NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTE
1: BASIS OF PRESENTATION
Fred’s,
Inc. and its subsidiaries (“Fred’s”, “We”, “Our”, “Us” or the “Company”)
operate, as of November 3, 2018, 589 discount general merchandise stores in fifteen states in the Southeastern United States.
Included in the count of discount general merchandise stores are 11 franchised locations. There are 346 full service pharmacy
departments (179 of which are now classified as Assets held-for-sale) located within our discount general merchandise stores,
including one within franchised locations.
The
accompanying unaudited condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted
accounting principles (“GAAP”) for interim financial information and are presented in accordance with the requirements
of Form 10-Q and Article 10 of Regulation S-X and therefore do not include all information and notes necessary for a fair presentation
of financial position, results of operations and cash flows in conformity with GAAP. The accompanying financial statements reflect
all adjustments (consisting of only normal recurring accruals) which are, in the opinion of management, necessary for a fair presentation
of financial position in conformity with GAAP. The accompanying financial statements should be read in conjunction with the Notes
to the Consolidated Financial Statements for the fiscal year ended February 3, 2018 included in our Annual Report on Form 10-K,
which we filed with the Securities and Exchange Commission (the “SEC”) on May 4, 2018.
We
meet the SEC’s definition of a “Smaller Reporting Company,” and therefore qualify for the SEC’s reduced
disclosure requirements for smaller reporting companies.
During
the fourth quarter of 2017, Fred’s Board of Directors approved a plan to actively market its specialty pharmacy business.
The specialty pharmacy business met the criteria for “Assets held for Sale” in accordance with Accounting Standards
Codification (“ASC”) Topic 360 (ASC 360), Property, Plant and Equipment, as of February 3, 2018. The specialty pharmacy
assets and liabilities are reflected as “Assets held-for-sale” on the consolidated balance sheets in this report in
accordance with ASC 360. In addition, the results of operations for the specialty pharmacy business have been presented in this
report as discontinued operations in accordance with ASC 205-20, Results of Operations – Discontinued Operations for all
periods presented. Amounts and percentages for all periods discussed below reflect the results of operations and financial condition
from Fred’s continuing operations, unless otherwise noted.
On
May 4, 2018, Fred’s entered into an Asset Purchase Agreement (the “Specialty Asset Purchase Agreement”) with
Advance Care Scripts, Inc. (the “Specialty Buyer”), pursuant to which the Specialty Buyer agreed to purchase certain
specialty pharmacy assets of certain subsidiaries of Fred’s, National Pharmaceutical Network, Inc. and Reeves-Sain Drug
Store, Inc. (collectively referred to as “Entrust”), consisting of three pharmacy locations, pharmaceutical inventory,
and related intellectual property. The Specialty Buyer paid Fred’s $40.0 million for the purchased assets (plus up to an
additional $5.5 million for inventory). On June 1, 2018, the sale of the specialty pharmacy assets was completed. See Note 2:
Assets Held for Sale and Discontinued Operations for additional information.
On September 7, 2018 the Company
entered into an Asset Purchase Agreement with Walgreen Co., an Illinois corporation. On October 23, 2018, the Company entered
into an amendment to the Asset Purchase Agreement (the “Amendment”). Under such Asset Purchase Agreement, as amended
by the Amendment (the “Amended WBA Asset Purchase Agreement”), the Company agreed to sell certain prescription files
and related data and records, retail pharmaceutical inventory, and certain other assets from 179 of the Company’s 346 retail
pharmacy stores (such assets from such 179 retail pharmacy stores collectively referred to as “Retail Pharmacy”) for
a cash purchase price of approximately $157 million plus an amount equal to the value of the inventory included in the Retail
Pharmacy assets up to an approximately $35 million cap, in each case subject to certain adjustments. During the third quarter
of 2018, the assets therefore met the criteria for “Assets held-for-sale” in accordance with ASC 360. Such assets
have been reflected as “held-for-sale” on the consolidated balance sheets in accordance with ASC 360. In addition,
the results of operations have been presented as discontinued operations in accordance with ASC 205-20, Results of Operations
– Discontinued Operations for all periods presented. Amounts and percentages for all periods discussed below reflect the
results of operations and financial condition from Fred’s continuing operations, unless otherwise noted.
See
Note 2: Assets Held for Sale and Discontinued Operations for additional information.
Certain
prior year amounts have been reclassified to conform to the 2018 presentation. Such reclassifications had no effect on previously
reported net loss.
The
results of operations for the thirteen-week and thirty-nine week periods ended November 3, 2018 are not necessarily indicative
of the results to be expected for the full fiscal year.
All
references in this Quarterly Report on Form 10-Q to 2017 and 2018 refer to the Company’s fiscal years ended February 3,
2018 and ending February 2, 2019, respectively.
Recent
Accounting Pronouncements
In February 2018, the
Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2018-02,
Income
Statement – Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive
Income.
This ASU provides companies with the option to reclassify tax effects resulting from the Tax Cuts and Jobs Act (“TCJA”)
within Accumulated Other Comprehensive Income into Retained Earnings. This ASU is effective for fiscal years beginning after December
15, 2018, and interim periods within those fiscal years. The Company is currently evaluating the effect this ASU will have on
its financial position, results of operations and cash flows.
In October 2016, the
FASB issued ASU 2016-16,
Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other than Inventory
. ASU 2016-16 requires
that an entity recognize the income tax consequences of an intra-entity transfer of assets other than inventory when the transfer
occurs. The guidance must be applied using the modified retrospective basis. This update is effective for the Company at the beginning
of fiscal 2018. The Company has adopted the provisions of ASU 2016-16 and it has had no impact on its financial statements.
In February 2016, the
FASB 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 has identified all leases
impacted by this pronouncement. The Company has selected a lease accounting and administration software to maintain all leases
in compliance with this pronouncement and is currently working on the software implementation and testing, as well as accounting
process development to ensure compliance with this standard upon adoption in 2019. The Company does not plan to early adopt and
expects material changes to the financial position created at the inception of compliance with this standard. The Company will
continue to evaluate the impact the guidance will have on the Company’s financial position, results of operations and cash
flows.
In August 2015, the FASB
issued ASU 2015-14, Revenue from Contracts with Customers (Topic 606), an update to ASU 2014-09. This ASU amends ASU 2014-09 to
defer the effective date by one year for annual reporting periods beginning after December 15, 2017. Subsequently, the FASB has
also issued accounting standards updates which clarify the guidance. This ASU removes inconsistencies, complexities and allows
transparency and comparability of revenue transactions across entities, industries, jurisdictions and capital markets by providing
a single comprehensive principles-based model with additional disclosures regarding uncertainties. The principles-based revenue
recognition model has a five-step analysis of transactions to determine when and how revenue is recognized. The core principle
is that a company should recognize revenue to depict the transfer of promised goods or services to customers in an amount that
reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. Early adoption
is permitted for annual reporting periods beginning after December 15, 2016. In transition, the ASU may be applied retrospectively
to each prior period presented or retrospectively with the cumulative effect recognized as of the date of adoption. The Company
has evaluated all contracts and has implemented this standard and there was no material impact to the Company’s statement
of position, results of operations, or statement of cash flow.
Revenue Recognition
Sales
The vast majority of
Fred’s contracts with customers are made at the point of sale (POS) in the retail stores, and the performance obligation
is the transfer of merchandise which is satisfied at POS when customer pays for merchandise and title transfers to them.
340B
Revenues
We evaluated principal
versus agent considerations with regards to the 340B Direct program under ASC 606. Because Fred’s is primarily responsible
for fulfilling the promise to provide the 340B Direct prescription drugs and assumes control of and risk for inventory prior to
transfer of goods to the customer, including pricing apart from when determined by federal mandate, Fred’s recognizes revenue
on a gross basis as principal for the 340B Direct program.
Gift
Card and Breakage
When
customers purchase gift cards, the sale is not recognized until the card is redeemed. The gift cards are not always fully redeemed
and as such, the Company recognizes breakage. Based on the results from our historical breakage model, the Company defines the
likelihood of redemption as remote after three years of no activity.
Layaway
Plans
Store layaways are agreements
with our customers to provide or deliver goods for a specified price at a future date. Layaway programs run annually for a duration
of less than one year and are most popular during the Christmas seasons. Under the Company’s layaway plan, the customer
is obligated to pay only the amount equivalent to the value of the good plus sales tax. The Company does not assess a layaway
fee or interest but requires an upfront deposit. The customer does not take delivery of the merchandise until the full value is
collected.
Our performance obligation
is the transfer of merchandise which is satisfied at the point of customer pick-up, not at transaction initiation. Any payments
received prior to customer pick-up are considered advance payments and deferred and recognized when the performance obligation
is satisfied. Layaway sales are deferred when the customer transaction is initiated and are recognized as revenue when the layaway
merchandise is transferred.
Disaggregated
Revenues
In the following table, consolidated sales are disaggregated by major merchandising category.
|
|
Thirteen Weeks Ended
|
|
|
Thirty-Nine Weeks Ended
|
|
(in thousands)
|
|
November 3, 2018
|
|
|
November 3, 2018
|
|
Pharmacy
|
|
$
|
203,570
|
|
|
$
|
692,766
|
|
Consumables
|
|
|
119,086
|
|
|
|
380,993
|
|
Household Goods and Softlines
|
|
|
80,277
|
|
|
|
270,401
|
|
Franchise
|
|
|
3,711
|
|
|
|
9,367
|
|
Total
|
|
$
|
406,644
|
|
|
$
|
1,353,527
|
|
Termination of Rite
Aid Asset Purchase Agreement
On
December 19, 2016, Fred’s and its wholly-owned subsidiary, AFAE, LLC (“AFAE”), entered into an Asset Purchase
Agreement (the “Rite Aid Asset Purchase Agreement”) with Rite Aid Corporation (“Rite Aid”) and Walgreens
Boots Alliance, Inc. (“Walgreens”), pursuant to which AFAE agreed to purchase 865 stores, certain intellectual property
and other tangible assets and to assume certain liabilities for a cash purchase price of $950 million. Pursuant to Section 8.01(g)
of the Rite Aid Asset Purchase Agreement, each of AFAE, Walgreens or Rite Aid was permitted to terminate the Rite Aid Asset Purchase
Agreement upon the termination of that certain Agreement and Plan of Merger, dated as of October 27, 2015, among Walgreens, Rite
Aid and the other parties thereto (as amended, the “Merger Agreement”).
On June 29, 2017, the Merger Agreement was terminated and, accordingly, the Rite Aid Asset Purchase Agreement
was also terminated. In connection with the termination of the Rite Aid Asset Purchase Agreement, the Company received a termination
fee payment of $25 million on June 30, 2017, which was recorded in selling, general and administrative expenses to offset the expenses
incurred.
See
Note 11: Indebtedness for additional information relating to the termination of the Rite Aid Asset Purchase Agreement.
NOTE
2: ASSETS HELD-FOR-SALE AND DISCONTINUED OPERATIONS
During the fourth quarter of 2017, Fred’s Board of Directors approved a plan to actively market its
specialty pharmacy business (“Entrust”). Accordingly, Entrust met the criteria for “Assets Held-for-Sale”
in accordance with ASC 360 as of February 3, 2018. Entrust’s assets and liabilities were reflected as “held-for-sale”
on the consolidated balance sheets in accordance with ASC 360 at February 3, 2018. In addition, the results of operations for the
Entrust business have been presented as discontinued operations in accordance with ASC 205-20 for all periods presented. On May
4, 2018, Fred’s entered into the Specialty Asset Purchase Agreement with the Specialty Buyer, pursuant to which, the Specialty
Buyer agreed to purchase Entrust, consisting of three pharmacy locations, pharmaceutical inventory, and related intellectual property.
The Specialty Buyer paid Fred’s $40.0 million for the purchased assets (plus up to an additional $5.5 million for inventory).
On June 1, 2018, the sale of the Entrust assets was completed.
The
results of the Entrust business were previously allocated to the Pharmacy segment within the sales mix. There were no earnings
related to the Entrust business in the third quarter of 2018, but Entrust recorded a loss from discontinued operations, net of
tax, of $1.9 million for the third quarter of 2017, and a loss from discontinued operations, net of tax, of $11.5 million and
$1.1 million for the first nine months of 2018 and 2017, respectively.
Certain
corporate overhead and other costs previously allocated to the specialty pharmacy business for segment reporting purposes did
not qualify for classification within discontinued operations and have been reallocated to continuing operations.
On September 7, 2018 the Company, entered into an Asset Purchase Agreement with Walgreen Co., an Illinois
corporation. On October 23, 2018, the Company entered into an amendment to the Asset Purchase Agreement (the “Amendment”).
Under the Asset Purchase Agreement, as amended by the Amendment (the “Amended WBA Asset Purchase Agreement”), the Company
agreed to sell certain prescription files and related data and records, retail pharmaceutical inventory, and certain other assets
from 179 of the Company’s 346 retail pharmacy stores (such assets from such 179 retail pharmacy stores collectively referred
to as “Retail Pharmacy”) for a cash purchase price of approximately $157 million plus an amount equal to the value
of the inventory included in the Retail Pharmacy assets up to an approximately $35 million cap, in each case subject to certain
adjustments. The Company decided to sell the assets to raise cash to pay down existing debt. As of November 3, 2018, the Company
had not yet completed any dispositions of assets. The Company intends to transfer ownership of the Retail Pharmacy assets to Walgreen
Co. in a series of ongoing closings, with the initial closing occurring on November 13, 2018 and the final closing expected to
occur in the first quarter of calendar year 2019. During the third quarter the assets therefore met the criteria for “Assets
Held-for-Sale” in accordance with ASC 360. Such assets have been reflected as “held-for-sale” on the consolidated
balance sheets in accordance with ASC 360. In addition, the results of operations have been presented as discontinued operations
in accordance with ASC 205-20 for all periods presented. Assets and liabilities which meet the held for sale criteria are carried
at the lesser of fair value less selling costs or carrying value. The Company determined the fair value less costs to sell exceeded
the carrying value of the held for sale, therefore no adjustment to the disposal group's net book value was recognized.
The results of the Retail Pharmacy business
were previously allocated to the Pharmacy segment within the sales mix. Retail Pharmacy recorded a profit from discontinued operations,
net of tax, of $3.4 million and $0.5 million for the third quarter of 2018 and 2017, respectively. Retail Pharmacy recorded a loss
from discontinued operations, net of tax, of $0.2 million and a profit from discontinued operations, net of tax, of $2.5 million,
for the first nine months of 2018 and 2017, respectively.
The total recorded profit from discontinued
operations for Entrust and Retail Pharmacy, net of tax, was $3.4 million for the third quarter of 2018 and the total recorded loss
from discontinued operations for Entrust and Retail Pharmacy, net of tax, was $1.4 million for the third quarter 2017. The total
recorded loss from discontinued operations for Entrust and Retail Pharmacy, net of tax, was $11.7 million for the first nine months
of 2018 and the total recorded profit from discontinued operations for Entrust and Retail Pharmacy, net of tax, was $1.4 million
for the first nine months of 2017.
Summarized
Discontinued Operations Financial Information
The
following table provides a reconciliation of the carrying amounts of major classes of assets and liabilities which are included
in assets and liabilities held-for-sale in the accompanying consolidated balance sheet for each of the periods presented:
|
|
Entrust Discontinued
Operations
|
|
|
Retail Pharmacy
Discontinued Operations
|
|
|
Total Discontinued
Operations
|
|
|
|
November 3,
|
|
|
February 3,
|
|
|
November 3,
|
|
|
February 3,
|
|
|
November 3,
|
|
|
February 3,
|
|
|
|
2018
|
|
|
2018
|
|
|
2018
|
|
|
2018
|
|
|
2018
|
|
|
2018
|
|
(in thousands)
|
|
(unaudited)
|
|
|
|
|
|
(unaudited)
|
|
|
|
|
|
(unaudited)
|
|
|
|
|
Current assets:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Receivables, less allowance for doubtful accounts
|
|
$
|
—
|
|
|
$
|
15,983
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
15,983
|
|
Inventories
|
|
|
—
|
|
|
|
3,756
|
|
|
|
13,849
|
|
|
|
15,344
|
|
|
|
13,849
|
|
|
|
19,100
|
|
Other non-trade receivables
|
|
|
—
|
|
|
|
152
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
152
|
|
Prepaid expenses and other current assets
|
|
|
—
|
|
|
|
12
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
12
|
|
Total current assets held-for-sale
|
|
$
|
—
|
|
|
$
|
19,903
|
|
|
$
|
13,849
|
|
|
$
|
15,344
|
|
|
$
|
13,849
|
|
|
$
|
35,247
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Property and equipment, less accumulated depreciation and amortization
|
|
|
—
|
|
|
|
1,036
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
1,036
|
|
Goodwill
|
|
|
—
|
|
|
|
30,609
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
30,609
|
|
Intangible assets, net
|
|
|
—
|
|
|
|
9,533
|
|
|
|
16,471
|
|
|
|
20,541
|
|
|
|
16,471
|
|
|
|
30,074
|
|
Other noncurrent assets, net
|
|
|
—
|
|
|
|
539
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
539
|
|
Total noncurrent assets held-for-sale
|
|
$
|
—
|
|
|
$
|
41,717
|
|
|
$
|
16,471
|
|
|
$
|
20,541
|
|
|
$
|
16,471
|
|
|
$
|
62,258
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Current liabilities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Accounts payable
|
|
|
—
|
|
|
|
22,045
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
22,045
|
|
Accrued expenses and other
|
|
|
—
|
|
|
|
4,527
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
4,527
|
|
Total current liabilities held-for-sale
|
|
$
|
—
|
|
|
$
|
26,572
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
26,572
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Deferred income taxes
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
Other noncurrent liabilities
|
|
|
—
|
|
|
|
48
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
48
|
|
Total noncurrent liabilities held-for-sale
|
|
$
|
—
|
|
|
$
|
48
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
48
|
|
The following tables summarize the results of discontinued operations for the thirteen and thirty nine weeks
ended November 3, 2018, and October 28, 2017, respectively:
Discontinued Operations - Entrust
|
|
For the Thirteen
Weeks Ended
|
|
|
For the Thirty Nine
Weeks Ended
|
|
|
|
(unaudited)
|
|
|
(unaudited)
|
|
|
|
November 3,
|
|
|
October 28,
|
|
|
November 3,
|
|
|
October 28,
|
|
(in thousands)
|
|
2018
|
|
|
2017
|
|
|
2018
|
|
|
2017
|
|
Net Sales
|
|
$
|
—
|
|
|
$
|
68,168
|
|
|
$
|
90,112
|
|
|
$
|
205,626
|
|
Cost of goods sold
|
|
|
—
|
|
|
|
66,238
|
|
|
|
88,454
|
|
|
|
196,097
|
|
Gross profit
|
|
|
—
|
|
|
|
1,930
|
|
|
|
1,658
|
|
|
|
9,529
|
|
Depreciation and amortization
|
|
|
—
|
|
|
|
631
|
|
|
|
796
|
|
|
|
2,010
|
|
Selling, general and administrative expenses
|
|
|
—
|
|
|
|
2,763
|
|
|
|
12,398
|
|
|
|
8,424
|
|
Loss from discontinued operations
|
|
|
—
|
|
|
|
(1,464
|
)
|
|
|
(11,536
|
)
|
|
|
(905
|
)
|
Income tax expense
|
|
|
—
|
|
|
|
394
|
|
|
|
—
|
|
|
|
244
|
|
Loss from discontinued operations, net of tax
|
|
$
|
—
|
|
|
$
|
(1,858
|
)
|
|
$
|
(11,536
|
)
|
|
$
|
(1,149
|
)
|
Discontinued Operations - Retail Pharmacy
|
|
For the Thirteen
Weeks Ended
|
|
|
For the Thirty Nine
Weeks Ended
|
|
|
|
(unaudited)
|
|
|
(unaudited)
|
|
|
|
November 3,
|
|
|
October 28,
|
|
|
November 3,
|
|
|
October 28,
|
|
(in thousands)
|
|
2018
|
|
|
2017
|
|
|
2018
|
|
|
2017
|
|
Net Sales
|
|
$
|
100,403
|
|
|
$
|
101,088
|
|
|
$
|
298,933
|
|
|
$
|
303,136
|
|
Cost of goods sold
|
|
|
80,948
|
|
|
|
78,432
|
|
|
|
241,695
|
|
|
|
230,847
|
|
Gross profit
|
|
|
19,455
|
|
|
|
22,656
|
|
|
|
57,238
|
|
|
|
72,289
|
|
Depreciation and amortization
|
|
|
616
|
|
|
|
1,751
|
|
|
|
4,071
|
|
|
|
5,549
|
|
Selling, general and administrative expenses
|
|
|
15,401
|
|
|
|
20,971
|
|
|
|
53,376
|
|
|
|
61,962
|
|
Income (loss) from discontinued operations
|
|
|
3,438
|
|
|
|
(66
|
)
|
|
|
(209
|
)
|
|
|
4,778
|
|
Income tax (benefit) expense
|
|
|
—
|
|
|
|
(546
|
)
|
|
|
—
|
|
|
|
2,253
|
|
Income (loss) from discontinued operations, net of tax
|
|
$
|
3,438
|
|
|
$
|
480
|
|
|
$
|
(209
|
)
|
|
$
|
2,525
|
|
Total Discontinued Operations
|
|
For the Thirteen
Weeks Ended
|
|
|
For the Thirty Nine
Weeks Ended
|
|
|
|
(unaudited)
|
|
|
(unaudited)
|
|
|
|
November 3,
|
|
|
October 28,
|
|
|
November 3,
|
|
|
October 28,
|
|
(in thousands)
|
|
2018
|
|
|
2017
|
|
|
2018
|
|
|
2017
|
|
Net Sales
|
|
$
|
100,403
|
|
|
$
|
169,256
|
|
|
$
|
389,045
|
|
|
$
|
508,762
|
|
Cost of goods sold
|
|
|
80,948
|
|
|
|
144,670
|
|
|
|
330,149
|
|
|
|
426,944
|
|
Gross profit
|
|
|
19,455
|
|
|
|
24,586
|
|
|
|
58,896
|
|
|
|
81,818
|
|
Depreciation and amortization
|
|
|
616
|
|
|
|
2,382
|
|
|
|
4,867
|
|
|
|
7,559
|
|
Selling, general and administrative expenses
|
|
|
15,401
|
|
|
|
23,734
|
|
|
|
65,774
|
|
|
|
70,386
|
|
Income (loss) from discontinued operations
|
|
|
3,438
|
|
|
|
(1,530
|
)
|
|
|
(11,745
|
)
|
|
|
3,873
|
|
Income tax (benefit) expense
|
|
|
—
|
|
|
|
(152
|
)
|
|
|
—
|
|
|
|
2,497
|
|
Income (loss) from discontinued operations, net of tax
|
|
$
|
3,438
|
|
|
$
|
(1,378
|
)
|
|
$
|
(11,745
|
)
|
|
$
|
1,376
|
|
NOTE
3: INVENTORIES
Merchandise
inventories are valued at the lower of cost or market using the retail first-in, first-out (FIFO) inventory method for goods in
our stores and the cost FIFO inventory 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
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 process, conducted 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 on a particular product class.
This review also considers current pricing trends and inflation to ensure that markups are taken if necessary. The estimation
of inventory losses (shrink) is a significant element in approximating the carrying value of inventory at net realizable value,
and as such the following paragraph describes our estimation method as well as the steps we take to mitigate the risk of this
estimate in the determination of the cost value of inventory.
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 third 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 inventories, which
were approximately $14.6 million and $18.0 million at November 3, 2018 and February 3, 2018, respectively, cost was determined
using the retail last-in, first-out (LIFO) inventory method in which inventory cost is maintained using the retail inventory method,
then adjusted by application of the Producer Price Index published by the U.S. Department of Labor for cumulative annual periods.
The current cost of inventories exceeded LIFO cost by approximately $27.6 million at November 3, 2018 and $28.8 million at February
3, 2018.
The
Company has historically included an estimate of inbound freight and certain general and administrative costs in merchandise inventory
as prescribed by GAAP. These costs include activities surrounding the procurement and storage of merchandise inventory such as
merchandise planning and buying, warehousing, accounting, information technology and human resources, as well as inbound freight.
The total amount of procurement and storage costs and inbound freight, inclusive of the accelerated recognition of freight capitalization
expense, included in merchandise inventory at November 3, 2018 is $17.6 million, with the corresponding amount of $17.2 million
at February 3, 2018.
During
2016, the Company recorded impairment charges for inventory clearance of product that management identified as low-productive
and does not fit our go-forward model. The Company recorded a below-cost inventory adjustment in accordance with FASB Accounting
Standards Codification (“ASC”) 330, “
Inventory
,” of approximately $13.0 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. At the beginning of 2018, there was $1.8 million (including $0.1
million, for the accelerated recognition of freight capitalization expense) of impairment charges remaining for inventory clearance
of product related to 2016 strategic initiatives. During the first nine months of 2018, the Company utilized $1.8 million of existing
impairment charges related to the 2016 initiatives (including $0.1 million for the accelerated recognition of freight capitalization
expense). No amounts remain related to the 2016 initiatives.
During
the third quarter of 2017, the Company recorded impairment charges for inventory clearance of product that management identified
as low-productive and does not fit our go-forward model. The Company recorded a below-cost inventory adjustment in accordance
with FASB Accounting Standards Codification (“ASC”) 330, “
Inventory
,” of approximately $15.6 million
(including $1.3 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. At the beginning of 2018, there was $4.3 million (including
$1.0 million, for the accelerated recognition of freight capitalization expense) of impairment charges remaining for inventory
clearance of product related to the 2017 initiatives. During the first nine months of 2018, the Company utilized $3.7 million
of existing impairment charges related to the 2017 initiatives (including $1.0 million, for the accelerated recognition of freight
capitalization expense) leaving approximately $0.6 million remaining.
The following table illustrates the inventory
impairment charges related to the inventory clearance initiatives discussed in the previous paragraph (in millions):
|
|
Balance at February 3, 2018
|
|
|
Additions
|
|
|
Utilization
|
|
|
Ending Balance November 3, 2018
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Inventory markdown on low-productive inventory (2016 initiatives)
|
|
$
|
1.7
|
|
|
|
—
|
|
|
|
(1.7
|
)
|
|
$
|
—
|
|
Inventory provision for freight capitalization expense (2016 initiatives)
|
|
|
0.1
|
|
|
|
—
|
|
|
|
(0.1
|
)
|
|
|
—
|
|
Inventory markdown on low-productive inventory (2017 initiatives)
|
|
|
3.3
|
|
|
|
—
|
|
|
|
(2.7
|
)
|
|
|
0.6
|
|
Inventory provision for freight capitalization expense (2017 initiatives)
|
|
|
1.0
|
|
|
|
—
|
|
|
|
(1.0
|
)
|
|
|
0.0
|
|
Total
|
|
$
|
6.1
|
|
|
$
|
—
|
|
|
$
|
(5.5
|
)
|
|
$
|
0.6
|
|
NOTE 4: STOCK-BASED COMPENSATION
The Company accounts for its stock-based
compensation plans in accordance with FASB ASC 718 “
Compensation – Stock Compensation.
” Under FASB ASC
718, stock-based compensation expense 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.
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 as required prior to FASB ASC 718. The following information includes separate disclosures for discontinued
operations. These disclosures relate solely to our Entrust discontinued operation. There are no stock-based compensation disclosures
related to the Retail Pharmacy discontinued operations. A summary of the Company’s stock-based compensation (a component
of selling, general and administrative expenses) and related income tax benefit is as follows:
|
|
Thirteen Weeks Ended
|
|
|
Thirty-Nine Weeks Ended
|
|
(in thousands)
|
|
November 3, 2018
|
|
|
October 28, 2017
|
|
|
November 3, 2018
|
|
|
October 28, 2017
|
|
Continuing Operations
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Stock option expense
|
|
$
|
215
|
|
|
$
|
307
|
|
|
$
|
709
|
|
|
$
|
1,152
|
|
Restricted stock expense
|
|
|
226
|
|
|
|
1,059
|
|
|
|
1,976
|
|
|
|
3,026
|
|
ESPP expense
|
|
|
—
|
|
|
|
244
|
|
|
|
—
|
|
|
|
428
|
|
Total stock-based compensation
|
|
$
|
441
|
|
|
$
|
1,610
|
|
|
$
|
2,685
|
|
|
$
|
4,606
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income tax benefit on stock-based compensation
|
|
$
|
11
|
|
|
$
|
414
|
|
|
$
|
34
|
|
|
$
|
1,192
|
|
|
|
Thirteen
Weeks Ended
|
|
|
Thirty-Nine
Weeks Ended
|
|
(in thousands)
|
|
November
3, 2018
|
|
|
October
28, 2017
|
|
|
November
3, 2018
|
|
|
October
28, 2017
|
|
Discontinued
Operations
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Stock option
expense
|
|
$
|
13
|
|
|
$
|
50
|
|
|
$
|
48
|
|
|
$
|
174
|
|
Restricted
stock expense
|
|
|
9
|
|
|
|
15
|
|
|
|
34
|
|
|
|
63
|
|
Total
stock-based compensation
|
|
$
|
22
|
|
|
$
|
65
|
|
|
$
|
82
|
|
|
$
|
237
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income tax benefit
on stock-based compensation
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
4
|
|
|
$
|
14
|
|
The fair value of each option granted
during the thirteen and thirty-nine week periods ended November 3, 2018 and October 28, 2017 is estimated on the date of grant
using the Black-Scholes option-pricing model with the following weighted average assumptions:
|
|
Thirteen Weeks Ended
|
|
|
Thirty Nine Weeks Ended
|
|
Continuing Operations
|
|
November 3, 2018
|
|
|
October 28, 2017
|
|
|
November 3, 2018
|
|
|
October 28, 2017
|
|
Stock Options
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Expected volatility
|
|
|
0.0
|
%
|
|
|
46.1
|
%
|
|
|
0.0
|
%
|
|
|
41.7
|
%
|
Risk-free interest rate
|
|
|
0.0
|
%
|
|
|
1.9
|
%
|
|
|
0.0
|
%
|
|
|
2.1
|
%
|
Expected option life (in years)
|
|
|
0
|
|
|
|
5.84
|
|
|
|
0
|
|
|
|
5.84
|
|
Expected dividend yield
|
|
|
0.00
|
%
|
|
|
1.98
|
%
|
|
|
0.00
|
%
|
|
|
1.87
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted average fair value at grant date
|
|
$
|
—
|
|
|
$
|
2.44
|
|
|
$
|
—
|
|
|
$
|
4.11
|
|
|
|
Thirteen Weeks Ended
|
|
|
Thirty Nine Weeks Ended
|
|
Discontinued Operations
|
|
November 3, 2018
|
|
|
October 28, 2017
|
|
|
November 3, 2018
|
|
|
October 28, 2017
|
|
Stock Options
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Expected volatility
|
|
|
0.0
|
%
|
|
|
0.0
|
%
|
|
|
0.0
|
%
|
|
|
43.1
|
%
|
Risk-free interest rate
|
|
|
0.0
|
%
|
|
|
0.0
|
%
|
|
|
0.0
|
%
|
|
|
2.2
|
%
|
Expected option life (in years)
|
|
|
0
|
|
|
|
0
|
|
|
|
0
|
|
|
|
5.84
|
|
Expected dividend yield
|
|
|
0.00
|
%
|
|
|
0.00
|
%
|
|
|
0.00
|
%
|
|
|
1.85
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted average fair value at grant date
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
4.89
|
|
|
|
Thirteen Weeks Ended
|
|
|
Thirty Nine Weeks Ended
|
|
|
|
November 3, 2018
|
|
|
October 28, 2017
|
|
|
November 3, 2018
|
|
|
October 28, 2017
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Employee Stock Purchase Plan
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Expected volatility
|
|
|
0.0
|
%
|
|
|
86.1
|
%
|
|
|
0.0
|
%
|
|
|
82.2
|
%
|
Risk-free interest rate
|
|
|
0.0
|
%
|
|
|
1.0
|
%
|
|
|
0.0
|
%
|
|
|
1.0
|
%
|
Expected option life (in years)
|
|
|
0.00
|
|
|
|
0.75
|
|
|
|
0.00
|
|
|
|
0.50
|
|
Expected dividend yield
|
|
|
0.00
|
%
|
|
|
1.24
|
%
|
|
|
0.00
|
%
|
|
|
0.81
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted average fair value at grant date
|
|
$
|
—
|
|
|
$
|
7.95
|
|
|
$
|
—
|
|
|
$
|
6.86
|
|
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 may 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 to ten 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.
Employee Stock Purchase Plan
The 2004 Employee Stock Purchase Plan
(“ESPP”) (the “2004 Plan”), which was approved by Fred’s shareholders, permits eligible employees
to purchase shares of our common stock through payroll deductions at the lower of 85% of the fair market value of the stock at
the time of grant, or 85% of the fair market value at the time of exercise. During the fourth quarter of 2017, management and
the Board of Directors suspended purchases through the ESPP effective December 31, 2017. The ESPP suspension resulted in zero
shares issued during the thirty-nine weeks ended November 3, 2018. There are 1,410,928 shares approved to be issued under the
2004 Plan and as of November 3, 2018, there were 595,681 shares available.
Stock Options
The following table summarizes stock option activity during
the thirty-nine weeks ended November 3, 2018:
Continuing Operations
|
|
Options
|
|
|
Weighted- Average Exercise Price
|
|
|
Weighted-Average Contractual
Life (years)
|
|
|
Aggregate Intrinsic Value (000s)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Outstanding at February 3, 2018
|
|
|
1,171,825
|
|
|
$
|
13.12
|
|
|
|
5.1
|
|
|
$
|
—
|
|
Granted
|
|
|
—
|
|
|
|
—
|
|
|
|
|
|
|
|
|
|
Cancelled
|
|
|
(537,254
|
)
|
|
|
12.29
|
|
|
|
|
|
|
|
|
|
Exercised
|
|
|
—
|
|
|
|
—
|
|
|
|
|
|
|
|
|
|
Outstanding at November 3, 2018
|
|
|
634,571
|
|
|
$
|
13.83
|
|
|
|
4.4
|
|
|
$
|
—
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Exercisable at November 3, 2018
|
|
|
442,605
|
|
|
$
|
14.60
|
|
|
|
4.2
|
|
|
|
—
|
|
Discontinued Operations
|
|
Options
|
|
|
Weighted- Average Exercise Price
|
|
|
Weighted-Average Contractual
Life (years)
|
|
|
Aggregate Intrinsic Value (000s)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Outstanding at February 3, 2018
|
|
|
167,375
|
|
|
$
|
14.23
|
|
|
|
5.4
|
|
|
$
|
—
|
|
Granted
|
|
|
—
|
|
|
|
—
|
|
|
|
|
|
|
|
|
|
Cancelled
|
|
|
(158,984
|
)
|
|
|
14.17
|
|
|
|
|
|
|
|
|
|
Exercised
|
|
|
—
|
|
|
|
—
|
|
|
|
|
|
|
|
|
|
Outstanding at November 3, 2018
|
|
|
8,391
|
|
|
$
|
15.44
|
|
|
|
4.5
|
|
|
$
|
—
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Exercisable at November 3, 2018
|
|
|
3,356
|
|
|
$
|
15.44
|
|
|
|
4.5
|
|
|
$
|
—
|
|
The aggregate intrinsic value in the table above represents
the total pre-tax intrinsic value (the difference between Fred’s closing stock price on the last trading day of the period
ended November 3, 2018 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. As of November 3, 2018, total
unrecognized stock-based compensation expense net of estimated forfeitures related to non-vested stock options for continuing
operations was approximately $1.0 million, which is expected to be recognized over a weighted average period of approximately
3.0 years. As of November 3, 2018, there was no unrecognized stock-based compensation expense, net of estimated forfeitures related
to non-vested stock options for discontinued operations. The total fair value of options vested during the thirty-nine weeks ended
November 3, 2018 for continuing operations was $146.3 thousand. The total fair value of options vested during the thirty-nine
weeks ended November 3, 2018 for discontinued operations was $10.3 thousand.
Restricted Stock
The following table summarizes restricted stock activity during
the thirty-nine weeks ended November 3, 2018:
Continuing Operations
|
|
Number of Shares
|
|
|
Weighted-Average Grant Date
Fair Value
|
|
|
|
|
|
|
|
|
Non-vested Restricted Stock at February 3, 2018
|
|
|
653,895
|
|
|
$
|
10.14
|
|
Granted
|
|
|
649,233
|
|
|
|
2.23
|
|
Forfeited / Cancelled
|
|
|
(109,512
|
)
|
|
|
10.68
|
|
Vested
|
|
|
(413,630
|
)
|
|
|
7.73
|
|
Non-vested Restricted Stock at November 3, 2018
|
|
|
779,986
|
|
|
$
|
4.77
|
|
Discontinued Operations
|
|
Number of Shares
|
|
|
Weighted-Average Grant Date
Fair Value
|
|
|
|
|
|
|
|
|
Non-vested Restricted Stock at February 3, 2018
|
|
|
11,194
|
|
|
$
|
15.35
|
|
Granted
|
|
|
—
|
|
|
|
—
|
|
Forfeited / Cancelled
|
|
|
(8,862
|
)
|
|
|
14.95
|
|
Vested
|
|
|
(2,332
|
)
|
|
|
15.44
|
|
Non-vested Restricted Stock at November 3, 2018
|
|
|
—
|
|
|
$
|
—
|
|
For continuing operations, the aggregate
pre-tax intrinsic value of restricted stock outstanding as of November 3, 2018 is $2.3 million with a weighted average remaining
contractual life of 8.6 years. The unrecognized compensation expense net of estimated forfeitures, related to the outstanding
stock is approximately $2.2 million, which is expected to be recognized over a weighted average period of approximately 2.9 years.
The total fair value of restricted stock awards that vested during the thirty-nine weeks ended November 3, 2018 was $3.2 million.
For discontinued operations, there was no aggregate pre-tax
intrinsic value of restricted stock outstanding as of November 3, 2018, no weighted average remaining contractual life, and no
unrecognized compensation expense related to the outstanding stock The total fair value of restricted stock awards related to
discontinued operations that vested during the thirty-nine weeks ended November 3, 2018 was $0.04 million.
NOTE 5: FAIR VALUE MEASUREMENTS
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.
|
Due to their short-term nature, the Company’s
financial instruments, which include cash and cash equivalents, receivables and accounts payable, are presented on the condensed
consolidated balance sheets at a reasonable estimate of their fair value as of November 3, 2018 and February 3, 2018. The fair
value of the revolving lines 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, notes payable and mortgage loans as of the following dates:
|
|
November 3, 2018
|
|
|
February 3, 2018
|
|
(in thousands)
|
|
Carrying Value
|
|
|
Fair Value
|
|
|
Carrying Value
|
|
|
Fair Value
|
|
Revolving line of credit
|
|
$
|
167,539
|
|
|
$
|
167,539
|
|
|
$
|
153,431
|
|
|
$
|
153,431
|
|
Mortgage loans on land & buildings
|
|
|
1,531
|
|
|
|
1,615
|
|
|
|
1,579
|
|
|
|
1,684
|
|
Notes Payable
|
|
|
13,000
|
|
|
|
12,185
|
|
|
|
13,000
|
|
|
|
12,421
|
|
NOTE 6: PROPERTY AND EQUIPMENT
Property and equipment are carried
at cost. Depreciation is recorded using the straight-line method over the estimated useful lives of assets. 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 shorter of the remaining term of the
lease (including the upcoming renewal option if the renewal is reasonably assured) or the useful life of the improvement. Assets
under capital leases 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. Gains or losses on the sale of assets are recorded as a component of selling, general and
administrative expenses.
The following illustrates the
breakdown of the major categories within property and equipment (in thousands):
(in thousands)
|
|
|
|
|
|
|
Property and equipment, at cost:
|
|
November 3, 2018
|
|
|
February 3, 2018
|
|
Buildings and building improvements
|
|
$
|
116,808
|
|
|
$
|
119,039
|
|
Leasehold improvements
|
|
|
89,071
|
|
|
|
86,402
|
|
Automobiles and vehicles
|
|
|
3,772
|
|
|
|
4,525
|
|
Furniture, fixtures and equipment
|
|
|
288,346
|
|
|
|
286,962
|
|
|
|
|
497,997
|
|
|
|
496,928
|
|
Less: Accumulated depreciation and amortization
|
|
|
(403,790
|
)
|
|
|
(390,633
|
)
|
|
|
|
94,207
|
|
|
|
106,295
|
|
Construction in progress
|
|
|
2,447
|
|
|
|
590
|
|
Land
|
|
|
8,470
|
|
|
|
8,581
|
|
Total Property and equipment, at depreciated cost
|
|
$
|
105,124
|
|
|
$
|
115,466
|
|
NOTE 7: 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 a discounted cash flow model, which are
considered Level 3 inputs.
In 2015, the Company recorded impairment
charges for fixed assets and leasehold improvements related to 2014 and 2015 planned store closures. In 2016, the Company utilized
all of the impairment charges related to the 2015 store closures and $0.2 million related to the 2014 store closures, leaving
$0.5 million of impairment charges. None of the remaining $0.5 million impairment charges were utilized as of November 3, 2018.
During fiscal 2016, the Company recorded
impairment charges of $3.6 million for fixed asset impairments related to the corporate headquarters. None of the impairment charges
relating to the corporate headquarters were utilized as of November 3, 2018.
In the third quarter of 2017, in association
with the planned closure of additional underperforming stores and pharmacies, the Company recorded charges in the amount of $0.8
million in selling, general and administrative expense for the impairment of fixed assets associated with the closing stores and
pharmacies and $1.4 million for the accelerated recognition of amortization of intangible assets associated with the closing pharmacies.
None of these charges were utilized as of November 3, 2018.
In the fourth quarter of 2017, the Company recorded a charge
of $1.1 million in selling, general and administrative expense for the impairment of fixed assets associated with several underperforming
locations. None of the impairment charges relating to these assets were utilized as of November 3, 2018.
Inventory
As discussed in Note 3 - 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.
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.
In the first quarter of 2017, the Company
recorded a lease liability relating to the 39 underperforming store closures in fiscal 2017 of $8.2 million. Additional $0.2 million
reserve was recorded in the fourth quarter of 2017 and $2.1 million of reserve was utilized during the year, leaving $6.3 million
reserve balance as of February 3, 2018. In the first three quarters of 2018, the Company utilized $1.7 million, leaving $4.6 million
reserve balance as of November 3, 2018.
The following table illustrates the exit
and inventory related to store closures, inventory strategic initiatives along with the lease liability related to the planned
store closures discussed in the previous paragraphs (in millions):
|
|
Balance at
February 3, 2018
|
|
|
Additions
|
|
|
Utilization
|
|
|
Ending Balance November 3, 2018
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Impairment charge for the disposal
of fixed assets for 2014 planned closures
|
|
$
|
0.5
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
0.5
|
|
Impairment charge for the disposal of fixed assets
for corporate office
|
|
|
3.6
|
|
|
|
—
|
|
|
|
—
|
|
|
|
3.6
|
|
Impairment charge for the disposal of fixed assets
for 2017 planned closures
|
|
|
0.8
|
|
|
|
—
|
|
|
|
—
|
|
|
|
0.8
|
|
Impairment charge for the disposal of intangible
assets for 2017 planned closures
|
|
|
1.4
|
|
|
|
—
|
|
|
|
—
|
|
|
|
1.4
|
|
Impairment charge for the
write down of fixed assets for underperforming stores
|
|
|
1.1
|
|
|
|
—
|
|
|
|
—
|
|
|
|
1.1
|
|
Subtotal
|
|
$
|
7.4
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
7.4
|
|
Lease contract termination
liability, 2017 closures
|
|
|
6.3
|
|
|
|
|
|
|
|
(1.7
|
)
|
|
|
4.6
|
|
Total
|
|
$
|
13.7
|
|
|
$
|
—
|
|
|
$
|
(1.7
|
)
|
|
$
|
12.0
|
|
NOTE 8: ACCUMULATED OTHER 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 are recorded as an element of shareholders’ equity but are excluded from net income pursuant to GAAP. The Company’s
accumulated other comprehensive income includes the unrecognized prior service costs, transition obligations and actuarial gains/losses
associated with our post-retirement benefit plan.
The following table illustrates the activity in accumulated
other comprehensive income:
|
|
Thirteen Weeks Ended
|
|
|
Year Ended
|
|
(in
thousands)
|
|
November 3, 2018
|
|
|
October 28, 2017
|
|
|
February 03, 2018
|
|
|
|
|
|
|
|
|
|
|
|
Accumulated other comprehensive income
|
|
$
|
559
|
|
|
$
|
466
|
|
|
$
|
466
|
|
Amortization of post-retirement
benefit
|
|
|
—
|
|
|
|
—
|
|
|
|
93
|
|
Ending balance
|
|
$
|
559
|
|
|
$
|
466
|
|
|
$
|
559
|
|
NOTE
9: 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 became employees of Fred’s as part of the acquisition. As of May 5, 2018, the
sellers were former employees. The notes payable are due in three equal installments to be paid on January 31
st
of
2021, 2022 and 2023 and are subordinate to the Company’s revolving line of credit. This amount is reflected in “Long
Term Portion of Indebtedness” on the Balance Sheet.
NOTE 10: LEGAL CONTINGENCIES
On October 15, 2015,
a lawsuit entitled Southern Independent Bank v. Fred’s, Inc. was filed in the U.S. District Court, Middle District of Alabama.
The complaint includes allegations made by the plaintiff on behalf of itself 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 includes allegations 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. This motion has since been
denied, and the Company filed a motion to reconsider by certifying the question to the Alabama Supreme Court for clarity. However,
the Company’s motion was denied, and the Company has now completed discovery and is moving to trial. A motion for class
certification is currently pending before the U.S. District Court, Middle District of Alabama. Future costs or liabilities related
to the incident may have a material adverse effect on the Company. The Company has not made an accrual for future losses related
to these claims at this time as the future losses are not considered probable. The Company has a cyber liability policy with a
$10 million limit and $100,000 deductible.
On July 27, 2016, a lawsuit
entitled The State of Mississippi v. Fred’s Inc., et al was filed in the Chancery Court of Desoto County, Mississippi, Third
Judicial District. The complaint alleges that the Company fraudulently reported their usual and customary prices to Mississippi’s
Division of Medicaid in order to receive higher reimbursements for prescription drugs. The complaint seeks declaratory and monetary
relief for the profits alleged to have been unfairly earned as well as attorney costs. The Company denies these allegations and
believes it acted appropriately in its dealings with the Mississippi Division of Medicaid. The Company successfully filed a Motion
to Transfer to Circuit Court. The State filed a Petition for Interlocutory Appeal with the Mississippi Supreme Court, but the
Mississippi Supreme Court ruled in our favor and the case is now proceeding in Circuit Court. Future costs and liabilities related
to this case may have a material adverse effect on the Company; however, the Company has not made an accrual for future losses
related to these claims as it is not possible at this time to evaluate the likelihood of an unfavorable outcome or to estimate
the amount or range of any potential loss. The Company has multiple insurance policies which the Company believes will limit its
potential exposure.
On September 29, 2016,
the Company reported to the Office of Civil Rights (“OCR”) that an unencrypted laptop containing clinical and demographic
data for 9,624 individuals had been stolen from an employee’s vehicle while the vehicle was parked at the employee’s
residence. On January 13, 2017, the OCR opened an investigation into the incident. The Company has fully complied with the investigation
and timely responded to all requests for information from the OCR. The Company received several supplemental requests for information
from the OCR during the third and fourth fiscal quarters of 2018, to which the Company has timely responded. Future costs and
liabilities related to this case may have a material adverse effect on the Company; however, the Company has not made an accrual
for future losses related to these claims as future losses are not considered probable and an estimate is unavailable.
On March 30, 2017, a
lawsuit entitled Tiffany Taylor, individually and on behalf of others similarly situated, v. Fred’s Inc. and Fred’s
Stores of Tennessee, Inc. was filed in the United Stated District Court for the Northern District of Alabama Southern Division.
The complaint alleges that the Company wrongfully and willfully violated the Fair and Accurate Credit Transactions Act (“FACTA”).
On April 11, 2017, a lawsuit entitled Melanie Wallace,
Sascha Feliciano, and
Heather Tyler, on behalf of themselves and all others similarly situated, v. Fred’s Stores of Tennessee, Inc. was filed
in the Superior Court of Fulton County in the state of Georgia. The complaint alleges that the Company wrongfully and willfully
violated FACTA. On April 13, 2017, a lawsuit entitled Lillie Williams and Cussetta Journey, on behalf of themselves and all others
similarly situated, v. Fred’s Stores of Tennessee, Inc. was filed in the Superior Court of Fulton County in the state of
Georgia. The complaint also alleges that the Company wrongfully and willfully violated FACTA. The complaints are filed as Class
Actions, with the class being open for five (5) years before the date the complaint was filed. The complaint seeks statutory damages,
attorney’s fees, punitive damages, an injunctive order, and other such relief that the court may deem just and equitable.
The Company filed a Motion to Dismiss the Taylor complaint, and this Motion has been granted by the Court. Plaintiff’s counsel
has appealed the Taylor complaint, which appeal is pending before the 11
th
Circuit Court of Appeals. The Company filed,
and the Court granted Motions to Remove and Motions to Transfer the Williams and Wallace matters to the U.S. District Court for
the Northern District of Alabama. Since the Williams and Wallace matters were removed and transferred to the U.S. District Court
for the Northern District of Alabama, the Company has filed a Motion to Consolidate the Williams and Wallace matters. When the
court granted the Company’s motion to dismiss in the Taylor case, the court simultaneously denied the Motion to Consolidate,
in light of the dismissal in Taylor. In the Wallace and Williams actions, the District Court entered an order staying both cases
until the U.S Court of Appeals for the 11
th
Circuit decides on the appeal. Oral argument for the appeal has been set
with the Court of Appeals for the 11
th
Circuit at the end of January 2019. Future costs and liabilities related to
this case may have a material adverse effect on the Company; however, the Company has not made an accrual for future losses related
to these claims as future losses are not considered probable and an estimate is unavailable.
On March 3, 2018, a lawsuit
entitled Abel Eddington and Judy Hudson, individually and on behalf of all others similarly situated, v. Fred’s Inc., and
Fred’s Stores of Tennessee, Inc. was filed in the United States District Court Eastern District of Texas, Marshall Division.
The complaint alleges that the Company committed various Federal and state wage and hours violations. The complaint is filed as
Class Action and seeks back wages, attorneys’ fees, and all other damages allowable by law. The Company denies these allegations
and believes it acted appropriately in its wage and hour calculations and payments. The Company and the named plaintiffs have
reached an agreement in principle to settle the case for $250,000, including plaintiffs’ attorneys’ fees, and the
Court has accepted the parties’ notice of settlement and cancelled all pending deadlines. The parties are currently negotiating
the formal settlement agreement and preparing the related court filings.
On March 16, 2018, a
lawsuit entitled Roxie Whitley , individually and as next friend of Baby Z.B.D., and Chris and Diane Denson, individually and
as next friends of Baby L.D.L., on behalf of themselves and all others similarly situated, v. Purdue Pharma L.P.; Purdue Pharma,
Inc.; The Purdue Frederick Company, Inc.; McKesson Corporation; Cardinal Health, Inc.; AmeriSourceBergen Corporation; Teva Pharmaceutical
Industries, Ltd.; Teva Pharmaceuticals USA, Inc.; Cephalon, Inc.; Johnson & Johnson; Janssen Pharmaceuticals, Inc.; Ortho-McNeil-Janssen
Pharmaceuticals, Inc. n/k/a Janssen Pharmaceuticals, Inc.; Janssen Pharmaceuticals, Inc. n/k/a Janssen Pharmaceuticals, Inc.;
Endo Health Solutions Inc.; Endo Pharmaceuticals, Inc; Allergan PLC; Watson Pharmaceuticals, Inc. n/k/a Actavis, Inc.; Watson
Laboratories, Inc.; Actavis LLC; Actavis Pharma, Inc. f/k/a Watson Pharma, Inc.; and Fred’s Stores of Tennessee, Inc. was
filed in the Circuit Court of Fayette County, Tennessee for the 25
th
Judicial District at Somerville. The complaint
fails to allege any wrong-doing by the Company. The Complaint is filed as a class action seeking various remedies allowed under
Federal and state laws. The Company denies any purported wrong-doing. On May 9, 2018, the Company filed a Motion to Dismiss for
Lack of Standing, a Motion to Dismiss Plaintiff’s Product Liability Causes of Action, a Motion to Dismiss for Statute of
Limitations, and a Motion to Dismiss for Failure to State a Claim on which Relief may be Sought (collectively, the “May
9, 2018 Motions”). The Court has not ruled on the May 9, 2018 Motions. On May 9, 2018 this matter was transferred to the
United States District Court for the Northern District of Ohio as part of the National Prescription Opiate Litigation Multidistrict
Litigation. Future costs and liabilities related to this case may have a material adverse effect on the Company; however, the
Company has not made an accrual for future losses related to these claims as future losses are not considered probable, and an
estimate is unavailable. The Company has multiple insurance policies which the Company believes will limit its potential exposure.
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 outcomes of these 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 Company’s 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 Company’s financial statements as a whole.
NOTE
11: INDEBTEDNESS
On April 9, 2015, the
Company entered into a Revolving Loan and Credit Agreement (the “Agreement”) with Regions Bank and Bank of America
to replace the Company’s previous revolving credit facility. The proceeds were used to refinance amounts outstanding
under the prior credit and to support acquisitions and the Company’s working capital needs. The Agreement initially provided
for a $150.0 million secured revolving line of credit, including a sublimit for letters of credit and swingline loans. The Agreement,
which expires on April 9, 2020, was amended effective January 30, 2017 to increase the loan commitment from $150.0 million to
$225.0 million. On July 31, 2017, the Company amended the Agreement and related security agreement to: (i) increase the
revolving loan commitment from $225 million to $270 million, (ii) increase the pharmacy scripts advance rate, (iii) revise the
excess availability requirements for certain acquisitions, and (iv) add Bank of America as a co-collateral agent. Draws
are limited to the lesser of the commitment amount or the borrowing base, which is periodically determined by reference to the
value of certain receivables, inventory and scripts, less applicable reserves. The Company may choose to borrow at a spread
to either LIBOR or a Base Rate. For LIBOR loans the spread ranges from 1.75% to 2.25% and for Base Rate loans the spread
ranges from 0.75% to 1.25%. The spread depends on the level of excess availability. Commitment fees on the unused
portion of the credit line are 37.5 basis points. The Agreement included an up-front credit facility fee which is being
amortized over the Agreement term. There were $167.5 million of borrowings outstanding and $33.3 million, net of borrowings
and letters of credit, remaining available under the Agreement at November 3, 2018.
On October 15, 2018,
the Company entered into the Third Amendment to the Amended and Restated Addendum to Credit Agreement (the “Third Amendment”).
The Third Amendment amends the Company’s existing Amended and Restated Addendum to Credit Agreement, dated as of January
27, 2017, as amended as of July 31, 2017 and August 23, 2018. The Third Amendment does not otherwise amend the Credit Agreement
dated as of April 9, 2015, as amended as of October 23, 2015, December 28, 2016, January 27, 2017, July 31, 2017, August 22, 2017,
April 5, 2018 and August 23, 2018 (the “Credit Agreement”), or the Security Agreement, dated as of April 9, 2015,
as amended as of July 31, 2017 and August 23, 2018 (the “Security Agreement”). Among other things, the Third
Amendment increases the frequency of certain financial reporting obligations of the Company and its subsidiaries to the lenders
that apply only during the period from October 15, 2018 until the earlier of November 30, 2018 and the date on which the Company
fails to comply with such reporting obligations, reduces the excess availability requirements during such period, and increases
the percentage of the projected value of customer prescription files under the borrowing base, potentially allowing for increased
borrowing capability during such period.
On August 23, 2018, the
Company entered into the Seventh Amendment to Credit Agreement, Second Amendment to Amended and Restated Addendum to Credit Agreement
and Second Amendment to Security Agreement (the “Amendment”). Among other changes, the Amendment decreases, at the
Company’s request, the revolving loan commitment from $270.0 million to $210.0 million, permits certain sale-leaseback transactions,
allows transfers of properties to non-Loan Party (as defined in the Credit Agreement) subsidiaries for financing and allows for
the assumption of debt and financing for such transactions, permits the sale of real estate, other than distribution centers for
fair market value and adds repurchases and redemption to the definition of restricted payments, which are limited under the restricted
payments covenant.
On December 19, 2016,
the Company entered into a commitment letter with respect to a senior secured asset based loan facility (the “ABL Commitment
Letter”), and a commitment letter with respect to a term loan facility (the “Term Loan Commitment Letter”);
and on January 18, 2017, the Company entered into an amended and restated ABL Commitment Letter (the “Amended and Restated
ABL Commitment Letter”). The Amended and Restated ABL Commitment Letter and the Term Loan Commitment Letter were entered
into with lenders who agreed to provide $1.65 billion of debt financing to be used by the Company to fund its proposed acquisition
of 865 stores, certain intellectual property and certain other tangible assets of Rite Aid Corporation.
On
June 9, 2017, the Company amended and restated the Amended and Restated ABL Commitment (the “Second Amended and Restated
ABL Commitment Letter”), and the Term Loan Commitment Letter (the “Amended and Restated Term Loan Commitment Letter”)
for the purpose of increasing the aggregate committed debt financing available thereunder to $2.2 billion.
Upon
termination of the Rite Aid Asset Purchase Agreement, as discussed in Note 1 above, the Company terminated the Second Amended
and Restated ABL Commitment Letter and the Amended and Restated Term Loan Commitment Letter. In connection with such termination,
the Company incurred applicable termination fees contemplated by the Second Amended and Restated ABL Commitment Letter and Amended
and Restated Term Loan Commitment Letter, which were paid in the third quarter of 2017.
In connection with the
aforementioned commitment letters, the Company incurred approximately $30 million of debt issuance costs. These costs are reflected
in SG&A in the Statement of Operations. The $25 million termination fee paid by Walgreens, on June 30, 2017, discussed in
Note 1: Basis of Presentation, partially offset these costs.
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%. Mortgages remain on two locations with a combined balance of $1.5 million outstanding at November 3, 2018.
The weighted average interest rate on mortgages outstanding at November 3, 2018 was 7.40%. The debt is collateralized by
the land and buildings.
NOTE 12: INCOME TAXES
The
Company accounts for its income taxes in accordance with FASB ASC 740 “
Income Taxes
.” Pursuant to FASB ASC
740, the Company must consider all positive and negative evidence regarding the realization of deferred tax assets including past
operating results and future sources of taxable income. A cumulative loss in recent years is a significant piece of negative evidence
when evaluating the need for a valuation allowance. Under the provisions of FASB ASC 740, the Company determined that a full valuation
allowance is needed given the cumulative loss in recent years.
NOTE
13: SUBSEQUENT EVENT
As described in Note 2, the Company entered into the Amended WBA Asset Purchase Agreement with Walgreen Co.,
an Illinois corporation, to sell certain prescription files and related data and records, retail pharmaceutical inventory, and
certain other assets from 179 of the Company’s 346 retail pharmacy stores (such assets collectively referred to as “Retail
Pharmacy”). The Company intends to transfer ownership of the Retail Pharmacy assets to Buyer in a series of ongoing closings,
with the goal of completing the asset transfers in the first month of calendar year 2019. As of December 12, 2018, the Company
had transferred to Walgreen Co. assets from 138 stores and had received cash proceeds of approximately $152.5 million for such
assets, subject to $11.2 million in adjustments for the final inventory valuation as described in the Amended WBA Asset Purchase
Agreement. The remaining transfers of such assets remain subject to certain customary closing conditions as specified in the Amended
WBA Asset Purchase Agreement.
Item
2: