Fiscal years
2015, 2014 and 2013 each had 52 weeks.
Business Strategy
The Company’s strategy is to meet the healthcare needs by improving the outcomes of the people in the small- to medium-sized towns
it serves by delivering solutions that are safe, affordable, innovative and easy to access, complimented by a broad assortment of valued
price and quality brands. The major elements of this strategy include:
Healthcare — Approximately 85% of our stores are located in markets with populations of 15,000 or less, where Fred’s provides often
the only, or one of only two, pharmacies in the town or county. We continue to evaluate additional opportunities where expansion
exists to further meet the needs of our customers. Along with prescription and over-the-counter pharmaceutical products, the
Company’s clinical services offerings include immunizations, medication therapy management, “Time My Meds” and disease
management services, with a special emphasis on diabetes management. In 2015, we opened the first telemedicine facility within a
full-service location, and additional openings are planned for 2016. Fred’s operates three specialty only locations commonly known as
EntrustRx, which are licensed in all 50 states. To further meet the needs of our customers and provide additional convenience, the
Company will continue to focus on leveraging our existing pharmaceutical sales with additional product offerings from our EntrustRx
facilities.
Value — The Company provides value and low prices to its customers (i.e., a good “price-to-value relationship”) through a
coordinated discount strategy and an “Everyday Low Pricing” program that focuses on strong values daily, while controlling the
Company’s reliance on promotional activities. As part of this strategy, Fred's maintains low opening price points and competitive
prices on key products across all departments and regularly offers seasonal specials and departmental promotions supported by direct
mail and newspaper advertising.
Convenience — Fred's stores are typically located in convenient shopping and/or residential areas. Approximately 58% of our
company-owned stores are freestanding as opposed to being located in strip shopping center sites. Freestanding sites allow for easier
access and shorter distances to the store entrance. Fred's full-service stores have a customer-centric assortment and easy checkouts.
Fred's combines everyday basic merchandise with certain specialty items to offer its customers a wide selection of over 12,000 general
merchandise items. The selection of merchandise is supplemented by seasonal specials, private label products, surprise and delight
items, and the inclusion of pharmacy departments in 372 of its stores.
Growth Strategy
We will continue to focus on increasing our pharmacy department penetration of our company-owned locations. To achieve this
desired pharmacy penetration, where economical, we will continue to concentrate on adding pharmacies to existing stores without
pharmacy departments, opening all new stores with a pharmacy department and making opportunistic acquisitions that will operate as
Xpress pharmacy locations until they become a future full-service location. These acquisitions provide an immediate sales benefit,
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and in many cases, the independent pharmacist becomes an employee of Fred's, thereby providing continuity in the pharmacist-patient
relationship.
The Company expects that store openings will occur primarily within its present geographic area and will be focused in small- to
medium-sized towns. The Company may also enter larger metropolitan and urban markets where it already has a market presence in
the surrounding area. As part of the Company’s continuing operations and based upon an analysis of store performance and expected
trends, we periodically evaluate the need to close underperforming stores.
Fred's opened eight full-service stores and Xpress locations, closed six locations, acquired one franchise location and converted three
locations to full-service stores during 2015. The Company also added 11 new pharmacies and closed 14 pharmacies. We opened the
majority of new stores in Tennessee and North Carolina. The Company’s store prototype normally has 14,000 to 16,000 square feet of
space and the typical size of an Xpress location ranges from 1,000 to 5,000 square feet. The Company prefers to use developers to
construct build-to-suit locations with leases beginning after completion. In certain cases, the Company leases second-generation
locations that may alter the size and layout of our typical build-to-suit store. Opening a new full-service store on average costs
between $550,000 and $700,000 for inventory, furniture, fixtures, equipment and leasehold improvements, while the average new
Xpress locations costs between $200,000 and $400,000.
Fred's “Xpress” Designation: The term “Xpress” refers to our locations that are smaller in square footage and offer pharmacy
services along with a scaled-down, convenience-centered general merchandise area. The Xpress designation is simply a way of
describing our locations that are atypical to our other full-service stores. These locations range in size from 1,000 to 5,000 square feet,
and enable the Company to enter a new market with an initial investment of under $400,000. These locations primarily sell
pharmaceuticals, other health and beauty related items, and limited general merchandise offerings, mainly consumables. Xpress
locations usually originate from a pharmacy acquisition and are in a location that is not suitable for the typical layout of a Fred's store.
Therefore, the new store location is given the Xpress designation, and is targeted for conversion to a typical Fred's store once a
suitable location can be obtained. In some cases, Xpress locations are located in areas that may not be able to support a full-service
store. In all other ways, including resource allocation, management, training, marketing and corporate support, it is treated just as any
other location in the Company’s network of stores. Given their smaller physical size, however, Xpress locations are not stocked with
the full breadth of merchandise in all departments that are carried by the Company’s other stores.
Within the population of Xpress locations, acquisitions are routinely being completed and existing Xpress locations are being
converted as suitable full-service locations are identified. Xpress sales, as a percentage of total sales, for 2015, 2014 and 2013 were
8.0%, 7.1% and 5.2%, respectively and gross profit, as a percentage of total gross profit, for the same time periods was 7.8%, 7.0%
and 5.0%, respectively.
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The following tables set forth certain information with respect to stores and pharmacies for each of the last five fiscal years:
Full-service stores open at the beginning of the year
Full-service stores opened/acquired
Full-service stores closed
Full-service stores open at the end of the year
Xpress stores open at the beginning of the year
Xpress stores opened/acquired
Xpress stores closed
Xpress stores converted to full-service stores
Xpress stores open at the end of the year
Total Company-owned stores
Franchise stores at end of period
Total Fred's retail stores
Number of stores with pharmacies at the end of the year (1)
Specialty pharmacy facilities
2015
579
3
(1)
581
62
6
(5)
(3)
60
641
18
659
372
3
2014
630
6
(57)
579
53
18
(5)
(4)
62
641
19
660
376
1
2013
644
11
(25)
630
47
14
(5)
(3)
53
683
21
704
361
1
2012
638
20
(14)
644
41
15
-
(9)
47
691
21
712
2011
620
26
(8)
638
33
17
(2)
(7)
41
679
21
700
352
331
-
-
Total selling square feet of full-service stores (in thousands)
8,600
8,536
9,355
9,624
9,590
Average selling square feet per full-service store
14,802
14,743
14,848
14,944
15,031
(1) Pharmacies are included in the count of full-service, Xpress and franchise stores.
Merchandising and Marketing
The business in which the Company is engaged is highly competitive. The principal competitive factors include location of stores,
price and quality of merchandise, in-stock consistency, merchandise assortment and presentation, and customer service. The Company
competes for sales and store locations in varying degrees with national, regional and local retailing establishments, including
department stores, discount stores, variety stores, dollar stores, discount clothing stores, drug stores, grocery stores, outlet stores,
convenience stores, warehouse stores and other stores. Many of the largest retail companies in the nation have stores in areas in which
the Company operates. Management believes that its knowledge of regional and local consumer preferences, developed over its
69 year history, enables the Company to compete very effectively within its region.
Management believes that Fred's has a distinctive niche in that it offers a pharmacy department along with a wider variety of
merchandise with a more attractive price-to-value relationship than either a drug store or smaller variety/dollar store and is more
shopper-convenient than a larger discount store. The variety and depth of merchandise offered in our high-traffic departments, such as
health and beauty aids and paper and cleaning supplies, are comparable to those of larger discount retailers.
Purchasing
The Company’s primary buying activities (other than prescription drug purchasing) are directed by the Chief Merchandising and
Marketing Officer, a Divisional Senior Vice President of Merchandising and Divisional Vice Presidents of Merchandising. The
merchandising department is supported by a staff of 31 merchants and assistants, some of which purchase for multiple, similar general
merchandise departments. The merchants are participants in an incentive compensation program, which is based upon both individual
and total company performance metrics, all of which are designed to drive shareholder value. The Company purchases its merchandise
from a wide variety of domestic and import suppliers. Many of the import suppliers generally require long lead times and orders are
placed four to six months in advance of delivery. These products are either imported directly by us or acquired from distributors based
in the United States and their purchase prices are denominated in United States dollars. The Supply Chain division manages all
replenishment and forecasting functions with the Company’s proprietary software which generates open-to-buy reports. Each
- 6 -
merchandising department develops vendor line reviews and assortment plans and tests new products and programs to continually
improve overall inventory productivity and in-stock positions.
In 2015, approximately 3.5% of the Company’s total purchases were from Procter and Gamble. Procter and Gamble purchases were
5.1% in 2014 and 5.3% in 2013. The decrease in Proctor and Gamble purchases as a percent of total purchases is due to the sales mix
shift towards higher dollar specialty pharmaceuticals. The Company believes that adequate alternative sources of products are
available for these categories of merchandise.
The Company’s prescription drugs are ordered by its pharmacies individually and shipped direct from the Company’s primary
pharmaceutical wholesaler, Cardinal Health, Inc. (“Cardinal Health”), to the pharmacies five days a week. Cardinal Health provides
substantially all of the Company’s prescription drugs. On August 6, 2014, the Company entered into a Prime Vendor Agreement with
Cardinal Health, replacing the Company's former primary pharmaceutical wholesaler, AmerisourceBergen Corporation (“Bergen”).
During 2015, 2014 and 2013 approximately 0%, 29% and 42%, respectively, of the Company’s total purchases were made from
Bergen. During 2015, 2014 and 2013, approximately 50%, 16% and 0%, respectively, of the Company's total purchases were made
from Cardinal Health. Although there are alternative wholesalers that supply pharmaceutical products, the Company operates under a
purchase and supply contract with Cardinal Health as its primary wholesaler, which continues through March 2018. Accordingly, the
unplanned loss of this particular supplier could have a short-term gross margin impact on the Company’s business until an alternative
wholesaler arrangement could be implemented.
Excluding the purchases made from our pharmaceutical supplier, Cardinal, our former pharmaceutical supplier, Bergen, and those
made from Procter and Gamble mentioned previously, no other supplier accounted for more than 5% of the Company’s total
purchases for 2015, 2014 and 2013.
Sales Mix
The Company’s sales, which occur through company-owned stores and to franchised Fred's stores, constitute a single reportable
operating segment.
The Company’s sales mix by major category for the preceding three years was as follows:
Pharmacy
Consumables
Household Goods and Softlines
Franchise
Total Sales Mix
January 30,
2016
For the Years Ended
January 31,
2015
February 1,
2014
50.2%
25.7%
22.6%
1.5%
100.0%
41.9%
31.2%
25.3%
1.6%
100.0%
37.7%
33.0%
27.6%
1.7%
100.0%
While the sales mix for the Company overall is 50.2% pharmacy, up from 41.9% in 2014, the sales mix varies from store to store
depending upon local consumer preferences and whether the stores include pharmacy departments or the Company’s full product line
offerings such as expanded hardware and auto, food and apparel. In 2015, the average customer transaction size for comparable stores
was approximately $23.01, and the number of customer transactions totaled approximately 82 million. The average transaction size
was approximately $21.94 in 2014 and $21.38 in 2013, and the customer transactions totaled approximately 84 million in 2014 and 87
million in 2013. The decrease in customer transaction volume in 2015 is primarily due to the store closures at the end of 2014.
Fred's Brand products include household cleaning supplies, health and beauty aids, disposable diapers, pet foods, paper products and a
variety of food and beverage products. Private label products afford the Company higher than average gross margins while providing
the customer with lower priced products that are of a quality comparable to that of competing branded products. An independent
laboratory-testing program is used for substantially all of the Company’s private label products. As part of our own brand initiative,
we expanded our private label program in 2015 to include additional over-the-counter pharmaceutical products and consumables and
plan to continue this expansion in 2016.
The Company sells merchandise to its 18 franchised Fred's stores. These sales totaled approximately $31.5 million in 2015, $31.5
million in 2014 and $32.6 million in 2013. Franchise and other fees earned totaled approximately $1.5 million in 2015, $1.5 million in
2014 and $1.6 million in 2013. These fees represent a reimbursement for use of the Fred's name and administrative costs incurred on
behalf of the franchised stores. One franchise location was purchased by the Company from a franchisee in 2015. The Company does
not intend to expand its franchise network.
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Advertising and Promotions
Net advertising and promotion costs represented approximately 0.9% of net sales in 2015, compared to 1.1% in 2014 and 1.0% in
2013. The Company uses direct mail, newspaper, email and social media advertising to deliver the Fred's value message. The
Company utilizes full-color circulars coordinated by our internal advertising staff to promote its merchandise, special promotional
events and a discount retail image. Additionally, the Company retains an outside advertising agency to assist with digital advertising,
and to develop and implement the Company’s branding strategy.
The Company offers regular clearance of seasonal merchandise and conducts sales and promotions of particular items. The Company
also executes, through its store managers, impactful in-store advertising displays and signage in order to increase customer traffic and
impulse purchases.
Store Operations
Fred's stores are open seven days a week and store hours at most locations are from 8:00 a.m. to 9:00 p.m. Pharmacy departments
typically close at 7:00 pm Monday through Saturday and are closed all day on Sunday. Each Fred's store is managed by a full-time
store manager and those stores with a pharmacy employ a pharmacist-in-charge, who manages the pharmacy department within the
store. The Company’s district managers, Regional Vice Presidents and Executive Vice President of Store Operations supervise the
management and operation of Fred's stores.
As of January 30, 2016, Fred's operates 372 retail pharmacies and three specialty pharmacy only locations, which offer brand name
and generic pharmaceuticals and are staffed by licensed pharmacists. The Company’s healthcare managers, Regional Vice Presidents,
Vice Presidents, Senior Vice Presidents and Executive Vice President manage and supervise the operation of Fred’s pharmacy
departments. The addition of pharmacy departments in the Company’s stores has resulted in increased store sales and sales per selling
square foot. Management believes that the Pharmacy department, in addition to the 42 other general merchandise departments,
increases customer traffic and repeat visits and is an integral part of the store’s operation and a key differentiating factor from our
discount store competitors.
The Company has an incentive compensation plan for store managers, pharmacists, district managers and healthcare managers based
on targeted profit goals. Among the factors included in determining profit goals are gross profits and controllable expenses at the
store level. These factors of operating performance are reviewed regularly by executive management. Management believes that this
incentive compensation plan, together with the Company’s store management training program, are instrumental in maximizing store
performance. The Company’s training program covers all aspects of the Company’s operation from product knowledge to handling
customers with courtesy.
Inventory Control
The Company’s centralized management information system maintains a daily stock-keeping unit (“SKU”) level inventory and
current and historical sales information for each store and the distribution centers. This system is supported by our in-store point-of-
sale (“POS”) system, which captures SKU and other data at the time of sale. In 2015, the Company partnered with JDA Software
Group, Inc. for a multi-year implementation of a new replenishment, allocation and space management planning system to significantly
enhance and streamline those processes. Additionally, the Company uses NEX/DEX technology for in-store receiving and inventory
control for all items delivered directly to our stores. The Company conducts annual physical inventory counts at all Fred's stores and
has implemented the use of radio frequency devices ("RF guns") to conduct cycle counts to ensure replenishment accuracy.
Distribution
The Company has an 850,000 square foot distribution center in Memphis, Tennessee that services 348 stores and a 600,000 square
foot distribution center in Dublin, Georgia that services 293 stores (see Item 2: “Properties”). Approximately 29% of the merchandise
received by Fred's stores in 2015 was shipped through these distribution centers, with the remainder (primarily pharmaceuticals,
certain snack food items, greeting cards, beverages and tobacco products) shipped directly to the stores by suppliers. For distribution,
the Company uses owned and leased trailers and tractors, as well as common carriers. The Company’s Warehouse Management
System is completely automated and provides conveyor control and pick, pack and ship processes by using portable radio-frequency
terminals. This system is integrated with the Company’s centralized management information system to provide up-to-date perpetual
records as well as facilitating merchandise allocation and distribution decisions. The Company uses weekly cycle counts throughout
the year to ensure accuracy within the Warehouse Management System.
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Seasonality
Our business is subject to both monthly and seasonal sales shifts. The Company’s sales volume is heavier around the first day of each
calendar month due to the fact many of the customers who shop at Fred's stores rely on government aid, social security, and other
means that are typically paid around this time. These governmental payment cycles, coupled with the concurrent distribution of our
direct and shared mail advertising, are major factors in concentrating sales earlier in the calendar month. Sales are also impacted by
the holiday selling season and the timing and severity of the cough, cold and flu season. We typically experience highest sales in the
first and fourth quarters as a result. Our quarterly results can also be affected by the timing of certain holidays and by store openings
and closings. Higher volumes of inventory are purchased in the third quarter in preparation for higher traffic and sales volume in the
fourth quarter.
The following table reflects the seasonality of net sales, gross profit, operating income, and net income by quarter:
For the year ended:
January 30, 2016
Net Sales
Gross Profit
Operating Income (Loss)
Net Income (Loss)
January 31, 2015
Net Sales
Gross Profit
Operating Income (Loss)
Net Income (Loss)
February 1, 2014
Net Sales
Gross Profit
Operating Income
Net Income
Employees
1st
Quarter
2nd
Quarter
3rd
Quarter
4th
Quarter
23.7%
25.2%
0.7%
(0.4%)
25.3%
28.3%
20.7%
21.2%
25.9%
26.9%
45.4%
43.9%
25.4%
24.2%
(74.8%)
(66.2%)
24.9%
22.6%
(54.0%)
(56.9%)
24.9%
24.3%
13.3%
12.8%
25.1%
26.2%
23.2%
19.5%
24.2%
24.5%
(34.2%)
(36.1%)
23.7%
25.0%
27.1%
28.1%
25.8%
24.4%
(49.1%)
(52.9%)
25.6%
24.6%
(32.5%)
(28.2%)
25.5%
23.8%
14.2%
15.2%
As of January 30, 2016, the Company had 4,870 full-time and 4,466 part-time employees, the majority of which are store employees.
The number of employees varies during the year, reaching a peak during the Christmas selling season, which typically begins after the
Thanksgiving holiday. The Memphis, Tennessee distribution center employees are represented by a union, UNITE-HERE, pursuant
to a three year collective bargaining agreement which went into effect on July 1, 2014. The Company believes that it continues to
have good relations with all of its employees.
Competition
The discount retail merchandise business is highly competitive. We compete with respect to price, store location, in-stock consistency,
merchandise quality, assortment and presentation, and customer service with many national, regional and local retailing
establishments, including department stores, discount stores, variety stores, dollar stores, discount clothing stores, drug stores, grocery
stores, outlet stores, convenience stores, warehouse stores and other stores. Our competitors range from smaller, growing companies to
considerably larger retail businesses that have greater financial, distribution, marketing and other resources than we do. There is no
assurance that we will be able to compete successfully with them in the future. See “Cautionary Statement Regarding Forward-
Looking Information” and Item 1A: “Risk Factors.”
Government Regulation
As a publicly-traded company, we are subject to numerous federal securities laws and regulations, including the Securities Act of
1933, as amended, and the Securities Exchange Act of 1934, as amended, and related rules and regulations promulgated by the
Securities and Exchange Commission ("SEC"), as well as the Sarbanes-Oxley Act of 2002 and the Dodd–Frank Wall Street Reform
and Consumer Protection Act. These laws and regulations impose significant requirements in the areas of accounting and financial
reporting, corporate governance and insider trading, among others.
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Each of our locations must comply with regulations adopted by federal and state agencies regarding licensing, health, sanitation,
safety, fire and other regulations. In addition, we must comply with the Fair Labor Standards Act, as amended, and various state laws
governing various matters such as minimum wage, overtime and other working conditions. We must also comply with provisions of
the Americans with Disabilities Act of 1990, as amended, which requires generally that employers provide reasonable accommodation
for employees with disabilities and that our stores be accessible to customers with disabilities. The Company’s pharmacy department,
in particular, is subject to extensive federal and state laws and regulations.
Licensure and Regulation of Retail Pharmacies
There are extensive federal and state regulations applicable to the practice of pharmacy at the retail level. We are subject to numerous
federal and state laws and regulations concerning the protection of confidential patient medical records and information, including the
federal Health Insurance Portability and Accountability Act (“HIPAA”). Most states have laws and regulations governing the
operation and licensing of pharmacies, and regulate standards of professional practice by pharmacy providers. These regulations are
issued by an administrative body in each state, typically a pharmacy board, which is empowered to impose sanctions for non-
compliance. Specialty pharmacies differ in the fact they carry multiple state licenses, something typically not seen with retail
pharmacies. Additionally, the Drug Enforcement Agency (“DEA”) requires that controlled substances be monitored and controlled at
all times.
Our business is also subject to federal, state and local laws, regulations, and administrative practices concerning the provision of and
payment for health care services, including, without limitation: federal, state and local licensure and registration requirements
concerning the operation of pharmacies and the practice of pharmacy; Medicare, Medicaid and other publicly financed health benefit
plan regulations prohibiting kickbacks, beneficiary inducement and the submission of false claims.
As a provider of Medicare prescription drug plan benefits, we are subject to various federal regulations promulgated by the Center for
Medicare and Medicaid Services under the Medicare Prescription Drug, Improvement and Modernization Act of 2003. In the future
we may also be subject to changes to various state and federal insurance laws and regulations in connection with the Company’s
pharmacy operations.
Healthcare Initiatives
Legislative and regulatory initiatives pertaining to such healthcare related issues as reimbursement policies, payment practices,
therapeutic substitution programs, and other healthcare cost containment issues are frequently introduced at both the state and federal
levels. The Patient Protection and Affordable Care Act of 2010 ("PPACA") has been fully implemented, but we did not experience a
material impact to our business. This PPACA legislation made it possible for states to expand their Medicaid rolls, but many chose
not to exercise their expansion ability under the new legislation. The majority of any incremental pharmacy business generated under
the healthcare exchanges created by PPACA has been assimilated into our traditional commercial payor networks. At this time we are
unable to predict any material changes to the current legislation that could alter our current pharmacy business practices.
Substantial Compliance
The Company’s management believes the Company is in substantial compliance with all existing statutes and regulations material to
the operation of the Company’s businesses and is unaware of any material non-compliance action against the Company.
Environmental Matters
We are not aware of any federal, state or local environmental laws or regulations that will materially affect our earnings or competitive
position, or result in material capital expenditures. However, we cannot predict the effect on our operations of possible future
environmental legislation or regulations. During fiscal year 2015, we did not incur any material capital expenditures for
environmental control facilities, and no such material expenditures are anticipated.
Available Information
Our website address is http://www.fredsinc.com. We make available through this website, without charge, our annual reports on Form
10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to these reports as soon as reasonably practicable
after these materials are electronically filed with or furnished to the SEC. Also included free of charge on our website is the
Company’s Code of Business Conduct and Ethics, Vendor Code of Conduct and our Board of Director’s committee charters.
Alternatively, the public may read and copy any of the materials the Company files with the SEC at the SEC's Public Reference
Room, at 100 F Street, NE, Washington DC 20549. The public may obtain information on the operation of the Public Reference Room
by calling the SEC at 1-800-SEC-0330. The SEC maintains a website at http://www.sec.gov that contains reports, proxy and
information statements and other information regarding issuers, such as Fred’s, that file electronically with the SEC.
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ITEM 1A. Risk Factors
Investors are encouraged to carefully consider the risks described below and other information contained in this document when
considering an investment decision with respect to Fred's securities. Additional risks and uncertainties not presently known to
management, or that management currently deems immaterial, may also impair the Company’s business operations. Any of the events
discussed in the risk factors below may occur. If one or more of these events do occur, business, results of operations or financial
condition could be materially adversely affected. In that instance, the trading price of Fred's securities could decline, and investors
might lose all or part of their investment.
Our business is somewhat seasonal.
We typically realize a significant portion of our net sales during the holiday selling season in the first and fourth quarters in addition to
the heavier sales volume we experience around the first day of each calendar month. Our inventories and short-term borrowings, if
required, increase in anticipation of this holiday season. A seasonal merchandise inventory imbalance could occur if, for any reason,
our net sales during the holiday selling season were to fall below seasonal norms. If for any reason our first and fourth quarter results
were substantially below expectations, our profitability and operating results could be adversely affected by unanticipated markdowns,
especially in seasonal merchandise.
We operate in a competitive industry.
We are in a highly competitive sector of the discount retail industry. This competitive environment subjects us to the risk of reduced
profitability because of lower prices, and lower margins, required to maintain our competitive position. We compete with discount
stores and with many other retailers all of which may operate a pharmacy not typically seen in our chain drug store competition,
including department stores, variety stores, dollar stores, discount clothing stores, drug stores, grocery stores, outlet stores,
convenience stores, warehouse stores and other stores, some of whom may have greater resources than we do. This competitive
environment subjects us to various risks, including the ability to continue to provide competitively priced merchandise to our
customers that will allow us to maintain profitability and continue store growth. Some of our competitors utilize aggressive
promotional activities, advertising programs, and pricing discounts and our results of operations could be adversely affected if we do
not respond effectively to these efforts.
Changes to current dividend payments could adversely affect the market price of our stock.
Our ability to pay dividends is dependent upon the success of our operations and the management of our cash flows. We cannot
provide assurance that the Company will continue to pay dividends at our current levels. If we fail to maintain dividends at the current
levels, the market price of our common stock could be adversely affected.
Changes in third-party reimbursements, including government programs, could adversely affect our business.
A significant portion of our sales are funded by federal and state governments and private insurance plans. For the years ended
January 30, 2016 and January 31, 2015, pharmaceutical sales were 50.2% and 41.9% of total sales, respectively. The health care
industry is experiencing a trend toward cost-containment with governments and private insurance plans seeking to impose lower
reimbursements and utilization restrictions while also moving to a more outcomes based payment model. Payments made under such
programs may not remain at levels comparable to present levels or be sufficient to cover our cost. Private insurance plans may base
their reimbursement rates on government rates. Accordingly, reimbursements may be limited or reduced, thereby adversely affecting
our revenues and cash flows. Also, access to existing and/or new patients may be hindered or prevented through the implementation
of preferred or restricted pharmacy provider networks ultimately impacting the financial results of the pharmacy department.
Additionally, and in light of the current macroeconomic environment and recent healthcare legislation such as the PPACA, which
includes provisions that are specific to our pharmacy department, government or private insurance plans may adjust scheduled
reimbursement payments to us in amounts that could have a material adverse effect on our cash flows and financial condition.
Changes in consumer demand and product mix and changes in overall economic conditions could adversely affect our business.
Our success depends on our ability to anticipate and respond in a timely manner to changing customer demands and preferences for
product mix. A general slowdown in the United States economy, rising personal debt levels, rising foreclosure rates, rising fuel prices,
or changes in government aid, social security, and other means that many of our customers rely upon may adversely affect the
spending of our consumers, which would likely result in lower net sales than expected on a quarterly or annual basis. In addition,
changes in the types of products available for sale and the selection of products by our customers affect sales, product mix and
margins. Future economic conditions affecting disposable consumer income, such as employment levels, business conditions, fuel and
energy costs, inflation, interest rates, and tax rates, could also adversely affect our business by reducing consumer spending or causing
consumers to shift their spending to other products. We might be unable to anticipate these buying patterns and implement appropriate
inventory strategies, which would adversely affect our sales and gross profit performance. In addition, increases in fuel and energy
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costs would increase our transportation costs and overall cost of doing business and could adversely affect our financial statements as
a whole.
Natural disasters or unusually adverse weather conditions could affect our business.
Unusually adverse weather conditions, natural disasters or similar disruptions, could significantly reduce our net sales. In addition,
these disruptions could also adversely affect our supply chain efficiency and make it more difficult for us to obtain sufficient
quantities of merchandise from suppliers. A number of our stores are located in areas that are susceptible to hurricanes and tornadoes.
A significant disruption in our computer systems could adversely affect our business.
We rely extensively on our computer systems to manage inventory, process customer transactions and record results. Our systems are
subject to damage or interruption from power outages, telecommunications failures, computer viruses, security breaches and natural
disasters. If our systems are damaged or fail to function properly, we may incur substantial costs to repair or replace them, and may
experience loss of critical data and interruptions or delays in our ability to manage inventories or process customer transactions, which
could adversely affect our results of operations.
If we fail to protect the security of personal information about our customer, we could be subject to costly government enforcement
actions or private litigation and our reputation could suffer.
The nature of our business involves the receipt of personal information about our customers. If we experience a data security breach,
we could be exposed to government enforcement actions, credit card brand assessments and fines and private litigation. In addition,
our customers could lose confidence in our ability to protect their personal information, which could cause them to discontinue usage
of credit cards in our stores, decline to use our pharmacy department services, or stop shopping at our stores altogether. Such events
could lead to lost future sales and adversely affect our results of operations.
Cyber-attacks could affect our business
If our information technology ("IT") systems are breached due to a cyber-attack, we could experience a material disruption to our IT
systems as well as data loss that could have an adverse effect on our business. We could experience operational delays due to the
disruption of our IT systems. Future results could be negatively impacted by data theft, destruction or loss, or unplanned release of
confidential information. In addition to the operational and data losses we could experience from a cyber-attack, the Company's
reputation with our customers, vendors or other third-party affiliates could be damaged.
Merchandise supply and pricing and the interruption of and dependence on imports could adversely affect our business.
We have maintained good relations with our vendors and believe that we are generally able to obtain attractive pricing and other terms
from vendors. We purchase a portion of our inventory from foreign suppliers, principally in China. As a result, political instability or
other events resulting in the disruption of trade from other countries or the imposition of additional regulations relating to duties on
imports could cause significant delays or interruptions in the supply of our merchandise or increase our costs. Also, our cost of goods
is affected by the fluctuation of local currencies against the dollar in countries where these goods are produced. Accordingly, changes
in the value of the dollar relative to foreign currencies may increase our cost of goods sold and, if we are unable to pass such cost
increases on to our customers, decrease our gross margins and ultimately our earnings. We purchase a significant amount of goods
from Cardinal Health, Procter and Gamble and several large domestic and import vendors and any disruption in that supply and or
pricing of such merchandise could negatively impact our operations and results.
Delays in openings and costs of operating new stores and distribution facilities could have an adverse impact on our business.
We maintain two distribution facilities, and plan on constructing new facilities as needed to support our growth. One of our key
business strategies is to expand our base of retail stores. We plan to expand and refresh our network of stores through new store
openings and by remodeling existing stores each year. Delays in opening, refreshing or remodeling stores or delays in opening
distribution facilities to service those new stores could adversely affect our future operations by slowing growth, which may in turn
reduce revenue and margin growth. Adverse changes in the cost to operate distribution facilities and stores, such as changes in labor,
utilities, fuel and transportation, and other operating costs, could have an adverse impact on us.
Operational difficulties could disrupt our business.
Our stores are managed through a network of geographically dispersed management personnel. Our inability to effectively and
efficiently operate our stores, including the ability to control losses resulting from inventory shrinkage, may negatively impact our
sales and/or margin. In addition, we rely upon our distribution and logistics network to provide goods to stores in a timely and cost-
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effective manner; any disruption, unanticipated expense or operational failure related to this process such as a decrease in the capacity
of carriers and strikes (e.g., the West Coast port strike spanning the latter part of 2014 and early 2015) could negatively impact the
timely receipt of merchandise and increase transportation costs disrupting our store operations. Our operation depends on a variety of
information technology systems for the efficient functioning of its business. We rely on certain software vendors to maintain and
upgrade these systems as needed. We rely on telecommunications carriers to gather and disseminate our operations information. The
disruption or failure of these systems or carriers could negatively impact our operations.
Use of a single supplier of pharmaceutical products and our ability to negotiate satisfactory terms could adversely affect our business.
We have a long-term supply contract from a single supplier, Cardinal Health, for our pharmaceutical operations. Any significant
disruption in our relationship with this supplier, deterioration in their financial condition, changes in terms, supplier increases in
pharmaceutical costs or an industry-wide change in wholesale business practices, including those of our supplier or the manufacturers
with whom our supplier transacts business, could have a material adverse effect on our operations.
Our plans depend significantly on strategies and initiatives designed to increase sales and improve the efficiencies, costs and
effectiveness of our operations. Failure to achieve or sustain these plans could affect the Company’s performance adversely.
We have strategies and initiatives (such as those relating to merchandising, pharmaceutical product expansion, sourcing, shrink,
private brand, distribution and transportation, store operations, store formats, budgeting and expense reduction, and real estate) in
various stages of testing, evaluation, and implementation, upon which the Company expects to rely to continue to improve our results
of operations and financial condition and to achieve our financial plans. These initiatives are inherently risky and uncertain, even
when tested successfully, in their application to our business in general. It is possible that successful testing can result partially from
resources and attention that cannot be duplicated in broader implementation, particularly in light of the decentralized nature of the
Company’s field management. General implementation also may be negatively affected by other risk factors described herein.
Successful system-wide implementation relies on consistency of training, stability of workforce, ease of execution, and the absence of
offsetting factors that can influence results adversely. Failure to achieve successful implementation of our initiatives, or the cost of
these initiatives exceeding management’s estimates, could adversely affect the Company’s business, results of operations and financial
condition.
The success of our merchandising initiatives, particularly those with respect to non-consumable merchandise such as pharmaceutical
products, as well as store-specific allocations such as those made to Xpress stores, depends in part upon our ability to predict
consistently and successfully the products that Fred’s customers will demand and to identify and timely respond to evolving trends in
demographics and consumer preferences, expectations and needs. If we are unable to select products that are attractive to customers,
in amounts that customers are likely to buy products, to timely obtain such products at costs that allow the Company to sell them at an
acceptable profit, or to effectively market such products, then the Company’s sales, market share and profitability could be adversely
affected. Further, if the Company’s merchandising efforts in the areas of general pharmaceutical products and higher margin
consumables are unsuccessful, it could be further adversely affected by our inability to offset the lower margins associated with the
Company’s other lines of business, such as specialty pharmaceutical products.
Higher than expected costs and not achieving our targeted results associated with the implementation of new programs, systems and
technology could adversely affect our business.
We are undertaking a variety of operating initiatives as well as store upgrades and infrastructure initiatives. The failure to properly
execute any of these initiatives could have an adverse impact on our future operating results.
Changes in state or federal legislation or regulations, including the effects of legislation and regulations on wage levels and
entitlement programs; trade restrictions, tariffs, quotas and freight rates could adversely affect our business.
Unanticipated changes in federal or state wage requirements or other changes in workplace regulation could adversely impact our
ability to achieve our financial targets. Changes in trade restrictions, new tariffs and quotas, and higher shipping costs for goods could
also adversely impact our ability to achieve anticipated operating results.
We depend on successfully increasing the utilization of our existing stores as well as our new store opening program, including
increasing our pharmacy department presence in new and existing stores, for a portion of our growth.
Our growth is dependent on both increases in sales in existing stores and the ability to open new stores with pharmacy
departments. Unavailability of store locations that we deem desirable, delays in the acquisition of pharmacies or opening of new
stores, difficulties in staffing and operating new store locations and the lack of customer acceptance of stores in expanded market
areas all may negatively impact our new store growth, the costs associated with new stores and/or the profitability of new stores. Our
ability to renew or enter into new leases on favorable terms could affect costs of operations or slow store expansions.
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We may never realize the expected benefits of our acquisitions.
We acquired Reeves-Sain Drug Store, Inc in the first quarter of 2015. Acquiring a new business involves a myriad of risks. There is a
risk we may fail to realize some or all of the anticipated benefits of the transaction. This can occur if integration of the acquired
business proves to be more complicated than planned, resulting in failure to realize operational synergies and/or failure to mitigate
operational dis-synergies, diversion of management attention, and loss of key personnel. It can also occur if the acquired business fails
to meet our revenue projections, exposes us to unexpected liabilities, or if our pre-acquisition due diligence fails to uncover issues that
negatively affect the value or cost structure of the acquired enterprise. Although we carefully plan our acquisitions, there can be no
assurance these and other risks will not prevent us from realizing the expected benefits of such acquisitions.
Changes in our ability to attract and retain employees, and changes in health care and other insurance costs could adversely affect our
business.
Our growth could be adversely impacted by our inability to attract and retain employees at the store operations level, in distribution
facilities, and at the corporate level, including our senior management team. The retail industry has a high turnover rate; therefore,
there is a continuous need to recruit and train new store managers and employees. Our failure to retain or successfully replace key
personnel at the corporate level may have an adverse effect on our business. Other factors that impact our ability to maintain
sufficient levels of qualified employees in all areas of the business include, but are not limited to, the Company's reputation, employee
morale, the current macroeconomic environment, competition from other employers, and our ability to offer adequate compensation
packages. Adverse changes in health care costs could also adversely impact our ability to achieve our operational and financial goals
and to offer attractive benefit programs to our employees.
Adverse impacts associated with legal proceedings and claims could affect our business.
We are a party to a variety of legal proceedings and claims, including those described elsewhere in this Form 10-K. Operating results
could be adversely impacted if legal proceedings and claims against us are made, requiring the payment of cash in connection with
those proceedings or changes to the operation of the business.
We may be subject to product liability claims.
Despite our best efforts to ensure the quality and safety of the products we sell, we may be subject to product liability claims from
customers or penalties from government agencies relating to products, including food products that are recalled, defective or otherwise
alleged to be harmful. Such claims may result from tampering by unauthorized third parties, product contamination or spoilage,
including the presence of foreign objects, substances, chemicals, other agents, or residues introduced during the growing, storage,
handling and transportation of products the Company sells. All of our vendors and their products must comply with applicable product
and food safety laws. We generally seek contractual indemnification and insurance coverage from our suppliers. However, if we do
not have adequate insurance or contractual indemnification available, such claims could have a material adverse effect on our
business, financial condition and results of operation. Our ability to obtain indemnification from foreign suppliers may be hindered by
the manufacturers' lack of understanding of U.S. product liability or other laws, which may make it more likely that we be required to
respond to claims or complaints from customers as if we were the manufacturer of the products. Even with adequate insurance and
indemnification, such claims could significantly damage our reputation and consumer confidence in our products. Our litigation
expenses could increase as well, which also could have a materially negative impact on our results of operations, even if a product
liability claim is unsuccessful or is not fully pursued.
Our ability to achieve the results of store closures under our strategic plan initiatives could adversely affect our business.
As part of our continuing operations, we perform research and analysis to discover potential underperforming stores. We use such
research and analysis to identify potential store closures. The estimated costs and charges associated with these initiatives may vary
materially and adversely based upon various factors, including the timing of execution, the outcome of negotiations with landlords and
other third parties, or unexpected costs, any of which could result in our not realizing the anticipated benefits from the strategic plan.
Increases in our insurance-related costs could significantly affect our business.
The costs of many types of insurance and self-insurance, especially workers’ compensation and employee health care, have been
increasing in recent years due to rising health care costs, legislative changes, economic conditions, terrorism and heightened scrutiny
of insurance brokers and insurance providers. Our pharmacy departments are also exposed to risks inherent in the packaging and
distribution of pharmaceuticals and other healthcare products, including with respect to improper filling of prescriptions, labeling of
prescriptions and adequacy of warnings, and are significantly dependent upon suppliers to provide safe, government-approved and
non-counterfeit products. We also sell a variety of products that we purchase from a large number of suppliers, including some who
operate in foreign countries, which could become subject to contamination, product tampering, mislabeling or other damage. While
we maintain reasonable quality assurance practices, no program can provide complete assurance that a product liability issue will not
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arise. Should a product liability issue arise, the coverage limits under our insurance programs may not be adequate to protect us
against future claims. In addition, we may not be able to maintain this insurance on acceptable terms in the future. Damage to our
reputation in the event of a product liability issue could have an adverse effect on our business. If our insurance-related costs increase
significantly, or we are unable to renew our insurance policies or protect against all the business risks facing us, our financial position
and results of operations could be adversely affected.
In 2010, Congress passed PPACA, which continues to result in significant structural changes to the health insurance system. Many of
these changes were implemented prior to the end of fiscal 2014, and several of the resulting regulations and sub-regulatory guidance
have yet to be issued and/or finalized. As a result, uncertainties exist regarding the full impact of PPACA on our business. While the
reforms affected the healthcare coverage and plans of Fred's employees as well as our pharmacy department customers, overall, our
benefit plan designs already met the affordable and minimum coverage standards PPACA required. We cannot predict what, if any,
further effect the PPACA may have on our pharmacy department business, insurance costs or labor. We also cannot predict other
legislative or market-driven changes within the health care system that could affect our business.
Adverse impacts associated with the current economic environment could affect our business.
The lingering economic downturn could have an adverse impact on our business and profitability. Many consumers have suffered
financial hardship as a result of job losses, foreclosures, or their inability to obtain short-term financing, all of which could negatively
affect their ability to shop in our stores and buy our products. Additionally, decreased consumer demand resulting from a pronounced
negative consumer sentiment regarding spending and an increasing personal savings rate could also negatively affect our sales and
profits. Also, our ability to obtain financing, should the need arise outside of our current contractual credit facility, could be at risk
due to tightened lending practices resulting from the continuing economic challenges in the United States.
Our ability to obtain additional financing on favorable terms, if needed, could be adversely affected by volatility in the capital
markets.
We obtain and manage liquidity from cash flows we generate from our operating activities as well as our access to capital markets,
including our credit facilities. Changes in the macroeconomic environment could adversely affect our ability to obtain additional
financing, if needed. Contraction in the credit markets, volatility and low liquidity in the capital markets could result in reduced
availability of credit and a higher cost of borrowing, making it more difficult to obtain additional financing on terms favorable to the
Company.
ITEM 1B: Unresolved Staff Comments
None.
ITEM 2: Properties
As of January 30, 2016, the geographical distribution of the Company’s 641 company-owned stores in 15 states was as follows:
State
Mississippi
Georgia
Tennessee
Alabama
Arkansas
Louisiana
South Carolina
North Carolina
Kentucky
Texas
Florida
Missouri
Illinois
Oklahoma
Indiana
Number of Stores
128
104
88
84
66
65
37
18
16
14
7
6
5
2
1
641
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The Company owns the real estate and the buildings for 90 locations, of which seven are closed and six are subleased. Of the 77
operational company-owned stores for which the Company owns the real estate and buildings, five stores are subject to ground leases.
Three of these locations are encumbered by mortgages (see Note 3 – Indebtedness). The Company leases the remaining 564
company-owned store locations from third parties pursuant to leases that provide for monthly rental payments primarily at fixed rates
(although a number of leases provide for contingent rent, which is additional rent based on sales). Store locations range in size from
1,000 to 5,000 square feet for Xpress locations and 8,000 to 25,000 square feet for full-service stores. Of the 564 locations we lease
from third parties, 265 are in strip centers or adjacent to a downtown-shopping district, with the remainder being freestanding.
It is anticipated that existing buildings and buildings to be developed by others will be available for lease to satisfy the Company’s
new store openings in the near term. It is management’s intention to enter into leases of relatively moderate length with renewal
options, rather than entering into long-term leases. The Company will thus have maximum relocation flexibility in the future, since
continued availability of existing buildings is anticipated in the Company’s market areas.
The Company owns its distribution center and corporate headquarters situated on approximately 60 acres in Memphis, Tennessee. The
site contains approximately 850,000 square feet of distribution center space, and 250,000 square feet of office and retail space.
Presently, the Company uses 90,000 square feet of office space and 22,000 square feet of retail space at the site. The retail space is
operated as a Fred's full-service store and is used to test new products, merchandising ideas and technology. The Company financed
the construction of its 600,000 square foot distribution center in Dublin, Georgia with taxable industrial development revenue bonds
issued by the City of Dublin and County of Laurens Development Authority. Presently, both distribution centers are able to serve a
combined total of approximately 1,000 to 1,100 stores.
ITEM 3: Legal Proceedings
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 were paid less than comparable males seeking compensable damages, liquidated
damages, attorney fees and court costs. The plaintiff filed a motion seeking collective action. On or about March 15, 2013, the judge
in the matter issued a Report and Recommendation that the case be conditionally certified as a collective action, which the District
Court Judge affirmed. As a result, notice of a collective action was sent to the appropriate class as required by the Court. One hundred
ninety four plaintiffs opted into the suit, and approximately 170 plaintiffs remained in the lawsuit. Although, the Company believes
that all of its assistant managers were always properly paid and that the matter was not appropriate for collective action treatment, the
Company and its Employment Practices Liability Insurance (“EPLI”) carrier participated in mediation with the plaintiffs. On March
26, 2015, the plaintiffs, their counsel, the Company and the Company’s EPLI carrier reached a settlement agreement whereby the case
would be settled for a total of $315,000, and the plaintiffs would be bound by the terms of a settlement agreement and the case would
be dismissed. Under the terms of the settlement the Company admitted no wrongdoing. The distribution of the settlement proceeds
has been completed and the matter was dismissed with prejudice on August 7, 2015.
On August 10, 2015, following an investigation by a third-party cyber-security firm, the Company reported that there had been
unauthorized access to two Company servers through which payment card data is routed. The investigation uncovered malware on the
two servers beginning on March 23, 2015, and that malware operated on one server until April 8, 2015 and on the other server until
April 24, 2015. The malware was designed to search only for "track 2" data—data from the magnetic stripe of payment cards that
contains only the card number, expiration date and verification code. During this time period, track 2 data was at risk of disclosure;
however, the third-party cyber-security firm did not find evidence that track 2 data was removed from the Company’s system. No
other customer information was involved. The malware has been removed from the Company’s system, and the Company has
implemented and is continuing to implement enhanced security measures to prevent similar events from occurring in the future. On
October 22, 2015, the Company received an assessment from MasterCard relating to this incident in the amount of approximately $2.9
million. The Company paid the assessment on February 26, 2016 after its appeal was denied. The Company has reached a settlement
with Discover to make certain security improvements, which if made, will not require the Company to make any payment to Discover
related to the incident. The Company is in the process of making these security improvements. American Express has also issued an
assessment related to the incident of $52,525. The Company is in discussions with American Express concerning this
assessment. The Company has not yet received an assessment from Visa. On October 15, 2015, a lawsuit entitled Southern
Independent Bank v. Fred’s, Inc. was filed in the United States District Court, Middle District of Alabama related to the data security
incident. The Complaint alleges on behalf of the plaintiff and financial institutions similarly situated (“alleged class of financial
institutions”) that the Company was negligent in failing to use reasonable care in obtaining, retaining, securing and deleting the
personal and financial information of customers who use debit cards issued by the plaintiff and alleged class of financial institutions to
make purchases at Fred’s stores. The complaint also alleges that the Company made negligent misrepresentations that the Company
possessed and maintained adequate data security measures and systems that were sufficient to protect the personal and financial
information of shoppers using debit cards issued by the plaintiff and alleged class of financial institutions. The complaint seeks
monetary damages and equitable relief to be proved at trial as well as attorneys’ fees and costs. The Company has denied the
allegations and has filed a motion to dismiss all claims, which is currently pending before the Court. The amount assessed by
MasterCard as well as other future costs or liabilities related to the incident may have a material adverse effect on the
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Company. Costs may include liabilities to payment card networks for reimbursement of payment card fraud and reissuance costs,
liabilities from current and future civil litigation, governmental investigations and enforcement proceedings, as well as legal and
investigative costs. The Company has cyber-security risk insurance with a $10 million limit and a sub-limit of $250,000 for PCI fines
including liabilities to payment card networks, which will offset some of these costs.
On January 21, 2016, a lawsuit styled as Stephanie Bryant, on behalf of herself and others similarly situated v. Fred’s Stores of
Tennessee, Inc. was filed in the United States District Court, Southern District of Mississippi. The complaint alleges that plaintiff and
other store managers were improperly classified as exempt employees under the Fair Labor Standards Act. The complaint seeks
declaratory and monetary relief for overtime compensation that plaintiff alleges was not paid as well as costs and attorneys’ fees. The
Company denies the allegations and believes that its managers are appropriately classified as exempt employees.
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 against the Company cannot be determined with certainty,
management of the Company is of the opinion that these proceedings and claims should not have a material adverse effect on the
financial statements as a whole. However, litigation involves an element of uncertainty. Future developments could cause these
actions or claims, individually or in aggregate, to have a material adverse effect on the financial statements as a whole.
ITEM 4: Mine Safety Disclosures
Not Applicable.
PART II
ITEM 5: Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
The Company’s Class A common stock is traded on the NASDAQ Global Select Market under the symbol “FRED.” The following
table sets forth the high and low sales prices, as reported in the regular quotation system of NASDAQ, together with cash dividends
paid per share on the Company’s common stock during each quarter in fiscal 2015 and fiscal 2014.
Fiscal 2015
High
Low
Dividends
Fiscal 2014
High
Low
Dividends
1st
Quarter
2nd
Quarter
3rd
Quarter
4th
Quarter
$
19.47
$
15.78
$
0.06
$
20.05
$
16.14
$
0.06
$
18.37
$
11.27
$
0.06
$
17.14
$
12.44
$
0.06
$
21.05
$
16.55
$
0.06
$
18.28
$
14.53
$
0.06
$
16.68
$
13.07
$
0.06
$
18.00
$
13.44
$
0.06
The Company’s stock price at the close of the market on April 8, 2016 was $14.22. As of April 8, 2016, there were approximately
6,000 shareholders, including beneficial owners holding shares in nominee or street name.
Dividend Policy
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.
- 17 -
Securities Authorized for Issuance under Equity Compensation Plans
Information for our equity compensation plans in effect as of January 30, 2016, is as follows:
Plan Category
Equity compensation plans approved by security holders
Employee stock purchase plan
Equity Compensation plans not approved by security holders
Total
Number of Securities
to be Issued upon
Exercise of
Outstanding Options,
Warrants and Rights
(a)
839,859
4,504
-
844,363
Weighted-Average
Exercise Price of
Outstanding
Options, Warrants
and Rights
(b)
$
$
15.38
12.67
$
-
15.36
Number of Securities
Remaining Available for
Issuance Under Equity
Compensation Plans
(Excluding Securities
Reflected in Column (a))
(c)
970,162
745,601
-
1,715,763
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, of which 90.0 thousand shares remained at January 28, 2012. On February 16, 2012, the Company’s
Board of Directors authorized the expansion of the Company's existing stock repurchase program by increasing the authorization to
repurchase an additional 3.6 million shares. 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. As
of January 31, 2015, there were 3.0 million shares available for repurchase under the plan. No repurchases were made in fiscal year
2015, leaving 3.0 million shares available for repurchase at January 30, 2016.
The remainder of the information required by this item is incorporated herein by reference to our 2015 annual report to shareholders.
- 18 -
ITEM 6: Selected Financial Data
Our selected financial data set forth below should be read in connection with Item 7: “Management’s Discussion and Analysis of
Financial Condition and Results of Operations”, Item 8: “Consolidated Financial Statements and Notes”, as well as the “Cautionary
Statement Regarding Forward-Looking Information” and Item 1A: “Risk Factors” disclosures of this Form 10-K.
(dollars in thousands, except per share amounts and store data)
2015
2014
2013
1
2012
2011
Statement of Income Data:
Net sales
Operating income (loss)
Income (loss) before income taxes
Provision (benefit) for income taxes
Net income (loss)
Net income (loss) per share:
Basic
Diluted
Cash dividends declared per common share 2
Selected Operating Data (unaudited):
$ 2,150,703
(10,399)
(11,830)
(4,459)
(7,371)
$ 1,970,049
(48,412)
(48,916)
(20,012)
(28,904)
$ 1,939,246
$ 1,955,275
39,198
38,711
12,696
26,015
39,078
38,529
8,900
29,629
$
1,879,059
51,155
50,758
17,330
33,428
$
(0.20)
(0.20)
$
(0.80)
(0.80)
$
0.71
0.71
$
0.81
0.81
$
0.88
0.87
0.24
0.24
0.24
0.43
0.20
Operating income (loss) as a percentage of net sales
Increase (decrease) in comparable store sales 3
Company owned stores open at end of period
(0.5)%
1.5%
641
(2.5)%
(0.6)%
641
2.0%
0.7%
683
2.0%
(1.4)%
691
2.7%
0.5%
679
Balance Sheet Data (at period end):
Total assets
Short-term debt (including capital leases)
Long-term debt (including capital leases)
Shareholders' equity
$
730,512
621
52,527
404,211
$
646,475
4,331
2,259
415,636
$
667,786
1,640
3,578
451,548
$
647,153
1,263
12,241
431,272
$
631,982
658
6,640
423,612
1 Fiscal year 2012 was a 53 week accounting period.
2 In addition to the 2012 regular quarterly dividend of $0.06, the Board of Directors declared a special, one-time dividend of $0.19 per share payable to
shareholders of record as of December 3, 2012.
3 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 (Comparable sales
are shown on an adjusted basis. In order to make 2013 comparable with 2012, we eliminated the first week of fiscal 2012. In order to make 2012 comparable
with 2011, we eliminated the 53rd week of fiscal 2012. Additional information regarding the calculation of comparable store sales is in Item 7: "Results of
Operations" section).
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ITEM 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations
General Accounting Periods
The following information contains references to years 2015, 2014 and 2013, which represent fiscal years ended January 30, 2016,
January 31, 2015 and February 1, 2014. This discussion and analysis should be read with, and is qualified in its entirety by, Item 8:
“Consolidated Financial Statements and Notes”, as well as the “Cautionary Statement Regarding Forward-Looking Information” and
Item 1A: “Risk Factors” disclosures of this Form 10-K.
Executive Overview
Fred's, Inc. and subsidiaries ("Fred's", “We”, “Our”, “Us” or “Company”) operates, as of January 30, 2016, 659 discount general
merchandise stores, including 18 franchised Fred's stores, in 15 states in the southeastern United States. There are currently 372 full
service pharmacies in our stores which includes four franchised pharmacies. Our mission is to be the hometown pharmacy and discount
store that provides a fast, fun and friendly low-price place to shop.
Fred’s is a unique combination of pharmacy, dollar store and mass merchant strategically located in smaller markets. We offer a
broader assortment of products than traditional dollar stores and pharmacies with greater convenience than big box retailers. We offer
product categories that drive shopping frequency (including consumables such as tobacco, food and beverage, prescription
pharmaceuticals, paper and cleaning supplies, pet supplies, health and beauty aids) and higher profitability (including discretionary
products such as home décor, seasonal merchandise, auto and hardware and lawn and garden). Our general merchandise selection
includes a diverse array of value priced staple and discretionary products from brand names and our private label. We operate in the
discount retail variety sector with approximately 90% of the products offered in our stores retailing between $1 and $10.
We introduced our new vision statement during our fourth quarter earnings call on March 23, 2016:
A growing regional pharmacy provider of healthcare services, improving the outcomes of the people in the communities that we serve
by delivering solutions that are safe, affordable, innovative and easy to access, complimented by a broad assortment of valued price
and quality national and private brands, all while delivering consistent, strong shareholder value.
This new vision will serve as a beacon for the Company as we continue to work toward our near and long term strategic goals.
Unique Combination of Convenience, Value and Healthcare
One of the Company’s competitive advantages is our unique combination of convenience, value and healthcare. We continue to serve
the value-oriented, budget conscious customer seeking convenience over destination shopping. We have a differentiated store format
and distribution network designed to serve small-town America. The Company’s average store size allows for more than double the
SKU count of our convenience competitors. Our migration towards becoming a healthcare company is critical for the communities
we serve. Strategically, we will accelerate the integration of general merchandise assortment, pharmacy, clinical services, specialty
pharmacy and access to other healthcare providers, with the ultimate goal to be a primary source for healthcare needs of our
customers.
Approximately 85% of our stores are located in markets with populations of 15,000 or less, where Fred’s provides often the only, or
one of only two, pharmacies in the town or county. Since 2010, we have improved our pharmacy department penetration rate from
48% to 57%. We will continue to concentrate on adding pharmacies to existing stores without pharmacy departments, opening all
new stores with a pharmacy department and making opportunistic acquisitions that will operate as Xpress pharmacy locations until
they become a future full-service location. The Company’s clinical services offerings are focused on driving increased
immunizations, assisting our customers with medication therapy management, rolling out “Time My Meds”, which is focused on
prescription adherence, and expanding our disease state management services, with a special emphasis on diabetes and HIV
management. In 2015, we opened the first telemedicine facility within a full-service location, and additional openings are planned for
2016. New and existing pharmacies will see an expansion of healthcare services in order to capitalize on recent industry trends.
On April 10, 2015, the Company acquired Reeves-Sain Drug Store, Inc., which includes a single retail pharmacy location and two
private EntrustRx specialty pharmaceutical facilities. This acquisition will further expand our presence and better position the
Company in the specialty pharmacy arena – the largest growth area of the pharmacy industry. The Company will continue to focus on
leveraging our existing pharmaceutical sales with additional product offerings from our EntrustRx facilities.
In addition to our healthcare advantages, the Company is increasing our front-end profitability by improving the customer experience
and growing front-end margins. In 2015, we began piloting a customer centric prototype in a select number of our stores. Along with
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healthcare assortment improvements, the front-end was reconfigured with new checkout queuing to improve customer convenience while
driving incremental sales. These prototypes have lower profile fixtures for improved sightlines, wider aisles for convenience and
improved layouts and product assortments. In 2015, front store general merchandise departments began to see positive comparable sales
trends. These trends are expected to continue in 2016.
Strategic Investments
In addition to our acquisition of Reeves-Sain Drug Store, Inc., the Company has strategic initiatives which began in 2015, that are
designed to leverage and differentiate our specialty pharmacy offerings, reduce our costs to fill and drive comparable prescriptions. In
the second half of 2015, the Company expanded our limited distribution drug portfolio, while also working with the payer community
to expand our pharmacy network access. We used real-time labor models in an effort to control labor expense by efficiently managing
our pharmacist and pharmacy technician hours. The Company has now completed multiple engagements utilizing the expertise of the
consulting firm A.T. Kearney and is implementing financial opportunities that were identified bringing us closer to our goal of
becoming the leading healthcare destination for both products and services within our markets. Also in 2015, we implemented new
inventory management technology, OrderInsite. This module improves our pharmacy department inventory forecasting based on
algorithms of dispensing history and anticipating future needs. This allows us to more effectively manage inventory levels and, most
importantly, improves the patient experience by reducing out of stocks and partial fills of prescriptions, thus also increasing script
volume. We have seen improvements in comparable script count in the second half of 2015, and we expect these increases to continue
in 2016. The work in 2015 around labor management and lowering cost-to-fill delivered benefits in the back half of 2015 and
established the foundation for which our 2016 pharmacy plan was built.
In 2015, we saw noticeable improvement in general merchandise areas such as supplier partnerships, supply chain efficiency and
import sourcing enhancements. Also, in early 2015, we engaged with a leading e-auction company as a primary platform for reducing
cost of goods. Completed e-auctions produced significant product cost reductions. In addition to e-auctions which are reducing
supply chain costs, we are reviewing all current supply chain expenses and suppliers, and will continue to execute initiatives that
improve efficiency and remove cost from supply chain operations. We will continue to work to improve our supplier partnerships and
enhance our importing process. Currently 5.0% of our total general merchandise purchases are direct imports, with our goal to import
10% of total general merchandise in the next 12 months. Another strategic investment made in 2015 was the Company’s partnership
with JDA Software Group, Inc. (“JDA”) for a new replenishment, allocation and space management planning system. JDA’s software
developed for the Company is a significant enhancement that will drive sales and improve product availability and overall inventory
productivity, which will ultimately improve our customers’ experience.
Arguably, the most important investment of 2015 was the investment we made in our leadership team. The new talent we added brings a
wealth of industry knowledge and experience which, when combined with the institutional knowledge of our existing team, sets the stage
for success. Our current leadership team consists of executives from multiple companies within our industry and brings together best
practices and insights from other major retail leaders. The benefits of these strategic investments will drive results in 2016 and beyond.
2015 Summary
The investments we have made in our pharmacy department have helped drive a net sales increase over prior year of 9.2% and
contributed to the comparable sales growth of 1.5%, and we expect these investments will continue to benefit the Company’s
operating results in the near and long terms.
During 2015, the Company invested $78.2 million in the expansion of our pharmacy departments, which were used to acquire eight
new pharmacy departments, 10 incremental pharmacy departments and two specialty pharmacy-only locations called EntrustRx. Our
pharmacy department is a key differentiating factor from our competitors, and our specialty pharmacy business is licensed in all 50
states and URAC and ACHC accredited, clearing the way for expanding this part of our pharmacy business.
While our sales mix saw the highest increases in our pharmacy department, our general merchandise departments saw a more balanced
mix of sales. This balance was a contributing factor to improved performance in general merchandise departments’ comparable sales
and gross margin rate increases. Selling, general and administrative expense dollars were limited to a less than 1% increase over the
prior year as top line revenues grew by 9.2%.
Gross margin for 2015 was 25.3% of sales compared to 25.6% of sales in 2014. Gross margin deleveraging in 2015 compared to 2014
was attributable to the ongoing compression of pharmacy department margins, which were driven by the sales mix shift toward low
margin specialty drugs, reimbursement pressures, and a considerable increase in LIFO expense. However, gross profit in 2015
increased $40.4 million compared to 2014. Despite the loss of sales volume from underperforming stores that were closed at the end
of 2014, gross profit increased in 2015, as a result of the growth in our retail and specialty pharmacy departments and the strategic
changes within our general merchandise and supply chain departments. Gross profit in 2014 was also negatively affected by
provisions for inventory reserves, which further contributed to the gross profit increase experienced in the current year.
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It is important to note that specialty pharmaceuticals have higher top-line sales and lower margin rates than our typical pharmacy
business. As specialty pharmacy sales grow, our overall gross margin rate may decline, but gross profit dollars are expected to be
higher. Additionally, we anticipate that selling, general and administrative expenses as a percent of sales will decrease. Our new
initiatives are built to drive strong financial performance in 2016 and beyond.
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 carrying values of assets and liabilities that are not readily apparent from other sources. While we believe
that 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. The critical accounting policies presented are those policies the Company has identified as having both
a highly subjective component and a material impact on the financial statements. These policies are intended to supplement the
summary of our critical accounting policies and related estimates and judgments 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 641 company-owned stores and 18 franchised stores as of
January 30, 2016. Net sales include sales of merchandise from company-owned stores, net of estimated 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.
Revenues from sales of pharmaceutical products are recognized at the time the prescription is filled. This approximates when the
customer picks up the prescription or when the prescription has been delivered and is recorded net of an allowance for prescriptions
filled but not picked up by the customer. For all periods presented, there is no material difference between the revenue recognized at
the time the prescription is filled and that which would be recognized when the customer picks up the prescription. Prescriptions are
generally not returnable.
The Company also sells gift cards for which revenue is recognized at the 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"). During 2015, the Company has recognized $0.1 million of gift card revenue, or less than $0.01 per
share. Going forward, the balance on gift cards activated at least 36 months will be considered to represent gift card breakage and the
liability balance on those cards will be recognized as part of revenue.
In addition, the Company charges its 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. Total
franchise income for 2015, 2014 and 2013 was $1.5 million, $1.5 million and $1.6 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 FIFO method for goods in our distribution centers. The retail inventory method is a reverse mark-up,
averaging method which has been widely used in the retail industry for many years. This method calculates a cost-to-retail ratio that is
applied to the retail value of inventory to determine the cost value of inventory and the resulting cost of goods sold and gross margin.
The assumptions that the retail inventory method provides for valuation at lower of cost or market and the inherent uncertainties
therein are discussed in the following paragraphs. In order to assure valuation at the lower of cost or market, the retail value of our
inventory is adjusted on a consistent basis to reflect current market conditions. These adjustments include increases to the retail value
of inventory for initial markups to set the selling price of goods or additional markups to adjust pricing for inflation and decreases to
the retail value of inventory for markdowns associated with promotional, seasonal or other declines in the market value. Because these
adjustments are made on a consistent basis and are based on current prevailing market conditions, they approximate the carrying value
of the inventory at net realizable value (market value). Therefore, after applying the cost to retail ratio, the cost value of our inventory
is stated at the lower of cost or market as is prescribed by U.S. GAAP.
Because the approximation of net realizable value (market value) under the retail inventory method is based on estimates such as
markups, markdowns and inventory losses (shrink), there exists an inherent uncertainty in the final determination of inventory cost
and gross margin. In order to mitigate that uncertainty, the Company has a formal review by product class which considers such
variables as current market trends, seasonality, weather patterns and age of merchandise to ensure that markdowns are taken currently,
or a markdown reserve is established to cover future anticipated markdowns. This review also considers current pricing trends and
inflation to ensure that markups are taken if necessary. The estimation of inventory losses (shrink) is a significant element in
- 22 -
approximating the carrying value of inventory at net realizable value, and as such the following paragraph describes our estimation
method as well as the steps we take to mitigate the risk of this estimate in the determination of the cost value of inventory.
The Company calculates inventory losses (shrink) based on actual inventory losses occurring as a result of physical inventory counts
during each fiscal period and estimated inventory losses occurring between yearly physical inventory counts. The estimate for shrink
occurring in the interim period between physical counts is calculated on a store-specific basis and is based on history, as well as
performance on the most recent physical count. It is calculated by multiplying each store’s shrink rate, which is based on the
previously mentioned factors, by the interim period’s sales for each store. Additionally, the overall estimate for shrink is adjusted at
the corporate level to a three-year historical average to ensure that the overall shrink estimate is the most accurate approximation of
shrink based on the Company’s overall history of shrink. The three-year historical estimate is calculated by dividing the “book to
physical” inventory adjustments for the trailing 36 months by the related sales for the same period. In order to reduce the uncertainty
inherent in the shrink 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 methodology that we have applied in estimating shrink has resulted in variability that is not material to our
financial statements.
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 department inventories, which were approximately
$49.9 million, and $43.5 million at January 30, 2016 and January 31, 2015, 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 highly inflationary 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 $47.5 million at January 30, 2016 and $39.9 million at January
31, 2015. The LIFO reserve increased by approximately $7.6 million and $4.7 million during 2015 and 2014, respectively.
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 30, 2016 was $21.2 million compared to $19.4 million at January 31, 2015.
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,” the Company reviews for impairment all stores open at least 3 years or remodeled
more than 2 years ago. 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. The Company’s 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.
Goodwill and indefinite-lived intangible assets are reviewed for impairment in the fourth quarter each year in accordance with the
provisions of Accounting Standards Codification topic 350, Intangibles – Goodwill and Other (“ASC 350”). ASC 350 provides the
option to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than
its carrying value or that an indefinite-lived intangible is impaired, a “Step 0” analysis. Qualitative factors include industry and
market considerations, overall financial performance, and other relevant events and factors affecting the fair value of the reporting unit
and the indefinite-lived intangible. If, based on a review of qualitative factors, it is more likely than not that the fair value of a
reporting unit or indefinite-lived intangible is less than its carrying value we perform a quantitative assessment by comparing the fair
value of the reporting unit or indefinite-lived intangible with its respective carrying value. If the carrying value exceeds the fair value,
we measure the amount of impairment loss, if any, by comparing the implied fair value of the reporting unit goodwill to its carrying
amount or by comparing the fair value of the indefinite-lived intangible asset to its carrying value.
Additionally, we make judgments about the recoverability of purchased finite-lived intangible assets whenever events or changes in
circumstances indicate that impairment may exist. Recoverability of finite-lived intangible assets is measured by comparing the
carrying amount of the asset to the future undiscounted cash flows that the asset is expected to generate. We perform an annual
impairment assessment in the fourth quarter of each year for finite-lived intangible assets, or more frequently if indicators of potential
impairment exist, to determine whether it is more likely than not that the carrying value of the assets may not be recoverable.
Recoverability of indefinite-lived intangible assets is measured by comparing the carrying amount of the asset to the future discounted
cash flows that the asset is expected to generate. If we determine that an individual asset is impaired, the amount of any impairment is
- 23 -
measured as the difference between the carrying value and the fair value of the impaired asset. The assumptions and estimates used to
determine future values and remaining useful lives of our intangible assets are complex and subjective. They can be affected by
various factors, including external factors such as industry and economic trends, and internal factors such as changes in our business
strategy and our forecasts for specific product lines.
Exit and Disposal Activities.
Fixed Assets
The Company’s policy is to review the carrying value of all long-lived assets for impairment whenever events or changes in
circumstances indicate that the carrying value of an asset may not be recoverable. We measure impairment losses of fixed assets and
leasehold improvements as the amount by which the carrying amount of a long-lived asset exceeds its fair value as prescribed by
FASB ASC 360, "Impairment or Disposal of Long-Lived Assets." 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.
During 2014, in association with the planned closure of stores not meeting the Company's operational performance targets, we
recorded a charge of $2.9 million in selling, general and administrative expense for the impairment of fixed assets and leasehold
improvements. During 2015, the Company recorded an additional charge of $0.3 million for fixed assets and leasehold improvements
related to the 2014 store closures.
In the fourth quarter of 2015, in association with the planned closure of stores not meeting the Company's operational performance
targets, we recorded a charge of $0.5 million in selling, general and administrative expense for the impairment of fixed assets and
leasehold improvements. Five stores are scheduled to close in early fiscal 2016.
Inventory
As discussed above, we adjust inventory values on a consistent basis to reflect current market conditions. In accordance with FASB
ASC 330, "Inventories," we write down inventory to net realizable value in the period in which conditions giving rise to the write-
downs are first recognized.
In the fourth quarter of 2013, we recorded a below-cost inventory adjustment of approximately $1.7 million for the discontinuance of
product categories from which the Company decided to exit. During 2014, the Company recorded an additional below-cost inventory
adjustment of approximately $0.3 million for the discontinuance of product categories from which the Company decided to exit.
During 2015, the Company did not record any adjustments related to the discontinuance of inventory product categories.
In the third quarter of 2014, we recorded a below-cost inventory adjustment of approximately $3.3 million to value inventory at the
lower of cost or market on inventory in 47 stores that were planned for closure in the fourth quarter of fiscal 2014.
In the fourth quarter of 2015, in association with the planned closure of five identified stores that were not meeting the Company's
operational performance targets, we recorded a below-cost inventory adjustment of approximately $0.7 million to record inventory at
the lower of cost or market. These stores are planned for closure by the end of the second quarter of fiscal 2016.
Lease Termination
For lease obligations related to closed stores, 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.
A lease obligation for some store closures that occurred in 2008 still existed as of January 31, 2015. During 2015, we utilized the
remaining $0.1 million of the lease liability for the fiscal 2008 store closures, leaving no reserve at January 30, 2016.
- 24 -
Property and Equipment and Intangibles. Property and equipment are carried at cost. Depreciation is recorded using the straight-
line method over the estimated useful lives of the assets and presented in selling, general and administrative expenses. Improvements
to leased premises are amortized 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 amortized over the lesser 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
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 primarily represent customer lists associated with acquired pharmacies. Based on the Company's
historical experience, seven years is an approximation of the actual lives of these assets.
The Company acquired customer list intangibles and certain other separately identifiable finite-lived intangibles in connection with its
acquisition of Reeves-Sain Drug Store, Inc. Based upon an analysis of historical customer attrition rates, specialty pharmacy scripts
are amortized on a straight line basis over four years. Other intangibles recorded in conjunction with the acquisition, including
specialty pharmacy licenses, referral relationships and non-compete agreements are being amortized on a straight line basis over lives
ranging from one to eight years.
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 30, 2016, the Company had approximately 1,000 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 earned within a month to longer-term
arrangements that could be earned over one year.
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 2015, 2014 and 2013,
were $24.0 million, $23.4 million and $22.8 million, respectively. Gross advertising expenses were reduced by vendor cooperative
advertising allowances of $4.5 million, $2.2 million and $2.8 million, for 2015, 2014 and 2013, respectively.
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 such as
PPACA. 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 for general liability and worker’s compensation runs August 1 through July 31 of each fiscal year. Our
employee medical insurance policy coverage runs from January 1 through December 31. The stop loss limits for excessive or
catastrophic claims for general liability and worker’s compensation remained unchanged at $350,000 and $500,000, respectively and
the employee medical stop loss limits remained at $175,000. The Company’s insurance reserve was $9.8 million and $10.0 million on
January 30, 2016 and January 31, 2015, respectively. Changes in the reserve for the year ended January 30, 2016, were attributable to
additional reserve requirements of $41.4 million netted with payments of $41.6 million.
- 25 -
Fair Value of Financial Instruments. Fair value is defined as the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the measurement date. The fair value hierarchy prioritizes the inputs
to valuation techniques used to measure fair value. The hierarchy, as defined below, gives the highest priority to unadjusted quoted
prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs.
•
•
•
Level 1, defined as quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity can
access at the measurement date.
Level 2, defined as inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either
directly or indirectly.
Level 3, defined as unobservable inputs for the asset or liability, which are based on an entity’s own assumptions as there is
little, if any, observable activity in identical assets or liabilities.
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.
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 5 – Income Taxes).
In June 2006, the Financial Accounting Standards Board issued FASB Interpretation No. 48 (“FASB ASC 740”), Accounting for
Uncertainty in Income Taxes — an Interpretation of FASB Statement No.109 that is codified in FASB ASC 740. We adopted FASB
ASC 740 as of February 4, 2007, the first day of fiscal 2007. This interpretation clarifies the accounting for uncertainty in income
taxes recognized in an enterprise’s financial statements in accordance with FASB ASC 740 and prescribes a minimum recognition
threshold of more-likely-than-not to be sustained upon examination that a tax position must meet before being recognized in the
financial statements. Under FASB ASC 740, the impact of an uncertain income tax position on the income tax return must be
recognized at the largest amount that is more-likely-than-not to be sustained upon audit by the relevant taxing authority. The Company
recognizes and measures tax benefits from uncertain tax positions if it is "more likely than not" that the position is sustainable, based
on its technical merits. The tax benefit of a qualifying position is the largest amount of tax benefit that has a greater than 50 percent
likelihood of being realized upon final settlement with a taxing authority fully knowing all relevant information. Additionally, FASB
ASC 740 provides guidance on de-recognition, measurement, classification, interest and penalties, accounting in interim periods,
disclosure and transition (see Note 5 – 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. Accrued interest and penalties related to our unrecognized tax benefits are
recorded in the consolidated balance sheet within “Other non-current liabilities.”
The Company records valuation allowances to reduce deferred tax assets when it is more likely than not that a tax benefit will not be
realized. Significant judgment is required in evaluating the need for and magnitude of appropriate valuation allowances against
deferred tax assets. The realization of these assets is dependent on generating future taxable income, as well as successful
implementation of various tax planning strategies.
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 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.
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.
- 26 -
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.
Business Combinations. The Company accounts for business combinations using the acquisition method of accounting. This requires
that once control is obtained, all the assets acquired and liabilities assumed be recorded at their respective fair values at the date of
acquisition. The determination of fair values of assets and liabilities acquired requires estimates and the use of valuation techniques
when market value is not readily available.
Goodwill. The Company records goodwill when the purchase price exceeds the fair value of assets acquired and liabilities assumed.
The Company accounts for goodwill and intangibles under ASC Topic 350, Intangibles – Goodwill and Other, which does not permit
amortization, but requires the Company to test goodwill and other indefinite-lived assets for impairment annually or whenever events
or circumstances indicate that impairment may exist.
Results of Operations
The following table provides a comparison of Fred's financial results for the past three years. In this table, categories of income and
expense are expressed as a percentage of sales.
Net sales
Cost of good sold 1
Gross profit
Selling, general and administrative expenses 2
Operating income
Interest expense, net
Income before taxes
Income taxes
Net income
January 30,
2016
For the Years Ended
January 31,
2015
February 1,
2014
100.0
%
100.0
%
100.0
%
74.7
25.3
25.8
(0.5)
0.1
(0.6)
(0.3)
(0.3)
%
74.4
25.6
28.1
(2.5)
-
(2.5)
(1.0)
(1.5)
%
71.1
28.9
26.9
2.0
-
2.0
0.7
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. T hese
costs are associated with products that have been sold and no longer remain in ending inventory.
Comparable Stores Sales. A store is first included in comparable store sales after the end of the 12th month following the store's
grand opening month. Our calculation of comparable store sales represents the increase or decrease in net sales for these stores, 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.
- 27 -
Fiscal 2015 Compared to Fiscal 2014
Sales
Net sales for 2015 increased to $2,150.7 million from $1,970.0 million in 2014 for a year-over-year increase of $180.7 million or
9.2%. Comparable store sales for 2015 increased 1.5% compared with a decrease of 0.6% in the same period last year.
General merchandise (non-pharmacy) sales decreased 6.8% over 2014 front store sales. The decrease is primarily due to the store
closures at the end of 2014. We also experienced sales decreases in categories such as food and beverage, paper, cleaning supplies and
tobacco which were partially offset by increases in snacks, toys and “As Seen on TV” products.
The Company’s pharmacy department sales were 50.2% of total sales in 2015 compared to 41.9% 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 31.0% over 2014, with
third party prescription sales representing approximately 93% of total pharmacy department sales in 2015 as compared to 92% in
2014. 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 specialty pharmacy and pharmacy departments in existing store locations.
Sales to Fred's 18 franchised locations during 2015 remained flat at $31.5 million (1.5% of sales) compared to $31.5 million in fiscal
2014 (1.6% of sales). The Company does not intend to expand its franchise network.
The sales mix for the period, unadjusted for deferred layaway sales, was 50.2% Pharmaceuticals, 25.7% Consumables, 22.6%
Household Goods and Softlines and 1.5% Franchise. The sales mix for the same period last year was 41.9% Pharmaceuticals, 31.2%
Consumables, 25.3% Household Goods and Softlines and 1.6% Franchise.
For 2015, comparable store customer traffic decreased 3.2% over last year while the average customer ticket increased 4.7% to
$23.01.
Gross Profit
Gross profit for the year increased to $544.2 million in 2015 from $503.8 million in 2014, a year-over-year increase of $40.4 million,
or 8.0%. The increase in gross profit was driven by below cost inventory adjustments in 2014 related to unproductive inventory, store
closures and product categories the Company has decided to exit. Gross margin rate, measured as a percentage of net sales, decreased
to 25.3% in 2015 from 25.6% in 2014, a 30 basis point decline. Gross margin rate deleveraging was driven by our sales mix shift
towards low margin specialty pharmaceuticals and continued reimbursement pressures.
Selling, General and Administrative Expenses
Selling, general and administrative expenses, including depreciation and amortization, increased to $554.5 million in 2015 (25.8% of
sales) from $552.2 million in 2014 (28.0% of sales). This 220 basis points leverage was primarily attributed to higher sales related to
our pharmacy growth initiatives (224 basis points) and lower occupancy costs (47 basis points). The improvement was partially offset
by increased legal and professional fees which were primarily due to a reserve recorded in the third quarter for our estimates of fines
resulting from a data security breach (30 basis points).
Operating Income (Loss)
Operating loss decreased $38.0 million to $10.4 million in 2015 (0.5% of sales) from operating loss of $48.4 million in 2014 (2.5% of
sales) due to a $40.4 million increase in gross profit driven by inventory below cost inventory adjustments in 2014 as well as higher
sales related to our pharmacy growth initiatives. Partially offsetting the increase in operating loss was an increase in certain selling,
general and administrative expenses as described in the Selling, General and Administrative Expenses section above.
Interest Expense, Net
Net interest expense for 2015 totaled $1.4 million or less than 0.1% of sales compared to $0.5 million which was also less than 0.1%
of sales in 2014.
Income Taxes
The effective income tax rate was 37.7% in 2015 compared to 40.9% in 2014.
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 5 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.
- 28 -
State net operating loss carry-forwards are available to reduce state income taxes in future years. These carry-forwards total
approximately $125.5 million for state income tax purposes at January 30, 2016 and expire at various times during 2016 through 2036.
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.
Net Income (Loss)
Net loss decreased to $7.4 million ($0.20 per share) in 2015 from a loss of $28.9 million ($0.80 per share) in 2014, a decrease of $21.5
million. The decrease in net loss is primarily attributable to a $40.4 million increase in gross profit driven by below cost inventory
adjustments in 2014 and higher sales related to our pharmacy growth initiatives. Partially offsetting the favorability was an increase in
selling, general and administrative expenses of $2.3 million as described in the Selling, General and Administrative Expenses section
above and a $15.6 million decrease in the income tax benefit.
Fiscal 2014 Compared to Fiscal 2013
The following information contains references to years 2014 and 2013, which represent fiscal years ended January 31, 2015 and
February 1, 2014.
Sales
Net sales for 2014 increased to $1,970.0 million from $1,939.2 million in 2013 for a year-over-year increase of $30.8 million or 1.6%.
Comparable store sales for 2014 decreased 0.6% compared with an increase of 0.6% in the same period in 2013.
General merchandise (non-pharmacy) sales decreased 5.2% over 2013 front store sales. We experienced sales decreases in categories
such as food, electronics, cleaning supplies, toys and bedding and window which were partially offset by increases in the sale of our
unproductive inventory clearance items which include select footwear, home furnishings, apparel and trim-a-home seasonal items.
The Company’s pharmacy department sales were 42.0% of total sales in 2014 compared to 37.7% 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 12.7% over 2013, with
third party prescription sales representing approximately 92% of total pharmacy department 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 EIRIS Specialty Pharmacy and pharmacy departments in existing store locations.
Sales to Fred's 19 franchised locations during 2014 declined 3.6% to $31.5 million (1.6% of sales) compared to $32.6 million in 2013.
The decrease in year-over-year franchise sales was due primarily to the franchise closings during the year.
The sales mix for the period, unadjusted for deferred layaway sales, was 41.9% Pharmaceuticals, 31.2% Consumables, 25.3%
Household Goods and Softlines and 1.6% Franchise. The sales mix for the same period in 2013 was 37.7% Pharmaceuticals, 33.0%
Consumables, 27.6% Household Goods and Softlines and 1.7% Franchise.
For 2014, comparable store customer traffic decreased 3.1% over 2013 while the average customer ticket increased 2.5% to $21.94.
Gross Profit
Gross profit for 2014 decreased to $503.8 million from $560.8 million in 2013, a year-over-year decrease of $57.0 million or 10.2%.
Gross margin rate, measured as a percentage of net sales, decreased to 25.6% in 2014 from 28.9% in 2013, a 330 basis point decline.
Gross margin rate deleveraging was negatively affected by a reserve for inventory clearance of product that management identified as
low-productive, a reserve for inventory markdowns on the discontinuance of product categories that the Company has decided to exit
and a reserve for inventory markdowns on the planned closure of stores. Also contributing to the gross margin deleveraging were
aggressive promotional activities and additional above-cost markdowns for the clearance of our promotional and exit related
categories. The gross margin deleveraging was also driven by historically large generic drug inflation coupled with the maturing
reimbursement rates on prior brand-to-generic conversions. The reimbursement adjustments from third parties have not been made at
the speed of the manufacturer’s rate of price increases. Finally, the sales mix changes in general merchandising toward other
consumable product departments negatively impacted gross margin.
Selling, General and Administrative Expenses
Selling, general and administrative expenses, including depreciation and amortization, increased to $552.2 million in 2014 (28.1% of
sales) from $521.6 million in 2013 (26.9% of sales). This 120 basis points deleverage was primarily attributed to 43 basis points of
increasing occupancy related expenses ($10.6 million) and 39 basis points of higher payroll expense ($11.9 million) driven by the year
over year pharmacy department growth related to the Company’s goal to increase pharmacy penetration in our stores. Also
contributing to the deleveraging of expenses were 17 basis points of loss on the disposal of fixed assets related to the planned store
closures ($3.3 million) and 10 basis points of lower proceeds from pharmacy script file sales ($1.7 million). Further deleveraging
expenses were a six basis point increase for professional fees driven by consulting services for Company business initiatives ($1.3
- 29 -
million) and five basis points of higher advertising expense associated with our new marketing program that began in 2014 ($1.2
million).
Operating Income (Loss)
Operating loss decreased $87.6 million to ($48.4) million in 2014 (2.5% of sales) from operating income of $39.2 million in 2013
(2.0% of sales) due to a $57.0 million decrease in gross profit driven by the inventory markdown reserves, the generic pharmaceutical
inflation combined with pressure on generic pharmaceutical reimbursement rates and the sales mix shift. Further contributing to the
operating loss was an increase in selling, general and administrative expenses of $30.6 million as described in the Selling, General and
Administrative Expenses section above.
Interest Expense, Net
Net interest expense for 2014 totaled $0.5 million or less than 0.1% of sales compared to $0.5 million which was also less than 0.1%
of sales in 2013.
Income Taxes
The effective income tax rate was 40.9% in 2014 compared to 32.8% in 2013. The higher effective tax rate reflects the impact of the
Work Opportunity Tax Credits which were passed by Congress during the fourth quarter. The higher tax rate on the operating loss in 2014
increased the tax credit which reduced our operating loss for the 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 5 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 $133.9 million for state income tax purposes at January 31, 2015 and expire at various times during 2015 through 2035.
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.
Net Income (Loss)
Net loss decreased to ($28.9) million ($0.80 per diluted share) in 2014 from income of $26.0 million ($0.71 per diluted share) in 2013,
a decrease of $54.9 million. The decrease in net income is primarily attributable to a $57.0 million decrease in gross profit driven by
the inventory markdown reserves, the generic pharmaceutical inflation combined with pressure on generic pharmaceutical
reimbursement rates and the sales mix shift as detailed in the gross profit section above. Further contributing to the loss is an increase
in selling, general and administrative expenses of $30.6 million as described in the Selling, General and Administrative Expenses
section above. Partially offsetting the unfavorability was $32.7 million in tax benefit stemming from the operating loss.
Liquidity and Capital Resources
The Company’s principal capital requirements include funding new stores and pharmacies, remodeling existing stores and pharmacies,
maintaining 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 $210.0 million, $226.8 million and $282.4 million at year-end 2015, 2014 and 2013, respectively. Working capital fluctuates in
relation to profitability, seasonal inventory levels, and the level of store openings and closings. Working capital at year-end 2015
decreased $16.8 million from 2014. The decrease was primarily due to an increase in accounts payable and accrued expenses of $41.4
million and $10.5 million at year-end, respectively. Partially offsetting the decrease in working capital are increases in inventory of
$25.0 million primarily as a result of spring inventory purchases and inventory in transit and accounts receivable of $11.8 million
which was driven by pharmacy growth and the related third-party sales volume.
We have incurred losses caused by wind and flood damage, which consisted primarily of losses of inventory and fixed assets and
interruption of business. 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 $50.7 million in 2015, $63.7 million in 2014 and $58.9 million in 2013. The
decrease in 2015 resulted from increases in operating assets offset by a decrease in our operating loss. Cash flows from operating
activities increased in 2014 as a result of inventory decreases and provisions for store closures and asset impairment offset by the
operating loss.
- 30 -
Net cash used in investing activities totaled $78.6 million in 2015, $56.1 million in 2014 and $44.5 million in 2013.
Capital expenditures in 2015 totaled $23.0 million compared to $23.3 million in 2014 and $25.9 million in 2013. The capital
expenditures during 2015 consisted primarily of existing store improvements ($12.1 million), technology ($6.8 million), new store and
pharmacy department growth ($2.2 million), and distribution and corporate expenditures ($1.9 million) Additionally, $42.8 million
was invested related to the acquisition of Reeves-Sain Drug Store, Inc. and $16.6 million was related to acquisitions of other
pharmacies during 2015.
Net cash provided by financing activities totaled $27.3 million in 2015, while net cash used in financing activities totaled $7.9 million
in 2014 and $15.7 million in 2013. The cash flows provided by financing activities in 2015 were driven by draws on our revolving line
of credit related to the acquisition of Reeves-Sain Drug Store Inc. which included two EntrustRx specialty pharmacy locations.
The Company’s 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. The per share amounts approved
resulted in the payment of dividends in fiscal 2015, 2014 and 2013 of $8.9 million, $8.8 million and $8.8 million, respectively.
In fiscal 2015, 2014 and 2013, the Company did not repurchase any shares. 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. On February 16, 2012, the Board
of Directors authorized the expansion of the Company's existing stock repurchase program by increasing the authorization to
repurchase an additional 3.6 million shares. 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.
On January 25, 2013, the Company entered into a Revolving Loan and Credit Agreement (the "Agreement") with Regions Bank and
Bank of America to replace the April 3, 2000 Revolving Loan and Credit Agreement, which was last amended September 27, 2010.
The Agreement provided for a $50 million revolving line of credit, and the term of the Agreement extended to January 25, 2016.
There were $3.8 million of borrowings outstanding and $46.2 million available under the Agreement at January 31, 2015. There were
no borrowings outstanding at February 1, 2014. The weighted average interest rate on borrowings outstanding at January 31, 2015
was 1.8%. The Agreement contained certain restrictive financial covenants, and at November 1, 2014 and January 31, 2015, the
Company was not in compliance with the trailing 12 month covenants for the Fixed Charge Coverage Ratio, for Consolidated
Tangible Net Worth and for positive Net Income.
On April 9, 2015, the Company entered into a new Revolving Loan and Credit Agreement (the “ New Agreement”) with Regions
Bank and Bank of America to replace the Agreement. The proceeds were used to refinance the Agreement and to support acquisitions
and the Company’s working capital needs. The New Agreement provides for a $150.0 million secured revolving line of credit, which
includes a sublimit for letters of credit and swingline loans. There were $38.3 million of borrowings outstanding and $102.7 million
available under the New Agreement at January 30, 2016. The New Agreement expires on April 9, 2020 and bears interest at 1.25% or
1.50% plus either LIBOR or the LIBOR index rate depending on our FIFO inventory balance. The weighted average interest rate on
borrowings outstanding at January 30, 2016 was 1.7%. Commitment fees on the unused portion of the credit line are 20.0 basis points.
The New Agreement included an up-front credit facility fee which is being amortized over the Agreement term.
Cash and cash equivalents were $5.9 million at the end of 2015 compared to $6.4 million at the end of 2014 and $6.7 million at the
end of 2013. 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, amounts available under the revolving line of credit and cash generated from future operations to sustain the Company’s
operations and to fund our strategic plans.
Off-Balance Sheet Arrangements
The Company has no off-balance sheet financing arrangements.
Effects of Inflation and Changing Prices
The Company believes that inflation has had a significant impact on gross margins beginning in the second half of 2013 and
continuing throughout 2014 and 2015. Historic levels of pharmacy generic price inflation has been experienced since 2013 and is
being accentuated by the lack of significant brand to generic conversions that have previously helped to offset any material cost
inflation as well as lagging payor reimbursements.
Contractual Obligations and Commercial Commitments
As discussed in Note 6 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
- 31 -
Company to pay contingent rent based upon a percentage of sales, taxes, maintenance, insurance and certain other operating expenses
applicable to the leased properties. In addition, the Company leases various equipment under noncancelable operating leases.
The following table summarizes the Company’s significant contractual obligations as of January 30, 2016, which excludes the effect
of imputed interest:
(dollars in thousands)
Operating leases 1
Inventory purchase obligations 2
3
Mortgage loans on land & buildings and other
4
Equipment leases
Postretirement benefits 5
2016
2017
2018
2019
2020
Thereafter
Total
$
45,886
$
37,441
$
26,915
$
20,248
$
16,284
$
47,730
194,504
83,354
-
-
-
621
1,272
51
60
722
58
65
568
58
70
568
60
-
4,408
568
62
-
10,035
757
321
83,354
15,259
4,455
610
Total contractual obligations
$
131,184
$
38,281
$
27,606
$
20,946
$
21,322
$
58,843
$
298,182
1 Operating leases are described in Note 6 to the Consolidated Financial Statements.
2 Inventory purchase obligations represent open purchase orders and any outstanding purchase commitments.
3 M ortgage loans for purchased land and buildings and amounts owed under the acquisition notes payable.
4 Equipment leases represent our tractor/trailer lease obligation.
5 Postretirement benefits are described in Note 10 to the Consolidated Financial Statements.
The Company had commitments approximating $7.3 million at January 30, 2016 and $4.5 million at January 31, 2015 on issued letters
of credit and open accounts, which support purchase orders for imported merchandise. Additionally, the Company had outstanding
standby letters of credit aggregating approximately $9.0 million at January 30, 2016 and $10.6 million at January 31, 2015 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, owns the land and buildings
occupied by three Fred’s stores. Richard H. Sain, Senior Vice President of Retail Pharmacy Business Development, owns the land and
building occupied by one of Fred’s Xpress Pharmacy locations. 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. The total rental payments for
related party leases were $511.3 thousand for the year ended January 30, 2016 and $310.0 and $301.0 thousand for the years ended
January 31, 2015 and February 1, 2014, respectively. The increase is due to the addition of Mr. Sain’s Xpress Pharmacy location and
the timing of property tax and insurance payments for the store locations.
On April 10, 2015, the Company completed the acquisition of Reeves-Sain Drug Store, Inc., a provider of retail and specialty
pharmaceutical services. As part of the total consideration for the purchase, Fred’s provided notes payable totaling $13.0 million to the
sellers of Reeves-Sain Drug Store, Inc. who joined Fred’s as part of the acquisition. The notes payable are due in three equal
installments to be paid on January 31st of 2021, 2022 and 2023 and are subordinate to the Company’s revolving line of credit. See
Note 13 – Business Combinations for further discussion of the acquisition.
Recent Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic
606). The amendments in the ASU are designed to clarify the principles for recognizing revenue and develop a joint standard between
U.S. GAAP and the International Financial Reporting Standards (“IFRS”) that strive to remove reporting inconsistencies, provide a
more robust framework for addressing revenue issues, improve comparability across entities, provide more useful information to the
users of financial statements and simplify the preparation of financial statements by reducing the number of requirements an entity
must refer to. The guidance in the ASU supersedes previous revenue recognition guidance in Topic 605: Revenue Recognition.
Subsequently, in August 2015, the Financial Accounting Standards Board issued ASU No. 2015-14, Revenue from Contracts with
Customers (Topic 606): Deferral of the Effective Date. This ASU defers the effect date from that previously stated in ASU no. 2014-
09. The amendments in these ASU’s are effective for the annual reporting periods beginning after December 15, 2017, including the
interim periods within that reporting period. Earlier adoption is permitted. The Company is still evaluating the impact the guidance
will have on the Company’s consolidated net earnings, cash flows and financial position.
- 32 -
In April 2015, the Financial Accounting Standards Board issued ASU 2015-16, Intangibles-Goodwill and Other-Internal-Use
Software (Subtopic 350-40): Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement. The amendments in the ASU
provide guidance to customers about whether a cloud computing arrangement includes a software license. If a cloud computing
arrangement includes a software license, then the customer should account for the software license element of the arrangement
consistent with the acquisition of other software licenses. If a cloud computing arrangement does not include a software license, the
customer should account for the arrangement as a service contract. The guidance will not change U.S. GAAP for a customer’s
accounting for service contracts. In addition, the guidance in this ASU supersedes paragraph 350-40-25-16 and this all software
licenses within the scope of Subtopic 350-40 will be accounted for consistent with other licenses of intangible assets. The amendments
in this ASU are effective for the annual reporting periods beginning after December 15, 2015, including interim periods within that
reporting period. To comply with the guidance, the Company has applied the guidance prospectively. During 2015, the Company
entered into one such arrangement and has included $1.8 million within Intangible Assets and $0.3 million within Property and
Equipment on the Consolidated Balance Sheet.
In September 2015, the Financial Accounting Standards Board issues ASU 2015-16, Business Combinations (Topic 805): Simplifying
the Accounting for Measurement-Period Adjustments. The amendments in the ASU require an acquirer to recognize adjustments to
provisional amounts that are identified during the measurement period in the reporting period in which the adjustment are determined.
The acquirer is also required to record, in the same period’s financial statements, the effect on earnings of changes in depreciation,
amortization, or other income effects as a result of the change to the provisional amounts as if the accounting had been completed at
the acquisition date. The acquirer is required to present separately on the face of the statement of operations or disclose in the notes the
portion recorded in current-period earnings by line item that would have been recorded in previous reporting periods. Previously,
acquirers were required to retroactively adjust provisional amounts with a corresponding adjustment to goodwill. The amendments in
this ASU are effective for the annual reporting periods beginning after December 15, 2015, including interim periods within that
reporting period. The Company does not expect adoption to have a material impact on the Company’s consolidated net earnings, cash
flows or financial position.
In November 2015, the Financial Accounting Standards Board issued ASU 2015-17, Income Taxes (Topic 740): Balance Sheet
Classification of Deferred Taxes. The amendments in the ASU are designed to simplify the presentation of deferred income taxes on
the balance sheet by requiring deferred tax liabilities and assets be classified as noncurrent in a classified statement of financial
position. The current requirement that deferred tax liabilities and assets be offset and presented as a single amount is not affected by
this ASU. The amendments in this ASU are effective for the annual reporting periods beginning after December 15, 2016, including
interim periods within that reporting period. Earlier adoption is permitted. The Company elected retrospective early adoption to
simplify the presentation of deferred taxes. The result is a reclassification of January 31, 2015 noncurrent deferred income tax of $2.8
million from other noncurrent assets, net to noncurrent deferred income taxes liability and a reclassification of $13.4 million from
current deferred income taxes liability to noncurrent deferred income taxes liability.
In February 2016, the Financial Accounting Standards Board issued ASU 2016-02, Leases (Topic 842). The amendments in the ASU
are designed to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the
balance sheet and disclosing key information about leasing arrangements. The amendments in this ASU are effective for the annual
reporting periods beginning after December 15, 2018, including the interim periods within that reporting period. Early adoption is
permitted. The Company is still evaluating the impact the guidance will have on the Company’s consolidated net earnings, cash flows
and financial position.
In March 2016, the Financial Accounting Standards Board issued ASU 2016-04, Liabilities – Extinguishments of Liabilities (Subtopic
405-20): Recognition of Breakage for Certain Prepaid Stored-Value Products. The amendments in the ASU are designed to provide
guidance and eliminate diversity in the accounting for derecognition of prepaid stored-value product liabilities. Typically, a prepaid
stored-value product liability is to be derecognized when it is probable that a significant reversal of the recognized breakage amount
will not subsequently occur. This is when the likelihood of the product holder exercising its remaining rights becomes remote. This
estimate shall be updated at the end of each period. The amendments in this ASU are effective for the annual reporting periods
beginning after December 15, 2017, including the interim periods within that reporting period. Early adoption is permitted. The
Company is still evaluating the impact the guidance will have on the Company’s consolidated net earnings, cash flows and financial
position.
ITEM 7A: Quantitative and Qualitative Disclosures about Market Risk
The Company has no holdings of derivative financial or commodity instruments as of January 30, 2016. The Company is exposed to
financial market risks, including changes in interest rates, primarily related to the effect of interest rate changes on borrowings
outstanding under our revolving line of credit. Borrowings under the New Agreement bear interest at 1.25% or 1.50% plus either
LIBOR or the LIBOR index rate depending on our FIFO inventory balance. Our potential additional interest expense over one year
that would result from a hypothetical and unfavorable change of 100 basis points in short term interest rates would be in the range of
$0.01 to $0.02 of earnings per share assuming borrowings levels of $50.0 million to $100.0 million throughout 2016. 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.
- 33 -
ITEM 8: Financial Statements and Supplementary Data
Report of Independent Registered Public Accounting Firm
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 30, 2016 and January
31, 2015 and the related consolidated statements of operations, comprehensive income (loss), changes in shareholders’ equity, and
cash flows for each of the three years in the period ended January 30, 2016. These financial statements are the responsibility of the
Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).
Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are
free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the
financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating
the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of
Fred's, Inc. at January 30, 2016 and January 31, 2015, and the results of its operations and its cash flows for each of the three years in
the period ended January 30, 2016, 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 30, 2016, based on criteria established in Internal Control – Integrated
Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated
April 14, 2016 expressed an unqualified opinion thereon.
/s/ BDO USA, LLP
Memphis, Tennessee
April 14, 2016
- 34 -
FRED’S, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except for number of shares)
ASSETS
Current assets:
Cash and cash equivalents
Receivables, less allowance for doubtful accounts of $2,936 and $2,404, respectively
Inventories
Other non-trade receivables
Prepaid expenses and other current assets
Total current assets
Property and equipment, less accumulated depreciation and amortization
Goodwill
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
Total current liabilities
Long-term portion of indebtedness
Deferred income taxes
Other noncurrent liabilities
Total liabilities
Commitments and contingencies (see Note 3-Indebtedness, Note 6-Long-Term Leases and
Note 10-Other Commitments and Contingencies)
Shareholders’ equity:
Preferred stock, nonvoting, no par value, 10,000,000 shares authorized, none outstanding
Preferred stock, Series A junior participating nonvoting, no par value,
224,594 shares authorized, none outstanding
Common stock, Class A voting, no par value, 60,000,000 shares authorized,
37,232,785 and 36,969,268 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
See accompanying notes to consolidated financial statements.
January 30,
2016
January 31,
2015
$ 5,917
53,171
340,730
40,049
11,494
451,361
138,993
41,490
97,153
1,515
$ 730,512
$
6,440
41,370
315,678
43,487
12,983
419,958
143,985
87
79,542
2,903
$ 646,475
$ 184,657
621
56,074
241,352
52,527
9,724
22,698
326,301
$ 143,250
4,331
45,599
193,180
2,259
10,615
24,785
230,839
-
-
-
-
109,596
104,653
-
294,140
475
404,211
$ 730,512
-
310,413
570
415,636
$ 646,475
- 35 -
FRED’S, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
Net sales
Cost of goods sold
Gross profit
Depreciation and amortization
Selling, general and administrative expenses
Operating income (loss)
Interest expense
Income (loss) before income taxes
Provision (benefit) for income taxes
Net income (loss)
Net income (loss) per share
Basic
Diluted
Weighted average common shares outstanding
Basic
Effect of dilutive stock options
Diluted
For the Ye ars Ende d
January 30,
January 31,
Fe bruary 1,
2016
$ 2,150,703
1,606,553
544,150
2015
$ 1,970,049
1,466,256
503,793
2014
$ 1,939,246
1,378,405
560,841
45,652
508,897
(10,399)
1,431
(11,830)
41,063
511,142
(48,412)
504
(48,916)
41,047
480,596
39,198
487
38,711
(4,459)
$ (7,371)
(20,012)
$ (28,904)
12,696
26,015
$
$
(0.20)
$
(0.80)
$
0.71
$
(0.20)
$
(0.80)
$
0.71
36,675
-
36,675
36,313
-
36,313
36,558
162
36,720
FRED’S, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(in thousands)
Comprehensive income (loss):
Net income (loss)
Other comprehensive expense, net of tax
Postretirement plan adjustment
For the Ye ars Ende d
January 30,
January 31,
Fe bruary 1,
2016
2015
2014
$ (7,371)
$ (28,904)
$ 26,015
(95)
(133)
(91)
Comprehensive income (loss)
$ (7,466)
$ (29,037)
$ 25,924
See accompanying notes to consolidated financial statements.
- 36 -
FRED’S, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
(in thousands, except share and per share amounts)
Balance, February 2, 2013
Cash dividends paid ($.24 per share)
Restricted stock grants, cancellations and
withholdings, net
Issuance of shares under employee stock purchase plan
Issuance of shares under employee stock ownership plan
Repurchased and cancelled shares
Stock-based compensation
Exercises of stock options
Income tax expense on exercise of stock options
Adjustment for postretirement benefits (net of tax)
Net income
Balance, February 1, 2014
Cash dividends paid ($.24 per share)
Restricted stock grants and cancellations
Issuance of shares under employee stock purchase plan
Issuance of shares under employee stock ownership plan
Repurchased and cancelled shares
Repurchased equity awards
Stock-based compensation
Exercises of stock options
Income tax expense on exercise of stock options
Adjustment for postretirement benefits (net of tax)
Net loss
Balance, January 31, 2015
Cash dividends paid ($.24 per share)
Restricted stock grants and cancellations
Issuance of shares under employee stock purchase plan
Issuance of shares under employee stock ownership plan
Repurchased and cancelled shares
Repurchased equity awards
Stock-based compensation
Exercises of stock options
Income tax expense on exercise of stock options
Adjustment for postretirement benefits (net of tax)
Net loss
Balance, January 30, 2016
Accumulated
Other
Common Stock
Shares
Amount
Retained Comprehensive
Earnings
Income
36,680,060
$
99,342
$
331,136
(8,830)
$
794
Total
$
431,272
(8,830)
(31,062)
60,912
(342)
712
81,369
1,791
998
23
36,791,279
102,524
112,566
54,992
(30,883)
41,314
751
(1,713)
2,433
499
159
26,015
348,321
(8,846)
(158)
(28,904)
36,969,268
104,653
310,413
(8,929)
(91)
703
(133)
570
27,250
57,972
693
(25,131)
202,733
737
(410)
2,262
2,134
220
37,232,785
$
109,596
27
(95)
(7,371)
294,140
$
$
475
(342)
712
-
-
1,791
998
23
(91)
26,015
451,548
(8,846)
-
751
-
-
(1,713)
2,433
499
1
(133)
(28,904)
415,636
(8,929)
-
737
-
(410)
-
2,262
2,134
247
(95)
(7,371)
404,211
$
See accompanying notes to consolidated financial statements.
- 37 -
FRED’S, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
Cash flows from operating activities:
Net income (loss)
Adjustments to reconcile net income to net cash flows from operating activities:
January 30, 2016
For the Years Ended
January 31, 2015
February 1, 2014
$
(7,371)
$
(28,904)
$
26,015
Depreciation and amortization
Net gain on asset disposition
Provision for store closures and asset impairment
Stock-based compensation
Provision for uncollectible receivables
LIFO reserve increase
Deferred income tax benefit
Income tax charge upon exercise of stock options
Benefit for postretirement medical
Changes in operating assets and liabilities, net of effects of business acquired:
(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 receivable
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)
Acquisition of Reeves-Sain Drug Store, Inc., net of cash
Net cash used in investing activities
Cash flows from financing activities:
Payments of indebtedness and capital lease obligations
Proceeds from revolving line of credit
Payments on revolving line of credit
Debt issuance costs
Excess tax benefit from stock-based compensation
Proceeds (payments) from exercise of stock options and employee stock purchase
Repurchase of shares
Cash dividends paid
Net cash provided by (used in) financing activities
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:
45,652
(2,887)
1,376
2,262
532
7,595
(831)
(247)
(45)
(2,306)
(301)
(31,178)
2,998
29,215
8,432
(2,197)
50,699
(22,954)
3,747
-
(16,596)
(42,757)
(78,560)
(554)
937,164
(902,681)
(371)
247
2,462
-
(8,929)
27,338
41,063
(3,601)
16,125
2,433
1,383
4,734
(13,289)
(1)
(84)
2,153
(441)
28,404
420
16,689
(13,683)
10,302
63,703
(23,308)
4,861
-
(37,605)
-
(56,052)
(2,438)
455,079
(451,236)
(34)
1
(462)
-
(8,846)
(7,936)
41,047
(3,972)
1,700
1,791
103
4,526
(5,165)
(23)
(82)
(5,213)
298
(14,953)
(111)
12,835
(921)
986
58,861
(25,918)
6,267
176
(25,066)
-
(44,541)
(1,308)
235,313
(242,279)
(11)
23
1,368
-
(8,830)
(15,724)
(523)
(285)
(1,404)
$
6,440
5,917
$
6,725
6,440
$
8,129
6,725
$
$
1,431
4,634
$
$
504
8,045
$
$
487
19,831
Acquisition related note payable, see Note 10 - Indebtedness
$
13,000
$
-
$
-
See accompanying notes to consolidated financial statements.
- 38 -
Notes to Consolidated Financial Statements
NOTE 1 — DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Description of business. The primary business of Fred's, Inc. and its subsidiaries ("Fred's", “We”, “Our”, “Us” or “Company”) is the
sale of general merchandise through its retail discount stores and full service pharmacies. In addition, the Company sells general
merchandise to its 18 franchisees. As of January 30, 2016, the Company had 659 retail stores, 372 pharmacies, and three specialty
pharmacy facilities located in 15 states mainly in the Southeastern United States. We are licensed to dispense pharmaceuticals in all 50
states.
Consolidated Financial Statements. The Consolidated Financial Statements include the accounts of Fred's, Inc. and its subsidiaries.
All significant intercompany accounts and transactions are eliminated. Amounts are in thousands unless otherwise noted.
Subsequent Events. The Company has evaluated subsequent events through the financial statement issue date. Based on this
evaluation, we are not aware of any events or transactions requiring recognition or disclosure in our consolidated financial statements.
Fiscal year. The Company utilizes a 52 - 53 week accounting period which ends on the Saturday closest to January 31. Fiscal years
2015, 2014 and 2013, as used herein, refer to the years ended January 30, 2016, January 31, 2015 and February 1, 2014, respectively.
Fiscal years 2015, 2014 and 2013 each had 52 weeks.
Use of estimates. The preparation of financial statements in accordance with U.S. Generally Accepted Accounting Principles ("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
based on the aging of receivables and additionally uses payor-specific information to assess collection risk, 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 stated 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
(market value). Therefore, after applying the cost to retail ratio, the cost value of our inventory is stated at the lower of cost or market
as is prescribed by U.S. GAAP.
Because the approximation of net realizable value (market value) under the retail inventory method is based on estimates such as
markups, markdowns and inventory losses (shrink), there exists an inherent uncertainty in the final determination of inventory cost
and gross margin. In order to mitigate that uncertainty, the Company has a formal review by product class which considers such
variables as current market trends, seasonality, weather patterns and age of merchandise to ensure that markdowns are taken currently,
or a markdown reserve is established to cover future anticipated markdowns. This review also considers current pricing trends and
inflation to ensure that markups are taken if necessary. The estimation of inventory losses (shrink) is a significant element in
- 39 -
approximating the carrying value of inventory at net realizable value, and as such, the following paragraph describes our estimation
method as well as the steps we take to mitigate the risk of this estimate in the determination of the cost value of inventory.
The Company calculates inventory losses (shrink) based on actual inventory losses occurring as a result of physical inventory counts
during each fiscal period and estimated inventory losses occurring between yearly physical inventory counts. The estimate for shrink
occurring in the interim period between physical counts is calculated on a store-specific basis and is based on history, as well as
performance on the most recent physical count. It is calculated by multiplying each store’s shrink rate, which is based on the
previously mentioned factors, by the interim period’s sales for each store. Additionally, the overall estimate for shrink is adjusted at
the corporate level to a three-year historical average to ensure that the overall shrink estimate is the most accurate approximation of
shrink based on the Company’s overall history of shrink. The three-year historical estimate is calculated by dividing the “book to
physical” inventory adjustments for the trailing 36 months by the related sales for the same period. In order to reduce the uncertainty
inherent in the shrink 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 methodology that we have applied in estimating shrink has resulted in variability that is not material to our
financial statements.
Management believes that the Company’s retail inventory method provides an inventory valuation which reasonably approximates
cost and results in valuing inventory at the lower of cost or market. For pharmacy department inventories, which were approximately
$49.9 million, and $43.5 million at January 30, 2016 and January 31, 2015, 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 highly inflationary 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 $47.5 million at January 30, 2016 and $39.9 million at January
31, 2015. The LIFO reserve increased by approximately $7.6 million and $4.7 million during 2015 and 2014, respectively.
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 30, 2016 is $21.2 million compared to $19.4 million at January 31, 2015.
In the second quarter of 2014, the Company recorded markdowns on product that management identified as low-productive and does
not fit our go-forward convenient and pharmacy healthcare services model. The Company recorded a below-cost inventory adjustment
in accordance with the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 330,
"Inventory," of approximately $12.5 million (including $1.6 million, for the accelerated recognition of freight capitalization expense)
in cost of goods sold to value inventory at the lower of cost or market on inventory identified as low-productive, which the Company
began liquidating in accordance with our strategic plan.
The Company recorded $0.7 million and $3.3 million of below-cost inventory adjustments during the years ended January 30, 2016
January 31, 2015, respectively, in connections with planned store closures. No below cost inventory adjustment was recorded during
the year ended February 1, 2014 in connection with planned store closures (see Note 12 - 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 and presented in selling, general and administrative expenses. Improvements to leased premises are
amortized 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 amortized over the lesser of the remaining term of the lease (including the
upcoming renewal option, if the renewal is reasonably assured) or the estimated useful life of the improvement. 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
- 40 -
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. There was no amortization expense on assets under capital lease for 2015.
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 expense 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 $0.7 million and $0.9 million at January 30, 2016
and January 31, 2015, 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 more than 2 years ago. 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.
During 2014, in association with the planned closure of stores not meeting the Company's operational performance targets, we
recorded a charge of $2.9 million in selling, general and administrative expense for the impairment of fixed assets and leasehold
improvements. The Company recorded an additional charge of $0.3 million in 2015 related to the 2014 store closures. In the fourth
quarter of 2015, the Company recorded an additional charge of $0.5 million related to five stores that are scheduled to close in early
fiscal 2016. No impairment charge was recorded in 2013.
Impairment of goodwill and other intangibles. Goodwill is reviewed for impairment in the fourth quarter each year in accordance
with the provisions of Accounting Standards Codification topic 350, Intangibles – Goodwill and Other (“ASC 350”). ASC 350
provides the option to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting
unit is less than its carrying value or that an indefinite-lived intangible is impaired, a “Step 0” analysis. Qualitative factors include
industry and market considerations, overall financial performance, and other relevant events and factors affecting the fair value of the
reporting unit and the indefinite-lived intangible. If, based on a review of qualitative factors, it is more likely than not that the fair
value of a reporting unit or indefinite-lived intangible is less than its carrying value we perform a quantitative assessment by
comparing the fair value of the reporting unit or indefinite-lived intangible with its respective carrying value. If the carrying value
exceeds the fair value, we measure the amount of impairment loss, if any, by comparing the implied fair value of the reporting unit
goodwill to its carrying amount or by comparing the fair value of the indefinite-lived intangible asset to its carrying value.
Additionally, we make judgments about the recoverability of purchased finite-lived intangible assets whenever events or changes in
circumstances indicate that impairment may exist. Recoverability of finite-lived intangible assets is measured by comparing the
- 41 -
carrying amount of the asset to the future undiscounted cash flows that the asset is expected to generate. We perform an annual
impairment assessment in the fourth quarter of each year for finite-lived intangible assets, or more frequently if indicators of potential
impairment exist, to determine whether it is more likely than not that the carrying value of the assets may not be recoverable.
Recoverability of indefinite-lived intangible assets is measured by comparing the carrying amount of the asset to the future discounted
cash flows that the asset is expected to generate. If we determine that an individual asset is impaired, the amount of any impairment is
measured as the difference between the carrying value and the fair value of the impaired asset. The assumptions and estimates used to
determine future values and remaining useful lives of our intangible assets are complex and subjective. They can be affected by
various factors, including external factors such as industry and economic trends, and internal factors such as changes in our business
strategy and our forecasts for specific product lines.
As of November 1, 2015, we concluded that there are no indicators of impairment that would cause us to believe that it is more likely
than not that the fair value of our reporting units is less than the carrying value or that the fair value of our indefinite-lived intangibles
is less than the carrying value. Accordingly, we did not perform the two-step impairment test for goodwill or indefinite-lived
intangibles.
Revenue recognition. The Company markets goods and services through 641 company-owned stores and 18 franchised stores as of
January 30, 2016. 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.
Revenue from sales of pharmaceutical products is recognized at the time the prescription is filled. This approximates when a customer
picks up the prescription or when the prescription has been delivered and is recorded net of an allowance for prescriptions that were
filled but not picked up by the customer. For all periods presented, there is no material difference between the revenue recognized at
the time the prescription is filled and that which would be recognized when the customer picks up the prescription. Prescriptions are
generally not returnable.
The Company also sells gift cards for which revenue is recognized at the 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. During 2015, we recognized $0.1 million of gift card revenue, or less than $0.01 per share, while during 2014 we recognized
$1.0 million of gift revenue, or $0.02 per share. No gift card revenue was recognized in 2013.
In addition, the Company charges its 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. Total
franchise income for 2015, 2014 and 2013 was $1.5 million, $1.5 million and $1.6 million, respectively.
Cost of goods sold. Cost of goods sold includes the purchase cost of inventory and the freight costs to the Company’s distribution
centers. Warehouse and occupancy costs, including depreciation and amortization, are not included in cost of goods sold, but are
included as a component of selling, general and administrative expenses.
Vendor rebates and allowances. The Company receives rebates for a variety of merchandising activities, such as volume
commitment rebates, relief for temporary and permanent price reductions, cooperative advertising programs, and for the introduction
of new products in our stores. FASB ASC 605-50 “Customer Payments and Incentives” addresses the accounting and income
statement classification for consideration given by a vendor to a retailer in connection with the sale of the vendor’s products or for the
promotion of sales of the vendor’s products. Such consideration received from vendors is reflected as a decrease in prices paid for
inventory and recognized in cost of sales as the related inventory is sold, unless specific criteria are met qualifying the consideration
for treatment as reimbursement of specific, identifiable incremental costs.
Selling, general and administrative expenses. The Company includes buying, warehousing, distribution, advertising, depreciation
and amortization and occupancy costs in selling, general and administrative expenses.
Advertising. In accordance with FASB ASC 720-35 “Advertising Costs”, the Company charges advertising, including production
costs, to selling, general and administrative expense on the first day of the advertising period. Gross advertising expenses for 2015,
2014 and 2013, were $24.0 million, $23.4 million and $22.8 million, respectively. Gross advertising expenses were reduced by vendor
cooperative advertising allowances of $4.5 million, $2.2 million and $2.8 million, for 2015, 2014 and 2013, respectively.
Pre-opening costs. The Company charges to expense the pre-opening costs of new stores as incurred. These costs are primarily labor
to stock the store, rent, pre-opening advertising, store supplies and other expendable items.
Intangible assets. Other identifiable intangible assets primarily represent customer lists associated with acquired pharmacies and are
being amortized on a straight-line basis over seven years. After testing the retention rate of customers obtained in acquisitions over the
- 42 -
last eight years, the Company changed the estimated life of customer lists associated with acquired pharmacies from five to seven
years in the fourth quarter of 2013. Based on the Company's historical experience, seven years is a closer approximation of the actual
lives of these assets. The change in estimate was applied prospectively. Expenses for the fourth quarter of 2013 were favorably
impacted by approximately $1.5 million ($.03 per diluted share) as a result of this change.
Other identifiable intangible assets, net of accumulated amortization, totaled $97.2 million at January 30, 2016, and $79.5 million at
January 31, 2015. Accumulated amortization at January 30, 2016 and January 31, 2015 totaled $85.1 million and $66.4 million,
respectively.
(in millions)
Customer prescription files
Non-compete agreements
Trade names
Software
Referral and relationships
Business licenses
January 30, 2016
76,811
$
10,417
7,300
1,765
817
43
97,153
$
January 31, 2015
69,601
$
9,941
-
-
-
-
79,542
$
Estimated Useful
Lives (years)
4 - 7
3 - 15
-
3
2
1
Amortization expense for 2015, 2014 and 2013, was $18.7 million, $12.1 million and $12.1 million, respectively.
Estimated amortization expense for the assets recognized as of January 30, 2016, in millions for each of the next 7 years is as follows:
(in millions)
Estimated amortization expense
2016
$
19.9
2017
$
19.1
2018
$
17.9
2019
$
13.7
2020
$
10.3
2021
$
5.9
2022
$
2.1
Goodwill. The Company records goodwill when the purchase price exceeds the fair value of assets acquired and liabilities assumed.
The Company accounts for goodwill and intangibles under ASC Topic 350, Intangibles – Goodwill and Other, which does not permit
amortization, but requires the Company to test goodwill and other indefinite-lived assets for impairment annually or whenever events
or circumstances indicate that impairment may exist.
Fair value of financial instruments. Fair value is defined as the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the measurement date. The fair value hierarchy prioritizes the inputs
to valuation techniques used to measure fair value. The hierarchy, as defined below, gives the highest priority to unadjusted quoted
prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs.
• Level 1, defined as quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity can
access at the measurement date.
• Level 2, defined as inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either
directly or indirectly.
• Level 3, defined as unobservable inputs for the asset or liability, which are based on an entity’s own assumptions as there is
little, if any, observable activity in identical assets or liabilities.
At January 31, 2016, 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 worker's compensation
and general liability insurance policy coverages run August 1 through July 31 of each fiscal year. Our employee medical insurance
policy coverage runs from January 1 through December 31. The Company purchases excess insurance coverage for certain of its self-
insured liabilities, or stop loss coverage. The stop loss limits for excessive or catastrophic claims for general liability remained at
- 43 -
$350,000, worker’s compensation remained at $500,000 and employee medical remained at $175,000. The Company’s insurance
reserve was $9.8 million and $10.0 million on January 30, 2016 and January 31, 2015, respectively. Changes in the reserve for the
year ended January 30, 2016, were attributable to additional reserve requirements of $41.4 million netted with payments of
$41.6 million.
Stock-based compensation. The Company uses the fair value recognition provisions of FASB ASC 718, “Compensation – Stock
Compensation”, whereby the Company recognizes share-based payments to employees and directors in the Consolidated Statements
of Operations on a straight-line basis for shares that cliff vest and under the graded vesting attribution method for those shares that
have graded vesting.
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.
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 5 – Income Taxes).
The Company also applies the guidance of FASB ASC 740-10-25, Income Taxes, Uncertain Tax Positions, 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 5 – Income Taxes).
Valuation allowances are recorded to reduce deferred tax assets when it is more likely than not that a tax benefit will not be realized.
Significant judgment is required in evaluating the need for and magnitude of appropriate valuation allowances against deferred tax
assets. The realization of these assets is dependent on generating future taxable income, as well as successful implementation of
various tax planning strategies.
While Fred’s believes that these judgments and estimates are appropriate and reasonable under the circumstances, actual resolution of
these matters may differ from recorded estimated amounts.
Business segments. The Company manages the business on the basis of multiple operating segments that aggregate to one reportable
segment. All operations are located in the United States.
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 applies the guidance of FASB ASC 715
“Compensation – Retirement Benefits” to the accounting and disclosure requirements of accumulated other comprehensive income.
See Note 10, 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 2015 presentation.
Recent Accounting Pronouncements. In May 2014, the Financial Accounting Standards Board issued ASU No. 2014-09, Revenue
from Contracts with Customers (Topic 606). The amendments in the ASU are designed to clarify the principles for recognizing
revenue and develop a joint standard between U.S. GAAP and the International Financial Reporting Standards (“IFRS”) that strive to
remove reporting inconsistencies, provide a more robust framework for addressing revenue issues, improve comparability across
- 44 -
entities, provide more useful information to the users of financial statements and simplify the preparation of financial statements by
reducing the number of requirements an entity must refer to. The guidance in the ASU supersedes previous revenue recognition
guidance in Topic 605: Revenue Recognition. Subsequently, in August 2015, the Financial Accounting Standards Board issued ASU
No. 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date. This ASU defers the effect date
from that previously stated in ASU no. 2014-09. The amendments in these ASU’s are effective for the annual reporting periods
beginning after December 15, 2017, including the interim periods within that reporting period. Earlier adoption is permitted. The
Company is still evaluating the impact the guidance will have on the Company’s consolidated net earnings, cash flows and financial
position.
In April 2015, the Financial Accounting Standards Board issued ASU 2015-16, Intangibles-Goodwill and Other-Internal-Use
Software (Subtopic 350-40): Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement. The amendments in the ASU
provide guidance to customers about whether a cloud computing arrangement includes a software license. If a cloud computing
arrangement includes a software license, then the customer should account for the software license element of the arrangement
consistent with the acquisition of other software licenses. If a cloud computing arrangement does not include a software license, the
customer should account for the arrangement as a service contract. The guidance will not change U.S. GAAP for a customer’s
accounting for service contracts. In addition, the guidance in this ASU supersedes paragraph 350-40-25-16 and this all software
licenses within the scope of Subtopic 350-40 will be accounted for consistent with other licenses of intangible assets. The amendments
in this ASU are effective for the annual reporting periods beginning after December 15, 2015, including interim periods within that
reporting period. To comply with the guidance, the Company has applied the guidance prospectively. During 2015, the Company
entered into one such arrangement and has included $1.8 million within Intangible Assets and $0.3 million within Property and
Equipment on the Consolidated Balance Sheet.
In September 2015, the Financial Accounting Standards Board issued ASU 2015-16, Business Combinations (Topic 805): Simplifying
the Accounting for Measurement-Period Adjustments. The amendments in the ASU require an acquirer to recognize adjustments to
provisional amounts that are identified during the measurement period in the reporting period in which the adjustment are determined.
The acquirer is also required to record, in the same period’s financial statements, the effect on earnings of changes in depreciation,
amortization, or other income effects as a result of the change to the provisional amounts as if the accounting had been completed at
the acquisition date. The acquirer is required to present separately on the face of the statement of operations or disclose in the notes the
portion recorded in current-period earnings by line item that would have been recorded in previous reporting periods. Previously,
acquirers were required to retroactively adjust provisional amounts with a corresponding adjustment to goodwill. The amendments in
this ASU are effective for the annual reporting periods beginning after December 15, 2015, including interim periods within that
reporting period. The Company does not expect adoption to have a material impact on the Company’s consolidated net earnings, cash
flows or financial position.
In November 2015, the Financial Accounting Standards Board issued ASU 2015-17, Income Taxes (Topic 740): Balance Sheet
Classification of Deferred Taxes. The amendments in the ASU are designed to simplify the presentation of deferred income taxes on
the balance sheet by requiring deferred tax liabilities and assets be classified as noncurrent in a classified statement of financial
position. The current requirement that deferred tax liabilities and assets be offset and presented as a single amount is not affected by
this ASU. The amendments in this ASU are effective for the annual reporting periods beginning after December 15, 2016, including
interim periods within that reporting period. Earlier adoption is permitted. The Company elected retrospective early adoption to
simplify the presentation of deferred taxes. The result is a reclassification of January 31, 2015 noncurrent deferred income tax of $2.8
million from other noncurrent assets, net to noncurrent deferred income taxes liability and a reclassification of $13.4 million from
current deferred income taxes liability to noncurrent deferred income taxes liability.
In February 2016, the Financial Accounting Standards Board issued ASU 2016-02, Leases (Topic 842). The amendments in the ASU
are designed to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the
balance sheet and disclosing key information about leasing arrangements. The amendments in this ASU are effective for the annual
reporting periods beginning after December 15, 2018, including the interim periods within that reporting period. Early adoption is
permitted. The Company is still evaluating the impact the guidance will have on the Company’s consolidated net earnings, cash flows
and financial position.
In March 2016, the Financial Accounting Standards Board issued ASU 2016-04, Liabilities – Extinguishments of Liabilities (Subtopic
405-20): Recognition of Breakage for Certain Prepaid Stored-Value Products. The amendments in the ASU are designed to provide
guidance and eliminate diversity in the accounting for derecognition of prepaid stored-value product liabilities. Typically, a prepaid
stored-value product liability is to be derecognized when it is probable that a significant reversal of the recognized breakage amount
will not subsequently occur. This is when the likelihood of the product holder exercising its remaining rights becomes remote. This
estimate shall be updated at the end of each period. The amendments in this ASU are effective for the annual reporting periods
beginning after December 15, 2017, including the interim periods within that reporting period. Early adoption is permitted. The
Company is still evaluating the impact the guidance will have on the Company’s consolidated net earnings, cash flows and financial
position.
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NOTE 2 – DETAIL OF CERTAIN BALANCE SHEET ACCOUNTS
Details of certain balance sheet accounts as of January 30, 2016 and January 31, 2015 are as follows:
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
(in thousands)
2015
2014
118,907
82,344
5,433
4,697
277,812
489,193
(361,608)
127,585
2,765
8,643
138,993
$
$
115,863
76,822
5,764
4,697
267,397
470,543
(339,195)
131,348
4,033
8,604
143,985
$
$
Depreciation expense totaled $27.0 million, $28.9 million and $28.9 million for 2015, 2014 and 2013, respectively.
Other non-trade receivables:
Vendor receivables
Income tax receivable
Franchise stores receivable
Insurance claims receivable
Coupon receivable
Other
Total other non-trade receivable
Prepaid expenses and other current assets:
Prepaid rent
Supplies
Prepaid insurance
Prepaid advertising
Other
Total prepaid expenses and other current assets
(in thousands)
2015
2014
23,981
11,484
1,459
742
347
2,036
40,049
4,436
3,803
1,397
162
1,696
11,494
$
$
$
$
19,683
19,487
1,732
441
532
1,612
43,487
2014
4,423
4,200
2,025
281
2,054
12,983
2015
$
$
$
$
- 46 -
Accrued expenses and other:
Insurance reserves
Payroll and benefits
Sales and use tax
Project costs accrual
Data Breach Fines
Deferred / contingent rent
Legal and professional fees
Pharmacy credit returns
Real estate tax
Advertising
Information technology
Personal property tax
Utilities
Repairs and maintenance
Giftcard liability
Warehouse freight and fuel
Franchise stores payable
Lease liability
Other
Total accrued expenses and other
Other noncurrent liabilities:
Unearned vendor allowances (see Note 1 - Vendor Rebates and Allowances)
Uncertain tax positions
Total other noncurrent liabilities
NOTE 3 — INDEBTEDNESS
(in thousands)
2015
$
2014
$
9,845
9,787
4,697
3,310
3,047
2,443
2,356
2,269
1,919
1,693
1,582
1,229
1,067
640
535
404
333
26
8,892
56,074
22,331
367
22,698
10,048
9,056
4,484
1,413
-
2,871
1,069
1,458
2,039
584
7
1,155
1,215
676
552
889
197
499
7,387
45,599
24,416
369
24,785
$
$
2015
$
2014
$
$
$
On January 25, 2013, the Company entered into a Revolving Loan and Credit Agreement (the "Agreement") with Regions Bank and
Bank of America to replace the April 3, 2000 Revolving Loan and Credit Agreement, which was last amended September 27, 2010.
The Agreement provided for a $50 million revolving line of credit, and the term of the Agreement extended to January 25, 2016. The
Agreement contained certain restrictive financial covenants, and at November 1, 2014 and January 31, 2015, the Company was not in
compliance with the trailing 12 month covenants for the Fixed Charge Coverage Ratio, for Consolidated Tangible Net Worth and for
positive Net Income. Subsequently, on April 9, 2015, the Company entered into a new Revolving Loan and Credit Agreement (the
“New Agreement”) with Regions Bank and Bank of America to replace the January 25, 2013 Revolving Loan and Credit Agreement.
Borrowings and unused fees under the Agreement bore interest at a tiered rate based on the Company’s previous four quarter average
of its Fixed Charge Coverage Ratio. There were $3.8 million of borrowings outstanding and $46.2 million remaining available under
the Agreement at January 31, 2015. The weighted average interest rate on borrowings outstanding at January 31, 2015 was 1.8%.
On April 9, 2015, the Company entered into a New Agreement with Regions Bank and Bank of America to replace the January 25,
2013 Revolving Loan and Credit Agreement. The proceeds were used in part to refinance our existing agreement and to support
acquisitions and our working capital needs. The New Agreement provides for a $150.0 million secured revolving line of credit, which
includes a sublimit for letters of credit and swingline loans. The New Agreement expires on April 9, 2020 and bears interest at 1.25%
or 1.50% plus either LIBOR or the LIBOR index rate depending on our FIFO inventory balance. Commitment fees for the unused
portion of the credit line are 20.0 basis points. The New Agreement also included an up-front credit facility fee which is being
amortized over the agreement term. There were $38.3 million of borrowings outstanding and $102.7 million, net of borrowings and
letters of credit, remaining available under the New Agreement at January 30, 2016. The weighted average interest rate on borrowings
outstanding at January 30, 2016 was 1.7%.
During the second and third quarter of fiscal 2007, the Company acquired the land and buildings, occupied by seven Fred's stores
which we had previously leased. In consideration for the seven properties, the Company assumed debt that has fixed interest rates
from 6.31% to 7.40%. On March 30, 2011, Fred’s purchased 10 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 six
- 47 -
of these locations (see Note 6 – Long-Term Leases) with fixed interest rates from 6.65% to 7.40%. The debt is collateralized by the
land and buildings.
Related Party Transactions
On April 10, 2015, the Company completed the acquisition of Reeves-Sain Drug Store, Inc., a provider of retail and specialty
pharmaceutical services. As part of the total consideration for the purchase, Fred’s provided notes payable totaling $13.0 million to the
sellers of Reeves-Sain Drug Store, Inc. who joined Fred’s as part of the acquisition. The notes payable are due in three equal
installments to be paid on January 31st of 2021, 2022 and 2023 and are subordinate to the Company’s revolving line of credit. The
notes payable have an adjustment mechanism based upon an earn-out provision that could result in an increase to the face value of the
notes if certain financial metrics are achieved. The table below shows the notes payable, along with the long term debt related to the
mortgages discussed above, due for the next five years as of January 30, 2016.
(in thousands)
Mortgage loans on land & buildings
Notes payable
Total
2016
621
$
-
$
621
2017
60
$
-
$
60
2018
65
$
-
$
65
2019
70
$
-
$
70
2020
$
75
4,333
4,408
$
Thereafter
1,368
$
8,667
10,035
$
Total
$
2,259
13,000
15,259
$
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 — FAIR VALUE MEASUREMENTS
Due to their short-term nature, the Company’s financial instruments, which include cash and cash equivalents, receivables, accounts
payable and indebtedness, are a reasonable estimate of their fair value as of January 30, 2016 and January 31, 2015. The fair value of
the revolving line of credit is consistent with the carrying amount as repayments are short-term in nature. The fair value of the
revolving line of credit and our mortgage loans are estimated using Level 2 inputs based on the Company's current incremental
borrowing rate for comparable borrowing arrangements.
The table below details the fair value and carrying values for the revolving line of credit and mortgage loans as of the following years:
(dollars in thousands)
Revolving line of credit
Mortgage loans on land & buildings
Notes payable
NOTE 5 — INCOME TAXES
January 30, 2016
January 31, 2015
Carrying Value
38,327
$
2,259
13,000
Fair Value
$
38,327
2,451
12,425
Carrying Value
3,777
$
2,813
-
Fair Value
$
3,777
3,072
-
The provision (benefit) for income taxes consists of the following for the years ended January 30, 2016, January 31, 2015 and
February 1, 2014:
(dollars in thousands)
Current
Federal
State
Deferred
Federal
State
2015
2014
2013
$
(4,649)
1,021
(3,628)
$
(6,746)
68
(6,678)
$
17,079
1,489
18,568
(824)
(7)
(831)
(11,061)
(2,273)
(13,334)
(5,060)
(812)
(5,872)
$
(4,459)
$
(20,012)
$
12,696
- 48 -
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
Deferred Revenue
Federal benefit on state reserves
WOTC Credit Carryforward
Amortization of intangibles
Contribution Carryforward
Total deferred income tax assets
Less: Valuation allowance
Deferred income tax assets, net of valuation allowance
Deferred income tax liabilities:
Postretirement benefits
Property, plant and equipment
Inventory valuation
Prepaid expenses
Total deferred income tax liabilities
2015
2014
$
1,076
1,166
1,651
82
6,157
523
90
2,631
16,527
101
30,004
2,549
27,455
$
569
927
1,921
6
5,788
859
90
1,318
14,383
-
25,861
2,249
23,612
(47)
(11,104)
(25,813)
(215)
(37,179)
(149)
(14,337)
(19,181)
(560)
(34,227)
Net deferred income tax liabilities
$
(9,724)
$
(10,615)
The net operating loss carryforwards are available to reduce state income taxes in future years. These carryforwards total
approximately $125.5 million for state income tax purposes and expire at various times during the fiscal years 2016 through 2036.
We maintain a valuation allowance for state net operating losses that we do not expect to utilize prior to their expiration. During
2015, the valuation allowance increased $0.3 million, and during 2014, the valuation allowance increased $0.2 million. Based upon
expected future income and the reversal of deferred tax liabilities, 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
State income taxes, net of federal benefit
Tax credits, principally jobs
Uncertain tax provisions
Change in state valuation allowance
Other
Permanent differences
Effective income tax rate
2015
2014
2013
35.0
0.3
10.4
-
(9.1)
0.3
0.8
37.7
%
%
35.0
4.5
2.6
0.1
(0.4)
(0.4)
(0.5)
40.9
%
%
35.0
2.2
(2.9)
(1.3)
0.2
(0.8)
0.4
32.8
%
%
- 49 -
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
2015
2014
2013
$
$
0.3
-
-
-
-
0.3
$
$
1.3
-
0.1
-
(1.1)
0.3
$
$
2.1
0.2
0.1
(1.1)
-
1.3
As of January 30, 2016, our liability for unrecognized tax benefits totaled $0.3 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,
but we are unable to estimate the amounts.
FASB ASC 740 further requires that interest and penalties required to be paid by the tax law on the underpayment of taxes should be
accrued on the difference between the amount claimed or expected to be claimed on the tax return and the tax benefit recognized in
the financial statements. The Company includes potential interest and penalties recognized in accordance with FASB ASC 740 in the
financial statements as a component of income tax expense. As of January 30, 2016, accrued interest and penalties related to our
unrecognized tax benefits totaled $0.1 million and $0.1 million, respectively. As of January 31, 2015, accrued interest and penalties
related to our unrecognized tax benefits totaled $0.2 million and $0.1 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 2012-2014. 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 6 — 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 $58.6
million, $61.4 million and $60.0 million, for 2015, 2014 and 2013, respectively. Total contingent rentals included in operating leases
above was $0.7 million for 2015, $0.9 million for 2014 and $0.8 million for 2013.
Future minimum rental payments under all operating leases as of January 30, 2016 are as follows:
(in thousands)
2016
2017
2018
2019
2020
Thereafter
Total minimum lease payments
Operating Leases
$
45,886
37,441
26,915
20,248
16,284
47,730
194,504
$
The gross amount of property and equipment under capital leases was $5.1 million at both January 30, 2016 and January 31, 2015.
Accumulated amortization on property and equipment under capital leases was $5.1 million at both January 30, 2016 and January 31,
2015. There was no amortization expense on assets under capital lease for 2015 while there was $29 thousand in 2014.
Related Party Transactions
Atlantic Retail Investors, LLC, which is partially owned by Michael J. Hayes, a director of the Company, owns the land and buildings
occupied by three Fred’s stores. Richard H. Sain, Senior Vice President of Retail Pharmacy Business Development, owns the land and
building occupied by one of Fred’s Xpress Pharmacy locations. 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. The total rental payments for
related party leases were $511.3 thousand for the year ended January 30, 2016 and $310.0 and $301.0 thousand for the years ended
- 50 -
January 31, 2015 and February 1, 2014, respectively. The increase is due to the addition of Mr. Sain’s Xpress Pharmacy location and
the timing of property tax and insurance payments for the store locations.
NOTE 7 — SHAREHOLDERS’ EQUITY
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, of which 90.0 thousand shares
remained at January 28, 2012. 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. 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. As of January 31, 2015, there were 3.0 million shares available for repurchase under
the plan. No repurchases were made in fiscal year 2015, leaving 3.0 million shares available for repurchase at January 30, 2016.
NOTE 8 – EQUITY INCENTIVE PLANS
Incentive stock option plan. The Company has a long-term incentive plan (the "2012 Plan"), which was reapproved by Fred's
stockholders at the 2012 annual shareholders meeting. The 2012 Plan is substantially identical to the prior plan. The 2012 Plan
increased the number of shares of the Company’s common stock authorized for issuance by 600,000 shares, from the 2,400,000 which
was available under the prior plan to 3,000,000 shares. The plan expires March 18, 2022, and Section 10 of the 2002 Plan, which
provides for supplemental cash payments or loans to individuals in connection with all or any part of an award under the plan, has
been removed and is not part of the 2012 Plan. Shares available to be granted under the long-term incentive plan were 970,162 as of
January 30, 2016 (1,212,243 shares as of January 31, 2015). Options issued under the 2002 and 2012 plans expire five to seven years
from the date of grant. Options outstanding at January 30, 2016 expire in fiscal 2016 through fiscal 2022.
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 eight 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 recognized using the graded vesting attribution method. The plan also provides for annual stock grants
at the market price of the common stock on the grant date to non-employee directors according to a non-discretionary formula. The
number of shares granted is dependent upon current director compensation levels.
Employee Stock Purchase Plan. The 2004 Employee Stock Purchase Plan ("ESPP") (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 market price at the time of exercise. There were 57,972,
54,992 and 60,912 shares issued during fiscal years 2015, 2014 and 2013, respectively. There are 1,410,928 shares approved to be
issued under the 2004 Plan and as of January 30, 2016 there were 745,601 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):
(in thousands)
Stock option expense
Restricted stock expense
ESPP expense
Total stock-based compensation
2015
$
2014
$
2013
$
251
1,777
234
2,262
862
1,331
240
2,433
$
$
$
610
984
197
1,791
Income tax benefit on stock-based compensation
$
594
$
606
$
473
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
- 51 -
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
2015
30.5%
1.8%
5.84
1.7%
2014
35.2%
1.9%
5.84
1.6%
2013
32.1%
1.2%
4.98
1.7%
$4.32
$4.79
$3.81
30.9%
0.3%
0.63
1.0%
32.4%
0.2%
0.63
1.1%
22.7%
0.2%
0.63
1.1%
$4.02
$4.36
$3.02
The following is a summary of the methodology applied to develop each assumption:
Expected Volatility — This is a measure of the amount by which a price has fluctuated or is expected to fluctuate. The
Company uses actual historical changes in the market value of our stock to calculate expected price volatility because
management believes that this is the best indicator of future volatility. The Company calculates weekly market value changes
from the date of grant over a past period representative of the expected life of the options to determine volatility. An increase
in the expected volatility will increase compensation expense.
Risk-free Interest Rate — This is the yield of a U.S. Treasury zero-coupon bond issue effective at the grant date with a
remaining term equal to the expected life of the option. An increase in the risk-free interest rate will increase compensation
expense.
Expected Lives — This is the period of time over which the options granted are expected to remain outstanding and is based
on historical experience. Options granted have a maximum term of seven and one-half years. An increase in the expected life
will increase compensation expense.
Dividend Yield — This is based on the historical yield for a period equivalent to the expected life of the option. An increase
in the dividend yield will decrease compensation expense.
- 52 -
Stock Options. The following table summarizes stock option activity from February 2, 2013 through January 30, 2016:
Outstanding at February 2, 2013
Granted
Forfeited / Cancelled
Exercised
Outstanding at February 1, 2014
Granted
Forfeited / Cancelled
Exercised
Repurchased and Cancelled 1
Outstanding at January 31, 2015
Granted
Forfeited / Cancelled
Exercised
Outstanding at January 30, 2016
Options
1,145,655
213,859
(135,716)
(81,369)
1,142,429
122,000
(31,510)
(41,314)
(245,052)
946,553
424,607
(328,568)
(202,733)
839,859
Weighted-
Averaged
Contractual
Life (years)
3.2
Aggregate
Intrinsic Value
(000s)
$
1,467
3.0
$
5,539
Weighted-
Average
Exercise Price
12.18
$
15.26
13.18
12.26
12.63
15.78
13.20
12.06
$
10.61
13.56
16.34
14.37
10.48
15.38
$
$
3.4
$
2,954
3.5
3.9
$
1,371
$
211
Exercisable at January 30, 2016
108,456
$
11.69
1 Shares represent options purchased and cancelled from Bruce Efird, former CEO, subsequent to the expiration of his
employment agreement.
The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the excess of Fred's closing stock price on
the last trading day of the fiscal year end and the exercise price of the option multiplied by the number of in-the-money options) that
would have been received by the option holders had all option holders exercised their options on that date. This amount changes based
on changes in the market value of Fred's stock. As of January 30, 2016, total unrecognized stock-based compensation expense net of
estimated forfeitures related to non-vested stock options was approximately $1.4 million, which is expected to be recognized over a
weighted average period of approximately 4.0 years.
Other information relative to option activity during 2015, 2014 and 2013 is as follows:
(dollars in thousands)
Total fair value of stock options vested
Total pretax intrinsic value of stock options exercised
2015
2014
2013
$
$
318
1,333
$
$
395
253
$
$
353
266
The following table summarizes information about stock options outstanding at January 30, 2016:
Range of Exercise Prices
$ 9.35 - $13.87
$14.02 - $16.73
$16.77 - $19.76
Options Outstanding
Weighted-
Averaged
Contractual
Life (years)
3.4
4.5
6.0
Weighted-
Average
Exercise Price
$
13.20
$
15.27
$
18.12
Shares
317,851
259,108
262,900
839,859
Options Exercisable
Weighted-
Average
Exercise Price
$
13.10
$
14.89
$
17.08
Shares
45,023
36,016
27,417
108,456
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.
- 53 -
Restricted stock has a maximum term of five to ten years from grant date. Compensation expense is recorded on a straight-line basis
for shares that cliff vest and under the graded vesting attribution method for those that have graded vesting.
The following table summarizes restricted stock from February 2, 2013 through January 30, 2016:
Non-vested Restricted Stock at February 2, 2013
Granted
Forfeited / Cancelled
Vested
Non-vested Restricted Stock at February 1, 2014
Granted
Forfeited / Cancelled
Vested
Non-vested Restricted Stock at January 31, 2015
Granted
Forfeited / Cancelled
Vested
Non-vested Restricted Stock at January 30, 2016
Shares
621,009
113,943
(125,686)
(58,253)
551,013
207,295
(94,729)
(106,058)
557,521
131,009
(103,759)
(70,798)
513,973
$
Weighted-
Average Grant
Date Fair Value
13.09
$
14.72
13.22
11.83
13.53
17.02
13.76
13.84
14.72
17.51
14.13
14.07
14.13
$
$
The aggregate pre-tax intrinsic value of restricted stock outstanding as of January 30, 2016 is $8.5 million with a weighted average
remaining contractual life of 6.7 years. The unrecognized compensation expense net of estimated forfeitures, related to the outstanding
restricted stock is approximately $5.4 million, which is expected to be recognized over a weighted average period of approximately
6.5 years. The total fair value of restricted stock awards that vested for the years ended January 30, 2016, January 31, 2015 and
February 1, 2014 was $1.0 million, $1.0 million and $0.7 million, respectively.
There were no significant modifications to the Company’s share-based compensation plans during fiscal 2015, 2014 or 2013.
NOTE 9 — 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. In fiscal years 2015 and 2014, the Company experienced a net loss, requiring the diluted earnings per share
calculation to exclude any assumptions of the exercise of securities, as these would have an antidilutive effect on EPS.
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 270,400 and 2,500 such options outstanding at January 31, 2015 and February 1, 2014, respectively.
NOTE 10 — OTHER COMMITMENTS AND CONTINGENCIES
Commitments. The Company had commitments approximating $7.3 million at January 30, 2016 and $4.5 million at January 31, 2015
on issued letters of credit and open accounts, which support purchase orders for merchandise. Additionally, the Company had
outstanding letters of credit aggregating approximately $9.0 million at January 30, 2016 and $10.6 million at January 31, 2015 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 $18,000. 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 2015, 2014
and 2013, were $0.2 million, $0.2 million and $0.2 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.
- 54 -
Effective February 3, 2007, the Company began recognizing the funded status of its postretirement benefits plan in accordance with
FASB ASC 715, "Compensation Retirement Benefits." 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 is 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
(in thousands)
Accumulated other comprehensive income
Deferred tax
Accumulated other comprehensive income, net
The Company’s components of net accumulated other comprehensive income were as follows:
January 30,
2016
For the Years Ended
January 31,
2015
February 1,
2014
$
$
$
559
25
17
30
(47)
584
440
29
17
122
(49)
559
$
$
$
January 30,
2016
For the Years Ended
January 31,
2015
$
$
February 1,
2014
$
1,045
(342)
703
936
(366)
570
$
$
$
584
46
19
92
(46)
695
780
(305)
475
The medical care cost trend used in determining this obligation is 6.9% at January 30, 2016, 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 on accumulated benefit obligations
1% increase effect on periodic cost
1% decrease effect on accumulated benefit obligations
1% decrease effect on periodic cost
January 30,
2016
January 31,
2015
February 1,
2014
$
86
12
(69)
(10)
$
47
5
(42)
(4)
43
5
(39)
(5)
The discount rate used in calculating the obligation was 3.5% in 2015 and 2.7% in 2014.
The annual net postretirement cost is as follows:
(in thousands)
Service cost
Interest cost
Amortization of prior service cost
Amortization of unrecognized prior service costs
Net periodic postretirement benefit cost
January 30,
2016
$
46
19
(13)
(51)
$
1
- 55 -
January 31,
2015
$
February 1,
2014
$
25
17
(13)
(66)
(37)
29
17
(13)
(66)
(33)
$
$
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
2016
2017
2018
2019
2020
Next 5 years
Postretirement
Medical Plan
$
51
58
58
60
62
321
Litigation. In July 2008, a lawsuit styled Jessica Chapman, on behalf of herself and others similarly situated, v. Fred's Stores of
Tennessee, Inc. was filed in the United States District Court for the Northern District of Alabama, Southern Division, in which the
plaintiff alleges that she and other female assistant store managers were paid less than comparable males seeking compensable
damages, liquidated damages, attorney fees and court costs. The plaintiff filed a motion seeking collective action. On or about March
15, 2013, the judge in the matter issued a Report and Recommendation that the case be conditionally certified as a collective action,
which the District Court Judge affirmed. As a result, notice of a collective action was sent to the appropriate class as required by the
Court. One hundred ninety four plaintiffs opted into the suit, and approximately 170 plaintiffs remained in the lawsuit. Although, the
Company believes that all of its assistant managers were always properly paid and that the matter was not appropriate for collective
action treatment, the Company and its Employment Practices Liability Insurance (“EPLI”) carrier participated in mediation with the
plaintiffs. On March 26, 2015, the plaintiffs, their counsel, the Company and the Company’s EPLI carrier reached a settlement
agreement whereby the case would be settled for a total of $315,000, and the plaintiffs would be bound by the terms of a settlement
agreement and the case would be dismissed. Under the terms of the settlement the Company admitted no wrongdoing. The
distribution of the settlement proceeds has been completed and the matter was dismissed with prejudice on August 7, 2015.
On August 10, 2015, following an investigation by a third-party cyber-security firm, the Company reported that there had been
unauthorized access to two Company servers through which payment card data is routed. The investigation uncovered malware on the
two servers beginning on March 23, 2015, and that malware operated on one server until April 8, 2015 and on the other server until
April 24, 2015. The malware was designed to search only for "track 2" data—data from the magnetic stripe of payment cards that
contains only the card number, expiration date and verification code. During this time period, track 2 data was at risk of disclosure;
however, the third-party cyber-security firm did not find evidence that track 2 data was removed from the Company’s system. No
other customer information was involved. The malware has been removed from the Company’s system, and the Company has
implemented and is continuing to implement enhanced security measures to prevent similar events from occurring in the future. On
October 22, 2015, the Company received an assessment from MasterCard relating to this incident in the amount of approximately $2.9
million. The Company paid the assessment on February 26, 2016 after its appeal was denied. The Company has reached a settlement
with Discover to make certain security improvements, which if made, will not require the Company to make any payment to Discover
related to the incident. The Company is in the process of making these security improvements. American Express has also issued an
assessment related to the incident of $52,525. The Company is in discussions with American Express concerning this
assessment. The Company has not yet received an assessment from Visa. On October 15, 2015, a lawsuit entitled Southern
Independent Bank v. Fred’s, Inc. was filed in the United States District Court, Middle District of Alabama related to the data security
incident. The Complaint alleges on behalf of the plaintiff and financial institutions similarly situated (“alleged class of financial
institutions”) that the Company was negligent in failing to use reasonable care in obtaining, retaining, securing and deleting the
personal and financial information of customers who use debit cards issued by the plaintiff and alleged class of financial institutions to
make purchases at Fred’s stores. The complaint also alleges that the Company made negligent misrepresentations that the Company
possessed and maintained adequate data security measures and systems that were sufficient to protect the personal and financial
information of shoppers using debit cards issued by the plaintiff and alleged class of financial institutions. The complaint seeks
monetary damages and equitable relief to be proved at trial as well as attorneys’ fees and costs. The Company has denied the
allegations and has filed a motion to dismiss all claims, which is currently pending before the Court. The amount assessed by
MasterCard as well as other future costs or liabilities related to the incident may have a material adverse effect on the
Company. Costs may include liabilities to payment card networks for reimbursement of payment card fraud and reissuance costs,
liabilities from current and future civil litigation, governmental investigations and enforcement proceedings, as well as legal and
investigative costs. The Company has cyber-security risk insurance with a $10 million limit and a sub-limit of $250,000 for PCI fines
including liabilities to payment card networks, which will offset some of these costs.
On January 21, 2016, a lawsuit styled as Stephanie Bryant, on behalf of herself and others similarly situated v. Fred’s Stores of
Tennessee, Inc. was filed in the United States District Court, Southern District of Mississippi. The complaint alleges that plaintiff and
other store managers were improperly classified as exempt employees under the Fair Labor Standards Act. The complaint seeks
- 56 -
declaratory and monetary relief for overtime compensation that plaintiff alleges was not paid as well as costs and attorneys’ fees. The
Company denies the allegations and believes that its managers are appropriately classified as exempt employees.
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 against the Company cannot be determined with certainty,
management of the Company is of the opinion that these proceedings and claims should not have a material adverse effect on the
financial statements as a whole. However, litigation involves an element of uncertainty. Future developments could cause these
actions or claims, individually or in aggregate, to have a material adverse effect on the financial statements as a whole.
NOTE 11 – 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 30, 2016, 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:
Pharmacy
Consumables
Household Goods and Softlines
Franchise
Total Sales Mix
NOTE 12 – EXIT AND DISPOSAL ACTIVITY
Fixed Assets
January 30,
2016
For the Years Ended
January 31,
2015
February 1,
2014
50.2%
25.7%
22.6%
1.5%
100.0%
41.9%
31.2%
25.3%
1.6%
100.0%
37.7%
33.0%
27.6%
1.7%
100.0%
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. We measure impairment losses of fixed assets and
leasehold improvements as the amount by which the carrying amount of a long-lived asset exceeds its fair value as prescribed by
FASB ASC 360, "Impairment or Disposal of Long-Lived Assets." 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.
During 2014, in association with the planned closure of stores not meeting the Company's operational performance targets, we
recorded a charge of $2.9 million in selling, general and administrative expense for the impairment of fixed assets and leasehold
improvements. During 2015, the Company recorded an additional charge of $0.3 million for fixed assets and leasehold improvements
related to the 2014 store closures.
In the fourth quarter of 2015, in association with the planned closure of stores not meeting the Company's operational performance
targets, we recorded a charge of $0.5 million in selling, general and administrative expense for the impairment of fixed assets and
leasehold improvements. Five stores are scheduled to close in early fiscal 2016.
Inventory
As discussed in Note 2 - Inventories, we adjust inventory values on a consistent basis to reflect current market conditions. In
accordance with FASB ASC 330, "Inventories," we write down inventory to net realizable value in the period in which conditions
giving rise to the write-downs are first recognized.
In the fourth quarter of 2013, we recorded a below-cost inventory adjustment of approximately $1.7 million for the discontinuance of
product categories from which the Company decided to exit. During 2014, the Company recorded a below-cost inventory adjustment
of an additional $0.3 million for the discontinuance of product categories from which the Company decided to exit. No inventory was
marked down for the discontinuance of product categories in 2015.
- 57 -
In the third quarter of 2014, we recorded a below-cost inventory adjustment of approximately $3.3 million to value inventory at the
lower of cost or market on inventory in 47 stores that were planned for closure in the fourth quarter of fiscal 2014.
In the fourth quarter of 2015, in association with the planned closure of five identified stores that were not meeting the Company's
operational performance targets, we recorded a below-cost inventory adjustment of $0.7 million to value inventory at the lower of cost
or market. These stores are planned for closure by the end of the second quarter of fiscal 2016.
Lease Termination
For lease obligations related to closed stores, 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.
A lease obligation for some store closures that occurred in 2008 still existed as of January 31, 2015. During 2015, we utilized and
added less than $0.1 million of the remaining lease liability for the fiscal 2008 store closures, leaving no reserve at January 30, 2016.
NOTE 13 – BUSINESS COMBINATIONS
On April 10, 2015, we acquired 100% of the equity interests in Reeves-Sain Drug Store, Inc., a provider of retail and specialty
pharmaceutical services. The acquisition expanded our presence in the specialty pharmacy arena – the largest growth area of the
pharmacy industry. The total consideration for the purchase was approximately $66.0 million, less working capital adjustments of
$10.3 million, which yielded an adjusted purchase consideration of $55.8 million. The Company incurred $0.5 million of transaction
costs in connection with the acquisition. The transaction expenses were expensed as incurred and are reflected in selling, general and
administrative expenses in the consolidated statement of operations. The adjusted consideration consisted of $42.8 million in cash at
the time of closing and $13.0 million in notes payable in three equal installments on January 31st of 2021, 2022 and 2023. The notes
payable have an adjustment mechanism based upon an earn-out provision that could result in an increase to the face value of the notes
if certain financial metrics are achieved. No amounts have been reflected in the 2015 consolidated financial statements for this
provision. If and when the provision is met, the expense will be treated as compensation expense in that year.
A summary of the purchase price allocation for Reeves-Sain Drug Store, Inc. is as follows (dollars in thousands):
Total purchase consideration:
Cash
Notes payable
Total purchase consideration
Allocation of the purchase consideration:
Accounts receivables
Inventory
Other assets
Goodwill
Identifiable intangible assets
Total assets acquired
Accounts payable
Other current liabilities
Total liabilities assumed
Net assets acquired
$
$
$
$
$
$
$
42,757
13,000
55,757
14,474
2,005
307
41,403
20,236
78,425
21,448
1,220
22,668
55,757
- 58 -
The following are the identifiable intangible assets acquired and their respective weighted average useful lives, as determined based
on valuations (dollars in thousands):
Estimated
Useful Lives
(years)
Amount
Customer prescription files
Trade name
Non-compete agreements
Referral and relationships
Business licenses
$
9,476
7,300
1,800
1,400
260
20,236
$
4 - 7
-
8
2
1
The following unaudited supplemental pro forma financial information includes the results of operations of the three Reeves-Sain
Drug Store, Inc. locations in 2015 and 2014 and is presented as if the locations had been consolidated as of the beginning of the year
immediately preceding the date of acquisition. The unaudited supplemental pro forma financial information has been provided for
illustrative purposes only and does not purport to be indicative of the actual results that would have been achieved by the combined
companies for the periods presented or of the results that may be achieved by the combined companies in the future. The unaudited
supplemental pro forma financial information presented below has been prepared by adjusting the historical results of the Company to
include the historical results of the acquisition described above. The 2014 unaudited pro forma historical results were then adjusted (i)
to add one-time acquisition costs of $0.5 million, (ii) to increase amortization expense by $3.3 million resulting from the incremental
intangible assets acquired and (iii) to increase interest expense by $1.1 million as a result of assumed debt financing for the
transaction. The 2015 unaudited pro forma historical results were then adjusted (i) to remove one-time acquisition costs of $0.5
million, (ii) to increase amortization expense by $0.6 million resulting from the incremental intangible assets acquired and (iii) to
increase interest expense by $0.2 million as a result of assumed debt financing for the transaction.
The unaudited pro forma financial information does not include any adjustments to reflect the impact of cost savings or other
synergies that may result from this acquisition.
(in thousands, except per share data)
Revenue
Earnings
Basic and diluted earnings per share
$
$
2015
2,198,054
(7,778)
(0.21)
2014
2,165,293
(31,327)
(0.86)
$
$
- 59 -
NOTE 14 – QUARTERLY FINANCIAL DATA (UNAUDITED)
The Company’s unaudited quarterly financial information for the fiscal years ended January 30, 2016 and January 31, 2015 is reported
below:
(in thousands, except per share data)
Year ended January 30, 2016
Net sales
Gross profit
Net income (loss)
Net income (loss) per share
Basic
Diluted
Cash dividends paid per common share
Year ended January 31, 2015
Net sales
Gross profit
Net income (loss)
Net income (loss) per share
Basic
Diluted
Cash dividends paid per common share
First
Quarter
Second
Quarter
Third
Quarter
Fourth
Quarter
$
509,047
$
546,083
$
540,996
$
554,577
137,091
(29)
131,917
(4,877)
142,263
1,436
132,879
(3,901)
$
$
$
-
-
0.06
$
$
$
(0.13)
(0.13)
0.06
$
$
$
0.04
0.04
0.06
$
$
$
(0.11)
(0.11)
0.06
$
498,264
$
491,185
$
476,175
$
504,425
142,474
6,118
113,669
(16,434)
123,489
(10,434)
124,161
(8,154)
$
$
$
0.17
0.17
0.06
$
$
$
(0.45)
(0.45)
0.06
$
$
$
(0.29)
(0.29)
0.06
$
$
$
(0.23)
(0.23)
0.06
NOTE 15: PRIME VENDOR AGREEMENT WITH PRIMARY PHARMACEUTICAL WHOLESALER
On August 6, 2014, the Company entered into a Prime Vendor Agreement (the “Vendor Agreement”) with Cardinal Health, Inc., one
of the nation’s largest healthcare services companies. Cardinal Health serves as Fred’s primary wholesale supplier for branded and
generic pharmaceuticals under a multi-year agreement that began on October 1, 2014. The Vendor Agreement replaced the Prime
Vendor Agreement the Company had with AmerisourceBergen Drug Corporation, which expired in accordance with the contract on
September 30, 2014.
Under the Vendor Agreement, Fred’s and Cardinal Health established a mutually beneficial strategic alliance designed to support
Fred’s key initiative of rapid pharmacy growth, and build on a foundation of premier supply chain and asset management tools. The
initial term of the Vendor Agreement commenced on October 1, 2014 and continues through the longer of 1) March 31, 2018 or 2) the
date upon which the Company’s net aggregate generic purchases reach a certain purchase requirement, provided that date is not before
September 30, 2017.
- 60 -
ITEM 9: Changes In and Disagreements with Accountants on Accounting and Financial Disclosure
Not Applicable.
ITEM 9A. Controls and Procedures
(a) Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures. As of the end of the period covered by this Form
10-K, the Company carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer and
Principal Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e)
under the Securities and Exchange Act of 1934, as amended (the “Exchange Act”)). Based on that evaluation, the Chief Executive
Officer and the Principal Financial Officer concluded that the Company’s disclosure controls and procedures are effective to ensure
that information required to be disclosed by the issuer in the reports that it files or submits under the Exchange Act is recorded,
processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Additionally, they concluded
that our disclosure controls and procedures are designed to ensure that information required to be disclosed by the Company in the
reports that the Company is required to file or submit under the Exchange Act is accumulated and communicated to management,
including the Chief Executive Officer and the Principal Financial Officer, as appropriate to allow timely decisions regarding required
disclosures.
(b) Management’s Annual Report on Internal Control Over Financial Reporting. The management of Fred's, Inc. is responsible for
establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a – 15(f) under the 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.
As allowed pursuant to guidance from the Securities and Exchange Commission (which states that management may omit an
assessment of an acquired business’ internal control over financial reporting from its assessment of internal control over financial
reporting for a period not to exceed one year), our assessment of and conclusion on the effectiveness of internal control over financial
reporting did not include the internal controls of the three operating segments purchased from Reeves-Sain Drug Store, Inc dba Entrust
(“the acquired business”), which were acquired on April 10, 2015, which are included in the consolidated balance sheet of Freds, Inc.
as of January 30, 2016, and the related consolidated statements of operations, cash flows and changes in shareholders’ equity for the
year then ended. From its acquisition date through January 30, 2016, the three acquired operating segments’ net sales represented the
following percentages of our consolidated net sales for the year ended January 30, 2016 (Entrust-TN 6.2%, Entrust-MS 2.3% and
Reeves-Sain Retail 0.4%). As of January 30, 2016, total assets and net tangible assets of acquired operating segments represented the
following percentages of consolidated total assets (Entrust-TN 6.9%, Entrust-MS 3.6% and Reeves–Sain Retail 0.6%) and the
following percentages of consolidated net tangible assets (Entrust-TN 2.3%, Entrust-MS 1.0% and Reeves-Sain Retail 0.4%),
respectively.
The management of Fred's, Inc. assessed the effectiveness of the Company’s internal control over financial reporting as of January 30,
2016. 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 (2013). Based on its assessment, management has concluded that
the Company’s internal control over financial reporting is effective as of January 30, 2016.
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.
(c) Changes in Internal Control over Financial Reporting. There have been no changes during the quarter ended January 30, 2016 in
the Company’s internal control over financial reporting (as defined in Exchange Act Rule 13a-15(f)) that have materially affected, or
are reasonably likely to materially affect, the Company’s internal control over financial reporting.
- 61 -
Report of Independent Registered Public Accounting Firm
Board of Directors and Shareholders
Fred’s, Inc.
Memphis, Tennessee
We have audited Fred’s, Inc.’s (the “Company’s”) internal control over financial reporting as of January 30, 2016, based on criteria
established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the
Treadway Commission (the COSO criteria). The Company’s management is responsible for maintaining effective internal control
over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the
accompanying report, “Item 9A(b), Management’s Annual Report on Internal Control Over Financial Reporting”. Our responsibility is
to express an opinion on the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those
standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over
financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over
financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness
of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in
the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of
financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting
principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the
maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the
company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in
accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in
accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding
prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect
on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections
of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in
conditions, or that the degree of compliance with the policies or procedures may deteriorate.
As indicated in the accompanying “Item 9A(b), Management’s Report on Internal Control over Financial Reporting”, management’s
assessment of and conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of
Reeves-Sain Drug Store, Inc., which was acquired on April 10, 2015 and which is included in the consolidated balance sheets of
Fred’s, Inc. as of January 30, 2016, and the related consolidated statements of income and comprehensive income (loss), changes in
stockholders’ equity, and cash flows for the year then ended. Reeves-Sain Drug Store, Inc. constituted 11.1% and 3.7% of total assets
and tangible assets, respectively, as of January 30, 2016, and 8.9% of revenues for the year then ended. Management did not assess the
effectiveness of internal control over financial reporting of Reeves-Sain Drug Store, Inc. because of the timing of the acquisition
which was completed on April 10, 2016. Our audit of internal control over financial reporting of Fred’s, Inc. also did not include an
evaluation of internal control over financial reporting of Reeves-Sain Drug Store, Inc.
In our opinion, Fred’s, Inc. maintained, in all material respects, effective internal control over financial reporting as of January 30,
2016, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the
consolidated balance sheets of the Company as of January 30, 2016 and January 31, 2015, and the related consolidated statements of
operations, comprehensive income (loss), changes in shareholders’ equity, and cash flows for each of the three years in the period
ended January 30, 2016 and our report dated April 14, 2016 expressed an unqualified opinion thereon.
/s/ BDO USA, LLP
Memphis, Tennessee
April 14, 2016
- 62 -
ITEM 9B. Other Information
None.
ITEM 10: Directors, Executive Officers and Corporate Governance
PART III
The following information is furnished with respect to each of the directors and executive officers of the Company:
Michael J. Hayes (1)
John R. Eisenman (1)
Thomas H. Tashjian (1)
B. Mary McNabb (1)
Michael T. McMillan (1)
Steven R. Fitzpatrick (1)
Jerry A. Shore (1)
Michael K. Bloom
Rick J. Hans
Craig L. Barnes
Rick A. Chambers
John J. Foley
W. Bryan Pugh
Mark C. Dely
Age
Postions and Offices
74 Director, Chairman of the Board
74 Director
61 Director
67 Director
56 Director
56 Director
63 Director, Chief Executive Officer
55
60
49
52
54
53
40
President and Chief Operating Officer
Executive Vice President - Chief Financial Officer
Executive Vice President - Supply Chain and Global and Domestic Logistics
Executive Vice President - Pharmacy Operations
Executive Vice President - Store Operations
Executive Vice President - Chief Merchandising and Marketing Officer
Senior Vice President, Chief Legal Officer, General Counsel and Secretary
1. Seven directors, constituting the entire current Board of Directors, are to be elected at the 2016 Annual Meeting to serve one year or until their
successors are elected.
Michael J. Hayes served as Managing Director of the Company from October 1989 until March 2002, when he was elected Chairman
of the Company’s Board of Directors. He was the Company’s Chief Executive Officer from October 1989 through January 2009. He
was previously employed by Oppenheimer & Company, Inc. in various capacities from 1976 to 1985, including Managing Director
and Executive Vice President — Corporate Finance and Financial Services. On April 15, 2016 Mr. Hayes will step down as Chairman
of the Board of Directors, and at that time, will become Chairman Emeritus of the Board of Directors.
John R. Eisenman is involved in real estate investment and development with REMAX Island Realty, Inc., located in Hilton Head
Island, South Carolina. Mr. Eisenman has been engaged in commercial and industrial real estate brokerage and development since
1983. Previously, he founded and served as President of Sally’s, a chain of fast food restaurants from 1976 to 1983, and prior thereto
held various management positions in manufacturing and in securities brokerage.
Thomas H. Tashjian was elected a director of the Company in March 2001. In March 2016, Mr. Tashjian was elected as the Chairman
of the Board of Directors, effective April 15, 2016. Mr. Tashjian is a private investor. Mr. Tashjian has served as a managing director
and consumer group leader at Banc of America Montgomery Securities in San Francisco. Prior to that, Mr. Tashjian held similar
positions at First Manhattan Company, Seidler Companies, and Prudential Securities. Mr. Tashjian’s earlier retail operating
experience was in discount retailing at the Ayr-way Stores, which were acquired by Target, and in the restaurant business at Noble
Roman’s.
B. Mary McNabb was elected a director of the Company in April 2005. Most recently, she served as Chief Executive Officer for Kid’s
Outlet in California. She has served as a member of the Board of Directors of C-ME ("Cyber Merchants Exchange"), a public
company. McNabb was executive vice president of merchandising and marketing for Factory 2-U from 1989 – 2001.
Michael T. McMillan was elected a director of the Company in February 2007. Mr. McMillan held a number of senior management
positions with Pepsi America Beverages, a Division of PepsiCo, where he has spent the last 31 years in various roles including
- 63 -
marketing, sales, franchise development, and general management of its bottling operations. Mr. McMillan was chosen to serve on our
Board because of his experience in sales, marketing and consumer insights in the Southeast.
Steven R. Fitzpatrick was elected a director in May 2012. Steven Fitzpatrick was the President of Accredo Health Group, Inc.,
Medco’s fast-growing specialty pharmacy organization, a position he held until he retired in June 2011. Mr. Fitzpatrick joined
Accredo in 2001 as President of its subsidiary, Sunrise Health Management, Inc., and was named President of Accredo Therapeutics,
Inc., in February 2002. With the acquisition of Accredo by Medco Health Solutions, Inc., in August 2005, Mr. Fitzpatrick assumed
responsibility for both Accredo Therapeutics and Accredo Specialty Care Services (formerly Medco Specialty Solutions). In March
2006, he became Chief Operating Officer of Accredo Health Group and was named President in June 2008. Prior to joining Accredo,
Mr. Fitzpatrick held senior management positions with Abbott Laboratories, Block Medical, PharmaThera and Nations Healthcare.
Jerry A. Shore was named Chief Executive Officer in October 2014 and elected a director in November 2014. Mr. Shore joined the
Company in April 2000 as Executive Vice President and Chief Financial Officer. Prior to joining the Company, Mr. Shore was
employed by Wang’s International, a major importing and wholesale distribution company as Chief Financial Officer from 1989 to
2000, and in various financial management capacities with IPS Corp., and Caterpillar, Inc. from 1975 to 1989.
Michael K. Bloom joined the Company in January 2015 as President and Chief Operating Officer. Prior to joining the Company, Mr.
Bloom served as the President and Chief Operating Officer for Family Dollar Stores, Inc. from September 2011 to January 2014. He
also spent more than 20 years with CVS Caremark Corporation, holding a variety of positions with increasing responsibilities in
merchandising and operations and rising finally to Executive Vice President of Merchandising, Marketing, Advertising, and Supply
Chain. Before joining CVS, Bloom spent 10 years in merchandising and operations management with Virginia-based Peoples Drug
Stores and the Florida division of Toronto-based Shoppers Drug Mart Corporation.
Rick J. Hans joined the Company in April 2016 as Executive Vice President – Chief Financial Officer. Prior to joining the Company,
Mr. Hans served as Vice President of Investor Relations and Finance of Walgreens Co. before retiring. He was a Director of Finance
and Assistant Treasurer prior to that where he championed a sound capital structure that provided the basis for major strategic
acquisitions. Throughout his 27 years at Walgreens, he held many position, beginning as a financial analyst in 1987.
Craig L. Barnes joined the Company in August 2014 as the Senior Vice President, Global Sourcing and Hardlines and was promoted
to Executive Vice President - General Merchandise Manager in November 2014 and Executive Vice President - Supply Chain and
Global and Domestic Logistics in March 2015. Mr. Barnes has more than 30 years of progressive retail merchandising/sourcing
experience. Prior to joining Fred's, Barnes was Vice President for the Global Independent Aftermarket and OE Service for Delphi
Products & Service Solution. Previously, he was the Senior Vice President, Merchandising, Pricing, Global Sourcing, Marketing, and
Inventory Demand Planning for General Parts/CARQUEST. Barnes began his retail career at AutoZone with experience in
merchandising and store operations.
Rick A. Chambers was named Executive Vice President – Pharmacy Operations in August 2006. Prior to this he held the position of
Senior Vice President – Pharmacy operations from June 2004 to August 2006. Mr. Chambers joined the Company in July of 1992 and
has served in various positions in Pharmacy Operations. Mr. Chambers earned a Doctor of Pharmacy Degree in 1992.
John J. Foley joined the Company in October 2015 as Executive Vice President - Store Operations. Prior to joining the Company, Mr.
Foley served as a Corporate Operations Vice President of Walgreens Co. from 2008 to November 2014 before retiring. As Corporate
Operations Vice President, he oversaw the overall development and growth of all drugstores, clinics, healthcare points of care,
personnel, and other objectives within the Eastern region. He spent more than 29 years in various positions with increasing
responsibilities within Walgreens Co., starting as an Assistant Store Manager in 1985.
W. Bryan Pugh joined the Company in March 2015 as the Chief Merchandising and Marketing Officer. From 2009 to 2014, Mr. Pugh
was employed by Walgreen's where he served as the Chief Merchandising Officer where he led the transformation of the front-end to
a more customer-friendly and faster-turning product selection. Prior to joining Walgreen's, Mr. Pugh acquired more than 25 years of
experience in food and general merchandise retail from his time at Wal-Mart and Tesco, a multinational grocery and general
merchandise retailer headquartered in the United Kingdom.
Mark C. Dely was named Senior Vice President - Chief Legal Officer/General Counsel and Assistant Secretary in January of 2013 and
Secretary in August of 2013. Prior to joining the Company, Mr. Dely was employed by the ServiceMaster Company as Divisional
General Counsel of the Franchise Services Group where he had responsibility for all of the domestic and international legal operations
for the group. From 2004 until 2007 Mr. Dely was employed as the first in-house counsel to Delta and Pine Land Company, a seed
and agricultural biotechnology company traded on the New York Stock Exchange. From 1999 until 2004 Mr. Dely was an attorney
with Fried Frank, LLP.
The remainder of the information required by this item is incorporated herein by reference to the proxy statement for our 2016 Annual
Meeting.
- 64 -
ITEM 11: Executive Compensation
Information required by this item is incorporated herein by reference to the proxy statement for our 2016 Annual Meeting.
ITEM 12: Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Information required by this item is incorporated herein by reference to the proxy statement for our 2016 Annual Meeting.
ITEM 13: Certain Relationships and Related Transactions, and Director Independence
Information required by this item is incorporated herein by reference to the proxy statement for our 2016 Annual Meeting.
ITEM 14. Principal Accountant Fees and Services
Information required by this item is incorporated herein by reference to the proxy statement for our 2016 Annual Meeting.
- 65 -
PART IV
ITEM 15: Exhibits, Financial Statement Schedules
(a)(1) Consolidated Financial Statements (See Item 8)
Report of Independent Registered Public Accounting Firm – BDO USA, LLP.
(a)(2) Financial Statement Schedules
Schedule II — Valuation and Qualifying Accounts
(a)(3) Those exhibits required to be filed as Exhibits to this Annual Report on Form 10-K pursuant to Item 601 of Regulation S-K are
as follows:
Exhibit
3.1
3.2
3.3
4.1
4.2
4.3
10.1
10.2
10.3
10.4
10.5
10.6
10.7
10.8
10.9
10.10
10.11
10.12
Exhibit Index
Description
Certificate of Incorporation, as amended [incorporated herein by reference to Exhibit 3.1 to the registration
statement on Form S-8 as filed with the Securities and Exchange Commission (“SEC”) on March 18, 2003
(SEC File No. 333-103904) (such registration statement, the “Form S-8”)]
Articles of Amendment to the Charter of Fred’s Inc. [incorporated herein by reference to Exhibit 3.1 to the
registration statement on Form 8-A as filed with the SEC on October 17, 2008 (SEC File No. 001-14565) (the
“Form 8-A”)]
By-laws, as amended [incorporated herein by reference to Exhibit 3.2 to the Form S-8]
Specimen Common Stock Certificate [incorporated herein by reference to Exhibit 4.2 to Pre-Effective
Amendment No. 3 to the Registration Statement on Form S-1 (SEC File No. 33-45637) (such Registration
Statement, the “Form S-1”)]
Preferred Share Purchase Plan [incorporated herein by reference to the Company’s Report on Form 10-Q for
the quarter ended October 31, 1998]
Rights Agreement, dated as of October 10, 2008, between Fred’s Inc. and Regions Bank [incorporated herein
by reference to Exhibit 4.1 to the Form 8-A]
Form of Fred's, Inc. Franchise Agreement [incorporated herein by reference to Exhibit 10.8 to the Form S-1]
401(k) Plan dated as of May 13, 1991 [incorporated herein by reference to Exhibit 10.9 to the Form S-1]
Employee Stock Ownership Plan ("ESOP") dated as of January 1, 1987 [incorporated herein by reference to
Exhibit 10.10 to the Form S-1]
Lease Agreement by and between Hogan Motor Leasing, Inc. and Fred's, Inc. dated February 5, 1992 for the
lease of truck tractors to Fred's, Inc. and the servicing of those vehicles and other equipment of Fred's, Inc.
[incorporated herein by reference to Exhibit 10.15 to Pre-Effective Amendment No. 1 to the Form S-1]
1993 Long Term Incentive Plan dated as of January 21, 1993 [incorporated herein by reference to the
Company’s report on Form 10-Q for the quarter ended July 31, 1993]
Term Loan Agreement between Fred's, Inc. and First American National Bank dated as of April 23, 1999
[incorporated herein by reference to the Company’s Report on Form 10-Q for the quarter ended May 1, 1999]
Prime Vendor Agreement between Fred's Stores of Tennessee, Inc. and Bergen Brunswig Drug Company,
dated as of November 24, 1999 [incorporated herein by reference to Company’s Report on Form 10-Q for the
quarter ended October 31, 1999]
Addendum to Leasing Agreement and Form of Schedules 7 through 8 of Schedule A, by and between Hogan
Motor Leasing, Inc. and Fred's, Inc dated September 20, 1999 (modifies the Lease Agreement included as
Exhibit 10.4) [incorporated herein by reference to the Company’s report on Form 10-K for the year ended
January 29, 2000]
Revolving Loan Agreement between Fred's, Inc. and Union Planters Bank, NA and SunTrust Bank dated April
3, 2000 [incorporated herein by reference to the Company’s report on Form 10-K for year ended January 29,
2000]
Loan modification agreement dated May 26, 2000 (modifies the Revolving Loan Agreement included as
Exhibit 10.9) [incorporated herein by reference to the Company’s report on Form 10-K for the year ended
January 29, 2000]
Seasonal Over line Agreement between Fred's, Inc. and Union Planters National Bank dated as of October 11,
2000 [incorporated herein by reference to the Company’s Report on Form 10-Q for the quarter ended October
28, 2000]
Second Loan modification agreement dated April 30, 2002 (modifies the Revolving Loan and Credit
Agreement included as exhibit 10.9). [incorporated herein by reference to the Company’s Report on Form 10-
Q for the quarter ended August 3, 2002].
Manner of Filing
Incorporated by Reference
Incorporated by Reference
Incorporated by Reference
Incorporated by Reference
Incorporated by Reference
Incorporated by Reference
Incorporated by Reference
Incorporated by Reference
Incorporated by Reference
Incorporated by Reference
Incorporated by Reference
Incorporated by Reference
Incorporated by Reference
Incorporated by Reference
Incorporated by Reference
Incorporated by Reference
Incorporated by Reference
Incorporated by Reference
- 66 -
10.15
10.16
10.17
10.18
10.19
10.20
10.21
10.22
10.23
10.24
10.25
10.26
10.27
10.28
10.29
10.30
10.31
10.32
10.33
21.10
23.10
31.1
31.2
32
101.INS
101.SCH
101.CAL
101.DEF
101.LAB
101.PRE
Third loan modification agreement dated July 31, 2003 (modified the Revolving Loan and Credit Agreement
dated April 3, 2000.) [incorporated herein by reference to the Company’s Report on Form 10-Q for the
quarter ended August 2, 2003]
Fourth modification agreement dated June 28, 2004 modifying the Revolving Loan and Credit Agreement to
grant a temporary over line. [incorporated herein by reference to the Company’s Report on Form 10-Q for
the quarter ended October 30, 2004]
Fifth modification agreement dated October 19, 2004 modifying the Revolving Loan and Credit Agreement
to grant a temporary over line. [incorporated herein by reference to the Company’s Report on Form 10-Q for
the quarter ended October 30, 2004]
Sixth Modification Agreement of the Revolving Loan and Credit Agreement dated July 29, 2005 (modifies
the Revolving Loan and Credit Agreement dated April 3, 2000.) [incorporated herein by reference to the
Company’s Report on Form 10-Q for the quarter ended July 30, 2005]
Lease agreement by and between Banc of America Leasing & Capital, LLC and Fred's Stores of Tennessee,
Inc. dated July 26, 2005 for the lease of equipment to Fred's Stores of Tennessee, Inc. [incorporated herein
by reference to the Company’s Report on Form 10-Q for the quarter ended October 29, 2005]
Seventh modification agreement dated October 10, 2005 modifying the Revolving Loan and Credit
Agreement to grant a temporary over line. [incorporated herein by reference to the Company’s report on
Form 10-K for the year ended January 28, 2006]
Eighth modification agreement dated October 30, 2007 modifying the Revolving Loan and Credit
Agreement. [incorporated herein by reference to the Company’s Report on Form 10-Q for the quarter ended
November 3, 2007]
Ninth Modification Agreement of the Revolving Loan and Credit Agreement” dated September 16, 2008
(modifies the Revolving Loan and Credit Agreement dated April 3, 2000)
Incorporated by Reference
Incorporated by Reference
Incorporated by Reference
Incorporated by Reference
Incorporated by Reference
Incorporated by Reference
Incorporated by Reference
Incorporated by Reference
Employment agreement, effective as of September 22, 2007, between the Company and Bruce A. Efird.
[incorporated herein by reference to the Company’s 8-K filed on March 24, 2008]
Incorporated by Reference
Amendment to Employment Agreement, dated December 22, 2008, between the Company and Bruce A.
Efird [incorporated herein by reference to the Company’s Form 8-K filed on December 16, 2008]
Amendment to Employment Agreement, dated February 16, 2009, between the Company and Bruce A. Efird
[incorporated herein by reference to the Company’s Form 8-K filed on February 20, 2009]
Amendment to Employment Agreement, dated December 16, 2008, between the Company and Michael J.
Hayes [incorporated herein by reference to the Company’s Form 8-K filed on December 23, 2008]
Tenth Modification Agreement of the Revolving Loan and Credit Agreement” dated September 27, 2010
(modifies the Revolving Loan and Credit Agreement dated April 3, 2000)
Revolving Loan and Credit Agreement between Fred's, Inc. and Regions Bank and Bank of America dated
January 25, 2013 [incorporated herein by reference to the Company’s report on Form 10-K for year ended
incorporated herein by reference to the Company’s report on Form 10-K for year ended February 2, 2013]
Prime Vendor Agreement between Fred's Stores of Tennessee, Inc. and Cardinal Health 110, LLC and
Cardinal Health 410, LLC as of October 1, 2014 [incorporated by reference to exhibit 10.29 to the Registrant's
Form 10-Q Report filed September 11, 2014]
Amendment to Employment Agreement, dated July 30, 2014, between the Company and Bruce A. Efird
[incorporated by reference to exhibit 10.30 to the Registrant's Form 10-Q Report filed September 11, 2014]
Incorporated by Reference
Incorporated by Reference
Incorporated by Reference
Incorporated by Reference
Incorporated by Reference
Incorporated by Reference
Incorporated by Reference
Employment Agreement, effective November 3, 2014, between the Company and Jerry A. Shore
[incorporated by reference to exhibit 10.31 to the Registrant's Form 10-Q Report filed December 11, 2014]
Incorporated by Reference
Employment Agreement, dated January 12, 2015 between the Company and Michael K. Bloom [incorporated
by reference to exhibit 10.32 to Registrant's Form 8-K filed January 14, 2015]
Incorporated by Reference
Revolving Loan and Credit Agreement between Fred's, Inc. and Regions Bank and Bank of America dated
April 9, 2015.
Incorporated by Reference
Subsidiaries of Registrant
Consent of BDO USA, LLP
Certification of Chief Executive Officer pursuant to Exchange Rule 13a-14(a) of the Securities Exchange Act
Certification of Executive Vice President - Chief Financial Officer pursuant to Exchange Rule 13a-14(a) of the
Securities Exchange Act
Certification of Chief Executive Officer and Executive Vice President - Chief Financial Officer pursuant to
rule 13a–14(b) under the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350
XBRL Instance Document
XBRL Taxonomy Extension Schema
XBRL Taxonomy Extension Calculation Linkbase
XBRL Taxonomy Extension Definition Linkbase
XBRL Taxonomy Extension Label Linkbase
XBRL Taxonomy Extension Presentation Linkbase
Filed Electronically
Filed Electronically
Filed Electronically
Filed Electronically
Filed Electronically
Filed Electronically
Filed Electronically
Filed Electronically
Filed Electronically
Filed Electronically
Filed Electronically
- 67 -
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Shareholders
Fred's, Inc.
Memphis, Tennessee
The audits referred to in our report dated April 14, 2016 relating to the consolidated financial statements of Fred's, Inc., which is
contained in Item 8 of this Form 10-K also included the audit of the financial statement schedule listed in the accompanying index.
This financial statement schedule is the responsibility of the Company's management. Our responsibility is to express an opinion on
this financial statement schedule based on our audits.
In our opinion such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a
whole, presents fairly, in all material respects, the information set forth therein.
/s/ BDO USA, LLP
Memphis, Tennessee
April 14, 2016
- 68 -
Schedule II — Valuation and Qualifying Accounts
(dollars in thousands)
Deducted from applicable assets:
Beginning Balance
Additions Charged
to Costs and
Expenses
Deductions and
Reclass
Adjustments
Ending Balance
Allowance for doubtful accounts
Year ended January 30, 2016
Year ended January 31, 2015
Year ended February 1, 2014
Insurance reserves
Year ended January 30, 2016
Year ended January 31, 2015
Year ended February 1, 2014
$
$
$
2,404
2,097
1,994
$
$
$
1,844
1,383
1,198
$
$
$
1,312
1,076
1,095
$
$
$
2,936
2,404
2,097
$
$
$
10,048
10,474
10,094
$
$
$
41,411
41,364
41,917
$
$
$
41,614
41,790
41,537
$
$
$
9,845
10,048
10,474
- 69 -
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report
to be signed on its behalf by the undersigned, thereunto duly authorized, on this 14th day of April, 2016.
FRED'S, INC.
By: /s/ Jerry A. Shore
Jerry A. Shore, Chief Executive Officer
By: /s/ Rick J. Hans
Rick J. Hans, Executive Vice President and
Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on
behalf of the Registrant and in the capacities indicated on this 14th day of April, 2016.
/s/ Michael J. Hayes
Michael J. Hayes
/s/ Jerry A. Shore
Jerry A. Shore
/s/ Rick J. Hans
Rick. J. Hans
/s/ John R. Eisenman
John R. Eisenman
/s/ Thomas H. Tashjian
Thomas H. Tashjian
/s/ B. Mary McNabb
B. Mary McNabb
/s/ Steven R. Fitzpatrick
Steven R. Fitzpatrick
/s/ Michael T. McMillan
Michael T. McMillan
Signature
Title
Director and Chairman of the Board
Director, Chief Executive Officer (Principal Executive
Officer)
Executive Vice President and Chief Financial
Officer (Principal Accounting and Financial Officer)
Director
Director
Director
Director
Director
- 70 -
(THIS PAGE INTENTIONALLY LEFT BLANK)
Board of Directors
Executive Officers
Jerry A. Shore
Chief Executive Officer
Michael K. Bloom
President and Chief Operating Officer
Rick Hans
Executive Vice President and Chief Financial Officer
Rick A. Chambers
Executive Vice President – Pharmacy Operations
Craig L. Barnes
Executive Vice President of Supply Chain,
Global and Domestic Logistics
W. Bryan Pugh
Chief Merchandising and Marketing Officer
John Foley
Executive Vice President of Store Operations
Mark C. Dely
Senior Vice President, Chief Legal Officer,
General Counsel and Secretary
Thomas J. Tashjian
Chairman of the Board
Fred's, Inc.
Michael J. Hayes
Chairman Emeritus
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
B. Mary McNabb
Former Chief Executive Officer
Kid’s Outlet in California
(retailing)
Michael T. McMillan
Former Sr. Director, Franchise Development
Pepsi America's Beverages
(consumer products)
Steven R. Fitzpatrick
Former President
Accredo Health Group, Inc.
(specialty pharmacy services)
Jerry A. Shore
Chief Executive Officer
Fred's, Inc.
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 30, 2016, as fi led with the
Securities and Exchange Commission, without
charge upon written request to Lilia Lauren, Chief
Accounting Offi cer. 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 fi led with or furnished
to the SEC. The reports are available as soon as
reasonably practical after we electronically fi le 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 2016 annual meeting of shareholders will
be held at 5:00 p.m. Eastern Daylight Time on
Wednesday, June 15, 2016, at the Holiday Inn
Express, 2192 S. Highway 441, Dublin, Georgia.
Shareholders of record as of April 29, 2016, 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 29, 2016,
the Company estimated that had approximately
6,000 shareholders, including benefi cial 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 fi scal quarter in the past two fi scal years.
Fiscal 2015
Fourth
Third
Second
First
Fiscal 2014
Fourth
Third
Second
First
High
Low
Dividends
Per Share
$ 17.14
$ 18.37
$ 20.05
$ 19.47
$ 12.44
$ 11.27
$ 16.14
$ 15.78
$ 0.06
$ 0.06
$ 0.06
$ 0.06
$ 18.00
$ 16.68
$ 18.28
$ 21.05
$ 13.44
$ 13.07
$ 14.53
$ 16.55
$ 0.06
$ 0.06
$ 0.06
$ 0.06
The following graph shows a comparison of the
cumulative total returns for the past fi ve years. The
total cumulative return on investment assumes that
$100 was invested in Fred’s on January 29, 2011,
and $100 was invested in the NASDAQ Retail Trade
Stocks Index and the NASDAQ Stock Market (U.S.)
Index on January 31, 2011, 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
$250
$200
$150
$100
$50
$0
1/29/11
1/28/12
2/2/13
2/1/14
1/31/15
1/30/16
FRED’S Inc.
NASDAQ Composite
NASDAQ Retail Trade
*$100 invested on 1/29/11 in stock or 1/31/11 in index, including
reinvestment of dividends. Indexes calculated on month-end basis.
Our Vision:
“A growing Regional Pharmacy provider of healthcare
services, improving the outcomes of the people in the
communities that we serve by delivering solutions that
are safe, affordable, innovative and easy to access,
complemented by a broad assortment of quality
National and Private brands at affordable prices all
while delivering consistent, strong shareholder value.”
fred’s, Inc.
4300 New Getwell Road
Memphis, TN 38118
fredsinc.com