FRED Freds Inc

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”) operated, as of May 4, 2019, 556 discount general merchandise stores in fifteen states in the Southeastern United States. Our mission is to improve the lives of customers by selling products that deliver value and convenience to the communities we serve. There are 169 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 2, 2019 included in our Annual Report on Form 10-K, which we filed with the Securities and Exchange Commission (the “SEC”) on May 3, 2019.

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 second quarter of fiscal year 2018, the Company completed the sale of its specialty pharmacy business for a cash purchase price of $40.0 million (plus an additional $5.5 million for inventory). During the fourth quarter of fiscal 2018, Fred’s completed its sale of certain prescription files and the related data and records, retail pharmaceutical inventory and certain other assets from 179 of the Company’s retail pharmacy stores for a cash purchase price of approximately $176.7 million. The results of operations for both businesses have been presented as discontinued operations in accordance with Accounting Standards Codification (“ASC” Topic 205-20) ASC 205-20- Results of Operations – Discontinued operations for all periods presented . See Note 2: Assets Held for Sale and Discontinued Operations for additional information.

In addition, during the fourth quarter of 2018, Fred’s Board of Directors (the “Board”) approved a plan to actively market its headquarters building located in Memphis, TN.  The building has been reflected as Assets Held for Sale on the consolidated balance sheets in accordance with ASC 360 – Assets held for sale . See Note 2: Assets Held for Sale and Discontinued Operations for additional information.

Excluding the “Assets Held for Sale and Discontinued Operations” subsection , amounts and percentages for all periods discussed below reflect the results of operations and financial condition from Fred’s continuing operations.

The results of operations for the thirteen-week period ended May 4, 2019 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.

Going Concern

As discussed in our Annual Report on Form 10-K for fiscal year 2018 filed with SEC on May 3, 2019, the Company has experienced significant net losses and negative cash flows from operating activities in recent years and cannot offer assurance that such losses and negative cash flows will not continue for the foreseeable future. For the fiscal years ended February 2, 2019 and February 3, 2018, the Company incurred net losses of $136.2 million and $144.5 million, respectively, and our net cash flows used in operating activities were $91.7 million and $44.7 million, respectively.  For the thirteen-week periods ended May 4, 2019 and May 5, 2018, the Company incurred net losses of $33.9 million and $22.0 million, respectively, and our net cash flows used in operating activities were $14.2 million and $12.8 million, respectively.  Furthermore, the Company has limited availability under its Revolving Credit Agreement (as defined below), which along with cash from operations has traditionally been the Company’s primary source of working capi tal.  As of May 4 , 2019, the Company had outstanding borrowings of $81.3 million under our Revolving Credit Agreement and excess availability of $33.0 million.  Under our Revolving Credit Agreement, we have a financial covenant to maintain at all times excess availability of at least 10% of the commitments, and if excess availability falls below such threshold ($21.0 million at May 4, 2019), it would constitute an event of default under the Revolving Credit Agreement.  The Company’s failure to comply with the financial covenants and other obligations under the Revolving Credit Agreement would result in an event of default, which if not cured or waived, may permit acceleration of our indebtedness and other remedies.  If our indebtedness is accelerated, wheth er due to the Revolver EODs described in Note 10 or otherwise, the Company cannot be certain that we will have sufficient funds available to pay the accelerated indebtedness or that we will have the ability to refinance the accelerated indebtedness on terms favorable to us or at all, which could have a material

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adverse effect on the Company’s business, results of operations and financial condition and could impact our ability to continue as a going concern.  Furthermore, our Revolving Credit Agreement has a maturity date of April 9, 2020, and we can provide no assurance that we will be able to renew or refinance such facility on terms acceptable to us or at all.  The foregoing conditions raise substantial doubt about the Company’s ability to continue as a go ing concern.

As further described in Note 10 below, on May 15, 2019, the Company and certain of its subsidiaries entered into the Forbearance Agreement, Eighth Amendment to Credit Agreement and Fourth Amendment to Amended and Restated Addendum to Credit Agreement (the “Forbearance Agreement and Eighth Amendment”) in response to certain events of default identified by our lenders. As a result of the Forbearance Agreement and Eighth Amendment, the lenders under the Revolving Credit Agreement have agreed, subject to the satisfaction of certain conditions, to not take any action to accelerate our indebtedness or exercise other remedies with respect to the Revolver EODs until July 22, 2019, but there can be no assurance that such lenders will not do so on or af ter such date or if the conditions in the Forbearance Agreement and Eighth Amendment are not met in the future. We are in discussions with potential financing sources relating to the condition in the Forbearance Agreement and Eighth Amendment to obtain a signed commitment letter for a refinancing of all loans under the Revolving Credit Agreement.  There can be no assurance that we will obtain such a commitment letter or complete a refinancing by the deadlines in the Forbearance Agreement and Eighth Amendment or at all.

The Company has evaluated its plans to alleviate this doubt, including engaging PJ Solomon in April 2019 to assist the Company in evaluating its strategic alternatives.  In addition, while we analyze these strategic alternatives, the Company is also assessing potential alternative financing arrangements and undertaking a number of operational measures that we believe will enhance our cash position and improve our profitability, including, among other things:

The Company can provide no assurance, however, regarding the outcome of its evaluation of strategic alternatives, that alternative financing will be on terms acceptable to us or at all, or that the operational measures being undertaken by the Company will be successful in improving the Company’s financial performance, in which case the Company may be unable to continue as a going concern.

The accompanying consolidated financial statements have been prepared assuming the Company will continue to operate as a going concern, which contemplates the realization of assets and settlement of liabilities in the normal course of business, and do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classifications of liabilities that may result from uncertainty related to its ability to continue as a going concern.

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 adopted the ASU during the thirteen weeks ended May 4, 2019, however, the adoption did not have a material impact to our financial position, results of operations or the cash flows.

In February 2016, the FASB established ASU No. 2016-02 Leases (Topic 842), which requires lessees to recognize a right-of-use (ROU) asset and a lease liability on their balance sheet for all leases, including operating leases, with a term of greater than 12 months. In July 2018, the FASB issued ASU 2018-11 which added a transition option permitting entities to apply the provisions of the new standard at its adoption date instead of the earliest comparative period presented in the condensed consolidated financial statements. Under this transition option, comparative reporting would not be required, and the provisions of the standard would be applied prospectively to leases in effect at the date of adoption. We adopted the new standard on February 3, 2019 and elected to use the optional transition method provided by ASU 2018-11. An adjustment to beginning retained earnings of $37.4 million was required related to the impairment of ROU at adoption. See Note 8-Leases for further discussion of the adoption Topic 842.  

The Company also elected the package of practical expedients permitted under the transition guidance within the new standard. The following practical expedients were applied when implementing the new standard:  

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The adoption of the new standard had a material impact on our condensed consolidated balance sheet for the addition of lease assets and liabilities, primarily related to real estate operating leases. The adoption of the new standard did not have a material impact on our results of operations or cash flows.

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. 

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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”). On May 4, 2018, Fred’s entered into the Specialty Asset Purchase Agreement with Advanced Care Scripts, Inc., a Florida corporation (“Specialty Buyer”) and an affiliate of CVS Health Corporation, pursuant to which, the 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 operations for the Entrust business have been presented as discontinued operations in accordance with ASC 205-20 for all periods presented.

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.

As of the end of the fourth quarter of fiscal 2018, the Company had closed the transactions contemplated by the Amended WBA Asset Purchase Agreement, and the Company received cash proceeds of approximately $156.1 million, plus approximately $20.6 million for the inventory sold in the transaction, in each case after adjustment as described in the Amended WBA Asset Purchase Agreement.  The Company recorded a gain of $145.7 million related to the Retail Pharmacy sale. The Company used the proceeds received in the transaction to pay down the Company’s existing indebtedness and for general corporate purposes.

During the fourth quarter of 2018, the Board approved a plan to actively market its headquarters building located in Memphis, TN.  As a result, the Company has reclassified the headquarters building to assets held for sale in accordance with ASC 360 – Assets held for sale . The building has been reclassified to held for sale on the consolidated balance sheet and the depreciation associated with the asset has concluded. The Company has assessed the fair value of the building base on the selling price of other assets within the surrounding area. The market price is reasonable in relation to the current selling price of similar assets on the market.

The following tables summarize the results of discontinued operations for the thirteen weeks ended May 4, 2019 and May 5, 2018, respectively:

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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.

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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 inventor y 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 relat ed 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 reli able 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 $12.0 million and $13.2 million at May 4, 2019 and February 2, 2019, 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 $27.3 million at May 4, 2019 and $28.8 million at February 2, 2019.

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 4, 2019 is $14.9 million, with the corresponding amount of $21.3 million at February 2, 2019.

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. For a discussion of the Company’s stock-based compensation plans, refer to “Note 9 – Equity Incentive Plans” of the Company’s Annual Report on Form 10-K for the year ended February 2, 2019 .  Stock based compensation expense was $0.5 million and $1.2 million for the thirteen weeks ended May 4, 2019 and May 5, 2018, respectively.

Employee Stock Purchase Plan

The 2004 Employee Stock Purchase Plan (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. In 2017, Management and the Board decided to suspend purchases through the ESPP effective December 31, 2017.  As such, there has been no additional shares issued under the ESPP plan in fiscal 2019. There were 1,410,928 shares approved to be issued under the 2004 Plan as of May 4, 2019 and 595,681 shares were available.

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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 4 , 201 9, and the exercise pr ice 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.

The aggregate pre-tax intrinsic value of restricted stock outstanding as of May 4, 2019 is $0.9 million with a weighted average remaining contractual life of 8.4 years.    

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.

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 4, 2019 and February 2, 2019. 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:

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.

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The following illustrates the breakdown of the major categories within property and equipment (in thousands):

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.

During the thirteen weeks ended May 4, 2019, the Company recorded $0.3 million in impairment expense related to the impairment of fixed assets associated with several underperforming and closing store locations. The impairment charge is included in impairment expense on the condensed consolidated statement of operations.

NOTE 8: LEASES

The Company’s lease portfolio consists of operating leases for its retail store locations, vehicles, trailers, distribution center space, and equipment. The Company determines if an arrangement is a lease at inception by  evaluating whether the arrangement conveys the right to use an identified asset and whether the Company obtains substantially all of the economic benefits from and has the ability to direct the use of the assets. The Company’s leases have remaining lease terms of approximately 1 year to 10 years, which may include the option to renew the lease if the Company is reasonably certain to exercise the options. The Company does not include renewal options in its determination of the lease term unless the renewals are deemed to be reasonably certain to be exercised at lease commencement.

Leases with an initial term in excess of 12 months are recognized on the condensed consolidated balance sheet based on the present value of the lease payments over the defined lease term at the lease commencement date. Leases with an initial term of 12 months or less are not recorded on the condensed consolidated balance sheet and instead are recognized on a straight-line basis over the lease term. Certain lease agreements include lease payments that are based on an index or rate while others are based on a percentage of retail sales over contractual levels. Variable lease payments that are not based on an index or rate are excluded from right-of-use-assets and lease liabilities and are recognized in the period in which the obligation for those payments occurred. The Company’s lease agreements do not contain any material residual value guarantees or material restrictive financial covenants.

As most of the Company’s leases do not provide an implicit rate the Company uses its incremental borrowing rate for equipment leases. The incremental borrowing rate is estimated, based on borrowings, that are consistent with the respective lease terms. The rate applied to real estates leases includes a range of rates between the incremental borrowing rate and the rate used to estimate the company’s fair market value overall, in determining the present value of lease payments. Operating lease right-of-use assets are periodically reviewed for impairment losses. The Company uses the long-lived assets impairment guidance in ASC Subtopic 360-10, “Property, Plant, and Equipment - Overall,” to determine whether a right-of-use asset is impaired, and if so, the amount of the impairment loss to recognize.

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The following tables summarizes the Company’s operating lease assets and lease liabilities as of May 4, 2019:

Information regarding the weighted-average remaining lease term and the weighted-average discount rate for operating leases as of May 4, 2019 is as follows:

The following table summarizes the Company’s operating lease costs as of May 4, 2019:

As of May 4, 2019, maturities of lease liabilities were as follows:

As previously disclosed in the Company’s Annual Report on Form 10-K for the year ended February 2, 2019 and in accordance with ASC 840, future minimum lease payments under non-cancellable operating leases were as follows as of February 2, 2019:

The above future minimum lease payments include amounts for leases that were signed prior to February 2, 2019 for stores that were not open as of February 2, 2019 and exclude contingent rentals that may be paid under certain store leases based on a percentage of sales in excess of stipulated amounts.

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The following represents supplemental noncash activity pertaining to the Company’s operating lease arrangements as of May 4, 2019:

NOTE 9: 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 included 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 included 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. On March 13, 2019, the U.S. District Court, Middle District of Alabama, denied plaintiff’s motion for class certification. The Company and Southern Independent Bank entered into a Confidential Settlement Agreement and Release on June 5, 2019, and the parties filed a stipulated dismissal with the U.S. District Court, Middle District of Alabama, on June 17, 2019.

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 Desoto County 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.  A hearing on the Company’s motion to dismiss was held in Circuit Court on March 28, 2019, and the Court issued an order on June 11, 2019 dismissing certain of the State’s fraud claims but giving the State thirty days to file an amended complaint with respect to such claims. 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, as well as two additional requests during the first fiscal quarter of 2019, 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 “Taylor Complaint”). The Taylor 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 was heard before the Court of Appeals for the 11 ^th  Circuit at the end of January 2019, and we await the Court’s ruling. 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.

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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 alleged that the Company committed various Federal and state wage and hours violations. The complaint was filed as class action and sought back wages, attorneys’ fees, and all other damages allowable by law. The Company denied these allegations and believes it acted appropriately in its wage and hour calculations and payments. The Company and the named plaintiffs have settled the case, and the settlement is currently being administered.

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 10: INDEBTEDNESS

Revolving Credit Agreement

On April 9, 2015, the Company entered into a Revolving Loan and Credit Agreement (as amended as of October 23, 2015, December 28, 2016, January 27, 2017, July 31, 2017, August 22, 2017, April 5, 2018, August 23, 2018 and May 15, 2019 , and as supplemented by the Addendum (as defined below), the “Revolving Credit Agreement”) with Regions Bank and Bank of America, N.A. As of May 4, 2019, the Revolving Credit Agreement provided for aggregate loan commitments of $210.0 million and matures on April 9, 2020.  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 is 4.25 % and for Base Rate loans the spread is 3.25%.  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.  

As of May 4, 2019, outstanding borrowings under our Revolving Credit Agreement were $81.3 million, $17.5 million of letters of credit were outstanding, and excess availability was $33.0 million (based on a borrowing base of $156.8 million at such time).  Under the Revolving Credit Agreement, the Company has a financial covenant to maintain at all times excess availability of at least 10% of the commitments, and if excess availability falls below such threshold ($21.0 million at May 4, 2019), it would constitute an event of default under the Revolving Credit Agreement.

The Revolving Credit Agreement contains restrictive covenants that, among other things, limit the Company’s ability and the ability of the Company’s subsidiaries to: (i) incur additional indebtedness or issue certain preferred shares; (ii) pay dividends, redeem stock or make other distributions; (iii) make acquisitions, investments and loans; (iv) create liens; (v) transfer or sell assets; (vi) merge, consolidate or sell, lease, transfer or otherwise dispose of all or substantially all of the Company’s assets; (vii) enter into hedging arrangement; and (viii) enter into certain transactions with the Company’s affiliates.

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These restrictions could limit the Company’s ability to plan for, or react to, market conditions or meet extraordinary capital needs or could otherwise restrict our activities. These restrictions could also adversely affect the Company’s ability to finance future operations or capital needs or to engage in other business activities that would be in the Company’s interest.

The Company’s failure to comply with obligations under the Revolving Credit Agreement would result in an event of default, which if not cured or waived, may permit acceleration of the Company’s indebtedness and other remedies. If our indebtedness is accelerated, the Company cannot be certain that it would have sufficient funds available to pay the accelerated indebtedness or that the Company will have the ability to refinance the accelerated indebtedness on terms favorable to us or at all, which could impact our ability to continue as a going concern. 

Recent Developments Relating to the Revolving Credit Agreement

On April 15, 2019, Bank of America, N.A. imposed an additional reserve of $20.0 million under our Revolving Credit Agreement in connection with the announced planned closures of 159 stores and related matters, which reduced our excess availability at such time to $37.9 million, and the administrative agent declared an “Account Control Event” under our Revolving Credit Agreement in connection with such Closures and exercised control over our collection accounts.

As referenced above in Note 1 under the heading “–Going Concern,” the audit report prepared by our auditors with respect to the financial statements in our Annual Report on Form 10-K, filed on May 3, 2019, with the SEC, includes an explanatory paragraph indicating that there is substantial doubt about Fred’s ability to continue as a going concern. The receipt of this explanatory paragraph with respect to Fred’s financial statements for the year ended February 2, 2019 resu lted in a breach of a covenant under the Revolving Credit Agreement that requires annual financial statements accompanied by an unqualified audit report to be delivered to the lenders within 120 days of fiscal year end and a breach of this covenant constituted an event of default under the Revolving Credit Agreement (the “Going Concern Event of Default”). In addition, Fred’s lenders under the Revolving Credit Agreement have indicated to Fred’s their belief that certain other events of default occurred under the Revolving Credit Agreement in connection with the Closures, the inventory sales at certain stores and the timing of delivery, and content, of a borrowing base certificate due under the Revolving Credit Agreement (such purported events of default, together with the Going Concern Event of Default, are referred to herein as the “Revolver EODs”).

An event of default, which is not cured or waived, would permit, among other remedies, acceleration of Fred’s indebtedness under the Revolving Credit Agreement and the addition, at the option of the Required Lenders (as defined in the Revolving Credit Agre ement), of 200 basis points to the applicable interest rate with respect to all loans under the Revolving Credit Agreement. As a result of the Forbearance Agreement and Eighth Amendment, the lenders under the Revolving Credit Agreement have agreed, subject to the satisfaction of certain conditions, to not take any action to accelerate our indebtedness or exercise other remedies with respect to the Revolver EODs until July 22, 2019 , but there can be no assurance that such lenders will not do so on or after such date or if the conditions in the Forbearance Agreement and Eighth Amendment are not met in the future. If the Company’s indebtedness is accelerated, whether due to the Revolver EODs or otherwise, the Company cannot be certain that we will have sufficie nt funds available to pay the accelerated indebtedness or that we will have the ability to refinance the accelerated indebtedness on terms favorable to us or at all.  As a result, the Company has classified the outstanding borrowings under the Revolving Credit Agreement as short-term, even though the maturity date is beyond twelve months from our balance sheet date.

Recent Amendments Affecting Revolving Credit Agreement

On May 15, 2019, the Company and certain of its subsidiaries entered into the Forbear ance Agreement and Eighth Amendment. The Forbearance Agreement and Eighth Amendment amends the Revolving Credit Agreement and the Amended and Restated Addendum to Credit Agreement, dated as of January 27, 2017 , as amended as of July 31, 2017, August 23, 20 18 and October 15, 2018 ( the “Addendum”). Among other things, the Forbearance Agreement and Eighth Amendment provided for: (i) the Company and certain of its subsidiaries’ stipulation of the occurrence of certain events of default under the Revolving Credit Agreement and the Addendum, including as the result of the commencement of 159 store closures, issues with timing and accuracy of a borrowing base certificate and the failure to deliver an annual audit report without a “going concern” or similar qualification; (ii) an agreement to forbear from exercising remedies under the Revolving Credit Agreement with respect to (a) the stipulated events of default and (b) the additional planned closure of 104 stores, in each case, until July 22, 2019, subject to the s atisfaction of certain conditions; (iii) requirements for the Company and certain of its subsidiaries to comply with certain conditions, including (a) working with a turnaround consultant, (b) providing certain deliverables including weekly cash flow forecasts and inventory reports, (c) requiring that collections, disbursements and inventory receipts are within 15% of forecasted amounts for any two week period, (d) maintaining certain levels of inventory at certain continuing stores and (e) obtaining a sign ed commitment letter or letters by June 21, 2019 for a refinancing of all loans under the Revolving Credit Agreement by July 22, 2019, with the failure to comply with such conditions resulting in the early termination of the forbearance period; (iv) an agreement to release certain reserves upon receipt of such commitment letter or letters; (v) a reduction of

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commitments from $210 million to $150 million, and additional reductions to $125 million on June 15, 2019 and to $100 million on July 6, 2019; (vi) a c hange in the availability requirements to 10% of commitments, allowing availability requirements to decrease with the commitment reductions; (vii) an increase of the interest rate by 200 basis points; and (viii) a consent to the sale of certain real estate .   We are in discussions with potential financing sources relating to the condition in the Forbearance Agreement and Eighth Amendment to obtain a signed commitment letter for a refinancing of all loans under the Revolving Credit Agreement.  There can be no a ssurance that we will obtain such a commitment letter or complete a refinancing by the deadlines in the Forbearance Agreement and Eighth Amendment or at all.

NOTE 11: 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.

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Item 2: