NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTE
1: BASIS OF PRESENTATION
Fred’s,
Inc. and its subsidiaries (“Fred’s”, “Fred’s Pharmacy”, “We”, “Our”, “Us”
or “Company”) operate, as of May 5, 2018, 595 discount general merchandise stores and three specialty pharmacy-only
locations (now classified as Assets Held-for-Sale), in fifteen states in the Southeastern United States. Included in the count
of discount general merchandise stores are 12 franchised locations. There are 348 full service pharmacy departments 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 on May 4, 2018.
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 accordance with
ASC 360. In addition, the results of operations for the specialty pharmacy business have been presented as discontinued operations
in accordance with ASC 205-20, Results of Operations – Discontinued Operations for all periods presented. Excluding the
“Assets Held-for-Sale” subsection, amounts and percentages for all periods discussed below reflect the results of
operations and financial condition from Fred’s continuing operations.
On
May 4, 2018, Fred’s entered into an Asset Purchase Agreement (“the Asset Purchase Agreement”) with Advance
Care Scripts, Inc. (“the Buyer”), pursuant to which the Buyer agreed to purchase certain Specialty Pharmacy
assets of National Pharmaceutical Network, Inc. and Reeves-Sain Drug Store, Inc. (collectively known as
“Entrust”), consisting of three pharmacy locations, pharmaceutical inventory, and related intellectual property.
The amount to be paid by the Buyer to Fred’s for the purchased assets is $40.0 million (plus an additional amount for
inventory, not to exceed $5.5 million), subject to any adjustments. On June 1, 2018, the specialty pharmacy assets
were sold. See Note 13, Subsequent Events 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 weeks ended May 5, 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 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. The Company
does not expect the provisions of ASU 2016-16 to have a material impact on its financial statements. This update will be
effective for the Company at the beginning of fiscal 2018.
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. Currently, the Company is evaluating different software available to maintain all leases
in compliance with this pronouncement. The Company has established a committee 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
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.
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, sales are disaggregated by major merchandising category.
|
|
Thirteen Weeks Ended
|
|
(in thousands)
|
|
May 05, 2018
|
|
Pharmacy
|
|
|
272,724
|
|
Consumables
|
|
|
136,442
|
|
Household Goods and Softlines
|
|
|
94,786
|
|
Franchise
|
|
|
3,007
|
|
Total
|
|
|
506,959
|
|
Termination
of Asset Purchase Agreement
On
December 19, 2016, Fred’s and its wholly-owned subsidiary, AFAE, LLC (“Buyer”), entered into an Asset Purchase
Agreement (the “Asset Purchase Agreement”) with Rite Aid Corporation (“Rite Aid”) and Walgreens Boots
Alliance, Inc. (“Walgreens”), pursuant to which Buyer agreed to purchase 865 stores, certain intellectual property
and other tangible assets (collectively, the “Assets”) and to assume certain liabilities for a cash purchase price
of $950 million (the “Rite Aid Transaction”). Pursuant to Section 8.01(g) of the Asset Purchase Agreement,
each of Buyer, Walgreens or Rite Aid is permitted to terminate the 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 Asset Purchase Agreement was also terminated, effective
immediately. In connection with the termination of the Asset Purchase Agreement, the Company received a termination fee payment
of $25 million on June 30, 2017.
See
Note 11: Indebtedness for additional information relating to the termination of the Asset Purchase Agreement.
NOTE
2: ASSETS HELD-FOR-SALE AND DISCONTINUED OPERATIONS
As
discussed in Note 1, during the fourth quarter of 2017, Fred’s Board of Directors approved a plan to actively market its
specialty pharmacy business. Accordingly, the specialty pharmacy business met the criteria for “Assets Held-for-Sale”
in accordance with ASC 360 as of February 3, 2018. The specialty pharmacy assets and liabilities are reflected as “held
for sale” on the consolidated balance sheets in accordance with ASC 360 at May 5, 2018 and April 29, 2017. In addition,
the results of operations for the specialty pharmacy business have been presented as discontinued operations in accordance with
ASC 205-20 for all periods presented.
The
results of the specialty pharmacy business were previously allocated to the Pharmacy segment within the sales mix. The specialty
pharmacy recorded a loss from discontinued operations, net of tax, of $2.2 million for the first quarter of 2018, and income of
$1.3 million for the first quarter of 2017.
Certain
corporate overhead and other costs previously allocated to the specialty pharmacy for segment reporting purposes did not qualify
for classification within discontinued operations and have been reallocated to continuing operations.
On
May 4, 2018, Fred’s entered into an Asset Purchase Agreement (“the Asset Purchase Agreement”) with Advance Care
Scripts, Inc. (“the Buyer”), pursuant to which the Buyer agreed to purchase certain Specialty Pharmacy assets of National
Pharmaceutical Network, Inc. and Reeves-Sain Drug Store, Inc. (collectively known as “Entrust”), consisting of three
pharmacy locations, pharmaceutical inventory, and related intellectual property. The amount to be paid by the Buyer to Fred’s
for the purchased assets is $40.0 million (plus an additional amount for inventory, not to exceed $5.5 million), subject to any
adjustments. On June 1, 2018, the specialty pharmacy assets were sold. See Note 13, Subsequent Events for additional information.
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:
|
|
May
5, 2018
|
|
|
February
3,
|
|
(in thousands)
|
|
(unaudited)
|
|
|
2018
|
|
Current
assets:
|
|
|
|
|
|
|
|
|
Accounts
Receivable, net
|
|
$
|
15,308
|
|
|
$
|
15,983
|
|
Inventories
|
|
|
5,586
|
|
|
|
3,756
|
|
Other
non-trade receivables
|
|
|
87
|
|
|
|
152
|
|
Prepaid
expenses and other current assets
|
|
|
11
|
|
|
|
12
|
|
Total
current assets held-for-sale
|
|
$
|
20,992
|
|
|
$
|
19,903
|
|
Property
and equipment, less accumulated depreciation and amortization
|
|
$
|
90
|
|
|
$
|
1,036
|
|
Goodwill
|
|
|
30,609
|
|
|
|
30,609
|
|
Intangible
assets, net
|
|
|
8,941
|
|
|
|
9,533
|
|
Other
noncurrent assets, net
|
|
|
539
|
|
|
|
539
|
|
Total
noncurrent assets held-for-sale
|
|
$
|
40,179
|
|
|
$
|
41,717
|
|
|
|
|
|
|
|
|
|
|
Current
liabilities:
|
|
|
|
|
|
|
|
|
Accounts
payable
|
|
$
|
28,036
|
|
|
$
|
22,045
|
|
Accrued
expenses and other
|
|
|
2,868
|
|
|
|
4,527
|
|
Total
current liabilities held-for-sale
|
|
$
|
30,904
|
|
|
$
|
26,572
|
|
|
|
|
|
|
|
|
|
|
Deferred
income taxes
|
|
$
|
—
|
|
|
$
|
—
|
|
Other
noncurrent liabilities
|
|
|
—
|
|
|
|
48
|
|
Total
noncurrent liabilities held-for-sale
|
|
$
|
—
|
|
|
$
|
48
|
|
The
following table summarizes the results of discontinued operations for the quarters ended May 5, 2018, and April 29, 2017:
|
|
For
the Thirteen
Weeks Ended
|
|
|
|
(unaudited)
|
|
|
|
May
5,
|
|
|
April
29,
|
|
(in
thousands)
|
|
2018
|
|
|
2017
|
|
Revenues
|
|
$
|
69,846
|
|
|
$
|
68,148
|
|
Cost
of Goods Sold
|
|
|
67,470
|
|
|
|
63,802
|
|
Gross
Profit
|
|
|
2,376
|
|
|
|
4,346
|
|
Depreciation and amortization
|
|
|
608
|
|
|
|
748
|
|
Selling,
general and administrative expenses
|
|
|
3,924
|
|
|
|
2,567
|
|
Income (loss) from
discontinued operations before Income taxes
|
|
|
(2,156
|
)
|
|
|
1,031
|
|
Income
tax expense (benefit)
|
|
|
—
|
|
|
|
(278
|
)
|
Income
(loss) from discontinued operations, net of tax
|
|
|
(2,156
|
)
|
|
|
1,309
|
|
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 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 inventories, which were approximately $45.9 million
and $31.6 million at May 5, 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 $52.0 million at May 5, 2018 and $53.9 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 May 5, 2018 is $18.8 million, with the corresponding amount of $17.3 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 quarter of 2018, the Company
utilized $0.9 million of existing impairment charges related to the 2016 initiatives (including $0.1 million for the accelerated
recognition of freight capitalization expense) leaving $0.9 million remaining.
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 quarter of 2018, the Company
utilized $2.6 million of existing impairment charges related to the 2017 initiatives (including $0.8 million, for the accelerated
recognition of freight capitalization expense) leaving $1.7 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 03, 2018
|
|
|
Additions
|
|
|
Utilization
|
|
|
Ending
Balance
May
05, 2018
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Inventory
markdown on low-productive inventory (2016 initiatives)
|
|
$
|
1.7
|
|
|
|
—
|
|
|
|
(0.8
|
)
|
|
$
|
0.9
|
|
Inventory provision
for freight capitalization expense (2016 initiatives)
|
|
|
0.1
|
|
|
|
—
|
|
|
|
(0.1
|
)
|
|
|
—
|
|
Inventory markdown
on low-productive inventory (2017 initiatives)
|
|
|
3.3
|
|
|
|
—
|
|
|
|
(1.8
|
)
|
|
|
1.5
|
|
Inventory
provision for freight capitalization expense (2017 initiatives)
|
|
|
1.0
|
|
|
|
—
|
|
|
|
(0.8
|
)
|
|
|
0.2
|
|
Total
|
|
$
|
6.1
|
|
|
$
|
—
|
|
|
$
|
(3.5
|
)
|
|
$
|
2.6
|
|
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. 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
|
|
(in thousands)
|
|
May 05, 2018
|
|
|
April 29, 2017
|
|
Continuing Operations
|
|
|
|
|
|
|
|
|
Stock option expense
|
|
$
|
232
|
|
|
$
|
464
|
|
Restricted stock expense
|
|
|
991
|
|
|
|
540
|
|
ESPP expense
|
|
|
—
|
|
|
|
91
|
|
Total stock-based compensation
|
|
$
|
1,223
|
|
|
$
|
1,095
|
|
|
|
|
|
|
|
|
|
|
Income tax benefit on stock-based compensation
|
|
$
|
222
|
|
|
$
|
240
|
|
|
|
|
|
|
|
|
|
|
|
|
Thirteen Weeks Ended
|
|
(in thousands)
|
|
May 05, 2018
|
|
|
April 29, 2017
|
|
Discontinued Operations
|
|
|
|
|
|
|
|
|
Stock option expense
|
|
$
|
43
|
|
|
$
|
63
|
|
Restricted stock expense
|
|
|
13
|
|
|
|
27
|
|
Total stock-based compensation
|
|
$
|
56
|
|
|
$
|
90
|
|
|
|
|
|
|
|
|
|
|
Income tax benefit on stock-based compensation
|
|
$
|
4
|
|
|
$
|
14
|
|
The fair value of each option granted
during the thirteen week period ended May 5, 2018 and April 29, 2017 is estimated on the date of grant using the Black-Scholes
option-pricing model with the following weighted average assumptions:
|
|
Thirteen Weeks Ended
|
|
Continuing Operations
|
|
May 5, 2018
|
|
|
April 29, 2017
|
|
Stock Options
|
|
|
|
|
|
|
|
|
Expected volatility
|
|
|
0.0
|
%
|
|
|
40.3
|
%
|
Risk-free interest rate
|
|
|
0.0
|
%
|
|
|
2.2
|
%
|
Expected option life (in years)
|
|
|
0
|
|
|
|
5.84
|
|
Expected dividend yield
|
|
|
0.00
|
%
|
|
|
1.86
|
%
|
|
|
|
|
|
|
|
|
|
Weighted average fair value at grant date
|
|
$
|
—
|
|
|
$
|
4.06
|
|
|
|
|
|
|
|
|
|
|
|
|
Thirteen Weeks Ended
|
|
Discontinued Operations
|
|
May 5, 2018
|
|
|
April 29, 2017
|
|
Stock Options
|
|
|
|
|
|
|
|
|
Expected volatility
|
|
|
0.0
|
%
|
|
|
43.1
|
%
|
Risk-free interest rate
|
|
|
0.0
|
%
|
|
|
2.2
|
%
|
Expected option life (in years)
|
|
|
0
|
|
|
|
5.84
|
|
Expected dividend yield
|
|
|
0.00
|
%
|
|
|
1.85
|
%
|
|
|
|
|
|
|
|
|
|
Weighted average fair value at grant date
|
|
$
|
—
|
|
|
$
|
4.61
|
|
|
|
|
|
|
|
|
|
|
|
|
Thirteen Weeks Ended
|
|
|
|
May 5, 2018
|
|
|
April 29, 2017
|
|
|
|
|
|
|
|
|
|
|
Employee Stock Purchase Plan
|
|
|
|
|
|
|
|
|
Expected volatility
|
|
|
0.0
|
%
|
|
|
61.8
|
%
|
Risk-free interest rate
|
|
|
0.0
|
%
|
|
|
1.0
|
%
|
Expected option life (in years)
|
|
|
0.00
|
|
|
|
0.25
|
|
Expected dividend yield
|
|
|
0.00
|
%
|
|
|
0.40
|
%
|
|
|
|
|
|
|
|
|
|
Weighted average fair value at grant date
|
|
$
|
—
|
|
|
$
|
4.19
|
|
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 0 shares
issued during the thirteen weeks ended May 5, 2018. There are 1,410,928 shares approved to be issued under the 2004 Plan and as
of May 5, 2018, there were 595,681 shares available.
Stock Options
The following table summarizes stock option activity during
the thirteen weeks ended May 5, 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
|
|
|
(297,074
|
)
|
|
|
12.62
|
|
|
|
|
|
|
|
|
|
Exercised
|
|
|
—
|
|
|
|
—
|
|
|
|
|
|
|
|
|
|
Outstanding at May 5, 2018
|
|
|
874,751
|
|
|
$
|
13.28
|
|
|
|
4.7
|
|
|
|
—
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Exercisable at May 5, 2018
|
|
|
309,674
|
|
|
$
|
14.73
|
|
|
|
4.1
|
|
|
|
—
|
|
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
|
|
|
(10,185
|
)
|
|
|
14.66
|
|
|
|
|
|
|
|
|
|
Exercised
|
|
|
—
|
|
|
|
—
|
|
|
|
|
|
|
|
|
|
Outstanding at May 5, 2018
|
|
|
157,190
|
|
|
$
|
14.39
|
|
|
|
5.1
|
|
|
|
—
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Exercisable at May 5, 2018
|
|
|
30,812
|
|
|
$
|
14.54
|
|
|
|
4.6
|
|
|
|
—
|
|
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 May 5, 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 May 5, 2018,
total unrecognized stock-based compensation expense net of estimated forfeitures related to non-vested stock options for continuing
operations was approximately $1.4 million, which is expected to be recognized over a weighted average period of approximately
3.2 years. As of May 5, 2018, total unrecognized stock-based compensation expense net of estimated forfeitures related to non-vested
stock options for discontinued operations was approximately $0.2 million, which is expected to be recognized over a weighted average
period of approximately 3.2 years. The total fair value of options vested during the thirteen weeks ended May 5, 2018 for continuing
operations was $165.7 thousand. The total fair value of options vested during the thirteen weeks ended May 5, 2018 for discontinued
operations was $10.3 thousand.
Restricted Stock
The following table summarizes restricted stock activity during
the thirteen weeks ended May 5, 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
|
|
|
222,836
|
|
|
|
2.74
|
|
Forfeited / Cancelled
|
|
|
(50,757
|
)
|
|
|
15.28
|
|
Vested
|
|
|
(79,012
|
)
|
|
|
10.04
|
|
Non-vested Restricted Stock at May 5, 2018
|
|
|
746,962
|
|
|
$
|
7.59
|
|
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
|
|
|
—
|
|
|
|
—
|
|
Vested
|
|
|
—
|
|
|
|
—
|
|
Non-vested Restricted Stock at May 5, 2018
|
|
|
11,194
|
|
|
$
|
15.35
|
|
For continuing operations, the aggregate
pre-tax intrinsic value of restricted stock outstanding as of May 5, 2018 is $1.2 million with a weighted average remaining contractual
life of 7.1 years. The unrecognized compensation expense net of estimated forfeitures, related to the outstanding stock is approximately
$2.4 million, which is expected to be recognized over a weighted average period of approximately 3.0 years. The total fair value
of restricted stock awards that vested during the thirteen weeks ended May 5, 2018 was $775.6 thousand.
For discontinued operations, the aggregate
pre-tax intrinsic value of restricted stock outstanding as of May 5, 2018 is less than $0.1 million with a weighted average remaining
contractual life of 5.2 years. The unrecognized compensation expense net of estimated forfeitures, related to the outstanding
stock is approximately $0.1 million, which is expected to be recognized over a weighted average period of approximately 3.3 years.
No restricted stock related to discontinued operations vested during the thirteen weeks ended May 5, 2018.
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
May 5, 2018 and February 3, 2018. There were $162.0 million and $153.4 million of borrowings on the Company’s revolving
line of credit as of May 5, 2018 and February 3, 2018, respectively. Refer to Note 11 – Indebtedness. 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:
|
|
May 5, 2018
|
|
|
February 3, 2018
|
|
(in thousands)
|
|
Carrying Value
|
|
|
Fair Value
|
|
|
Carrying Value
|
|
|
Fair Value
|
|
Revolving line of credit
|
|
$
|
162,014
|
|
|
$
|
162,014
|
|
|
$
|
153,431
|
|
|
$
|
153,431
|
|
Mortgage loans on land & buildings
|
|
|
1,563
|
|
|
|
1,645
|
|
|
|
1,579
|
|
|
|
1,684
|
|
Notes Payable
|
|
|
13,000
|
|
|
|
12,237
|
|
|
|
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:
|
|
May 05, 2018
|
|
|
February 3, 2018
|
|
Buildings and building improvements
|
|
$
|
118,985
|
|
|
$
|
119,039
|
|
Leasehold improvements
|
|
|
87,202
|
|
|
|
86,402
|
|
Automobiles and vehicles
|
|
|
4,433
|
|
|
|
4,525
|
|
Furniture, fixtures and equipment
|
|
|
287,396
|
|
|
|
286,962
|
|
|
|
|
498,016
|
|
|
|
496,928
|
|
Less: Accumulated depreciation and amortization
|
|
|
(396,045
|
)
|
|
|
(390,633
|
)
|
|
|
|
101,971
|
|
|
|
106,295
|
|
Construction in progress
|
|
|
1,637
|
|
|
|
590
|
|
Land
|
|
|
8,581
|
|
|
|
8,581
|
|
Total Property and equipment, at depreciated cost
|
|
$
|
112,189
|
|
|
$
|
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 May 5, 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 May 5, 2018.
In
the second 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 May 5, 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 May 5, 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 quarter of 2018, the Company
utilized $0.6 million, leaving $5.7 million reserve balance as of May 5, 2018.
The
following table illustrates the exit and disposal activity 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
May 5, 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
|
|
|
|
|
|
|
|
(0.6
|
)
|
|
|
5.7
|
|
Total
|
|
$
|
13.7
|
|
|
$
|
—
|
|
|
$
|
(0.6
|
)
|
|
$
|
13.1
|
|
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)
|
|
May 05, 2018
|
|
|
April 29, 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. 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 and the Mississippi Supreme Court has accepted the State’s Petition for Interlocutory Appeal, despite the
Company filing a Joint Response in opposition to the Petition. 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 has not received
any response from the OCR at this time. 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 has
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. 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. The Court has yet to rule on the Motion to Consolidate. Plaintiff’s counsel for each of the
Williams and Wallace matters has filed a Motion to Remand the matters. Fred’s opposed the Motion to Remand, and the Motion
to Remand was denied by the 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 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. 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.
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 million to $225 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 $162.0 million of borrowings outstanding and $72.7 million, net of borrowings
and letters of credit, remaining available under the Agreement at May 5, 2018.
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 that certain Asset Purchase Agreement, dated as of December 19, 2016, by and between the Company, Buyer, Rite Aid
and Walgreens, on July 21, 2017, 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 selling, general and administrative expenses 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 $1.6 million outstanding at October 28, 2017.
The weighted average interest rate on mortgages outstanding at October 28, 2017 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
On
May 4, 2018, Fred’s entered into an Asset Purchase Agreement (the “Specialty Pharmacy Purchase Agreement”) with
Advance Care Scripts, Inc. (the “ACS”), pursuant to which the ACS agreed to purchase certain specialty pharmacy assets
of National Pharmaceutical Network, Inc. and Reeves-Sain Drug Store, Inc. (collectively, “Entrust”), consisting of
three pharmacy locations, pharmaceutical inventory, and related intellectual property. The purchase price for the purchased assets
was $40.0 million (plus an additional amount for inventory, not to exceed $5.5 million), subject to any adjustments. On June 1,
2018, the transactions contemplated by the Specialty Pharmacy Agreement were consummated. For additional information, see the
Company’s Current Report on Form 8-K filed with the SEC on June 4, 2018.
Item
2: