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 July 29, 2017, 601 discount general merchandise stores and three specialty pharmacy-only
locations, in fifteen states in the Southeastern United States. Included in the count of discount general merchandise stores are
14 franchised locations. There are 350 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 January 28, 2017 included in our Annual Report on Form 10-K,
which we filed with the Securities and Exchange Commission on April 13, 2017.
Certain prior year amounts have been reclassified to conform to the 2017 presentation. Such reclassifications
had no effect on previously reported net loss.
The results
of operations for the thirteen week and twenty-six week periods ended July 29, 2017 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 2016 and 2017 refer to the fiscal years ended
January 28, 2017 and ending February 3, 2018, respectively.
Recent Accounting
Pronouncements
In January
2017,
the Financial Accounting Standards Board (“FASB”)
issued Accounting Standards Update (“ASU”) 2017-04,
Intangibles - Goodwill and Other (Topic 350): Simplifying the
Test for Goodwill Impairment.
This ASU is intended to simplify the accounting for goodwill impairment by removing the requirement
to perform a hypothetical purchase price allocation. A goodwill impairment will now be the amount by which the reporting unit’s
carrying value exceeds its fair value, not to exceed the carrying amount of goodwill. All other goodwill impairment guidance will
remain largely unchanged. This new standard will be applied prospectively and is effective for annual or interim goodwill impairment
tests in fiscal years beginning after December 15, 2019. Early adoption is permitted after January 1, 2017.
The Company
does not anticipate the adoption of this standard will have a material impact on its financial position, results of operations
and cash flows.
In
November 2016, the FASB issued ASU 2016-18,
Statement of Cash Flows (Topic 230): Restricted Cash
. This ASU requires that
a statement of cash flows explain the change during the period in the total of cash, cash equivalents, and amounts generally described
as restricted cash or restricted cash equivalents. Therefore, amounts generally described as restricted cash and restricted cash
equivalents should be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total
amounts shown on the statement of cash flows. This ASU is effective for fiscal years beginning after December 15, 2017, and interim
periods within those fiscal years, with early adoption permitted.
The Company does not anticipate
the adoption of this standard will have a material impact on our consolidated statement of cash flows.
In
August 2016, the FASB issued ASU 2016-15,
Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and
Cash Payments
. This ASU addresses the classification of certain specific cash flow issues including debt prepayment or extinguishment
costs, settlement of certain debt instruments, contingent consideration payments made after a business combination, proceeds from
the settlement of certain insurance claims and distributions received from equity method investees. This ASU is effective for
fiscal years beginning after December 15, 2017, and interim periods within those fiscal years, with early adoption permitted.
An entity that elects early adoption must adopt all of the amendments in the same period.
The
Company does not anticipate the adoption of this standard will have a material impact on our consolidated statement of cash flows.
In
March 2016, the FASB issued ASU 2016-04,
Liabilities – Extinguishments of Liabilities (Subtopic 405-20): Recognition
of Breakage for Certain Prepaid Stored-Value Products
. The amendments in the ASU are designed to provide guidance and eliminate
diversity in the accounting for derecognition of prepaid stored-value product liabilities. Typically, a prepaid stored-value product
liability is to be derecognized when it is probable that a significant reversal of the recognized breakage amount will not subsequently
occur. This is when the likelihood of the product holder exercising its remaining rights becomes remote. This estimate shall be
updated at the end of each period. The amendments in this ASU are effective for the annual reporting periods beginning after December
15, 2017, including the interim periods within that reporting period. Early adoption is permitted. The Company does not anticipate
the adoption of this standard will have a material impact on its financial position, results of operations and cash flows.
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 is in the process of developing additional controls to ensure proper oversight and actively working to comply with
this guidance as it relates to gift cards sales, loyalty programs, coupons and discounts and other areas of the business impacted
by the pronouncement. Transition to the new guidance may be made by retroactively revising prior year financial statements or
by a cumulative effect on retained earnings. If a cumulative effect through retained earnings is chosen, additional disclosures
are required. The Company is currently evaluating the impact the guidance will have on the Company’s financial position,
results of operations and cash flows, and the method of transition to the new guidance that will be adopted.
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 10: Indebtedness for additional information relating to the termination of the Asset Purchase Agreement.
NOTE
2: 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 $29.4 million
and $39.5 million at July 29, 2017 and January 28, 2017, 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 $51.5 million at July 29, 2017 and $52.8 million at January 28, 2017.
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 July 29, 2017 is $21.4 million, with the corresponding amount of $19.1 million
at January 28, 2017.
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 convenient and pharmacy
healthcare services 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 2017, there was $9.2 million (including $1.2 million, for the accelerated recognition of freight capitalization
expense) of impairment charges remaining for inventory clearance of product related to 2016 strategic initiatives.
The Company
utilized $0.5 million (including $0.2 million for the accelerated recognition of freight capitalization expense) of impairment
charges in the first quarter of 2017 and $1.4 million (including $0.2 million for the accelerated recognition of freight capitalization
expense) in the second quarter of 2017. (See Note 12 – Exit and Disposal Activity).
The following
table illustrates the inventory impairment charges related to the inventory clearance initiatives discussed in the previous paragraph
(in millions):
|
|
Balance at January 28, 2017
|
|
|
Additions
|
|
|
Utilization
|
|
|
Ending Balance July 29, 2017
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Inventory markdown on low-productive inventory (2016 initiatives)
|
|
$
|
8.0
|
|
|
|
—
|
|
|
|
(1.5
|
)
|
|
$
|
6.5
|
|
Inventory provision for freight capitalization expense (2016 initiatives)
|
|
|
1.2
|
|
|
|
—
|
|
|
|
(0.4
|
)
|
|
|
0.8
|
|
Total
|
|
$
|
9.2
|
|
|
|
—
|
|
|
|
(1.9
|
)
|
|
$
|
7.3
|
|
NOTE 3:
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:
(in thousands)
:
|
|
Thirteen Weeks Ended
|
|
|
Twenty-Six Weeks Ended
|
|
|
|
July 29, 2017
|
|
|
July 30, 2016
|
|
|
July 29, 2017
|
|
|
July 30, 2016
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Stock option expense
|
|
$
|
442
|
|
|
$
|
304
|
|
|
$
|
969
|
|
|
$
|
(120
|
)
|
Restricted stock expense
|
|
|
1,448
|
|
|
|
387
|
|
|
|
2,014
|
|
|
|
1,513
|
|
ESPP expense
|
|
|
93
|
|
|
|
51
|
|
|
|
185
|
|
|
|
103
|
|
Total stock-based compensation
|
|
$
|
1,983
|
|
|
$
|
742
|
|
|
$
|
3,168
|
|
|
$
|
1,496
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income tax benefit on stock-based compensation
|
|
$
|
538
|
|
|
$
|
170
|
|
|
$
|
791
|
|
|
$
|
379
|
|
The fair value of each option granted during the thirteen and twenty-six week periods ended July
29, 2017 and July 30, 2016 is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted
average assumptions:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Thirteen Weeks Ended
|
|
|
Twenty-Six Weeks Ended
|
|
|
|
July 29, 2017
|
|
|
July 30, 2016
|
|
|
July 29, 2017
|
|
|
July 30, 2016
|
|
Stock Options
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Expected volatility
|
|
|
43.9
|
%
|
|
|
33.2
|
%
|
|
|
41.5
|
%
|
|
|
33.3
|
%
|
Risk-free interest rate
|
|
|
2.0
|
%
|
|
|
1.4
|
%
|
|
|
2.1
|
%
|
|
|
1.5
|
%
|
Expected option life (in years)
|
|
|
5.84
|
|
|
|
5.84
|
|
|
|
5.84
|
|
|
|
5.84
|
|
Expected dividend yield
|
|
|
1.87
|
%
|
|
|
1.80
|
%
|
|
|
1.86
|
%
|
|
|
1.79
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted average fair value at grant date
|
|
$
|
4.99
|
|
|
$
|
4.05
|
|
|
$
|
4.35
|
|
|
$
|
4.06
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Employee Stock Purchase Plan
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Expected volatility
|
|
|
98.8
|
%
|
|
|
60.3
|
%
|
|
|
80.3
|
%
|
|
|
59.8
|
%
|
Risk-free interest rate
|
|
|
1.0
|
%
|
|
|
0.9
|
%
|
|
|
1.0
|
%
|
|
|
0.9
|
%
|
Expected option life (in years)
|
|
|
0.50
|
|
|
|
0.50
|
|
|
|
0.38
|
|
|
|
0.38
|
|
Expected dividend yield
|
|
|
0.78
|
%
|
|
|
0.79
|
%
|
|
|
0.59
|
%
|
|
|
0.59
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted average fair value at grant date
|
|
$
|
7.67
|
|
|
$
|
3.78
|
|
|
$
|
6.31
|
|
|
$
|
3.60
|
|
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 (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. There were 33,878 shares issued during the
twenty-six weeks ended July 29, 2017. There are 1,410,928 shares approved to be issued under the 2004 Plan and as of July 29,
2017, there were 652,029 shares available.
Stock
Options
The following table summarizes
stock option activity during the twenty-six weeks ended July 29, 2017:
|
|
|
Options
|
|
|
Weighted-
Average
Exercise Price
|
|
|
Weighted-Average Contractual Life
(years)
|
|
|
Aggregate
Intrinsic Value
(000s)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Outstanding at January 28, 2017
|
|
|
|
1,607,656
|
|
|
$
|
13.55
|
|
|
|
6.0
|
|
|
$
|
2,070
|
|
Granted
|
|
|
|
215,573
|
|
|
|
12.40
|
|
|
|
|
|
|
|
|
|
Cancelled
|
|
|
|
(120,140
|
)
|
|
|
15.19
|
|
|
|
|
|
|
|
|
|
Exercised
|
|
|
|
—
|
|
|
|
—
|
|
|
|
|
|
|
|
|
|
Outstanding at July 29, 2017
|
|
|
|
1,703,089
|
|
|
$
|
13.29
|
|
|
|
5.7
|
|
|
|
—
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Exercisable at July 29, 2017
|
|
|
|
319,403
|
|
|
$
|
15.66
|
|
|
|
4.7
|
|
|
|
—
|
|
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 July 29, 2017 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 July 29, 2017, total unrecognized stock-based compensation expense net of estimated forfeitures related to non-vested
stock options was approximately $3.1 million, which is expected to be recognized over a weighted average period of approximately
3.9 years. The total fair value of options vested during the twenty-six weeks ended July 29, 2017 was $827.4 thousand.
Restricted
Stock
The following table summarizes
restricted stock activity during the twenty-six weeks ended July 29, 2017:
|
|
Number of
Shares
|
|
|
Weighted-Average Grant Date Fair Value
|
|
|
|
|
|
|
|
|
Non-vested Restricted Stock at January 29, 2017
|
|
|
598,784
|
|
|
$
|
15.08
|
|
Granted
|
|
|
182,124
|
|
|
|
12.18
|
|
Forfeited / Cancelled
|
|
|
(36,647
|
)
|
|
|
18.18
|
|
Vested
|
|
|
(219,886
|
)
|
|
|
15.09
|
|
Non-vested Restricted Stock at July 29, 2017
|
|
|
524,375
|
|
|
$
|
13.86
|
|
The aggregate
pre-tax intrinsic value of restricted stock outstanding as of July 29, 2017 is $3.6 million with a weighted average remaining
contractual life of 6.6 years. The unrecognized compensation expense net of estimated forfeitures, related to the outstanding
stock is approximately $4.0 million, which is expected to be recognized over a weighted average period of approximately 4.3 years.
The total fair value of restricted stock awards that vested during the twenty-six weeks ended July 29, 2017 was $3.3 million.
NOTE 4 — 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 July 29,
2017 and January 28, 2017. There were $125.0 million and $114.3 million of borrowings on the Company’s revolving line of
credit as of July 29, 2017 and January 28, 2017, respectively. Refer to Note 10 – 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:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
July 29, 2017
|
|
|
January 28, 2017
|
|
(in thousands)
|
|
Carrying Value
|
|
|
Fair Value
|
|
|
Carrying Value
|
|
|
Fair Value
|
|
Revolving line of credit
|
|
$
|
125,000
|
|
|
$
|
125,000
|
|
|
$
|
114,331
|
|
|
$
|
114,331
|
|
Mortgage loans on land & buildings
|
|
|
1,609
|
|
|
|
1,746
|
|
|
|
1,639
|
|
|
|
1,881
|
|
Notes Payable
|
|
|
13,000
|
|
|
|
12,528
|
|
|
|
13,000
|
|
|
|
12,740
|
|
NOTE 5:
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):
|
|
July 29, 2017
|
|
|
January 28, 2017
|
|
Property and equipment, at cost:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Buildings and building improvements
|
|
$
|
117,744
|
|
|
$
|
117,501
|
|
Leasehold improvements
|
|
|
84,720
|
|
|
|
86,019
|
|
Automobiles and vehicles
|
|
|
4,916
|
|
|
|
5,029
|
|
Airplane
|
|
|
4,697
|
|
|
|
4,697
|
|
Furniture, fixtures and equipment
|
|
|
282,260
|
|
|
|
288,868
|
|
|
|
|
494,337
|
|
|
|
502,114
|
|
Less: Accumulated depreciation and amortization
|
|
|
(381,180
|
)
|
|
|
(381,579
|
)
|
|
|
|
113,157
|
|
|
|
120,535
|
|
Construction in progress
|
|
|
2,944
|
|
|
|
1,806
|
|
Land
|
|
|
8,581
|
|
|
|
8,581
|
|
Total Property and equipment, at depreciated cost
|
|
$
|
124,682
|
|
|
$
|
130,922
|
|
NOTE 6:
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 July 29, 2017.
During
fiscal 2016, a decision was made to close 39 underperforming stores in fiscal year 2017, which included 18 underperforming pharmacies.
As a result, the Company recorded charges in the amount of $2.0 million in selling, general and administrative expense for the
impairment of fixed assets associated with the closing stores and pharmacies and $2.3 million for the accelerated recognition
of amortization of intangible assets associated with the closing pharmacies of which $0.1 million was utilized during 2016. Additional
impairment charges of $3.6 million were for fixed asset impairments related to the corporate headquarters. During the first quarter
of 2017, the locations were closed and the Company utilized the remaining balance of $4.2 million of impairment charges relating
to the 2016 planned store closures. None of the impairment charges relating to the corporate headquarters were utilized as of
July 29, 2017.
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 July 29, 2017.
Inventory
As
discussed in Note 2 - Inventories, we adjust inventory values on a consistent basis to reflect current market conditions. In accordance
with FASB ASC 330,
“Inventories,”
we write down inventory to net realizable value in the period in which conditions
giving rise to the write-downs are first recognized.
In
the third quarter of 2016, the Company recorded a below-cost inventory adjustment of approximately $3.2 million (including $1.3
million for the accelerated recognition of freight capitalization expense) to value inventory at the lower of cost or market in
39 stores that were planned for closure in 2017. In the fourth quarter of 2016, an additional below-cost inventory adjustment
was recorded in the amount of $1.1 million and $0.2 million of the acceleration recognition of freight cap expense was utilized.
In the first quarter of 2017, the locations were closed and the Company utilized the full amount of the inventory adjustment charges
including the accelerated recognition of freight capitalization expense. No charges were recorded in the second quarter related
to planned store closures.
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.
During
fiscal 2016, the Company increased the lease liability for stores closed in 2016 by $0.5 million and utilized $0.3 million, leaving
a liability of $0.2 million. In the first quarter of 2017, $0.1 million of this reserve was utilized. None of the remaining liability
was utilized during the second quarter leaving $0.1 million at July 29, 2017.
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. In the second quarter of 2017, $1.1 million was utilized.
The following
table illustrates the exit and inventory related to store closures, inventory strategic initiatives along with the lease liability
related to the planned store closures discussed in the previous paragraphs (in millions):
|
|
Balance at January 28, 2017
|
|
|
Additions
|
|
|
Utilization
|
|
|
Ending Balance July 29, 2017
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
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 disposal of fixed assets for 2016 planned closures
|
|
|
2.0
|
|
|
|
—
|
|
|
|
(2.0
|
)
|
|
|
—
|
|
Impairment charge for the disposal of intangible assets for 2016 planned closures
|
|
|
2.2
|
|
|
|
—
|
|
|
|
(2.2
|
)
|
|
|
—
|
|
Impairment charge for the disposal of fixed assets for corporate office
|
|
|
3.6
|
|
|
|
—
|
|
|
|
—
|
|
|
|
3.6
|
|
Impairment charge for the disposal of fixed assets for 2014 planned closures
|
|
|
0.5
|
|
|
|
—
|
|
|
|
—
|
|
|
|
0.5
|
|
Inventory markdowns for 2016 planned closures
|
|
|
3.0
|
|
|
|
—
|
|
|
|
(3.0
|
)
|
|
|
—
|
|
Inventory provision for freight capitalization expense, 2016 planned closures
|
|
|
1.1
|
|
|
|
—
|
|
|
|
(1.1
|
)
|
|
|
—
|
|
Subtotal
|
|
$
|
12.4
|
|
|
$
|
2.2
|
|
|
$
|
(8.3
|
)
|
|
$
|
6.3
|
|
Lease contract termination liability, 2014 - 2016 closures
|
|
|
0.2
|
|
|
|
—
|
|
|
|
(0.1
|
)
|
|
|
0.1
|
|
Lease contract termination liability, 2017 closures
|
|
|
—
|
|
|
|
8.2
|
|
|
|
(1.1
|
)
|
|
|
7.1
|
|
Total
|
|
$
|
12.6
|
|
|
$
|
10.4
|
|
|
$
|
(9.5
|
)
|
|
$
|
13.5
|
|
NOTE 7:
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)
|
|
July 29, 2017
|
|
|
July 30, 2016
|
|
|
January 28, 2017
|
|
|
|
|
|
|
|
|
|
|
|
Accumulated other comprehensive income
|
|
$
|
466
|
|
|
$
|
475
|
|
|
$
|
765
|
|
Amortization of post-retirement benefit
|
|
|
—
|
|
|
|
—
|
|
|
|
(299
|
)
|
Ending balance
|
|
$
|
466
|
|
|
$
|
475
|
|
|
$
|
466
|
|
NOTE 8:
RELATED PARTY TRANSACTIONS
Atlantic
Retail Investors, LLC, which is partially owned by Michael J. Hayes, a former director of the Company, owns the land and buildings
occupied by three Fred’s stores. Richard H. Sain, former Senior Vice President of Retail Pharmacy Business Development,
owns the land and building occupied by one of Fred’s Xpress Pharmacy locations. The terms and conditions regarding the leases
on these locations were consistent in all material respects with other stores’ leases of the Company with unrelated landlords.
The total rental payments made to related party leases were $286.4 thousand and $367.8 thousand for the twenty-six weeks
ended July 29, 2017 and July 30, 2016, respectively.
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 July
29, 2017, 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.
NOTE 9:
LEGAL CONTINGENCIES
On October 15, 2015, a lawsuit entitled Southern Independent Bank v. Fred’s, Inc. was filed in the
United States District Court, Middle District of Alabama related to the Company’s malware data security incident. 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 has now filed a motion to reconsider by certifying the question to the
Alabama Supreme Court for clarity, which is still pending before the court. 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 general liability policy with a $10 million limit and $350,000 deductible. The $350,000 deductible represents the Company’s
estimate of potential exposure related to this matter.
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 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
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. 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 is still pending before the court. The Company filed and the Court
Granted Motions to Remove and Motions to Transfer the Williams and Wallace matters to the Northern District of Alabama. Since
the Williams and Wallace matters were removed and transferred to the Northern District of Alabama, the Company has filed a Motion
to Consolidate the Taylor, Williams, and Wallace matters. The Court has yet to rule on the Motion to Consolidate. Plaintiff’s
counsel for the Williams and Wallace matters has filed a Motion to Remand the matters. Fred’s has opposed the Motion to
Remand, and the Motion to Remand is still pending. 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
.
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. The Company has not made any material accruals for future losses related to these proceedings
and claims as future losses are not considered probable at this time and estimates are unavailable.
NOTE
10: 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 $125.0 million of borrowings outstanding and $91.0 million, net of borrowings and letters of credit, remaining available
under the Agreement at July 29, 2017.
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 SG&A in the Statement of Operations. The $25 million termination fee paid by Walgreens, on June
30, 2017, discussed in Note 1: Basis of Presentation, partially offset these costs.
During
the second and third quarter of fiscal 2007, the Company acquired the land and buildings, occupied by seven Fred’s stores
which we had previously leased. In consideration for the seven properties, the Company assumed debt that has fixed interest rates
from 6.31% to 7.40%.
Mortgages remain on two locations with a combined balance of $1.6 million outstanding
at July 29, 2017. The weighted average interest rate on mortgages outstanding at July 29, 2017 was 7.40%.
The debt
is collateralized by the land and buildings.
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.
Item
2: