10-K 1 a2191754z10-k.htm FORM 10-K

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-K


ý

 

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 27, 2008

OR

o

 

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                             to                            

Commission file number: 001-13843

DUANE READE HOLDINGS, INC.
(Exact name of registrant as specified in its charter)

Delaware
(State or other jurisdiction of
incorporation or organization)
  05-0599589
(I.R.S. Employer
Identification No.)

440 Ninth Avenue, New York, NY
(Address of principal executive offices)

 

10001
(Zip Code)

(212) 273-5700
(Registrant's telephone number, including area code)

None
(Former name, former address and former fiscal year, if changed since last report)

Securities registered pursuant to Section 12(b) of the Act:

Title of each Class   Name of each exchange on which registered
None   Not applicable

Securities registered pursuant to Section 12(g) of the Act: None

         Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o    No ý

         Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes ý*    No o

         Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý    No o

         Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ý

         Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act.

  Large accelerated filer o   Accelerated filer o   Non-accelerated filer ý
(Do not check if a smaller reporting company)
  Smaller reporting company o

         Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o    No ý

         As of March 9, 2009, the aggregate market value of the registrant's common stock held by non-affiliates of the registrant was not significant. All but 20,100 shares of the common stock of the registrant are held by its parent.

DOCUMENTS INCORPORATED BY REFERENCE
None

*
The registrant is not subject to the filing of Section 13 or 15(d) of the Securities Exchange Act of 1934. The registrant is a voluntary filer.


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INDEX

 
   
 
Page

PART I

       

ITEM 1.

 

Business

  6

ITEM 1A.

 

Risk Factors

  21

ITEM 2.

 

Properties

  32

ITEM 3.

 

Legal Proceedings

  33

ITEM 4.

 

Submission of Matters to a Vote of Security Holders

  35

PART II

       

ITEM 5.

 

Market for Registrant's Common Equity and Related Stockholder Matters

  36

ITEM 6.

 

Selected Financial Data

  36

ITEM 7.

 

Management's Discussion and Analysis of Financial Condition and Results of Operations

  39

ITEM 7A.

 

Quantitative and Qualitative Discussions About Market Risk

  63

ITEM 8.

 

Financial Statements and Supplementary Data

  64

ITEM 9.

 

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

  109

ITEM 9A.

 

Controls and Procedures

  109

ITEM 9B.

 

Other Information

  109

PART III

       

ITEM 10.

 

Directors and Executive Officers of the Registrant

  110

ITEM 11.

 

Executive Compensation

  113

ITEM 12.

 

Security Ownership of Certain Beneficial Owners and Management

  147

ITEM 13.

 

Certain Relationships and Related Transactions

  149

ITEM 14.

 

Principal Accountant Fees and Services

  152

PART IV

       

ITEM 15.

 

Exhibits and Financial Statement Schedule

  153

SIGNATURES

 
163

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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

        This and other of our public filings or public statements contain forward-looking statements within the meaning of Section 27A of the Securities Act, Section 21E of the Securities Exchange Act and the Private Securities Litigation Reform Act of 1995, that involve a number of risks and uncertainties. These forward-looking statements relate to future events or our future financial performance with respect to our financial condition, results of operations, business plans and strategies, operating efficiencies or synergies, competitive positions, growth opportunities for existing products such as private label merchandise, plans and objectives of management, capital expenditures, growth and maturation of our stores and other matters. These forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause our or our industry's actual results, levels of activity, performance or achievements to be materially different from those expressed or implied by any forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as "may," "will," "could," "would," "should," "expect," "plan," "anticipate," "intend," "believe," "estimate," "predict," "potential," "pro forma," "seek," or "continue" or the negative of those terms or other comparable terminology. These forward-looking statements are only predictions and such expectations may prove to be incorrect. Some of the things that could cause our actual results to differ substantially from our expectations are:

    the ability to open and operate new stores on a profitable basis, the maturation of those stores and the ability to increase sales in existing stores;

    the competitive environment in the drugstore industry in general and in the New York greater metropolitan area;

    our significant indebtedness;

    the continued efforts of health maintenance organizations, managed care organizations, pharmacy benefit management companies and other third party payers to reduce prescription reimbursement rates and pricing pressure from internet-based and mail-order-based providers;

    the continued efforts of federal, state and municipal government agencies to reduce Medicaid reimbursement rates, modify Medicare benefits and/or reduce prescription drug costs and/or coverages;

    the impact of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (P.L. 108-179), or the Medicare Modernization Act, and the Medicare Part D benefit created thereunder;

    the impact of the initiative announced by the Office of the New York State Medicaid Inspector General to recover and recoup significant amounts of Medicaid payments that were allegedly improperly paid to New York State retail pharmacies;

    changes in pharmacy prescription reimbursement rates attributable to modifications in the definition of indexed pricing terms such as "Average Wholesale Price" or "Average Manufacturer Price";

    the impact of the changing regulatory environment in which our pharmacy department operates, especially the proposed implementation of the federally approved change in the pricing formula for generic pharmaceuticals supplied to Medicaid beneficiaries based on the use of Average Manufacturer Price, which could negatively affect the profitability of filling Medicaid prescriptions;

    the impact of aggressive enforcement by federal, state and local law enforcement agencies of federal and state laws dealing with the submission of false claims and fraud and abuse;

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    the strength of the economy in general and the economic conditions in the New York greater metropolitan area including, in particular, employment and income-related factors, seasonal and weather-related factors, special events, changes in consumer purchasing power and/or spending patterns;

    changes in the cost of goods and services;

    trends in the healthcare industry, including the continued conversion of various prescription drugs to over-the-counter medications, negative publicity and the related sales declines for certain categories of drugs including, without limitation, certain pain medications and the increasing market share of internet-based and mail-order-based providers;

    employment disputes and labor relations;

    our ability to prevent fraud and limit inventory shrink;

    changes in federal and state laws and regulations, including the potential impact of changes in regulations surrounding the importation of pharmaceuticals from foreign countries and changes in laws governing minimum wage requirements;

    the outcome of the arbitration proceeding that has been instituted against us by Anthony J. Cuti, a former Chairman, President and Chief Executive Officer;

    the progress and outcome of the criminal indictments against former executives of the Company by the United States District Attorney's Office for the Southern District of New York and the civil securities fraud charges filed by the Securities and Exchange Commission (the "SEC");

    liability and other claims asserted against us, including the items discussed in "Item 3. Legal Proceedings" included elsewhere in this report;

    changes in our operating strategy or development plans;

    our ability to attract, hire and retain qualified personnel, including our ability to attract qualified pharmacists at acceptable wage rates;

    interest rate fluctuations and changes in capital market conditions or other events affecting our ability to obtain necessary financing on favorable terms to operate and fund the anticipated growth of our business or to refinance our existing debt;

    the continuation or further deterioration of current credit market conditions under which business credit is severely restricted;

    the effects of the current economic recession on our customers and the markets we serve, particularly the difficulties in the financial services industry and the general economic downturn that began in the latter half of 2007 and which has significantly deteriorated during the fourth quarter of 2008 and the beginning of 2009;

    the effects of increased energy, transportation or other costs, increased unemployment, decreases in housing prices, decreases in wages or other similar factors that may have a negative effect on the disposable income or spending patterns of our customers;

    natural and man-made disasters and the continued impact of, or new occurrences of, terrorist attacks in the New York greater metropolitan area and any actions that may be taken by federal, state or municipal authorities in response to or in anticipation of such events and occurrences;

    changes in levels of vendor rebates, allowances and related payment terms;

    changes in timing of our acquisition of stores and prescription files and capital expenditure plans;

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    changes in real estate market conditions and our ability to continue to renew expiring leases or to secure suitable new store locations under acceptable lease terms;

    our ability to successfully implement and manage new computer systems and technologies;

    demographic changes; and

    other risks and uncertainties detailed elsewhere in this report and from time to time in our other filings with the SEC.

        We undertake no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, after the date of this report. We do not, nor does any other person, assume responsibility for the accuracy and completeness of those statements.

        We caution you that the areas of risk described above may not be exhaustive. We operate in a continually changing business environment, and new risks emerge from time to time. Management cannot predict such new risks, nor can it assess the impact, if any, of such risks on our businesses or the extent to which any risk or combination of risks may cause actual results to differ materially from those projected in any forward-looking statements. In light of these risks, uncertainties and assumptions, you should keep in mind that any forward-looking statement made in this report might not occur.

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PART I

ITEM 1.    BUSINESS

The Acquisition

        On July 30, 2004, the acquisition of Duane Reade Inc. (the "Acquisition") was completed by a group of investors, including Oak Hill Capital Partners, L.P. ("Oak Hill"), and both former and certain current members of our management team. As part of the Acquisition, Duane Reade Acquisition Corp., our wholly-owned subsidiary, merged with and into Duane Reade Inc., with Duane Reade Inc. remaining as the surviving corporation.

        As a result of the Acquisition, Duane Reade Inc.'s shares ceased to be listed on the New York Stock Exchange, and we operate as a privately held company. Each share of Duane Reade Inc.'s common stock outstanding immediately prior to the Acquisition was converted into the right to receive $16.50 per share, without interest, in cash.

General

        We are the largest drugstore chain in New York City, which is the largest sales volume drugstore market in the United States. In 2008, we believe that we led the drugstore market in New York City in sales of both back-end (pharmacy) and front-end (non-pharmacy) categories. As of December 27, 2008, we operated 148 of our 251 stores in Manhattan's high-traffic business and residential districts, representing over twice as many stores as our next largest competitor in Manhattan. In addition, at December 27, 2008, we operated 77 stores in New York's densely populated outer boroughs and 26 stores in the surrounding New York and New Jersey suburbs, including the Hudson River communities of northeastern New Jersey, as well as Westchester, Nassau and Suffolk counties in New York. Since opening our first store in 1960, we have executed a marketing and operating strategy tailored to the unique characteristics of New York City, the most densely populated major market in the United States. Sales of higher margin front-end items accounted for approximately 54% of our total sales in fiscal 2008, one of the highest ratios in the chain drug industry.

        Our name is derived from our first successful full-service drugstore, which opened in 1960 on Broadway, between Duane and Reade Streets in Manhattan. We enjoy strong brand name recognition in the New York greater metropolitan area, which we believe results from our many locations in high-traffic areas of New York City, promotional advertising, and our Dollar Rewards customer loyalty program.

        We have developed an operating strategy designed to capitalize on the unique characteristics of the New York greater metropolitan area, which include high-traffic volume, complex distribution logistics, and high costs of occupancy, advertising and personnel. The key elements of our operating strategy are:

    a convenient and value-oriented shopping experience;

    a low-cost operating structure supported by high sales per square foot store locations and relatively low warehouse, distribution and advertising costs; and

    a differentiated real estate strategy using flexible store formats.

        We believe that our customer service orientation, competitive price format, broad product offerings and Dollar Rewards Loyalty Card program provide a convenient and value-oriented shopping experience for our customers and help to build customer loyalty.

        Despite the high costs of operating in the New York greater metropolitan area, our high sales per square foot stores generally allow us to effectively leverage occupancy costs, payroll and other store expenses. Our approximately 506,000 square foot primary distribution facility is centrally located in Maspeth, Queens, New York City. The facility is located within ten miles of approximately 90% of our

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stores, and none of our retail locations are farther than 50 miles from this facility. We also operate a second, smaller warehouse facility in North Bergen, New Jersey for the distribution of certain seasonal and other promotional merchandise. This approximately 114,000 square foot support facility enjoys similar proximity to most of our New York City locations while providing additional capacity and closer proximity to our stores located in New Jersey. We believe that these two central locations allow us to maintain relatively low warehouse and distribution costs as a percentage of sales.

        As of December 27, 2008, we operated 251 stores, 15 of which were opened during fiscal 2008. During fiscal 2007 and 2006, we opened ten stores and five stores, respectively. We closed six stores in 2008, 16 stores in 2007 and eight stores in 2006. Among the 15 new stores we opened during 2008, 11 were in Manhattan, three were in the densely populated outer boroughs of New York City and one was in New Jersey. As of December 27, 2008, approximately 59% of our stores were in Manhattan, 31% were in the outer boroughs of New York City and 10% were located outside New York City. At December 27, 2008, we occupied approximately 1.7 million square feet of retail space, approximately 3% more than at the end of fiscal 2007. Approximately 46% of the stores we operated at December 27, 2008 had been opened since the beginning of fiscal 2001.

        In March 2006, as part of an expansion and realignment of the senior management team that started in November 2005, we implemented a six-point strategic plan to transform our business and improve performance, known as "Duane Reade Full Potential." The successful implementation of "Duane Reade Full Potential" allowed us to stabilize our business performance and resulted in improved sales and margin performance during 2008, 2007 and 2006, compared to 2005, as well as improved leveraging of costs and improved working capital management. In April 2008, John A. Lederer was appointed as our Chairman and Chief Executive Officer.

        We believe our current market position provides us with an opportunity to become one of the New York metropolitan area's most recognized and trusted brands. During 2008, we sought to further strengthen our management team and build upon the success we have achieved by adding new senior management executives in operations, supply chain and merchandising to execute several strategic plans that we believe will return us to profitability and further strengthen our brand in the New York metropolitan area. Our strategic plan for 2009 includes:

    Improving the pharmacy through maintenance of improved in-stock conditions, more convenient operating hours, faster customer prescription fulfillment and enhanced accessibility and interaction between our customers and pharmacists.

    Enhancing the customer's experience by providing our store personnel with additional training on planning, directing and organizing the store for success.

    Improve our merchandise and private label offerings and differentiate ourselves from competitors through the use of exclusive brand products, improved presentations and a strengthened loyalty program.

    Modernizing our store locations through store renovations, new interior and exterior design graphics and décor. Several of our 2008 store openings reflect these new store design concepts.

        Our strategic plan will focus on serving the needs of our customers by providing them with the products they need to look and feel better and will offer them a wide assortment of products designed to meet their everyday needs. The implementation of this strategic plan began in the second half of 2008 and will continue throughout 2009.

    Where you can find additional information

        We maintain a company website at www.duanereade.com. We make copies of our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and any amendments

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to those reports filed with or furnished to the SEC available to investors on or through our website free of charge as soon as reasonably practicable after we have electronically filed them with or furnished them to the SEC. The contents of our website do not constitute a portion of this report.

        The public may read and copy any materials filed by us with the SEC at the SEC's Public Reference Room, located at 100 F Street, N.E. Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. In addition, the SEC maintains a website at which reports, proxy and information statements and other information regarding issuers that file electronically with the SEC are available. This website may be accessed at http://www.sec.gov.

Company Operations

Front-End Merchandising

        Our overall front-end merchandising strategy is to provide a broad selection of competitively priced, branded and private label drugstore products in convenient, customer-friendly presentations. To further enhance customer service and loyalty, we attempt to maintain a consistent in-stock position in all merchandise categories. We offer brand name and private label health and beauty care products (including over-the-counter items), food and beverage items (including beer in all stores which have obtained the appropriate licenses), tobacco products, cosmetics, housewares, greeting cards, photofinishing services, photo supplies, seasonal and general merchandise and other products. Health and beauty care products represent our highest volume product categories within front-end sales, and we allocate ample shelf space to popular brands of these items. We place convenience items, such as candy, snacks and seasonal goods, near the check-out registers to provide all customers with optimum convenience and to stimulate impulse purchases. To further enhance our health and beauty offerings, we operate Skin Wellness Centers in 38 stores. Our Skin Wellness Centers are staffed by trained beauty advisors and offer our customers high-end skin care brands.

        In addition to a wide array of branded products, we also offer our own private label products under various names including "5th Avenue", "Apt. 5", "Christmas in New York" and "Duane Reade." Private label products provide customers with high-quality, lower priced alternatives to brand name products, while generating generally higher gross profit margins than brand name products. These offerings also enhance our reputation as a value-oriented retailer, build customer loyalty and differentiate ourselves from competitors. We believe that our strong brand image, reputation for quality and reliability in the New York City market, and our economies of scale in purchasing allow us to effectively manage an improved assortment of private label goods that offer an alternative for increased value to the consumer with higher profitability than comparable branded products. In fiscal 2008, our private label products accounted for approximately 8.9% of non-pharmacy sales.

        We further complement our product offerings with additional customer services such as ATMs, sales of lottery tickets and postage stamps, money transfer services and acceptance of food stamps and other government-sponsored benefits. We also offer on-site photofinishing services in over 90 of our stores.

Pharmacy

        Our pharmacy business is central to our customer identity and provides a critical link to our health and wellness business and sales in over-the-counter front-end products. Sales of prescription medications are expected to experience strong long-term growth trends attributable to the aging population, new drug discoveries, and increased use of quality of life prescription products. Increased prescription coverage through various private and government sponsored plans such as the Medicare Part D program as well as other favorable demographic trends are expected to result in strong growth for all aspects of this business. Our same-store prescription retail drug sales grew by 3.1% in 2008 as

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compared to 2007 and by 5.9% in 2007 as compared to 2006. Sales of prescription drugs represented 46.1% of total sales in 2008, compared to 46.0% of total sales in 2007 and 46.5% of total sales in 2006. The number of generic prescriptions filled represented 59.6% of total prescriptions filled in 2008 as compared to 55.7% of total prescriptions filled in 2007 and 52.1% of total prescriptions filled in 2006. While the increase in the percentage of generic prescriptions filled reduces the rate of pharmacy same-store sales growth overall, it increases our gross margin per prescription filled. This increased gross margin is due to lower cost generic prescriptions generally being more profitable than their branded equivalents. The trend of increases in generic prescriptions filled is the result of several high volume branded drug patent expirations that have enabled the introduction of lower cost generic alternatives and the conversion of certain popular prescription drugs to over-the-counter drugs. We have also continued to emphasize the value of using lower cost generic products to our customers.

        We believe that our extensive network of conveniently located stores, strong local market position and reputation for high quality healthcare products help in attracting pharmacy business from individual customers as well as managed care organizations, insurance companies, employers and other third party payers. The percentage of our total prescription drug sales covered by third party plans, which include government-paid plans, increased to approximately 93.4% in 2008, as compared to approximately 93.0% in 2007 and approximately 92.8% in 2006. Gross margins on sales covered by third party plans are generally lower than cash prescription drug sales because of the highly competitive nature of pricing for this business.

        The Medicare Modernization Act created a Medicare Part D benefit that expanded Medicare coverage of prescription drugs for senior citizens as well as for certain "dual eligible" individuals that were previously covered under state administered Medicaid plans. This Medicare coverage has resulted in decreased pharmacy margins resulting from lower reimbursement rates than our current margins on state Medicaid prescriptions. The Medicare Part D program has grown rapidly since taking effect in 2006. The program's growth may continue as more seniors have become eligible and enroll for the coverage.

        In July 2007, the Centers for Medicare & Medicaid Services, or CMS, issued a final rule that may negatively affect our level of reimbursements for certain generic drugs by setting an upper limit on the amount of reimbursement for such drugs based on the "Average Manufacturer Price" ("AMP"). As a result of a lawsuit brought by the National Association of Chain Drug Stores and the National Community Pharmacists Association to challenge the implementation of the new rule, a federal court temporarily enjoined the implementation of the new rule pending the outcome of the lawsuit and the lawsuit remains pending. In July 2008, Congress enacted H.R. 6331, the Medicare Improvements for Patients and Providers Act of 2008 ("MIPPA"). The former President Bush subsequently vetoed MIPPA and, on July 15, 2008, Congress overrode the veto. MIPPA delayed the implementation of the use of Average Manufacturer Price with respect to payments made by State Medicaid Plans for multiple source generic drugs until September 30, 2009. MIPPA also prohibited the Secretary of Health and Human Services from making public any Average Manufacturer Price information that was previously disclosed to the Secretary of Health and Human Services. The outcomes of the lawsuit and the impact of MIPPA are uncertain at this time, so we currently are unable to determine what effect the new rule will ultimately have on our business.

        In an effort to offset some of the adverse pharmacy gross margin impacts from the trends discussed above, there has been an intensified effort on the part of retailers to support increased utilization of lower priced but higher margin generic prescriptions in place of branded medications. New generic drug introductions have also enabled retailers to increase the proportion of generic prescriptions to total prescriptions dispensed. Improved generic utilization rates as well as a combination of direct purchases and contractual wholesaler purchases enabled us to offset the adverse margin impact of Medicare Part D and reduced state Medicaid reimbursement rates during 2008 and 2007. In addition, we believe that the higher volume of pharmacy sales to third party plan customers

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helps to offset the related lower gross profit margins and allows us to leverage other fixed store operating expenses. We believe that increased third party plan sales also generate additional general merchandise sales by increasing customer traffic in our stores. As of December 27, 2008, we had contracts with over 370 third party plans, including virtually all major third party plans in our market areas. During fiscal 2008, New York Medicaid represented approximately 14% and 6% of our retail pharmacy and net retail store sales, respectively.

        Over the past several years, New York State reduced Medicaid and Elderly Pharmaceutical Insurance Coverage (EPIC) prescription reimbursement rates, adversely impacting our pharmacy gross margins. Under the New York State Medicaid program, reimbursement for multiple source prescription drugs for which an upper limit has been set by CMS will be an amount equal to the specific upper limit set by CMS. For a multiple source prescription drug or a brand-name prescription drug for which CMS has not set a specific upper limit, the lower of the estimated acquisition cost of such drug to pharmacies or the dispensing pharmacy's usual and customary price charged to the general public will be applied. Under the Medicaid guidelines, providers cannot refuse to dispense prescriptions to Medicaid recipients who claim they do not have the means to pay the required co-payments. Most Medicaid recipients do in fact decline to make the co-payments resulting in the requirement for the provider to absorb this cost.

        The current economic downturn may result in additional reductions in New York Medicaid prescription reimbursements. Budget proposals for New York State in 2009 currently include reductions in the reimbursements for pharmacies in the Medicaid and EPIC programs. The State of New Jersey is also proposing Medicaid reductions in their 2009 budget proposals. Neither state has approved their final budget proposals, and while it is highly likely that there will ultimately be further reductions in reimbursements, the economic stimulus package recently passed by Congress and signed into law by President Obama could provide states with additional Medicaid funding and may reduce the extent of each state's proposed reductions in Medicaid reimbursements. Under the economic stimulus package, over $80 billion would be allocated to help states with Medicaid. In addition, the economic stimulus package includes provisions to subsidize health care insurance premiums for the unemployed under the COBRA program and provisions that will aid states in defraying budget cuts.

        In 2008, we experienced pharmacy sales growth due to increased utilization of Medicare Part D, pharmacy same-store sales growth of 3.1% and increases in average price per prescription. Previous factors that have influenced our pharmacy sales are the level of third party plan co-payments, publicity surrounding certain medications, conversion of certain prescription drugs to over-the-counter status and increased mail order and internet based penetration.

        Our pharmacies are linked by a central computer system that makes central patient records available in real time, so that our customers can fill prescriptions at any Duane Reade pharmacy. The system provides customers with a broad range of services, including concurrent, prospective and retrospective drug reviews. Our pharmacy computer network profiles customer medical and other relevant information, supplies customers with information concerning their drug purchases for income tax and insurance purposes and prepares prescription labels and receipts. The computer network also expedites transactions with third party plans by electronically transmitting prescription information directly to the third party plan and providing on-line adjudication. At the time of sale, on-line adjudication confirms customer eligibility, prescription coverage, pricing and co-payment requirements and automatically bills the respective plan. On-line adjudication also reduces losses from rejected claims and eliminates a portion of our administrative burden related to the billing and collection of receivables and related costs.

        We currently operate two Diabetes Resource Centers, one center is located in Manhattan and the second center is located in Brooklyn. Both Diabetes Resource Centers are designed to assist individuals and their families in managing diabetes and serve as educational facilities which provide free training.

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The Diabetes Resource Centers and their services, managed by licensed pharmacists and certified diabetes educators, are open to the public and are free of charge.

        In 2007, in partnership with Consumer Health Services, Inc., we launched DR Walk-in Medical Care. These sites are designed to provide customers with convenient access to high-quality, urgent and non-emergency medical services at affordable prices, with the option to see on-site physicians on a walk-in basis for immediate examination and treatment. We currently have two of these DR Walk-in Medical Care centers in our stores and believe these services enhance our convenience image, promote stronger customer loyalty and assist us in addressing the wellness needs of our customers.

Internet

        Our interactive website, www.duanereade.com, is a convenient and efficient means that customers may use to access our Duane Reade ePharmacy. Customers can register to have access to view their prescription records, print insurance and tax reports, order refills, order new prescription and transfers, access drug information and ask our pharmacists a question.

        Our website also allows our customers to:

    View our latest circular and company information.

    Obtain information about our customer loyalty program and our Dollar Rewards card.

    Place orders for contact lenses.

    View our durable medical equipment catalog.

        Our strategy has been to develop the website as an additional vehicle to deliver superior customer service, enhance our brand recognition and to supplement our convenient store locations. We believe www.duanereade.com provides one more important touch point to provide pharmacy services as well as allowing customers to contact us though the internet.

Store Operations

        Our stores range in size from under 500 to approximately 12,700 square feet, with an average of approximately 6,764 square feet per store as of December 27, 2008. Our stores are designed to facilitate customer convenience. We attempt to group merchandise logically in order to enable customers to locate items quickly and conveniently. During 2008, we undertook an initiative to modernize our store locations through several store renovations, new interior and exterior design graphics and décor. Several of our 2008 store openings reflect these new store design concepts.

        We establish each store's hours of operation in an attempt to best serve customer traffic patterns and purchasing habits. Most stores in Manhattan's business districts are generally open six days per week. In residential and certain business/shopping districts, most stores are open seven days per week, with a heavy emphasis on convenient, early morning openings and late evening closings. We intend to continue to identify stores where we believe extended operating hours would improve customer service and convenience and contribute to our profitability. Most of our stores offer delivery services as an added customer convenience. Customers can arrange for delivery via phone, fax or internet. Each store is supervised by a store manager and one or more assistant store managers. Our stores are supplied up to five times per week from our two warehouses which enables us to maintain a high in-stock position, maximizes store selling space and minimizes our inventory investment per store.

Purchasing and Distribution

        In total, we purchase from over 1,000 vendors. We believe that there are ample sources of supply for the merchandise we currently sell, and that the loss of any one non-pharmacy supplier would not

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have a material effect on our business. We distribute approximately 84% of our non-pharmacy merchandise through our warehouses and receive direct-to-store deliveries for approximately 16% of our non-pharmacy purchases. Direct-to-store deliveries are made primarily for greeting cards, photofinishing, convenience foods, beverages and various categories of general merchandise.

        We generally purchase prescription medications under long-term supply agreements. Approximately $30 million of our pharmacy inventory at December 27, 2008 was shipped directly to our stores on a consignment basis.

Advertising and Promotion

        We advertise for our stores in a number of traditional and non-traditional ways. We use circulars, radio, direct mail, subway and bus advertising, the internet and electronic indoor and outdoor advertising which highlight promotional items, special service offerings and programs. To promote our brand within our trade area, we provide customers with distinctive shopping bags bearing our Duane Reade logo.

        To maximize the benefits of membership, many of our promotions are linked to our Dollar Rewards Loyalty Card and are targeted towards our most frequent shoppers. Dollar Rewards was the first loyalty card program in the U.S. chain drug store industry. Approximately one-half of our front-end sales are attributable to the approximately 2.6 million card members who used the loyalty card in fiscal 2008.

Management Information Systems

        We have computerized pharmacy and inventory management information systems. We use scanning point-of-sale (POS) systems in each of our stores. These systems allow better control of pricing, inventory and shrink. POS also provides sales analysis that allows for improved labor scheduling and helps optimize product shelf space allocation and design by allowing detailed analysis of stock-keeping unit sales.

        We utilize a fully automated computer-assisted merchandise replenishment system for store front-end and pharmacy orders sourced through our distribution centers and our primary pharmacy supply distributor. These systems use item-specific and store-specific sales history to produce "suggested" orders for each store, which can be accepted or modified by the stores before being released.

        We also use radio frequency hand held scanning devices to communicate directly with our central processing facilities that permit real-time updates of our perpetual inventory information. These devices are also used to support inventory ordering, transfers, price changes and direct store deliveries. We utilize a chain-wide specific item cost-based inventory tracking and valuation system which provides improved controls over inventory management and shrink-related losses. Our in-store shelf labeling system is designed to improve pricing accuracy, upgrade our ability to communicate item prices to our customers and reduce the costs associated with processing weekly price changes.

Competition

        Our stores compete on the basis of convenience of location and store layout, product mix, selection, customer service and price. The New York City drugstore market is highly fragmented due to the complexities and costs of doing business in the most densely populated area of the country. We believe the diverse labor pool, local customer needs and the complex real estate market in New York City all favor regional chains that are familiar with the market. We tailor our store format to meet all of these requirements, which has proven successful in the business and residential neighborhoods of Manhattan, the outer boroughs and surrounding areas. Currently, we have the largest market share in

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New York City compared to our chain drug competitors in the drugstore business. Our primary competition comes from over 1,400 independent pharmacies located in New York City, as well as stores operated by major drugstore chains including CVS, Rite Aid and Walgreens. We believe that we have significant competitive advantages over independent drugstores in New York City. These include purchasing economies of scale, two strategically located warehouses that minimize store inventory and maximize selling space, a broad line of in-stock, brand name merchandise, the ability to offer a broad range of value-oriented private label products and a convenient store format. Against major drug chain competition, we enjoy the advantages of strategically located warehouses, a larger number of convenient locations and greater experience operating stores in the New York greater metropolitan area. In addition to competition from the drugstore chains named above, our pharmacy business also competes with hospitals, health maintenance organizations and Canadian imports.

        We also compete to a lesser extent with other classes of retail trade, including supermarkets and mass merchants. We believe that our concentration in the densely populated New York City market limits the ability of big box retailers and supermarkets to expand meaningfully in many of our prime trading areas.

        An adverse trend for drugstore retailing has been the growth in mail-order and internet-based prescription processors. These prescription distribution methods have grown in market share relative to drugstores as a result of the rapid rise in drug costs experienced in recent years. Mail-order prescription distribution methods have been perceived by many employers and insurers as being less costly than traditional distribution methods and have been mandated by an increasing number of third party pharmacy benefit managers, many of which also own and manage mail-order distribution operations. In addition to these forms of mail-order distribution, there have also been an increasing number of internet-based prescription distributors that specialize in offering certain high demand lifestyle drugs at deeply discounted prices. A number of these internet-based distributors operate illicitly and outside the reach of regulations that govern legitimate drug retailers. Competition from Canadian imports has also created volume and pricing pressure. Imports from foreign countries may increase further if recently introduced legislation seeking to legalize the importation of drugs from Canada and other countries is eventually enacted. We believe these alternate distribution channels have acted to restrain the rate of sales growth for traditional chain drug retailers in the last several years.

        Since 1996, the national market share of prescription drug sales attributable to drugstore chains have remained flat at approximately 40%, while industry data shows the mail-order market share increasing from approximately 12% in 1996 to a current market share of approximately 21%. We expect the increase in market share for mail-order to continue, which will continue to restrain growth for market participants and cause negative pricing pressure. While mail-order market share is expected to continue to increase, we believe that the use of mail-order is limited due to the time delay associated with mail-order sales, which limits the ability of customers to use this channel to obtain drugs to treat acute conditions. Approximately 56% of our new prescriptions are for acute cases. Further, we believe the cost savings associated with mail-order prescriptions are generally achieved through large volume orders, and typically orders of less than a 90-day supply will cost the same or more than a retail purchase due to shipping costs.

Government Regulation

        Our business is subject to extensive federal, state and local regulations. These regulations cover required qualifications, day to day operations, reimbursement and documentation of activities. We continuously monitor the effects of regulatory activity on our pharmacy and non-pharmacy related operations.

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Licensure and Registration Laws

        New York and New Jersey require that companies operating a pharmacy within the state be licensed by the state board of pharmacy. We currently have pharmacy licenses for each pharmacy we operate in New York and New Jersey. Pharmacists who provide services on our behalf are required to obtain and maintain professional licenses and are subject to state regulations regarding professional standards of conduct. Each of our pharmacists located in New York is required to be licensed by the State of New York. The State of New Jersey requires the pharmacists employed at our stores in New Jersey to be licensed in New Jersey.

Medicare and Medicaid

        The pharmacy business operates under regulatory and cost containment pressures from federal and state legislation primarily affecting Medicaid and, to a lesser extent, Medicare.

        We receive reimbursement from government sponsored third party plans, including Medicaid and Medicare, non-government third party plans such as managed care organizations and also directly from individuals (i.e. private-pay). For the 2008 fiscal year, our pharmacy payer mix, as a percentage of total prescription sales, was approximately 66% managed care organizations, 27% Medicaid/Medicare and 7% private-pay. Pricing for private-pay patients is based on prevailing regional market rates. However, federal laws and regulations contain a variety of requirements relating to the reimbursement and furnishing of prescription drugs under Medicaid. First, states are given authority, subject to applicable standards, to limit or specify conditions for the coverage of some drugs. Second, as discussed below, federal Medicaid law establishes standards for pharmacy practice, including patient counseling and drug utilization review. Third, federal regulations impose reimbursement requirements for prescription drugs furnished to Medicaid beneficiaries. Prescription drug benefits under Medicare are paid pursuant to the Medicare Prescription Drug Improvement and Modernization Act of 2003 (P.L. 108-173), or the Medicare Modernization Act. In addition to requirements mandated by federal law, individual states have substantial discretion in determining administrative, coverage, eligibility and reimbursement policies under their respective state Medicaid programs that may affect our pharmacy operations.

        The Medicare and Medicaid programs are subject to statutory and regulatory changes, retroactive and prospective rate adjustments, administrative rulings, executive orders and freezes and funding restrictions, all of which may significantly impact our pharmacy operations. We cannot assure you that payments for pharmaceuticals under the Medicare and Medicaid programs will continue to be based on current methodologies or even remain similar to present levels. We may be subject to rate reductions as a result of federal or state budgetary constraints or legislative or other changes related to the Medicare and Medicaid programs including, but not limited to, the Medicare Part D drug benefit. Over the past several years, New York State has reduced Medicaid and EPIC prescription reimbursement rates, adversely impacting our pharmacy sales and gross margins.

Fraud, Waste and Abuse Laws

        We are subject to federal and state laws and regulations governing financial and other arrangements between healthcare providers. Commonly referred to as the fraud, waste and abuse laws, these laws prohibit certain financial relationships between pharmacies and physicians, vendors and other referral sources. Violations of fraud, waste and abuse laws and regulations could subject us to, among other things, significant fines, penalties, injunctive relief, pharmacy shutdowns and possible exclusion from participation in federal and state healthcare programs, including Medicare and Medicaid. Changes in healthcare laws or new interpretations of existing laws may significantly affect

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our pharmacy business. Some of the fraud, waste and abuse laws that have been applied in the pharmaceutical industry include:

        Federal Anti-Kickback Statute:    The federal anti-kickback statute, Section 1128B(b) of the Social Security Act (42 U.S.C. 1320a-7b(b)), prohibits, among other things, the knowing and willful offer, payment, solicitation or acceptance of remuneration, directly or indirectly, in return for referring an individual to a provider of services for which payment may be made in whole or in part under a federal healthcare program, including the Medicare or Medicaid programs. In addition, the federal anti-kickback statute prohibits the knowing and willful solicitation or receipt of any remuneration, directly or indirectly, in return for purchasing, leasing, ordering or arranging for or recommending the purchasing, leasing or ordering of any good, facility, service or item for which payment may be made in whole or in part under a federal health care program, including Medicare or Medicaid. Remuneration has been interpreted to include any type of cash or in-kind benefit, including long-term credit arrangements, gifts, supplies, equipment, prescription switching fees, or the furnishing of business machines. Several courts have found that the anti-kickback statute is violated if any purpose of the remuneration, not just the primary purpose, is to induce referrals.

        Potential sanctions for violations of the anti-kickback statute include felony convictions, imprisonment, substantial criminal fines and exclusion from participation in any federal healthcare program, including the Medicare and Medicaid programs. Violations may also give rise to civil monetary penalties in the amount of $50,000 per violation, plus treble damages. In addition to the federal anti-kickback statute, many states, including New Jersey, have enacted State Medicaid anti-kickback statutes that are similar to the prohibitions of the federal anti-kickback statute. Potential sanctions and violations of state anti-kickback statutes are similar to those of federal anti-kickback statutes. Although we believe that our relationships with vendors, physicians, and other potential referral sources have been structured in compliance with fraud, waste and abuse laws, including the federal and state anti-kickback statutes, the Department of Health and Human Services has acknowledged in its pharmaceutical industry compliance guidance that many common business activities potentially implicate the anti-kickback statute. We cannot offer any assurance that a government enforcement agency, private litigant, or court will not interpret our business relations to violate the fraud, waste and abuse laws.

        The False Claims Act:    Under the False Claims Act, civil penalties may be imposed upon any person who, among other things, knowingly or recklessly submits, or causes the submission of false or fraudulent claims for payment to the federal government, for example, in connection with Medicare and Medicaid. Any person who knowingly or recklessly makes or uses a false record or statement in support of a false claim, or to avoid paying amounts owed to the federal government, may also be subject to damages and penalties under the False Claims Act.

        Moreover, private individuals may bring qui tam, or "whistle blower," suits under the False Claims Act, and may receive a portion of amounts recovered on behalf of the federal government. Such actions must be filed under seal pending their review by the Department of Justice. Penalties of between $5,500 and $11,000 and treble damages may be imposed for each violation of the False Claims Act. Several federal district courts have held that the False Claims Act may apply to claims for reimbursement when an underlying service was delivered in violation of other laws or regulations, including the anti-kickback statute.

        In addition to the False Claims Act, the federal government has other civil and criminal statutes, which may be utilized if the government suspects that we have submitted false claims. Criminal provisions that are similar to the False Claims Act provide that if a corporation is convicted of presenting a claim or making a statement that it knows to be false, fictitious or fraudulent to any federal agency, it may be fined not more than twice any pecuniary gain to the corporation, or, in the

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alternative, no more than $500,000 per offense. Many states also have similar false claims statutes that impose liability for the types of acts prohibited by the False Claims Act.

        In April 2007, former New York State Governor Elliot Spitzer signed legislation implementing the Health and Mental Hygiene Budget for the 2007-2008 fiscal year. New York State's False Claims Act was included within that legislation. The New York State False Claims Act is modeled after the federal False Claims Act. The New York State False Claims Act provides that a false claim can result in civil penalties between $6,000 to $12,000 per claim and possible treble damages. In addition, the New York State Medicaid Inspector General James G. Sheehan has announced the commencement of an aggressive audit program targeting Medicaid payments to New York State retail pharmacies. The New Jersey Health Care Claims Fraud Act (N.J.S.A. 2C:21-4.2, et seq.) prohibits the filing of false or misleading claims for payment for health care services and imposes penalties including imprisonment and fines of five times the amount of the claim or more. Section 6031 of the Deficit Reduction Act of 2005 and Section 1901 of the Social Security Act provide a financial incentive for states to enact false claims acts that establish liability to the state for the submission of false or fraudulent claims to the state's Medicaid program.

        If a state false claims act is determined to meet certain enumerated requirements, the state is entitled to an increase of 10 percentage points in its share of any amounts recovered under a state action brought under such law. Under Section 1909(b) of the Social Security Act, the United States Department of Health and Human Services, Office of Inspector General is required to determine, in consultation with the Attorney General of the United States, whether a state has in effect a law relating to false or fraudulent claims submitted to a state Medicaid Program that meets the enumerated requirements. The effective date of Section 1909 of the Social Security Act is January 1, 2007. On August 7, 2007, the Office of Inspector General notified the New York State Attorney General that the New York State False Claims Act met the requirements of Section 1909(b). The Office of the Inspector General has reviewed the New Jersey State False Claims Act and has notified the New Jersey Attorney General that the New Jersey State False Claims Act does not meet the enumerated requirements of Section 1909(b). On May 19, 2005, New York City Mayor Michael Bloomberg signed into law the New York City False Claims Act (Local Law 53 of 2005) which authorizes citizens to bring lawsuits to recover treble damages for fraudulent claims submitted to the city. Finally, the submission of false claims may result in termination of our participation in federal or state healthcare programs. Members of management and persons who actively participate in the submission of false claims can also be excluded from participation in federal healthcare programs.

        We believe that we have sufficient procedures in place to provide for the accurate completion of claim forms and requests for payment. Nonetheless, given the complexities of the Medicare, Medicaid and other third party payer programs, some of our billing and record-keeping practices may be alleged to be false claims by the enforcing agency or a private litigant.

Physician Self-Referral Laws

        The federal physician self-referral law, Section 1877 of the Social Security Act (42 U.S.C. § 1395nn, commonly known as the "Stark Law") prohibits physicians from referring Medicare patients for certain designated health services to entities with which the physician or an immediate family member of the physician has a financial relationship, unless an exception applies. The Stark Law is implicated if the physician has an ownership or financial relationship with the entity that is providing the designated health service. The Stark Law also prohibits the entity from billing for services provided pursuant to a prohibited referral. Among the designated services covered by the Stark Law include outpatient prescription drugs. Sanctions for violating the Stark Law include denial of payment and civil monetary penalties of not more than $15,000 for each bill or claim for a service. Any physician or other entity that enters into an arrangement or scheme (such as a cross-referral arrangement) which the physician or entity knows, or should know, has a principal purpose of issuing referrals by the physician

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to a particular entity which, if the physician directly made referrals to such entity, would be in violation of the Stark Law, and subject to a civil monetary penalty of not more than $100,000 for each such arrangement or scheme. The Stark Law is implicated if the physician, or an immediate family member of such physician, has an ownership or compensation arrangement with the entity. Both New York and New Jersey have enacted state physician self-referral statutes and regulations that are similar to the Stark Law in scope and purpose. The federal and state physician self-referral laws are also commonly referred to as fraud, waste and abuse laws. Although we believe that our relationships with physicians and other individuals are in compliance with the Stark Law and its state equivalents, a government enforcement agent, private litigant or court may determine that our business relationships violate the fraud, waste and abuse laws.

Drug Utilization Review

        The Omnibus Budget Reconciliation Act of 1990, or OBRA 90, establishes a number of regulations regarding state Medicaid prescription drug benefits. Although OBRA 90 primarily focuses on drug manufacturers' obligations to provide drug rebates under state Medicaid programs, it also requires states to create drug utilization review, or DUR, requirements in order to combat fraud, abuse, gross overuse and inappropriate or medically unnecessary care as well as to educate patients about potential adverse reactions. DUR requires pharmacists to discuss with patients relevant information in connection with dispensing drugs to patients. This information may include the name and description of the medication, route and dosage form of the drug therapy, special directions and precautions for patients, side effects, storage, refill and actions to be taken upon a missed dosage. Under DUR requirements, pharmacists are also required to make a reasonable effort to obtain the patient's identification information, medical history and drug reaction history and to keep notes relevant to an individual's drug therapy. We believe our pharmacists provide the required drug use consultation with our customers.

Healthcare Information Practices

        The Health Insurance Portability and Accountability Act of 1996, or HIPAA, sets forth standards for electronic transactions; unique provider, employer, health plan and patient identifiers; security and electronic signatures as well as privacy protections relating to the exchange of individually identifiable health information. The Department of Health and Human Services, or DHHS, has released several rules mandating compliance with the standards set forth under HIPAA. We believe our pharmacies initially achieved compliance with DHHS's standards governing the privacy of individually identifiable health information that became effective on April 14, 2003 and with DHHS's standards governing the security of electronically stored health information that became effective on April 20, 2005. In addition, we have implemented the uniform standards governing common healthcare transactions by the required compliance date of October 16, 2003. Finally, management has taken or will continue to take all necessary steps to achieve and maintain compliance with the HIPAA standards mentioned above and with other HIPAA rules as applicable, including the standard unique employer identifier rule, the standard health care provider identifier rule and the enforcement rule.

        We continue to evaluate the effect of the HIPAA standards on our business. At this time, management believes that our pharmacies have taken all appropriate steps to achieve compliance with the HIPAA requirements. Moreover, HIPAA compliance is an ongoing process that will require continued attention and adaptation even after the official compliance dates. Management does not currently believe that the cost of compliance with the existing HIPAA requirements will be material to us; however, management cannot predict the cost of future compliance with HIPAA requirements. Noncompliance with HIPAA may result in criminal penalties and civil sanctions. The HIPAA standards have increased our regulatory and compliance burden and have significantly affected the manner in which our pharmacies use and disclose health information, both internally and with other entities.

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        In addition to the HIPAA restrictions relating to the exchange of healthcare information, individual states have adopted laws protecting the confidentiality of patient information which impact the manner in which pharmacy records are maintained. Violation of patient confidentiality rights under common law, state law or federal law could give rise to damages, penalties, civil or criminal fines and/or injunctive relief. We believe that our pharmacy operations, data sales arrangements and prescription file-buying program are in compliance with applicable federal and state privacy protections. However, an enforcement agency or court may find a violation of state or federal privacy protections arising from our pharmacy operations, our data sales arrangements or our prescription file-buying program and such finding of a violation may have a material adverse effect upon our business and our financial results.

Healthcare Reform and Federal Budget Legislation

        In recent years, Congress has passed a number of federal laws that have created major changes in the healthcare system. In December 2000, the Medicare, Medicaid and SCHIP (State Children's Health Insurance Program) Benefits Improvement and Protection Act of 2000, or BIPA, was signed into law. Generally, BIPA addressed attempts to modify the calculation of average wholesale prices of drugs, or AWPs, upon which Medicare and Medicaid pharmacy reimbursement has been based. The federal government has been actively investigating whether pharmaceutical manufacturers have been improperly manipulating average wholesale prices, and several pharmaceutical manufacturers have paid significant civil and criminal penalties to resolve litigation relating to allegedly improper practices affecting AWP. In October 2006, in connection with a class action filed in the United States District for the District of Massachusetts, First Data Bank, which is one of two primary sources of AWP price reporting, announced that it had entered into a settlement agreement related to its reporting of average wholesale prices, subject to final court approval. Under the terms of the proposed settlement agreement, First Data Bank agreed to reduce the reported AWP of certain drugs by four percent and to discontinue the publishing of AWP at a future time. In May 2007, in connection with a separate class action filed in the same court, Medi-Span, the other primary source of average wholesale price reporting, entered into a similar settlement agreement, also subject to final court approval.

        In January 2008, the court denied approval of the First Data Bank and Medi-Span settlements as proposed. Subsequently, new settlement agreements were submitted to the court. On March 17, 2009, the court issued an order approving the revised settlements. Pursuant to the settlements, as approved, First Data Bank and Medi-Span have agreed to reduce the reported AWP for certain drugs by four percent. Separately, and not pursuant to the settlement agreements, First Data Bank and Medi-Span have indicated that they will also reduce the reported AWP for a large number of additional drugs not covered by the settlement agreements and that they intend to discontinue the reporting of AWP in the future. Under the terms of the court's decision, the settlement agreements can become effective no earlier than 180 days from the entry of final judgment. Although the court's ruling will take effect no earlier than 180 days from March 17, 2009, we believe that some parties will appeal the court's ruling and seek a stay of the implementation of the settlement. The court's ruling, if not revised on appeal, could potentially have a significant adverse impact on us and the drugstore industry as a whole.

        A number of contracts with third-party plans contain provisions that allow us to adjust our pricing to maintain the relative economics of the contract in light of a change in AWP methodology. Most of our contracts with both private and governmental plans also include provisions that allow us to terminate the contracts unilaterally, either because parties cannot renegotiate our pricing to account for the change in AWP methodology or for any reason upon 30 to 90 days' notice. While we expect to negotiate with the various governmental and non-governmental third-party plans for adjustments relating to the expected changes to AWP, we cannot be certain that these negotiations will be successful. Due to these factors and the uncertainty over future appeals or stays of the court ruling, which could delay the effective date of the implementation of the settlement agreements, we cannot

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predict with certainty or accurately quantify the ultimate effect of the AWP reduction on our revenues, profitability, future operations or business relationships.

        In response to BIPA and other criticisms of AWP pricing methodologies, the Medicare Modernization Act described above contains a number of drug pricing reforms, some of which were effective January 1, 2004. Section 1927 of the Social Security Act established the Medicaid drug rebate program. For a manufacturer's covered outpatient drugs to be eligible for federal Medicaid funding under the Medicaid drug rebate program, the manufacturer must enter into a rebate agreement with the CMS, and pay quarterly rebates to the states. Section 1927(b)(3) of the Act requires a participating manufacturer to report quarterly to CMS the average manufacturer price for each covered outpatient drug. Section 1927(k)(1) of the Social Security Act defines the "average manufacturer price" as the average price paid to the manufacturer by wholesalers for drugs distributed to the retail pharmacy class of trade, after deducting customary prompt pay discounts.

        Under Section 1902(a)(54) of the Social Security Act, each state is required to submit a Medicaid state plan to CMS describing its payment methodology for covered outpatient drugs. Federal regulations require, with certain exceptions, that each state's Medicaid reimbursement for a drug not exceed (in the aggregate) the lower of (a) its estimated acquisition costs plus a reasonable dispensing fee or (b) the provider's usual and customary charge to the public.

        The Deficit Reduction Act of 2005 requires the Secretary of the United States Department of Health and Human Services to provide average manufacturer price data to the states on a monthly basis beginning July 1, 2006. On July 17, 2007, CMS issued a final rule that implemented the provisions of the Deficit Reduction Act with respect to prescription drug reimbursement under the Medicaid program. This rule defined the terms "average manufacturer price" and "best price". It specifies the items that must be included and excluded in the calculation of each term. This rule became effective on October 1, 2007. The rule also implemented the Deficit Reduction Act provision establishing a new reimbursement formula for generic drugs under Medicaid and establishes federal upper limits for generics based on 250% of the lowest AMP in a given drug class. In November 2007, the National Association of Chain Drug Stores and the National Community Pharmacists Association filed a lawsuit in federal court seeking to enjoin the implementation of the proposed AMP reimbursement rules. On December 19, 2007, the United States District Court for the District of Columbia granted a preliminary injunction enjoining CMS from implementing the proposed AMP reimbursement rules. The preliminary injunction remains in place. However, it is uncertain at this time whether HHS and CMS will revise and reissue the AMP reimbursement rules and what impact, if any, the revised and reissued rules, if any, will have on us.

        The Medicare Part D drug benefit went into effect on January 1, 2006. Prior to January 1, 2006, Medicare beneficiaries were able to receive some assistance with their prescription drug costs through a prescription drug discount card program which began in June 2004. This discount card program gave enrollees access to negotiated discount prices for prescription drugs.

        On January 28, 2005, CMS published a final rule to implement the Medicare Part D drug benefit. Under the Medicare Part D drug benefit, Medicare beneficiaries are able to enroll in prescription drug plans offered by private entities or, to the extent private entities fail to offer a plan in a given area, through a government contractor. Medicare Part D prescription drug plans include both plans providing the drug benefit on a stand alone basis and Medicare Advantage plans that provide drug coverage as a supplement to an existing medical benefit under the applicable Medicare Advantage plan. Pursuant to the CMS final rule, we will be reimbursed for drugs that we provide to enrollees of a given Medicare Part D prescription drug plan in accordance with the terms of the agreements negotiated between the Medicare Part D plan and us. We accept most Medicare Part D plans in our market areas. The amount of reimbursement to us under Medicare Part D plans is less than the amount under New York and New Jersey State Medicaid, and generally less than traditional nongovernmental third-party plans.

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        CMS is continuing to issue sub-regulatory guidance on many additional aspects of the CMS final rule. We are monitoring these government pronouncements and statements of guidance, and we cannot predict at this time the ultimate effect of the CMS final rule or other potential developments relating to its implementation on our business or results of operations.

        It is uncertain at this time what additional healthcare reform initiatives, if any, will be implemented, or whether there will be other changes in the administration of governmental healthcare programs or interpretations of governmental policies or other changes affecting the healthcare system. We cannot assure you that future healthcare or budget legislation or other changes, including those referenced above, will not materially adversely impact our pharmacy business.

Non-Healthcare Licenses

        We have been granted cigarette tax stamping licenses from the State of New York and the City of New York, which permit us to buy cigarettes directly from the manufacturers and stamp the cigarettes ourselves. Our stores possess cigarette tax retail dealer licenses issued by the State of New York, the City of New York and the State of New Jersey. Most of our stores have been granted licenses by the United States Department of Agriculture, enabling them to serve as certified Food Stamp retailers. In addition, most of our stores possess beer licenses and food licenses issued by the State of New York. We seek to comply with all of these licensing and registration requirements and continue to actively monitor our compliance. By virtue of these license and registration requirements, we are obligated to observe certain rules and regulations, and a violation of these rules and regulations could result in suspension or revocation of one or more licenses or registrations and/or the imposition of monetary penalties or fines.

Minimum Wage Requirements

        We are impacted by legislation to increase the minimum hourly wages. New York State increased the minimum hourly wage from $5.15 to $6.00 on January 1, 2005, to $6.75 on January 1, 2006, and again to $7.15 on January 1, 2007. New Jersey increased the minimum hourly wage from $5.15 to $6.15 on October 1, 2005 and again to $7.15 on October 1, 2006. In addition, the federal minimum hourly wage increased to $6.55 in July 2008 and the U.S. Congress passed legislation that will result in a federal minimum hourly wage increase to $7.25 in July 2009. While these increases have impacted our cost of labor, we have, and believe we can continue to, offset a significant portion of these cost increases through initiatives designed to further improve our labor efficiency.

Employees

        As of December 27, 2008, we had approximately 6,800 employees. Unions represent approximately 5,000 of our employees. Non-union employees include employees at corporate headquarters, store and warehouse management and all of our store pharmacists. The distribution facility employees are represented by the International Brotherhood of Teamsters, Chauffeurs and Warehousemen and Helpers of America, Local 210 under a collective bargaining agreement that expires on August 31, 2011. At December 27, 2008, employees in 141 stores were represented by RWDSU/Local 338 and employees in 109 stores were represented by Local 340A New York Joint Board, UNITE AFL CIO. Our three year contracts with RWDSU/Local 338 and Local 340A expire on March 31, 2009. We are currently engaged in negotiating new collective bargaining agreements with these two unions.

Intellectual Property

        We hold a number of registered and unregistered trademarks. Trademarks we have registered with the United States Trademark Office include the name "Duane Reade;" the distinctive "DR" logo; "DR

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Express," and its associated logo; "Christmas in New York;" "Mayfair Chemists;" "Fifth Avenue Preferred;" "Color for the City;" "Apt. 5"; and the logo "Performance Script Network". We have applications currently pending before the United States Trademark Office to register our trademarks "City Chic"; "Duane Reade DRC Diabetes Resource Center," with its associated logo; and "We Pledge" with the Duane Reade logo. We regard the Duane Reade name and logo, as well as our other trademarks, as valuable assets. In September of 1998, we acquired twenty-nine Rock Bottom stores, which we converted to the Duane Reade format in the 1999 fiscal year. In addition, in connection with the Rock Bottom acquisition, we acquired the "Rock Bottom" name and the "Rock Bottom" logo, each of which are registered trademarks.

ITEM 1A.    Risk Factors

        The following risk factors should be read carefully in connection with evaluating us and this annual report on Form 10-K. Certain statements in this "Risk Factors" section are forward-looking statements. See Special Note Regarding "Forward-Looking Statements" above.

Risks Related to Our Business

We face a high level of competition in our markets.

        We operate in highly competitive markets. In the New York greater metropolitan area, we compete against national, regional and local drugstore chains, discount drugstores, supermarkets, combination food and drugstores, discount general merchandise stores, mass merchandisers, independent drugstores and local merchants. Major chain competitors in the New York greater metropolitan area include CVS, Rite Aid and Walgreens. In addition, other chain stores may enter the New York greater metropolitan area and become significant competitors in the future. Many of our competitors have greater financial and other resources than we do. Currently, we have the largest market share in the New York metropolitan area compared to our competitors in the drugstore business. If any of our current competitors, or new competitors, were to devote significant resources to enhancing or establishing an increased presence in the New York greater metropolitan area, they could make it difficult for us to maintain or grow our market share or maintain our margins, and our advertising and promotional costs could increase. This competition could materially adversely affect our results of operations and financial condition in the future. In addition to competition from the drugstore chains named above, our pharmacy business also competes with hospitals, health maintenance organizations and Canadian imports.

        Another adverse trend for drugstore retailing has been the growth in mail-order and internet-based prescription processors. These prescription distribution methods have grown in market share relative to drugstores as a result of the rapid rise in drug costs experienced in recent years. Mail-order prescription distribution methods have been perceived by employers and insurers as being less costly than traditional distribution methods and are being mandated by an increasing number of third party pharmacy benefit managers, many of which also own and manage mail-order distribution operations, as well as a growing number of employers and unions. In addition to these forms of mail-order distribution, there have also been an increasing number of internet-based prescription distributors that specialize in offering certain high demand lifestyle drugs at deeply discounted prices. A number of these internet-based distributors operate illicitly and outside the reach of regulations that govern legitimate drug retailers. Competition from Canadian imports has also created volume and pricing pressure. Imports from foreign countries may increase further if recently introduced legislation seeking to legalize the importation of drugs from Canada and other countries is eventually enacted. These alternate distribution channels have acted to restrain the rate of sales growth for traditional chain drug retailers in the last several years.

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We operate in a concentrated region and, as a result, our business is significantly influenced by the economic conditions and other characteristics of the New York greater metropolitan area.

        Substantially all of our stores are located in the greater New York metropolitan area. In addition, in a number of respects, the current economic downturn can affect retailers disproportionately, as consumers may prioritize reductions in discretionary spending on consumer goods in response to the deterioration of the economy. As a result, we are sensitive to, and our success will be substantially affected by, economic conditions and other factors affecting this region, such as the regulatory environment, unemployment levels, cost of energy, real estate, insurance, taxes and rent, weather, demographics, the availability of labor, financial markets and geopolitical factors such as terrorism. We cannot predict economic conditions in this region. During the 1990s, the New York City economy grew substantially, and our business benefited from this high rate of economic growth. As a result of the economic recession and the terrorist attack on the World Trade Center in September 2001, however, the New York City economy was materially and adversely affected. In the latter half of 2008 and the beginning of 2009, economic conditions worsened considerably and the level of national economic activity as measured by a number of recent key economic indicators has shown that the economy entered into a recession in 2008. The New York City economy may be particularly susceptible to a downturn because of difficulties in the financial services industry. Furthermore, to the extent that personal disposable income declines as a result of rising unemployment, higher taxes, reduced bonus income, falling housing prices, higher consumer debt levels, increased energy costs or other macroeconomic factors, we could experience lower profit margins, lower sales (particularly in front-end merchandise) and increased levels of shrink. Because most of our stores are located in the highly urbanized areas throughout New York City and the surrounding metropolitan area, our stores experience a higher rate of shrink than our national competitors.

        Our sales and profitability have in the past been affected by events and other factors that affect New York City. Examples include smoking-ban legislation, the August 2003 Northeast power blackout, significant non-recurring increases in real estate taxes and insurance costs and the 2004 Republican National Convention. In 2005, our results were negatively affected by increased labor costs associated with the ongoing shortage of pharmacists in the New York City metropolitan area and increases in New York state and to a lesser extent New Jersey state minimum wage rates. We have continued to experience cost pressures from increased pharmacist salary and benefit costs as well as further increases in minimum wage rates. Any increases in federal taxes or in city or state taxes in New York City or the Tri-State Area resulting from state or local government budget deficits may further reduce consumers' disposable income, which could have a further negative impact on our business. Any other unforeseen events or circumstances that affect the New York City metropolitan area could also materially adversely affect our revenues and profitability.

        In addition, perceived instability in our business and in the financial health of New York City and the surrounding areas may negatively affect our relations with our suppliers and trade creditors. As a result, our suppliers or trade creditors may present us with terms that are materially more disadvantageous to us than those we currently enjoy, which may have a negative impact on our ability to operate our business and manage our liquidity.

Continued volatility and disruption to the global capital and credit markets may adversely affect our results of operations and financial condition, as well as our ability to access credit and the financial soundness of our customers, third party providers and vendors.

        Recently, the global capital and credit markets have been experiencing a period of unprecedented turmoil and upheaval, characterized by the bankruptcy, failure, collapse or sale of various financial institutions and an unprecedented level of intervention from the United States federal government. These conditions could adversely affect the demand for our products and services and, therefore,

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reduce purchases by our customers, which would negatively affect our revenue growth and cause a decrease in our profitability. In addition, reduced consumer spending may drive us and our competitors to offer additional products at promotional prices, which would have a negative impact on gross profit. A continued softening in consumer sales may adversely affect our industry, business and results of operations.

        In addition, interest rate fluctuations, financial market volatility or credit market disruptions may limit our access to capital and may also negatively affect our customers' and our vendors' ability to obtain credit to finance their businesses on acceptable terms. As a result, our customers' needs and ability to purchase our products may decrease, and our vendors may increase their prices, reduce their output or change their terms of sale. If our third party providers' or vendors' operating and financial performance deteriorates, or if they are unable to make scheduled payments or obtain credit, our third party providers may not be able to pay, or may delay payment of, accounts receivable owed to us, and our vendors may restrict credit or impose different payment terms. Any inability of customers to pay us for our products, or any demands by vendors for different payment terms, may adversely affect our operations and cash flow.

        Declining economic conditions may also increase our costs. If the economic conditions do not improve or continue to deteriorate, our results of operations or financial condition could be adversely affected.

We require a significant amount of cash flow from operations and third party financing to pay our indebtedness, to execute our business plan and to fund our other liquidity needs.

        We may not be able to generate sufficient cash flow from operations, our suppliers may not continue to extend us normal trade payments terms, and future borrowings may not be available to us under our amended asset-based revolving loan facility or otherwise in an amount we will need to pay our indebtedness, to execute our business plan or to fund our other liquidity needs. We spent $47.0 million in 2008 on capital expenditures, lease acquisitions, pharmacy customer file acquisitions and other capital items and expect to invest between $40.0 million and $45.0 million in 2009. We also require working capital to support inventory for our existing stores. In addition, we may need to refinance some or all of our indebtedness, including indebtedness under our amended asset-based revolving loan facility, our senior subordinated notes and our senior secured floating rate notes, or our preferred stock at or before maturity. We may not be able to refinance any of our indebtedness on commercially reasonable terms or at all. Failure to generate or raise sufficient funds may require us to modify, delay or abandon some of our future business initiatives or expenditure plans.

Our operations are subject to trends in the healthcare industry.

        Pharmacy sales, which typically generate lower margins than front-end sales, represent a significant percentage of our total sales. Pharmacy sales, including resales of certain retail inventory, accounted for approximately 46.1% of total sales in the fiscal year ended December 27, 2008, approximately 46.0% of total sales in the fiscal year ended December 29, 2007 and approximately 46.5% of total sales in the fiscal year ended December 30, 2006. Pharmacy sales not only have lower margins than non-pharmacy sales but are also subject to increasing margin pressure, as managed care organizations, insurance companies, government funded programs, employers and other third party payers, which collectively we call third party plans, have become prevalent in the New York greater metropolitan area and as these plans continue to seek cost containment. Also, any substantial delays in reimbursement or significant reduction in coverage or payment rates from third party plans may have a material adverse effect on our business. In addition, an increasing number of employers are now requiring participants in their plans to obtain some of their prescription drugs, especially those for non-acute conditions, through mail-order providers. Medicare Part D benefits for senior citizens that became available in January

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2006 resulted in lower reimbursement rates and resultant gross margins than the non-third party plan margins and state Medicaid reimbursement rates they replaced. These factors and other factors related to pharmacy sales described below may have a negative impact on our pharmacy sales in the future. See the risk factor "We face a high level of competition in our markets" for further discussion on drugstore retail trends. Sales to third party prescription plans, which include government-paid plans, represented 93.4% of our prescription drug sales for the fiscal year ended December 27, 2008, 93.0% of our prescription drug sales for the fiscal year ended December 29, 2007 and 92.8% of our prescription drug sales for the fiscal year ended December 30, 2006.

        The continued conversion of various prescription drugs to over-the-counter medications may materially reduce our pharmacy sales and customers may seek to purchase such medications at non-pharmacy stores. Also, if the rate at which new prescription drugs become available slows or if new prescription drugs that are introduced into the market fail to achieve popularity, our pharmacy sales may be adversely affected. The withdrawal of certain drugs from the market or concerns about the safety or effectiveness of certain drugs or negative publicity surrounding certain categories of drugs may also have a negative effect on our pharmacy sales or may cause shifts in our pharmacy or front-end product mix. For example, the rate of growth in pharmacy sales declined in 2005 due to a number of factors, including a decline in demand for hormonal replacement medications, increasing third party plan co-payments, negative publicity surrounding certain arthritis medications, conversion of certain prescription drugs to over-the-counter status and increased mail order and internet based penetration.

        Healthcare reform and enforcement initiatives sponsored by federal and state governments may also affect our revenues from prescription drug sales. These initiatives include:

    proposals designed to significantly reduce spending on Medicare, Medicaid and other government programs;

    changes in programs providing for reimbursement for the cost of prescription drugs by third party plans;

    the Medicare Modernization Act;

    increased scrutiny of, and litigation relating to, prescription drug manufacturers' pricing and marketing practices; and

    regulatory changes relating to the approval process for prescription drugs.

        These initiatives could lead to the enactment of, or changes to, federal regulations and state regulations in New York and New Jersey that could adversely impact our prescription drug sales and, accordingly, our results of operations. It is uncertain at this time what additional healthcare reform initiatives, if any, will be implemented, or whether there will be other changes in the administration of governmental healthcare programs or interpretations of governmental policies or other changes affecting the healthcare system. Future healthcare or budget legislation or other changes, including those referenced above, may materially adversely impact our pharmacy business.

Changes in reimbursement levels for certain prescription drugs continue to reduce our margins on pharmacy sales and could have a material adverse effect on our overall performance.

        During the fiscal years ended December 27, 2008, December 29, 2007, and December 30, 2006, we were wholly or partially reimbursed by third party plans for approximately 93.4%, 93.0% and 92.8%, respectively, of the prescription drugs that we sold. The percentage of prescription sales reimbursed by third party plans has been increasing, and we expect that percentage to continue to increase. Prescription sales reimbursed by third party plans, including Medicare and Medicaid plans, have lower gross margins than other pharmacy sales. Third party plans may not increase reimbursement rates

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sufficiently to offset expected increases in prescription acquisition costs, thereby reducing our margins and adversely affecting our profitability. In addition, continued increases in co-payments by third party plans may result in decreases in drug usage.

        In particular, Medicare and Medicaid programs are subject to statutory and regulatory changes, retroactive and prospective reimbursement rate adjustments, administrative rulings, executive orders and freezes and funding restrictions, all of which may significantly impact our pharmacy operations. For the 2008 fiscal year, approximately 27% of our total prescription sales were paid for by Medicaid or Medicare. Over the last several years, a number of states experiencing budget deficits have moved to reduce Medicaid prescription reimbursement rates. Over the past several years, New York State reduced Medicaid and EPIC prescription reimbursement rates, adversely impacting our pharmacy gross margins. Under the New York State Medicaid Program, reimbursement for a multiple source prescription drug for which a federal upper limit has been set by CMS will be in an amount equal to the specific federal upper limit for the multiple source prescription drug. For a multiple source prescription drug or a brand name prescription drug for which no specific federal upper limit has been set, the lower of the estimated cost of each drug to pharmacies or the dispensing pharmacy's usual and customary price charged to the public will be applied.

        In July 2007, the Centers for Medicare & Medicaid Services, or CMS, issued a final rule that may negatively affect our level of reimbursements for certain generic drugs by setting an upper limit on the amount of reimbursement for such drugs based on the "Average Manufacturer Price." As a result of a lawsuit brought by the National Association of Chain Drug Stores and the National Community Pharmacists Association to challenge the implementation of the new rule, a federal court temporarily enjoined the implementation of the new rule pending the outcome of the lawsuit and the lawsuit remains pending. In July 2008, Congress enacted H.R. 6331, the Medicare Improvements for Patients and Providers Act of 2008 ("MIPPA"). The former President Bush subsequently vetoed MIPPA and, on July 15, 2008, Congress overrode the veto. MIPPA delayed the implementation of the use of Average Manufacturer Price with respect to payments made by State Medicaid Plans for multiple source generic drugs until September 30, 2009. MIPPA also prohibited the Secretary of Health and Human Services from making public any Average Manufacturer Price information that was previously disclosed to the Secretary of Health and Human Services. The outcomes of the lawsuit and the impact of MIPPA are uncertain at this time, so we currently are unable to determine what effect the new rule will ultimately have on our business.

        The Medicare Modernization Act created a Medicare Part D benefit that expanded Medicare coverage of prescription drugs for senior citizens as well as for certain "dual eligible" individuals that were previously covered under state administered Medicaid plans. This Medicare coverage has resulted in decreased pharmacy margins resulting from lower reimbursement rates than our current margins on state Medicaid prescriptions. The Medicare Part D program has grown rapidly since taking effect in 2006. The program's growth may continue as more seniors have become eligible and enroll for the coverage.

        In recent years, Congress has passed a number of federal laws that have created major changes in the healthcare system. In December 2000, the Medicare, Medicaid and SCHIP Benefits Improvement and Protection Act of 2000, or BIPA, was signed into law. Generally, BIPA addressed attempts to modify the calculation of average wholesale prices of drugs, or AWPs, upon which Medicare and Medicaid pharmacy reimbursement has been based. The federal government has been actively investigating whether pharmaceutical manufacturers have been improperly manipulating average wholesale prices, and several pharmaceutical manufacturers have paid significant civil and criminal penalties to resolve litigation relating to allegedly improper practices affecting AWP. In October 2006, in connection with a class action filed in the United States District for the District of Massachusetts, First Data Bank, which is one of two primary sources of AWP price reporting, announced that it had

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entered into a settlement agreement related to its reporting of average wholesale prices, subject to final court approval. Under the terms of the proposed settlement agreement, First Data Bank agreed to reduce the reported AWP of certain drugs by four percent and to discontinue the publishing of AWP at a future time. In May 2007, in connection with a separate class action filed in the same court, Medi-Span, the other primary source of average wholesale price reporting, entered into a similar settlement agreement, also subject to final court approval.

        In January 2008, the court denied approval of the First Data Bank and Medi-Span settlements as proposed. Subsequently, new settlement agreements were submitted to the court. On March 17, 2009, the court issued an order approving the revised settlements. Pursuant to the settlements, as approved, First Data Bank and Medi-Span have agreed to reduce the reported AWP for certain drugs by four percent. Separately, and not pursuant to the settlement agreements, First Data Bank and Medi-Span have indicated that they will also reduce the reported AWP for a large number of additional drugs not covered by the settlement agreements and that they intend to discontinue the reporting of AWP in the future. Under the terms of the court's decision, the settlement agreements can become effective no earlier than 180 days from the entry of final judgment. Although the court's ruling will take effect no earlier than 180 days from March 17, 2009, we believe that some parties will appeal the court's ruling and seek a stay of the implementation of the settlement. The court's ruling, if not revised on appeal, could potentially have a significant adverse impact on us and the drugstore industry as a whole.

        A number of contracts with third-party plans contain provisions that allow us to adjust our pricing to maintain the relative economics of the contract in light of a change in AWP methodology. Most of our contracts with both private and governmental plans also include provisions that allow us to terminate the contracts unilaterally, either because parties cannot renegotiate our pricing to account for the change in AWP methodology or for any reason upon 30 to 90 days' notice. While we expect to negotiate with the various governmental and non-governmental third-party plans for adjustments relating to the expected changes to AWP, we cannot be certain that these negotiations will be successful. Due to these factors and the uncertainty over future appeals or stays of the court ruling, which could delay the effective date of the implementation of the settlement agreements, we cannot predict with certainty or accurately quantify the ultimate effect of the AWP reduction on our revenues, profitability, future operations or business relationships.

If we fail to comply with all of the government regulations that apply to our business, we could incur substantial reimbursement obligations, damages, penalties, injunctive relief and/or exclusion from participation in federal or state healthcare programs.

        Our pharmacy operations are subject to a variety of complex federal, state and local government laws and regulations, including federal and state civil fraud, anti-kickback, false claims and other laws. We endeavor to structure all of our relationships to comply with these laws. However, if any of our operations are found to violate these or other government regulations, we could suffer severe penalties, including suspension of payments from government programs; loss of required government certifications; loss of authorizations to participate in or exclusion from government reimbursement programs, such as the Medicare and Medicaid programs; loss of licenses; and significant fines or monetary penalties for anti-kickback law violations, submission of false claims or other failures to meet reimbursement program requirements.

        In addition to the regulations relating to the conduct of our pharmacy business, our pharmacists are subject to licensing requirements and are required to comply with various federal and state laws regarding compliance with dispensing procedures, anti-fraud statutes, false claims and other rules and regulations. Although we have a compliance program in place, in the event that a pharmacist is determined to not have a valid license for purposes of processing certain state and federal claims or is listed on a federal or state excluded provider list, we could be subject to significant fines and penalties.

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        Federal and state laws that require our pharmacists to offer free counseling to their customers about medication, dosage, delivery systems, common side effects and other information the pharmacists deem significant can impact our business. Our pharmacists may also have a duty to warn customers regarding any potential negative effects of a prescription drug if the warning could reduce or negate these effects. Violations of federal, state, and common law privacy protections could give rise to significant damages, penalties, and/or injunctive relief. Additionally, we are subject to federal and state regulations relating to our pharmacy operations, including purchasing, storing and dispensing of controlled substances. Laws governing our employee relations, including minimum wage requirements, overtime and working conditions also impact our business. Increases in the federal minimum wage rate, employee benefit costs or other costs associated with employees could significantly increase our cost of operations, which could materially adversely affect our level of profitability.

Budgetary pressures may cause various governmental agencies to reduce health care expenditures or change the terms of their payments to us. Any such reductions could negatively impact our business.

        Both state and federal government sponsored payers, as a result of budget deficits or reductions, may seek to reduce their health care expenditures by renegotiating the terms of their payments with us.

        The current economic downturn may result in additional reductions in New York Medicaid prescription reimbursements. Budget proposals for New York State for 2009 currently include reductions in the reimbursements for pharmacies in the Medicaid and EPIC programs. The State of New Jersey is also proposing reductions in dispensing fees and reimbursement rates in 2009. Neither state has approved their final budget proposals, but it is highly likely that there will ultimately be further reductions in reimbursements, and any reduction in payments by such government sponsored payers may adversely affect our operations and cash flow.

We could be materially and adversely affected if either of our distribution centers is shut down.

        We operate two centralized distribution centers, one in Queens, New York and the other in North Bergen, New Jersey. We ship most of our non-pharmacy products to our stores through our distribution centers. If either of our distribution centers is destroyed, or shut down for any other reason, including because of weather or labor issues, we could incur significantly higher costs and longer lead times associated with distributing our products to our stores during the time it takes for us to reopen or replace the centers. We maintain business interruption insurance to protect us from the costs relating to matters such as a shutdown, but our insurance may not be sufficient, or the insurance proceeds may not be timely paid to us, in the event of a shutdown.

We rely on a primary supplier of pharmaceutical products to sell products to us on satisfactory terms. A disruption in our relationship with this supplier could have a material adverse effect on our business.

        We are party to multi-year, merchandise supply agreements in the normal course of business. The largest of these is with AmerisourceBergen, our primary pharmaceutical supplier, which supplied most of our pharmaceutical products in fiscal 2008 and 2007. Management believes that if any of these agreements were terminated or if any contracting party were to experience events precluding fulfillment of its obligations, we would be able to find a suitable alternative supplier. However, we may not be able to do so without significant disruption to our business. Finding suitable alternative suppliers could take a significant amount of time and result in a loss of customers.

We may be unable to attract, hire and retain qualified pharmacists, which could harm our business.

        As our business expands, we believe that our future success will depend greatly on our continued ability to attract and retain highly skilled and qualified pharmacists. The competition for qualified

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pharmacists and other pharmacy professionals may make it difficult for us to attract, hire and retain qualified pharmacists. Although we generally have been able to meet our pharmacist staffing requirements in the past, our inability to do so in the future at costs that are favorable to us, or at all, could negatively impact our revenue, and our customers could experience lower levels of customer care. In 2008, we continued to experience cost pressures from increased pharmacist salary and benefit costs.

Most of our employees are covered by collective bargaining agreements. A failure to negotiate new agreements when the existing agreements terminate could disrupt our business.

        As of December 27, 2008, we had approximately 6,800 employees. Unions represent approximately 5,000 of our employees. Non-union employees include employees at corporate headquarters, store and warehouse management and all of our store pharmacists. The distribution facility employees are represented by the International Brotherhood of Teamsters, Chauffeurs and Warehousemen and Helpers of America, Local 210 under a collective bargaining agreement that expires on August 31, 2011. Local 210 represents approximately 400 employees in our Maspeth, New York and North Bergen, New Jersey warehouse facilities. At December 27, 2008, employees in 141 stores were represented by the RWDSU/Local 338 and employees in 109 stores were represented by Local 340A New York Joint Board, UNITE AFL-CIO. Our three year collective bargaining agreements with RWDSU/Local 338 and Local 340A expire on March 31, 2009.

        While we are currently engaged in negotiating new collective bargaining agreements with RWDSU/Local 338 and Local 340A, there can be no assurance that these negotiations will be successful, and we may be unable to reach new collective bargaining agreements on terms favorable to us. Our business operations may be interrupted as a result of labor disputes, strikes, work stoppages or difficulties and delays in the process of renegotiating our collective bargaining agreements.

We may be subject to significant liability should the consumption of any of our products cause injury, illness or death.

        Products that we sell could become subject to contamination, product tampering, mislabeling or other damage requiring us to recall our private label products. In addition, errors in the dispensing and packaging of pharmaceuticals could lead to serious injury or death. Product liability claims may be asserted against us with respect to any of the products or pharmaceuticals we sell and we may be obligated to recall our private label products. A product liability judgment against us or a product recall could have a material adverse effect on our business, financial condition or results of operations.

We depend on our management team, and the loss of their services could have a material adverse effect on our business.

        Our success depends to a large extent on the continued service of our executive management team. Departures by our executive officers could have a negative impact on our business, as we may not be able to find suitable management personnel to replace departing executives on a timely basis. We do not maintain key-man life insurance on any of our executive officers.

Continued volatility in insurance related expenses and the markets for insurance coverage could have a material adverse effect on us.

        The costs of employee health, workers' compensation, property and casualty, general liability, director and officer and other types of insurance could rise, while the amount and availability of coverage can decrease. These conditions are exacerbated by rising healthcare costs, legislative changes, economic conditions and the threat of terrorist attacks such as that which occurred on September 11, 2001. If our insurance-related costs increase significantly, or if we are unable to obtain adequate levels of insurance, our financial position and results of operations could be materially adversely affected.

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Certain risks are inherent in providing pharmacy services, and our insurance may not be adequate to cover any claims against us.

        Pharmacies are exposed to risks inherent in the packaging, dispensing and distribution of pharmaceuticals and other healthcare products. Although we maintain professional liability and errors and omissions liability insurance, the coverage limits under our insurance programs may not be adequate to protect us against future claims, and we may not have the ability to maintain this insurance on acceptable terms in the future, which could materially adversely affect our business.

We are subject to trends in the retail industry and changes in consumer preferences, and a failure to anticipate such changes or react to such changes in a timely manner may have a material adverse effect on our business.

        Our success depends on our ability to respond to changing trends and shifting consumer demand. If we misjudge trends and are unable to adjust our product offerings in a timely manner, our sales may decline or fail to meet expectations and any excessive inventory may need to be sold at lower prices. For instance, over the past several years, our overall photofinishing business and sales of film have experienced significant declining sales as the industry as a whole experiences declines in the use of traditional technologies and as we have made the transition to digital photofinishing. We have placed self-serve kiosks in several of our store locations in an attempt to respond to the transition to digital photofinishing but our digital photofinishing business may not grow as expected. As a result, our business and prospects could suffer. Trends other than changes in product demand in the retail industry may also adversely affect our business. For example, changing demands for customer and ancillary services, developments in our loyalty card programs and other such trends may also affect the business.

        Our operations are also impacted by consumer spending levels, which are affected by general economic conditions, consumer confidence, employment levels, availability of consumer credit and interest rates on that credit, consumer debt levels, cost of consumer staples, including food and energy, cost of other goods, adverse weather conditions and other factors over which we have little or no control.

The outcome of current and future litigations and other proceedings in which we are involved may have a material adverse effect on our results of operations and cash flow.

        We are subject to various litigations and other proceedings in our business, which if determined unfavorably to us, could have a material adverse effect on our results of operations and cash flow. In addition, any of the current or possible future civil or criminal actions in which we may be involved could require significant management and financial resources, which could otherwise be devoted to the operation of our business. For a more detailed discussion of these litigations and other proceedings, see "Item 3. Legal Proceedings."

Risks Related to Our Capital Structure

Our substantial indebtedness could prevent us from fulfilling our obligations under our indebtedness and may otherwise restrict our activities.

        We have a significant amount of indebtedness. As of December 27, 2008, we had a total of approximately $555.7 million of indebtedness outstanding, consisting of approximately $144.6 million outstanding under the amended asset-based revolving loan facility, $210.0 million of outstanding senior secured floating rate notes, $195.0 million of outstanding senior subordinated notes and approximately $6.0 million of capital lease obligations.

        Our outstanding indebtedness could:

    make it more difficult for us to satisfy our obligations with respect to either of the notes;

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    limit our ability to obtain additional financing for funding our growth strategy, capital expenditures, acquisitions, working capital or other purposes;

    require us to dedicate a substantial portion of our operating cash flow to service our debt, thereby reducing funds available for our growth strategy, capital expenditures, acquisitions, working capital and other purposes;

    increase our vulnerability to adverse economic, regulatory and industry conditions;

    limit our flexibility in planning for, or responding to, changing business and economic conditions, including reacting to any economic slowdown in the New York greater metropolitan area;

    place us at a competitive disadvantage relative to our competitors with less indebtedness; and

    subject us to financial and other restrictive covenants, and our failure to comply with these covenants could result in an event of default, which, if not cured or waived, could result in the acceleration of all of our indebtedness.

        During 2006, we extended the maturity of the amended asset-based revolving loan facility from 2008 to 2011. As a condition of this extension, we are required to refinance any outstanding amounts under the $210.0 million of senior secured floating rate notes not later than 120 days prior to their maturity date of December 15, 2010. Our ability to refinance our indebtedness will depend on, among other things, our financial condition at the time, credit market conditions and the availability of financing. Our ability to refinance our indebtedness could be impaired if debt holders develop a negative perception of our long-term or short-term financial prospects. Such negative perceptions could result if we suffer a decline in the level of our business activity, among other reasons. In addition, because of disruptions in the worldwide credit markets, because of the economic downturn and its impact on our business or for other reasons, we may not be able to obtain refinancing on commercially reasonable terms or at all. Failure to refinance our indebtedness could have a material adverse effect on us and could require us to dispose of assets if we cannot refinance our indebtedness. We may be unable to sell some of our assets, or we may have to sell assets at a substantial discount from market value, either of which could adversely affect our results of operations.

Despite current indebtedness levels, we and our subsidiaries may still be able to incur substantial additional indebtedness. This could further exacerbate the risks associated with our existing substantial indebtedness.

        We and our subsidiaries may be able to incur substantial additional indebtedness in the future. We are able to incur up to $220.0 million in total indebtedness under the amended asset-based revolving loan facility, of which approximately $144.6 million was outstanding as of December 27, 2008. Our ability to borrow under the amended asset-based revolving loan facility is subject to a borrowing base formula. The agreement governing the amended asset-based revolving loan facility also allows us to incur additional other indebtedness. The indentures governing the senior secured floating rate notes and the senior subordinated notes contain some limitations on the ability of Duane Reade Inc., Duane Reade GP and their restricted subsidiaries to incur indebtedness; however, those indentures may not prohibit those entities from incurring additional indebtedness. There is no restriction on the ability of Duane Reade Holdings, Inc. to incur indebtedness. If new indebtedness is added to our and our subsidiaries' current indebtedness levels, the related risks that we and they now face would intensify.

The agreements governing our indebtedness include restrictive and financial covenants that may limit our operating and financial flexibility.

        The indenture governing the senior secured floating rate notes, the agreement governing the amended asset-based revolving loan facility and the indenture governing the senior subordinated notes contain covenants that, among other things, restrict our ability to take specific actions, even if we

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believe them to be in our best interest. These include restrictions on the ability of Duane Reade Inc., Duane Reade GP and their restricted subsidiaries to:

    incur additional indebtedness;

    pay dividends or distributions on, or redeem or repurchase, capital stock;

    incur certain liens;

    prepay, redeem or repurchase specified indebtedness;

    merge, consolidate or sell assets or enter into other business combination transactions;

    make acquisitions, capital expenditure investments or other investments;

    enter into transactions with affiliates;

    enter into sale-leaseback transactions;

    use proceeds from sale of assets;

    permit restrictions on the payment of dividends by their subsidiaries;

    impair the collateral; and

    change their business.

        In addition, the agreement governing the amended asset-based revolving loan facility contains a single fixed charge coverage requirement which only becomes applicable when borrowings exceed 90 percent of the borrowing base, as defined in the agreement governing the amended asset-based revolving loan facility. Borrowings under the amended asset-based revolving loan facility have not exceeded 90 percent of the borrowing base and, as a result, the fixed charge covenant has not become applicable. There are no credit ratings related triggers in the amended asset-based revolving loan facility that would impact the cost of borrowing, annual amortization of principal or related indebtedness maturity.

Issues affecting financial institutions could adversely affect financial markets generally as well as our ability to raise capital or access liquidity.

        Factors that we cannot control, such as disruption of the financial markets or negative views about the financial services industry generally could impair our ability to raise necessary funding. The creditworthiness of many financial institutions may be closely interrelated as a result of credit, derivative, trading, clearing or other relationships between the institutions. As a result, concerns about, or a default or threatened default by, one institution could lead to significant market-wide liquidity and credit problems, losses or defaults by other institutions. This may adversely affect the financial institutions, such as banks and insurance providers, with which we interact on a daily basis, and therefore could adversely affect our ability to raise needed funds or access liquidity.

We are a company whose equity is not publicly traded and which is effectively controlled by a single stockholder. That stockholder may effect changes to our board of directors, management and business plan, and interests of that stockholder may conflict with the interests of our noteholders.

        Duane Reade Shareholders owns approximately 99.2% of the outstanding shares of our common stock. Oak Hill owns a majority of the voting membership interests in Duane Reade Shareholders. See "Item 6. Selected Financial Data."

        Accordingly, Oak Hill indirectly beneficially owns a majority of our outstanding shares of common stock and can determine the outcomes of the elections of members of our board of directors and the outcome of corporate actions requiring stockholder approval, including mergers, consolidations and the sale of all or substantially all of our assets. Oak Hill also controls our management, policies and

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financing decisions and is in a position to prevent or cause a change of control. The interests of Oak Hill could conflict with those of our public debt holders. For example, if we encounter financial difficulties or are unable to pay our debts as they come due, the interests of Oak Hill as an equity holder might conflict with the interests of our noteholders. Oak Hill may have an interest in pursuing acquisitions, divestitures or financings or other transactions that, in its judgment could enhance its equity investment, even though such transactions may involve significant risks to our noteholders. In addition, Oak Hill and its affiliates may in the future own interests in businesses that compete with ours.

ITEM 2.    PROPERTIES

        As of December 27, 2008, we were operating stores in the following locations:

 
  No. of
Stores
 

Manhattan, NY

    148  

Brooklyn, NY

    31  

Queens, NY

    27  

Bronx, NY

    11  

New Jersey

    11  

Staten Island, NY

    8  

Nassau County, NY

    8  

Westchester County, NY

    6  

Suffolk County, NY

    1  
       

Total

    251  
       

        All of our stores operated at December 27, 2008 are leased. The average remaining lease term for stores operating as of December 27, 2008 is 8.9 years, which does not include the exercise of lease renewal options available to us. The exercise of the lease renewal options available to us would increase the average remaining lease term to 13.0 years. The following table sets forth the lease expiration dates of our leased stores on an annual basis through 2013 and thereafter. Of the 59 stores with leases expiring by December 31, 2013, 27 have renewal options. During the first quarter of the 2009 fiscal year, we entered into new leases for two of the four leases that were scheduled to expire in 2009. For all of our store locations, we believe that we will be able to either renew the expiring leases on economically favorable terms or find other economically attractive locations to lease.

Year
  No. of Leases
Expiring
  Number With
Renewal Options
 

2009

    4     0  

2010

    6     0  

2011

    10     3  

2012

    15     8  

2013

    24     16  

Thereafter

    192     90  

        We occupy approximately 70,000 square feet for our corporate headquarters, located in Manhattan, New York City, under a lease that expires in 2012. We have a renewal option to extend the lease for an additional five years beyond the initial expiration date.

        We occupy approximately 506,000 square feet of warehouse space in Maspeth, Queens, New York City under a lease that expires in 2017.

        We occupy approximately 114,000 square feet of warehouse space in North Bergen, New Jersey under a lease that expires in 2018.

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ITEM 3.    LEGAL PROCEEDINGS

        We are party to legal actions arising in the ordinary course of business. Based on information presently available to us, we believe that the ultimate outcome of these actions will not have a material adverse effect on the financial position, results of operations or cash flows of our company. In addition, we are a party to the following legal actions and matters:

        During 2002, we initiated a legal action against our former property insurance carrier, in an attempt to recover what we believed to be a fair and reasonable settlement for the business interruption portion of our claim originating from the September 11, 2001 World Trade Center terrorist attack, during which our single highest volume and most profitable store was completely destroyed. After a lengthy litigation and appraisal process, an appraisal panel awarded us approximately $5.6 million (in addition to the $9.9 million that was paid by the insurer to us in 2002). As a result of the insurer's refusal to pay this amount and also as a result of the Second Circuit Court of Appeals' interpretation of our insurance policy, in January 2007, we commenced another action in the U.S. District Court for the Southern District of New York to recover both the appraisal panel's award and additional amounts under the policy. In August 2007, the District Court entered judgment in the amount of $0.8 million plus interest, and both parties appealed. The appeals have been briefed and oral argument in the Second Circuit Court of Appeals has been held. However, due to the inherent uncertainty of litigation, there can be no assurance that this appeal will be successful.

        Accordingly, given the risks and uncertainties inherent in litigation, there can be no definitive assurance that we will actually receive any or all of the panel's appraised value of this claim, and we have not recognized any income related to this matter, other than $9.4 million of the original $9.9 million paid by the insurer in 2002. It should be noted that any payment to us that might be forthcoming as a result of this claim may also result in the incurrence of additional expenses that are contingent upon the amount of such insurance claim settlement. These expenses, if incurred, are not expected to exceed $4.0 million.

        In November 2004, we were served with a purported class action complaint, Damassia v. Duane Reade Inc. The lawsuit was filed in the U.S. District Court for the Southern District of New York. The complaint alleges that, from the period beginning November 1998, we incorrectly gave some employees the title "Assistant Manager," in an attempt to avoid paying these employees overtime, in contravention of the Fair Labor Standards Act and New York law. In May 2008, the court certified this case as a class action. In April 2006, we were served with a purported class action complaint, Chowdhury v. Duane Reade Inc. and Duane Reade Holdings, Inc. The complaint alleges that, from a period beginning March 2000, we incorrectly classified certain employees in an attempt to avoid paying overtime to such employees, thereby violating the Fair Labor Standards Act and New York law. In May 2008, the court certified this case as a class action. The complaint seeks an unspecified amount of damages. In January 2009, we announced that, without admitting liability, we have entered into a Memorandum of Understanding to settle these two class action cases for $3.5 million. The settlement is subject to the approval of the U.S. District Court for the Southern District of New York. While we believe that we can strongly defend ourselves against the matters involved in this litigation, we have agreed to this settlement so that we may avoid future defense costs and uncertainty surrounding this litigation. As a result of this settlement agreement, we recorded a $3.5 million one-time, pre-tax charge for the fourth quarter ended December 27, 2008.

        In November 2007, we were served with a subpoena from the Office of the Attorney General of the State of New York. The subpoena requested information regarding our services to customers with limited English proficiency. We are cooperating with the Office of the Attorney General and believe this matter will be settled on terms acceptable to us. Should this matter not be settled, we believe that we have valid defenses to any claims that may be made against us and we will vigorously defend ourselves.

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        In January 2008, we were served with a subpoena from the Department of Health and Human Services, Office of the Inspector General. The subpoena seeks information relating to the operation of our pharmacy kiosks and information relating to a business relationship that we had with Mobility Plus, a provider of durable medical equipment. In February 2008, we received an identical subpoena from the Office of the Attorney General of the State of New York, Medicaid Fraud Control Unit. We are in the process of responding to the information requests from both entities. While we believe that we have been in compliance with all applicable rules and regulations, at this stage, there can be no assurance as to the ultimate outcome of this matter.

Proceedings Relating to Anthony J. Cuti

        On September 1, 2006, Anthony J. Cuti, a former Chairman, President and Chief Executive Officer of the Company, initiated an arbitration before the American Arbitration Association against Duane Reade Inc., Duane Reade Holdings, Inc. and Duane Reade Shareholders, LLC, which we refer to as the "respondents." The arbitration relates to his termination in November 2005. Mr. Cuti asserts various claims including, with respect to his employment agreement, breach of contract relating to the notice of termination provision, failure to make certain payments toward his 1998 corporate-owned life insurance policy, relief from the non-competition and non-solicitation covenants, failure to provide adequate information relating to the valuation of his profits interest and breach of the covenant of good faith and fair dealing. Other claims relate to the patent rights for our virtual pharmacy kiosk system and payment of an alleged deferred 2001 bonus based on any insurance recovery we may obtain on our business interruption claim in connection with the 2001 World Trade Center tragedy. On March 16, 2007, Mr. Cuti sought leave to file an amended demand asserting additional allegations in support of his claim for breach of contract for failure to comply with the notice of termination provision in his employment agreement, and a claim for defamation. On May 17, 2007, the arbitrator issued an order granting leave to file Mr. Cuti's amended demand. Mr. Cuti seeks monetary damages, declaratory relief, rescission of his employment agreement and the payment of his legal costs and fees associated with his termination and the arbitration.

        On November 22, 2006, the respondents filed counterclaims and affirmative defenses against Mr. Cuti in the arbitration, alleging that between 2000 and 2005, Mr. Cuti was responsible for improper practices involving invoice credits and rebillings for the construction of our stores, that led to overstating our publicly reported earnings, and that caused us to create and maintain inaccurate records and publish financial statements containing misstatements. These counterclaims were based on information uncovered as of that date by an investigation conducted by independent legal counsel and forensic accountants at the direction of the Audit Committee.

        In a press release dated April 2, 2007, we disclosed that, based on new information provided to us, the Audit Committee, with the assistance of independent counsel and forensic accountants, was conducting a review and investigation concerning the propriety of certain real estate transactions and related matters and whether the accounting for such transactions was proper. On April 9, 2007, the respondents sought leave to file proposed amended counterclaims based on that new information. On May 17, 2007, the arbitrator issued an order granting leave to file the amended counterclaims. The amended counterclaims seek rescission of employment agreements entered into between us and Mr. Cuti, return of all compensation paid under the employment agreements, other compensatory and punitive damages, and legal costs and fees associated with the Audit Committee's investigation and the arbitration.

        On May 18, 2007, the independent counsel and the forensic accountants completed their review and investigation. The independent counsel concluded that Mr. Cuti orchestrated certain real estate and other transactions that led to overstating our publicly reported earnings, and that caused us to create and maintain inaccurate records and publish financial statements containing misstatements. On May 22, 2007, the Audit Committee determined, after considering the results of the review and

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investigation, that certain of our previously-issued financial statements would have to be restated. We filed the necessary restated financial statements for the periods affected.

        On May 22, 2007, we received a grand jury subpoena from the United States Attorney's Office for the Southern District of New York seeking documents relating to the allegations in the amended counterclaims discussed above. We have cooperated fully with the investigation. The SEC also requested that we provide it with information related to this matter.

        On May 25, 2007, the United States Attorney's Office for the Southern District of New York filed an application requesting that the arbitrator stay further proceedings in the arbitration, including discovery, pending further developments in its criminal investigation of Mr. Cuti. Following briefing by the parties on the application, the arbitrator entered an order staying the arbitration proceedings. The stay has been extended from time to time.

        On October 9, 2008, the United States Attorney's Office for the Southern District of New York and the SEC announced the filing of criminal and civil securities fraud charges against Mr. Cuti and another former executive of the Company, William Tennant. In the criminal indictment, the government charges that Mr. Cuti and Mr. Tennant engaged in a scheme, involving the credits and rebillings and real estate-related transactions discussed above, to falsely inflate the income and reduce the expenses that we reported to the investing public and others. The SEC's complaint similarly alleges that Mr. Cuti and Mr. Tennant entered into a series of fraudulent transactions designed to boost reported income and enable us to meet quarterly and annual earnings guidance. Both proceedings are continuing.

ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

        During fiscal 2008, we did not submit any matters to a vote of our security holders.

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PART II

ITEM 5.    MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

        As a result of the Acquisition, we have no publicly traded common stock and we have not paid dividends on our common stock since the Acquisition. We currently do not have any intention to pay a dividend on our common stock.

ITEM 6.    SELECTED FINANCIAL DATA

        The Selected Financial Data presented below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Audited Financial Statements and the notes related to those statements contained herein.

        Duane Reade Holdings, Inc. was formed in December 2003 to acquire Duane Reade Inc. and its subsidiaries. Approximately 99% of the common stock of Duane Reade Holdings, Inc. is owned by Duane Reade Shareholders, LLC, a parent entity also established to effectuate the Acquisition. The Acquisition was completed on July 30, 2004 through the merger of Duane Reade Acquisition (a wholly-owned subsidiary of Duane Reade Holdings, Inc.) into Duane Reade Inc., with Duane Reade Inc. being the surviving entity and a wholly-owned subsidiary of Duane Reade Holdings, Inc. after the merger transaction. As a result of the Acquisition and resulting change in control and change in historical cost basis of accounting, the operating results are presented separately for the predecessor period December 28, 2003 through July 30, 2004 and the successor periods following the closing date of the Acquisition (July 31, 2004 through December 25, 2004 and the fiscal years ending December 31, 2005, December 30, 2006, December 29, 2007 and December 27, 2008). The predecessor period financial statements include Duane Reade Inc. and all its subsidiaries and the successor period financial statements include Duane Reade Holdings, Inc. and all its subsidiaries. Duane Reade Holdings, Inc. had nominal activity and no operations prior to the completion of the Acquisition. Except where the context otherwise requires, all references to "we," "us," and "our" (and similar terms) in the data below and the related footnotes mean the successor for periods ending after July 30, 2004 and the predecessor for periods ending on or prior to July 30, 2004.

        The summary historical consolidated financial and other data set forth below as of and for the periods from December 28, 2003 to July 30, 2004 and from July 31, 2004 to December 25, 2004 and for the fiscal years ended December 31, 2005, December 30, 2006, December 29, 2007 and December 27,

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2008 have been derived from our audited consolidated financial statements. The dollar amounts shown in the table below are in thousands.

 
  Successor   Predecessor  
 
   
   
   
   
  Period from
July 31, 2004
through
December 25,
2004(2)
  Period from
December 28,
2003 through
July 30,
2004(2)
 
 
  Fiscal Year(1)  
 
  2008   2007   2006   2005  

Statement of Operations Data

                                     

Net sales

  $ 1,774,029   $ 1,686,752   $ 1,584,778   $ 1,589,451   $ 670,568   $ 927,801  

Cost of sales(3)

    1,227,129     1,176,376     1,108,727     1,135,596     485,961     668,271  
                           

Gross profit(3)

    546,900     510,376     476,051     453,855     184,607     259,530  

Selling, general & administrative expenses

    476,574     446,696     426,532     425,931     162,067     219,970  

Transaction expenses(4)

                681     37,575     3,005  

Labor contingency expense (income)(5)

            (18,004 )   4,400     1,789     2,611  

Depreciation and amortization

    68,539     73,080     71,932     70,594     27,009     21,396  

Store pre-opening expenses

    797     600     305     364     365     470  

Gain on sale of pharmacy files

        (1,337 )                

Other(6)

    16,808     15,948     14,747     31,761     26,433      
                           

Operating (loss) income

    (15,818 )   (24,611 )   (19,461 )   (79,876 )   (70,631 )   12,078  

Interest expense, net

    54,915     60,977     56,947     50,004     15,880     7,977  

Debt extinguishment(7)

                    7,525      
                           

(Loss) income before income taxes

    (70,733 )   (85,588 )   (76,408 )   (129,880 )   (94,036 )   4,101  

Income tax (expense) benefit

    (2,045 )   (2,192 )   (2,956 )   29,492     36,499     (1,046 )
                           

Net (loss) income

    (72,778 ) $ (87,780 ) $ (79,364 ) $ (100,388 ) $ (57,537 ) $ 3,055  
                           

Balance Sheet Data (at end of period)

                                     

Working capital (deficit)(8)

  $ (13,316 ) $ 8,611   $ 6,204   $ 50,384   $ 67,073     N/A  

Total assets

    712,600   $ 742,489   $ 798,581   $ 869,602   $ 953,918     N/A  

Total debt and capital lease obligations

  $ 555,652   $ 555,853   $ 572,464   $ 554,222   $ 511,690     N/A  

Stockholders' equity (deficit)

  $ (146,701 ) $ (73,323 ) $ 2,737   $ 81,834   $ 181,961     N/A  

Operating and Other Data

                                     

Net cash (used in) provided by operating activities

  $ 44,317   $ 19,271   $ 11,616   $ 3,004   $ (11,561 ) $ 20,694  

Net cash used in investing activities

  $ (47,001 ) $ (41,921 ) $ (29,070 ) $ (26,629 ) $ (437,249 ) $ (31,619 )

Net cash provided by financing activities

    2,734   $ 22,635   $ 17,487   $ 23,658   $ 448,801   $ 11,011  

Number of stores at end of period

    251     242     248     251     255     N/A  

Same store sales growth(9)

    4.2 %   7.4 %   4.6 %   1.9 %   0.6 %   N/A  

Pharmacy same store sales growth(9)

    3.1 %   5.9 %   2.6 %   0.8 %   5.0 %   N/A  

Front-end same store sales growth(9)

    5.0 %   8.6 %   6.2 %   2.8 %   -2.8 %   N/A  

Average store size (selling square feet) at end of period

    6,764     6,813     6,987     6,955     7,035     N/A  

Sales per square foot

  $ 1,010   $ 975   $ 881   $ 862   $ 813     N/A  

Pharmacy sales as a % of net sales(10)

    46.1 %   46.0 %   46.5 %   48.1 %   51.0 %   N/A  

Third party plan sales as a % of prescription sales

    93.4 %   93.0 %   92.8 %   92.7 %   92.3 %   N/A  

Investing Activities:

                                     

Purchase of Duane Reade

  $   $   $   $   $ 413,684   $  

New, remodeled and relocated stores

    29,700     23,584     14,104     14,056     11,803     17,214  

Acquisitions

    1,177     1,342         2,437     7,361     8,741  

Asset proceeds

    (525 )   (3,335 )   (2,500 )   (7,069 )        

Other

    16,649     20,330     17,466     17,205     4,401     5,664  
                           

Total

  $ 47,001   $ 41,921   $ 29,070   $ 26,629   $ 437,249   $ 31,619  
                           

(1)
The 2005 fiscal year contains 53 weeks. All other fiscal years shown contain 52 weeks.

(2)
Statistics shown in the successor period reflect data for the 12 months ended December 25, 2004, as we do not provide these statistics on a partial year basis. Items identified as N/A are not reported by us for the 2004 predecessor period.

(3)
Shown exclusive of depreciation expense for our distribution centers which is included in the separate line item captioned depreciation and amortization.

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(4)
We incurred pre-tax expenses of approximately $0.7 million in fiscal 2005, $37.6 million in the period from July 31, 2004 through December 25, 2004 and $3.0 million in the period from December 28, 2003 through July 30, 2004 related to the Acquisition.

(5)
We recognized pre-tax income of $18.0 million in fiscal 2006 and incurred pre-tax charges of $4.4 million in fiscal 2005, $1.8 million in the period from July 31, 2004 through December 25, 2004 and $2.6 million in the period from December 28, 2003 through July 30, 2004 in connection with the recognition and subsequent resolution of a National Labor Relations Board decision in a litigation matter relating to our collective bargaining agreement with one of our former unions.

(6)
Note 16 to the consolidated financial statements provides a detailed explanation of these charges.

(7)
We incurred pre-tax expenses of approximately $7.5 million in the period from July 31, 2004 to December 25, 2004 related to the retirement of a portion of our debt.

(8)
For the successor periods ended December 27, 2008, December 29, 2007, December 30, 2006, December 31, 2005 and December 25, 2004, working capital (deficit) reflects the classification of our asset-based revolving loan facility as a current liability, rather than as long-term debt, because cash receipts controlled by the lenders are used to reduce outstanding debt, and we do not meet the criteria of SFAS No. 6, "Classification of Short-Term Obligations Expected to be Refinanced—An Amendment of ARB No. 43, Chapter 3A," to classify the debt as long-term. At such dates, the revolving loan balance was $144.6 million, $141.4 million, $157.1 million, $135.7 million and $153.9 million, respectively.

(9)
Same-store sales figures include stores that have been in operation for at least 13 months.

(10)
Includes resales of certain retail inventory.

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ITEM 7.   MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

        The following discussion regarding our financial condition and results of operations for the 52 weeks ended December 27, 2008, December 29, 2007 and December 30, 2006 should be read in connection with the more detailed financial information contained in our consolidated financial statements and their notes included elsewhere in this annual report. Certain of the statements in this section are forward-looking statements and involve numerous risks and uncertainties including, but not limited to, those described in "Item 1A. Risk Factors." See also "Special Note Regarding Forward-Looking Statements."

        The following Management's Discussion and Analysis of Financial Condition and Results of Operations is organized as follows:

    Executive Summary—This section provides a general description of our business, including opportunities, risks and uncertainties that we focus on in the operation of our business, a brief discussion of the considerations related to operating in the New York City marketplace and describes the impact of our acquisition on July 30, 2004.

    Results of Operations—This section provides an analysis of the significant line items on the consolidated statements of operations.

    Liquidity and Capital Resources—This section provides an analysis of our working capital position, liquidity, cash flows, sources and uses of cash, contractual obligations and other factors influencing our liquidity.

    Critical Accounting Policies and Estimates—This section discusses those accounting policies that are considered important to our financial condition and results of operations, and which require us to exercise subjective or complex judgments in their application. In addition, this section discusses the impact of recently issued accounting pronouncements.

Executive Summary

General Description

        Our business consists of the sale of a wide variety of health and beauty care products, convenience oriented food and general merchandise items and a pharmacy operation managed to supply customers with their prescription needs. We refer to the non-prescription portion of our business as front-end sales because most of these sales are processed through the front check-out sections of our stores. This portion of our business consists of brand name and private label health and beauty care items, food and beverages, tobacco products, cosmetics, housewares, greeting cards, photofinishing services, photo supplies, seasonal and general merchandise and other products for our customers' daily needs. Health and beauty care products, including over-the-counter items, represent our highest volume categories within front-end sales. The front-end portion of our business represented 53.9% and 54.0% of our sales in fiscal 2008 and fiscal 2007, respectively, and is characterized by generally higher gross margins as compared to our pharmacy or back-end business.

        Because of our numerous convenient locations in high-traffic commercial and residential areas and the lack of other convenience-oriented retailers in our core market areas, our front-end business is generally a larger proportion of our total sales than for other major conventional drugstore chains, whose front-end sales average between 30% and 40% of total sales. Over the last few years, pharmacy sales have experienced a slower rate of growth primarily due to increases in third party plan co-payments, reduced sales of hormonal replacement drugs and certain arthritis medications, reduced third party reimbursement rates resulting from changes in regulations or cost-saving measures, limitations on maximum reimbursements for certain generic medications by third party plans, increases in the percentage of sales represented by lower-priced generic medications and increased penetration

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by mail order and internet-based pharmacies. Our pharmacy sales include all items we sell by prescriptions filled at our retail locations or deliver direct to customers. In addition, we include in our pharmacy sales certain resales of retail pharmaceutical inventory. Sales processed through third party, private and government-sponsored plans that contract with us as an authorized provider of prescriptions represented 93.4% of our prescription sales in 2008 and 93.0% of our prescription sales in 2007.

        The Medicare Modernization Act created a Medicare Part D benefit that expanded Medicare coverage of prescription drugs for senior citizens as well as for certain "dual eligible" individuals that were previously covered under state administered Medicaid plans. This Medicare coverage has resulted in decreased pharmacy margins resulting from lower reimbursement rates than our current margins on state Medicaid prescriptions. The Medicare Part D program has grown rapidly since taking effect in 2006. The program's growth may continue as more seniors have become eligible and enroll for the coverage. While the program has had an adverse impact on our pharmacy margins, we expect that increased utilization of prescription drugs by senior citizens participating in the new programs who previously were cash paying customers will partially offset the effect of the lower margins, although we are not certain this will be the case. The Medicare Part D program represented approximately 13% of our retail pharmacy sales for the year ended December 27, 2008 and 12% of our retail pharmacy sales for the year ended December 29, 2007.

        State Medicaid programs which provide prescription benefits to low income households and individuals represented approximately 14% of our retail pharmacy sales in 2008 and 2007. Over the past several years, New York State reduced Medicaid and EPIC prescription reimbursement rates, and increased the number of generic drugs subject to maximum allowable cost reimbursement limits, adversely impacting our pharmacy gross margins. Under the Medicaid guidelines, providers cannot refuse to dispense prescriptions to Medicaid recipients who claim they do not have the means to pay the required co-payments. Most Medicaid recipients do in fact decline to make the co-payments, resulting in the requirement for the provider to absorb this cost. The current economic downturn may result in additional reductions in New York Medicaid prescription reimbursements. Budget proposals for New York State in 2009 currently include reductions in the reimbursements for pharmacies in the Medicaid and EPIC programs. The State of New Jersey is also proposing Medicaid reductions in their 2009 budget proposals. Neither state has approved their final budget proposals, and while it is highly likely that there will ultimately be further reductions in reimbursements, the economic stimulus package recently passed by Congress and signed into law by President Obama could provide states with additional Medicaid funding and may reduce the extent of each state's proposed reductions in Medicaid reimbursements. Under the economic stimulus package, over $80 billion would be allocated to help states with Medicaid. In addition, the economic stimulus package includes provisions to subsidize health care insurance premiums for the unemployed under the COBRA program and provisions that will aid states in defraying budget cuts.

        In July 2007, the Centers for Medicare & Medicaid Services, or CMS, issued a final rule that may negatively affect our level of reimbursements for certain generic drugs by setting an upper limit on the amount of reimbursement for such drugs based on the "Average Manufacturer Price." As a result of a lawsuit brought by the National Association of Chain Drug Stores and the National Community Pharmacists Association to challenge the implementation of the new rule, a federal court temporarily enjoined the implementation of the new rule pending the outcome of the lawsuit and the lawsuit remains pending. In July 2008, Congress enacted H.R. 6331, the Medicare Improvements for Patients and Providers Act of 2008 ("MIPPA"). The former President Bush subsequently vetoed MIPPA and, on July 15, 2008, Congress overrode the veto. MIPPA delayed the implementation of the use of Average Manufacturer Price with respect to payments made by State Medicaid Plans for multiple source generic drugs until September 30, 2009. MIPPA also prohibited the Secretary of Health and Human Services from making public any Average Manufacturer Price information that was previously disclosed to the Secretary of Health and Human Services. The outcome of the lawsuit and the impact of MIPPA are

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uncertain at this time, so we currently are unable to determine what effect the new rule will ultimately have on our business. See "Item 1. Business—Company Operations—Pharmacy."

        In October 2006, in connection with a class action filed in the United States District for the District of Massachusetts, First Data Bank, which is one of two primary sources of AWP price reporting, announced that it had entered into a settlement agreement related to its reporting of average wholesale prices, subject to final court approval. Under the terms of the proposed settlement agreement, First Data Bank agreed to reduce the reported AWP of certain drugs by four percent and to discontinue the publishing of AWP at a future time. In May 2007, in connection with a separate class action filed in the same court, Medi-Span, the other primary source of average wholesale price reporting, entered into a similar settlement agreement, also subject to final court approval.

        In January 2008, the court denied approval of the First Data Bank and Medi-Span settlements as proposed. Subsequently, new settlement agreements were submitted to the court. On March 17, 2009, the court issued an order approving the revised settlements. Pursuant to the settlements, as approved, First Data Bank and Medi-Span have agreed to reduce the reported AWP for certain drugs by four percent. Separately, and not pursuant to the settlement agreements, First Data Bank and Medi-Span have indicated that they will also reduce the reported AWP for a large number of additional drugs not covered by the settlement agreements and that they intend to discontinue the reporting of AWP in the future. Under the terms of the court's decision, the settlement agreements can become effective no earlier than 180 days from the entry of final judgment. Although the court's ruling will take effect no earlier than 180 days from March 17, 2009, we believe that some parties will appeal the court's ruling and seek a stay of the implementation of the settlement. The court's ruling, if not revised on appeal, could potentially have a significant adverse impact on us and the drugstore industry as a whole.

        A number of contracts with third-party plans contain provisions that allow us to adjust our pricing to maintain the relative economics of the contract in light of a change in AWP methodology. Most of our contracts with both private and governmental plans also include provisions that allow us to terminate the contracts unilaterally, either because parties cannot renegotiate our pricing to account for the change in AWP methodology or for any reason upon 30 to 90 days' notice. While we expect to negotiate with the various governmental and non-governmental third-party plans for adjustments relating to the expected changes to AWP, we cannot be certain that these negotiations will be successful. Due to these factors and the uncertainty over future appeals or stays of the court ruling, which could delay the effective date of the implementation of the settlement agreements, we cannot predict with certainty or accurately quantify the ultimate effect of the AWP reduction on our revenues, profitability, future operations or business relationships.

        In an effort to offset some of the adverse pharmacy gross margin impacts from the trends discussed above, there has been an intensified effort on the part of retailers to support increased utilization of lower priced but higher margin generic prescriptions in place of branded medications. New generic drug introductions have also enabled retailers to increase the proportion of generic prescriptions to total prescriptions dispensed. Improved generic utilization rates as well as a combination of direct purchases and contractual wholesaler purchases enabled us to partially offset the adverse margin impact of Medicare Part D and reduced state Medicaid reimbursement rates during 2008 and 2007. In addition, we believe that the higher volume of pharmacy sales to third party plan customers help to offset the related lower gross profit margins and allows us to leverage other fixed store operating expenses. We believe that increased third party plan sales also generate additional general merchandise sales by increasing customer traffic in our stores. As of December 27, 2008, we had contracts with over 370 third party plans, including virtually all major third party plans in our market areas. During fiscal 2008, New York Medicaid represented approximately 14% and 6% of our retail pharmacy and net retail store sales, respectively.

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        We are also impacted by legislation to increase the minimum hourly wages. New York State increased the minimum hourly wage from $5.15 to $6.00 on January 1, 2005, to $6.75 on January 1, 2006, and again to $7.15 on January 1, 2007. New Jersey increased the minimum hourly wage from $5.15 to $6.15 on October 1, 2005 and again to $7.15 on October 1, 2006. In addition, the federal minimum hourly wage was increased to $6.55 in July 2008 and the U.S. Congress passed legislation that will result in a federal minimum hourly wage increase to $7.25 in July 2009. While these increases have impacted our cost of labor, we have, and believe we can continue to, offset a significant portion of these cost increases through initiatives designed to further improve our labor efficiency.

        We operate approximately 90% of our 251 stores in New York City and the remainder in the surrounding areas, and our financial performance is therefore heavily influenced by the local economy. We analyze a number of economic indicators specific to New York City to gauge the health of this economy, including unemployment rates, job creation, gross city product, hotel occupancy rates and bridge and tunnel commuter traffic volumes. We also analyze market share data, same-store sales trends, average store sales and sales per square foot data among other key performance indicators to monitor our overall performance.

        Our primary assets are our ownership of 100% of the outstanding capital stock of Duane Reade Inc., which in turn owns 99% of the outstanding partnership interest of Duane Reade GP and all of the outstanding common stock of DRI I Inc. DRI I Inc. owns the remaining 1% partnership interest in Duane Reade GP. Substantially all of our operations are conducted through Duane Reade GP. In August 1999, we established two new subsidiaries, Duane Reade International, Inc. and Duane Reade Realty, Inc. Duane Reade GP distributed to Duane Reade Inc. and DRI I Inc. all rights, title, and interest in all its trademarks, trade names and all other intellectual property rights. In turn, Duane Reade Inc. and DRI I Inc. made a capital contribution of these intellectual property rights to Duane Reade International. This change created a controlled system to manage and exploit these intellectual property rights separate and apart from the retail operations. In addition, Duane Reade GP distributed some of its store leases to Duane Reade Inc. and DRI I Inc., which in turn made a capital contribution of these leases to Duane Reade Realty. Duane Reade Realty is the lessee under certain store leases entered into after its creation. Duane Reade Realty subleases to Duane Reade GP the properties subject to those leases.

Considerations Related to Operating in the New York City Marketplace

        All of our operations are conducted within the New York greater metropolitan area. As a result, our performance will be substantially affected by economic conditions and other factors affecting the region such as the regulatory environment, unemployment levels, cost of energy, real estate, insurance, taxes and rent, weather, demographics, availability of labor, financial markets and geopolitical factors such as terrorism.

        Since the second half of 2004, the New York City economy began a gradual improvement over the economic downturn experienced in the aftermath of the 2001 World Trade Center attack to the point where it had essentially achieved a full recovery by the latter part of 2006. Strength in employment rates, tourism and overall commerce continued throughout 2007. In 2008, economic conditions worsened considerably, particularly so during the fourth quarter, and the level of national economic activity as measured by a number of recent key economic indicators has shown that the economy entered into a recession in 2008. The financial services industry, which is highly concentrated in the New York City marketplace, experienced significant difficulties during 2008. The total unemployment rate for New York City increased 2.4% from 4.8% in December 2007 to 7.2% in December 2008. This represents the highest level of unemployment in New York City since April 2004. The national rate of unemployment increased 2.3% from 4.9% in December 2007 to 7.2% in December 2008.

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        Furthermore, because most of our stores are located in the highly urbanized areas throughout New York City and the surrounding metropolitan area, our stores experience a higher rate of shrink than our national competitors.

        Our sales and profitability have in the past been affected by events and other factors that affect New York City. Examples include smoking-ban legislation, the August 2003 Northeast power blackout, significant non-recurring increases in real estate taxes and insurance costs and the 2004 Republican National Convention. In 2005, our results were negatively affected by increased labor costs associated with the ongoing shortage of pharmacists in the New York City metropolitan area and increases in New York state and to a lesser extent New Jersey state minimum wage rates. We have continued to experience cost pressures from increased pharmacist salary and benefit costs as well as further increases in minimum wage rates. Any increases in federal taxes or in city or state taxes in New York City or the Tri-State Area resulting from state or local government budget deficits may further reduce consumers' disposable income, which could have a further negative impact on our business. Any other unforeseen events or circumstances that affect the New York City metropolitan area could also materially adversely affect our revenues and profitability.

        In addition, perceived instability in our business and in the financial health of New York City and the surrounding areas may negatively affect our relations with our suppliers and trade creditors. As a result, our suppliers or trade creditors may present us with terms that are materially more disadvantageous to us than those we currently enjoy, which may have a negative impact on our ability to operate our business and manage our liquidity.

Certain Line Items Presented

        Net sales:    Net sales include all front-end and pharmacy sales as well as certain resales of retail pharmaceutical inventory that are required to be reported on a gross basis in accordance with Emerging Issues Task Force Issue No. 99-19, "Reporting Revenue Gross as a Principal versus Net as an Agent". We refer to net sales excluding such resale activity as "net retail sales" and pharmacy sales excluding such resale activity as "pharmacy net retail sales." "Same-store sales" represent sales for stores that have been open for at least 13 months and exclude any resale activity.

        Cost of goods sold:    Cost of goods sold includes all costs of products sold, net of any promotional income or rebates received from manufacturers or wholesalers. Cost of goods sold is shown exclusive of depreciation and amortization expense for our distribution centers. Shrink losses are also recorded in cost of goods sold.

        Selling general & administrative expenses:    SG&A includes employee wages and related costs, professional fees, store occupancy costs, advertising expenses, credit card fees and all other store and office-related operating expenses. In addition, real estate-related income is included in store occupancy costs.

        Depreciation and amortization:    Depreciation and amortization consists primarily of depreciation of store fixtures and equipment and amortization of leasehold improvements as well as intangible assets, including pharmacy files and lease acquisition costs.

        Store pre-opening expenses:    These expenses primarily represent the labor costs we incur related to our employees performing various tasks associated with the opening of a new location.

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RESULTS OF OPERATIONS

2008 Overview

        For the 2008 fiscal year, we achieved net sales of $1.774 billion and incurred a net loss of $72.8 million, as compared to net sales of $1.687 billion and a net loss of $87.8 million in the 2007 fiscal year. The reduction in our net loss for the 2008 fiscal year, as compared to fiscal 2007, was primarily attributable to the following factors:

    An increase in gross margin of $36.5 million, primarily attributable to increased sales, improved front-end selling margins resulting from improved assortments of higher margin products, increased pharmacy margins related to higher rates of generic utilization and reductions in the level of inventory shrink losses.

    A decrease in interest expense of $6.1 million that was primarily due to lower interest rates applicable to our variable rate debt and reduced levels of borrowing on our revolving credit facility.

    A decrease in non-cash depreciation and amortization expenses of $4.5 million in 2008. The decrease is primarily due to reduced amortization expense for certain intangible assets which became fully amortized.

The positive impact of the above items was partially offset by an increase in selling, general and administrative expenses of $29.9 million, primarily due to the following factors:

    An increase of $14.4 million for additional store payroll and related costs associated with an increased number of stores as well as wage and salary rate increases.

    An increase of $10.2 million in store occupancy costs related to new stores, relocations and reduced real estate related income.

    Higher general and administrative costs associated with a $3.5 million litigation settlement charge for two class action lawsuits and additional recruitment fees and relocation costs paid in connection with the hiring of senior management executives.

        The 2007 fiscal year also included a $1.3 million gain from the sale of several pharmacy prescription files, which did not recur in the 2008 fiscal year.

2007 Overview

        For the 2007 fiscal year, we achieved net sales of $1.687 billion and incurred a net loss of $87.8 million, as compared to net sales of $1.585 billion and a net loss of $79.4 million in the 2006 fiscal year. The increased net loss sustained in the 2007 fiscal year was primarily attributable to a pre-tax labor contingency credit of $18.0 million recorded in 2006 that resulted from the favorable settlement of the National Labor Relations Board (NLRB) litigation. Excluding the impact of this credit, our net loss would have declined by $9.6 million as compared to the 2006 fiscal year. Following are the other major factors impacting our results in fiscal 2007, compared to fiscal 2006:

    An increase in gross margin of $34.3 million, reflecting a continuation of the improved trend of increasing net sales and front-end margins exhibited over several quarters. These results were partially offset by reduced pharmacy margins resulting from lower margin Medicare Part D sales, and reductions in Medicaid reimbursement rates that went into effect in July 2007.

    An increase in selling, general and administrative expenses of $20.2 million, primarily reflecting increased pharmacist's labor costs, increases in minimum wage rates, union contract wage increases and payroll costs associated with additional corporate staffing to support the continued implementation of the Duane Reade Full Potential program.

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    The sale of several pharmacy prescription files in 2007 that resulted in a separately reported gain of $1.3 million.

    An increase in other expenses of $1.2 million in 2007, which consists of increases in our closed store costs of $4.3 million, expenses related to Mr. Cuti of $4.7 million and accounting investigation costs of $1.4 million. This was partially offset by a decrease in asset impairment charges of $9.3 million in 2007.

    An increase in non-cash depreciation and amortization expenses of $1.1 million in 2007. The increase is primarily due to the recent new store openings, renovations, and other capital spending in recent periods as well as the $1.0 million cumulative depreciation adjustment recorded in the third quarter of 2006 resulting from the Audit Committee's accounting investigations. For further discussion, see Note 2 of the notes to the consolidated financial statements.

    An increase in interest expense of $4.0 million that was primarily attributable to higher non-cash interest expense associated with the preferred stock offering completed during the second quarter of 2007.

    A decrease in the income tax provision of $0.8 million that was primarily attributable to a lower estimated effective tax rate.

        The following sets forth our results of operations in dollars (in thousands) and as a percentage of sales for the periods indicated.

 
  Fiscal Year
Ended
December 27, 2008
  Fiscal Year
Ended
December 29, 2007
  Fiscal Year
Ended
December 30, 2006
 
 
  Dollars   % of Sales   Dollars   % of Sales   Dollars   % of Sales  

Net sales

  $ 1,774,029     100.0 % $ 1,686,752     100.0 % $ 1,584,778     100.0 %

Cost of sales (exclusive of depreciation and amortization shown separately below)

    1,227,129     69.2 %   1,176,376     69.7 %   1,108,727     70.0 %
                           

Gross profit

    546,900     30.8 %   510,376     30.3 %   476,051     30.0 %

Selling, general and administrative expenses

    476,574     26.9 %   446,696     26.5 %   426,532     26.9 %

Labor contingency expense

        0.0 %       0.0 %   (18,004 )   -1.1 %

Depreciation and amortization

    68,539     3.9 %   73,080     4.3 %   71,932     4.5 %

Store pre-opening expenses

    797     0.0 %   600     0.0 %   305     0.0 %

Gain on sale of pharmacy files

        0.0 %   (1,337 )   -0.1 %       0.0 %

Other

    16,808     0.9 %   15,948     0.9 %   14,747     0.9 %
                           

Operating loss

    (15,818 )   -0.9 %   (24,611 )   -1.5 %   (19,461 )   -1.2 %

Interest expense, net

    54,915     3.1 %   60,977     3.6 %   56,947     3.6 %
                           

Loss before income taxes

    (70,733 )   -4.0 %   (85,588 )   -5.1 %   (76,408 )   -4.8 %

Income tax expense

    2,045     0.1 %   2,192     0.1 %   2,956     0.2 %
                           

Net loss

  $ (72,778 )   -4.1 % $ (87,780 )   -5.2 % $ (79,364 )   -5.0 %
                           

The Twelve Months Ended December 27, 2008 Compared to the Twelve Months Ended December 29, 2007

        Net sales were $1.77 billion in 2008 and $1.69 billion in 2007. The 2008 net sales increased by 5.2% as compared to the prior year net sales. Resale activity increased by $20.8 million as compared to

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2007, which represented a 1.2% increase in overall net sales, while net retail sales to customers increased by 4.1% over this same period. Total same-store sales in 2008 increased by 4.2% over the prior year.

        Pharmacy sales increased to $817.5 million in 2008 from $776.4 million in 2007, an increase of 5.3%, and represented 46.1% of total sales, as compared with 46.0% of total sales in 2007. Resale activity accounted for 2.7% of the pharmacy sales increase, while pharmacy net retail sales accounted for the remaining 2.6% of the increase. Pharmacy same-store sales increased by 3.1% from last year, and third-party reimbursed pharmacy sales represented 93.4% and 93.0% of total prescription sales in 2008 and 2007, respectively. The percentage of generic drugs dispensed increased by 3.9% over the prior year, negatively impacting the pharmacy same-store sales increase by approximately 3.7%, but contributing to an increase in gross margin per prescription dispensed. Generic drugs generally have lower retail sales prices but are more profitable for us than branded drugs. The switch of Zyrtec, a prescription allergy medication, to over-the-counter status negatively impacted pharmacy same-store sales by 0.4% during 2008.

        Front-end sales increased to $956.5 million in 2008 from $910.3 million in 2007, an increase of 5.1%, and represented 53.9% of total sales, as compared to 54.0% of total sales in 2007. Front-end same-store sales increased by 5.0%, due to improved merchandise offerings and the strong performance in the food and beverage categories, over-the-counter products and health and beauty items. The aforementioned switch of Zyrtec to over-the-counter status positively impacted front-end same-store sales by approximately 0.3% in 2008. Additionally, in June 2008 we raised the sales price on our cigarettes commensurate with an increase in cigarette excise taxes in New York State. Although such additional sales do not result in any additional profit to us, the June 2008 increase in the sales price on our cigarettes positively impacted front-end sales by 0.5%.

        As of December 27, 2008, we operated 251 stores, 15 of which were opened during fiscal 2008. We closed six stores in 2008. In fiscal 2007, we opened ten stores and we closed 16 stores.

        Cost of sales as a percentage of net sales was 69.2% and 69.7% in 2008 and 2007, respectively, resulting in gross profit margins of 30.8% and 30.3% in each respective period. The improved gross profit margin in 2008 reflects the impact of improved front-end selling margins due to improved assortments of higher margin products, increased pharmacy margins due to higher rates of generic utilization and reductions in the level of inventory shrink losses. These improvements were offset in part by a higher LIFO charge in 2008 and modestly reduced levels of vendor allowances. Cost of sales includes a LIFO provision of $4.0 million in 2008 as compared to a LIFO provision of $1.6 million in 2007.

        Selling, general and administrative expenses were $476.6 million, or 26.9% of net sales, and $446.7 million, or 26.5% of net sales, in 2008 and 2007, respectively. The increase in the 2008 expense percentage as compared to 2007 is primarily due to an increase of 0.2% in store occupancy costs related to new stores, relocations and reduced real estate related income, a 0.9% increase in store payroll and related costs associated with an increased number of stores, as well as wage and salary rate increases, and higher general and administrative costs associated with a $3.5 million litigation settlement for two class action lawsuits and additional recruitment and relocation fees paid in connection with the hiring of senior management executives. These items were partially offset by improved leveraging of costs against strong same-store sales growth in both pharmacy and front-end. Excluding the litigation settlement charge, selling, general and administrative expenses as a percentage of net sales were 26.7% in 2008.

        Depreciation and amortization of property and equipment and intangible assets decreased $4.5 million to $68.5 million in 2008, as compared to $73.1 million in 2007. The decrease in 2008 is due primarily to reduced amortization expense for certain intangible assets becoming fully amortized. The

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decrease was partially offset by the additional depreciation and amortization for the 15 stores opened during 2008.

        We incurred store pre-opening expenses of $0.8 million in 2008, attributable to the opening of 15 stores, as compared to $0.6 million in 2007, reflecting ten new stores opened during that period.

        The prior year period included a $1.3 million gain from the sale of several pharmacy prescription files, which did not recur in the current year.

        In 2008, we incurred other expenses of $16.8 million, including asset impairment charges ($7.7 million), costs associated with the closing of various stores ($3.6 million), Oak Hill management fees ($1.25 million), and costs associated with various matters related to Mr. Cuti ($6.0 million). The asset impairment charges are non-cash expenses and are necessary to reduce the carrying value of certain store assets to their estimated fair value. The 2008 other expenses also includes a $1.8 million net benefit related to fair value adjustments to reverse excess liabilities for the phantom stock liability and the profits interest liability as well as additional pension benefit costs related to a March 2006 union contract settlement. In the corresponding 2007 period, we incurred other expenses of $15.9 million, including costs associated with the completed audit committee investigations ($2.3 million) and various other matters related to Mr. Cuti ($6.0 million), costs associated with the closing of various stores ($4.4 million), Oak Hill management fees ($1.25 million), asset impairment charges ($0.9 million) and other costs ($1.2 million).

        Net interest expense for 2008 was $54.9 million, as compared to $61.0 million in 2007. The decrease of $6.1 million was primarily attributable to lower outstanding borrowings on our revolving credit facility and lower interest rates on our variable rate debt. At December 27, 2008, the weighted average interest rate on our variable rate debt was 5.2%, as compared to 8.4% at December 29, 2007.

        In 2008, we recorded an income tax provision of $2.0 million, inclusive of a valuation allowance of $30.9 million, while in 2007, we recorded an income tax provision of $2.2 million, inclusive of a valuation allowance of $43.5 million. The valuation allowances reflect the significant losses incurred in these years, as well as the anticipated financial performance over the next several years and the unlikelihood of recognizing the future tax benefits of the accumulated losses.

The Twelve Months Ended December 29, 2007 Compared to the Twelve Months Ended December 30, 2006

        Net sales were $1.69 billion in 2007 and $1.58 billion in 2006. The 2007 net sales increased by 6.4% as compared to the prior year net sales. Resale activity increased by $9.1 million as compared to 2006, which represented a 0.6% increase in overall net sales, while net retail sales to customers increased by 5.9% over this same period. Total same store sales in 2007 increased by 7.4% over the prior year.

        Pharmacy sales increased to $776.4 million in 2007 from $736.1 million in 2006, an increase of 5.5%, and represented 46.0% of total sales, as compared with 46.5% of total sales in 2006. Resale activity accounted for 1.2% of the pharmacy sales increase, while pharmacy net retail sales accounted for the remaining 4.3% of the increase. Pharmacy same-store sales increased by 5.9% from 2006, and third-party reimbursed pharmacy sales represented 93.0% and 92.8% of total prescription sales in 2007 and 2006, respectively. The percentage of generic drugs dispensed increased by 3.6% over the prior year, negatively impacting the pharmacy same-store sales increase by approximately 3.1%, but contributing to an increase in gross margin per prescription dispensed. Generic drugs generally have lower retail sales prices but are more profitable for us than branded drugs. The average weekly prescriptions filled per store during 2007 increased 1.6% as compared to the prior year.

        Front-end sales increased to $910.3 million in 2007 from $848.6 million in 2006, an increase of 7.3%, and represented 54.0% of total sales, as compared to 53.5% of total sales in 2006. Front-end same-store sales increased by 8.6%, due to improved merchandise offerings, enhanced customer service

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reflecting the continuing implementation of our "Full Potential" initiative and our store renovation program. Additionally, the stronger New York City economy, a generally improved level of consumer demand resulting from increased tourism and favorable weather patterns positively influenced our front-end same-store sales. Front-end sales were driven by strong performance in our food and beverage categories, over-the-counter products and health and beauty categories.

        As of December 29, 2007, we operated 242 stores, ten of which were opened during fiscal 2007. We closed 16 stores in 2007. In fiscal 2006, we opened five stores and we closed eight stores.

        Cost of sales as a percentage of net sales was 69.7% and 70.0% in 2007 and 2006, respectively, resulting in gross profit margins of 30.3% and 30.0% in each respective period. The gross profit margin in 2007 reflects the impact of improved front-end selling margins associated with a more favorable mix of promotional and regularly-priced products, improved assortments of higher margin products and a lower LIFO charge. These improvements were offset in part by higher shrink losses, modestly reduced levels of vendor allowances and lower pharmacy margins resulting from increased lower margin Medicare Part D sales. In addition, our gross profit margin was negatively impacted by lower New York Medicaid reimbursement rates. Cost of sales includes a LIFO provision of $1.6 million in 2007 as compared to a LIFO provision of $3.0 million in 2006.

        Selling, general and administrative expenses were $446.7 million, or 26.5% of net sales, and $426.5 million, or 26.9% of net sales, in 2007 and 2006, respectively. Approximately 0.2% of the decrease in the 2007 expense percentage as compared to 2006 was attributable to improved leveraging of our store occupancy expenses and higher real estate related income. The remaining 0.2% was due to improved leveraging of costs against strong same-store sales growth in both pharmacy and front-end, process related improvements, reduced advertising costs and lower legal and professional fees, partially offset by increased minimum wage rates and higher costs associated with pharmacist salaries.

        Depreciation and amortization of property and equipment and intangible assets was $73.1 million in 2007, as compared to $71.9 million in 2006. The increase reflects depreciation and amortization due to new store openings, renovations and other capital spending as well as the cumulative depreciation adjustment recorded in the third quarter of 2006 resulting from the Audit Committee's accounting investigations. For further discussion of the accounting investigations, see Note 2 of the notes to our annual consolidated financial statements.

        We incurred store pre-opening expenses of $0.6 million in 2007, attributable to the opening of ten stores, as compared to $0.3 million in 2006, reflecting five new stores opened during that period.

        During 2007, we sold several pharmacy prescription files that resulted in a separately reported gain of $1.3 million.

        In 2007, we incurred other expenses of $15.9 million, including costs associated with the completed audit committee investigations ($2.3 million) and various other matters related to Mr. Cuti ($6.0 million), costs associated with the closing of various stores ($4.4 million), Oak Hill management fees ($1.25 million), asset impairment charges ($0.9 million) and other costs ($1.2 million). In the corresponding prior year period, we incurred other expenses of $14.8 million, including asset impairment charges ($10.2 million), Oak Hill management fees ($1.25 million), costs associated with audit committee investigations ($0.8 million) and costs associated with various matters related to Mr. Cuti ($1.3 million), as well as other miscellaneous costs associated with our management reorganization and the reversal of the excess liability for our phantom shares ($1.2 million).

        Net interest expense for 2007 was $61.0 million, as compared to $56.9 million in 2006. This $4.1 million increase was primarily attributable to higher non-cash interest expense associated with the accretion of the discount on the liability recorded for the preferred stock offering completed during the second quarter of 2007.

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        In 2007, we recorded an income tax provision of $2.2 million, inclusive of a valuation allowance of $43.5 million, while in 2006, we recorded an income tax provision of $3.0 million, inclusive of a valuation allowance of $38.1 million. The valuation allowances reflect the significant losses incurred in these years, as well as the anticipated financial performance over the next several years and the unlikelihood of recognizing the future tax benefits of the accumulated losses.

Liquidity and Capital Resources

Working Capital

        We had a working capital deficit of $13.3 million as of December 27, 2008, as compared to a working capital balance of $8.6 million as of December 29, 2007 and $6.2 million as of December 30, 2006. Working capital reflects the classification of outstanding borrowings under our amended asset-based revolving loan facility of $144.6 million at December 27, 2008, $141.4 million at December 29, 2007 and $157.1 million at December 30, 2006 as current liabilities. This current classification is required because cash receipts controlled by the lenders are used to reduce outstanding debt, and we do not meet the criteria of SFAS No. 6, "Classification of Short-Term Obligations Expected to be Refinanced—An Amendment of ARB No. 43, Chapter 3A" to classify the debt as long-term, but is not an indication that this credit facility is expected to be retired within the next year. The amended asset-based revolving loan expires in July of 2011, and we intend to continue to access it for our working capital needs throughout its remaining term.

        The decrease in our working capital balance is primarily due to the timing of merchandise receipts versus the previous year, the increased revolving loan borrowings at December 27, 2008 compared to December 29, 2007 and increases in our December 27, 2008 accrued expenses for a $3.5 million litigation settlement for two class action lawsuits and a $4.7 million liability related to our interest rate collar.

Cash Flow for the Twelve Months Ended December 27, 2008 as Compared to the Twelve Months Ended December 29, 2007

        Net cash provided by operating activities was $44.3 million in fiscal 2008 as compared to $19.3 million in the 2007 fiscal year. The increase against the prior year reflects the improved operating results in 2008, during which our operating loss was reduced by $8.8 million to $15.8 million from $24.6 million. Our operating losses include non-cash asset impairment charges of $7.7 million in fiscal 2008 and $0.9 million in the 2007 fiscal year. While the asset impairment charges increase our operating loss, they are non-cash in nature. During fiscal 2008, we also benefited from reduced interest expense due to lower interest rates and lower average outstanding borrowings on our revolving credit facility.

        Net cash used in investing activities in 2008 was $47.0 million, as compared to $41.9 million in 2007. The increase is primarily due to capital expenditures for new store openings during 2008. We opened 15 new stores in 2008, compared to ten new stores in 2007. Our capital expenditures in 2008 were $33.1 million compared to $26.1 million in 2007. We had lease acquisition and other investing activities of $14.4 million in 2008, compared to $19.2 million in 2007. Fiscal 2008 cash flow used in investing activities included $0.5 million of proceeds related to the disposition of certain properties, while fiscal 2007 cash flow used in investing activities included $3.3 million of proceeds resulting from similar property dispositions.

        Net cash provided by financing activities in 2008 was $2.7 million, as compared to $22.6 million in 2007. The prior year net cash provided by financing activities reflects the issuance of $39.1 million in preferred stock and warrants (net of expenses of $0.3 million), a portion of which was used to fund the acquisition of six Gristedes supermarket leases. As of December 27, 2008, we have opened new stores at each location. Our agreement with Gristedes has expired and we are not obligated to acquire any

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additional leases. See Note 14 to the notes to our consolidated financial statements contained elsewhere in this report for additional information regarding this transaction.

Cash Flow for the Twelve Months Ended December 29, 2007 as Compared to the Twelve Months Ended December 30, 2006

        Net cash provided by operating activities was $19.3 million in fiscal 2007 as compared to $11.6 million in the 2006 fiscal year. The increase over the prior year primarily reflects improved operating results (which exclude the non-cash labor contingency credit recorded in 2006) and the benefits of our working capital management initiatives.

        Net cash used in investing activities in 2007 was $41.9 million, as compared to $29.1 million in 2006. Capital expenditures in 2007 of $26.1 million were $0.9 million higher than 2006, while lease acquisition, pharmacy customer file and other costs in 2007 of $19.2 million were higher than 2006 by $12.7 million, principally due to five Gristedes supermarket lease acquisitions completed during the year. Fiscal 2007 cash flow used in investing activities included $3.3 million of proceeds related to the disposition of certain properties, while fiscal 2006 cash flow used in investing activities included $2.5 million of proceeds resulting from similar property dispositions.

        Net cash provided by financing activities in 2007 was $22.6 million, as compared to $17.5 million in 2006. The increase in cash provided by financing activities in 2007 reflects the issuance of $39.1 million in preferred stock and warrants (net of expenses of $0.3 million), a portion of which was used to fund the acquisition of five Gristedes supermarket leases and other capital expenditures. This was partially offset by repayments of revolver borrowings with unspent proceeds from the issuance of the preferred stock and warrants as well as the improvement in cash flow from operations. See Note 14 to the notes to our consolidated financial statements contained elsewhere in this report for additional information regarding this transaction.

Operating Capital Requirements

        Our operating capital requirements primarily result from opening and stocking new stores, remodeling and renovating existing retail locations, purchasing pharmacy files and the continuing development of management information systems. We opened 15 new stores in 2008, ten new stores in 2007 and five new stores in 2006. We currently plan to open between 10 to 12 new stores in 2009 and between 10 to 15 new stores in 2010. Capital spending in 2009 is expected to be approximately $40 to $45 million, with approximately $17 million related to maintenance capital spending and approximately $23 to $28 million related to growth capital spending. We also require working capital to support inventory for our existing and new stores. Historically, we have been able to lease almost all of our store locations, so acquisitions of real estate are not expected to have a significant impact on our capital requirements.

        As a result of the recession, we experienced declines in consumer demand that accelerated during the fourth quarter of 2008 and are expected to continue throughout fiscal 2009. Expected higher rates of unemployment, reduced levels of tourism and decreased commercial activity are factors impacting our outlook for the current year. We are implementing certain measures to mitigate the impact of these recessionary economic conditions. These actions include hiring and wage freezes in administrative and certain other areas of the business, as well as the implementation of a number of strategic cost savings initiatives to improve efficiency and eliminate non-value added activities. The total cost savings associated with the program is expected to be in the range of $7.0 to $10.0 million in fiscal 2009.

Liquidity Assessment

        Duane Reade Holdings, Inc. is a holding company formed in connection with the Acquisition to hold the common stock of Duane Reade Inc. Duane Reade Holdings, Inc. operates all of its business

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through Duane Reade Inc. and its subsidiaries and has no other independent assets, liabilities or operations. To the extent it has liquidity requirements, it will depend on distributions of cash from Duane Reade Inc., to the extent permitted by the various agreements to which Duane Reade Inc. is a party. Currently, we do not expect Duane Reade Holdings, Inc. to have any material liquidity requirements.

        We have incurred losses since the Acquisition date due primarily to the additional depreciation and amortization expense relating to the stepped-up fair value of our assets on the Acquisition date, and increased interest expense on Acquisition indebtedness. We have an accumulated deficit of $397.8 million at December 27, 2008. We have generated positive net cash flows from operations of $44.3 million in fiscal 2008, $19.3 million in fiscal 2007 and $11.6 million in fiscal 2006. We have never been subject to the single quarterly fixed charge financial coverage requirement specified in the amended asset-based revolving loan facility agreement. The fixed charge financial covenant becomes applicable when borrowings exceed 90 percent of the borrowing base, as defined in the agreement. Historically, our borrowings have never exceeded 90 percent of the borrowing base and we do not expect to exceed this threshold during 2009. If the fixed charge coverage ratio was in effect during fiscal 2008, we would have been in full compliance with the covenant.

        We intend to refinance our senior floating rate notes due 2010 and senior subordinated notes due 2011 in the amounts of $210 million and $195 million, respectively, prior to their maturity dates. There can be no assurance that such refinancing will actually take place.

        We believe that, based on current levels of operations and anticipated growth, cash flow from operations, together with other available sources of funds, including revolving loan borrowings under the amended asset-based revolving loan facility, will be adequate to make required payments on our indebtedness, to fund anticipated capital expenditures and to satisfy our working capital requirements for fiscal 2009. We base this belief on our recent levels of cash flow from operations of approximately $44.3 million in fiscal 2008, projected improvements in working capital management, anticipated levels of capital expenditures and the available borrowing capacity under the $225.0 million amended asset-based revolving loan facility, which was approximately $69.0 million at December 27, 2008. As of March 24, 2009, our availability has decreased to approximately $56.2 million. The decrease in our availability is primarily due to the February 1, 2009 payment of the semi-annual interest payment on our senior subordinated notes and an additional $3.5 million letter of credit required for the litigation settlement agreement relating to two class action lawsuits. Our stockholders' deficit is expected to increase in 2009 due to continued losses; however, this deficit does not impact our liquidity as noted above and has no impact on our debt covenants.

        Our ability to meet our debt service obligations and reduce or refinance our total debt will depend upon our future performance and financial condition, credit market conditions and the availability of financing which, in turn, will be subject to general economic, financial, business, competitive, legislative, regulatory and other conditions, many of which are beyond our control. In addition, our operating results, cash flow and capital resources may not be sufficient for repayment of our indebtedness in the future. Some risks that could adversely affect our ability to meet our debt service obligations include, but are not limited to, reductions in third party prescription reimbursement rates, declines in the New York City economy, increases in competitive activity, adverse changes in vendor credit terms, changes in drug consumption patterns, additional adverse legislative changes or a major disruption of business in our markets from a terrorist event, natural disaster or other unexpected events. Other factors that may adversely affect our ability to service our debt are described above under "Special Note Regarding Forward-Looking Statements."

        We may, from time to time, seek to retire or purchase our outstanding debt in open market purchases, in privately negotiated transactions, or otherwise. Such retirement or purchase of debt may be funded from the operating cash flows of the business or other sources and will depend upon

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prevailing market conditions, liquidity requirements, contractual restrictions and other factors, and the amounts involved may be material.

        During 2006, we extended the maturity of the amended asset-based revolving loan facility from 2008 to 2011. As a condition of this extension, we are required to refinance any outstanding amounts under the $210.0 million of senior secured floating rate notes not later than 120 days prior to their maturity date of December 15, 2010.

        Borrowings under the amended asset-based revolving loan facility and the aggregate $210.0 million senior secured floating rate notes bear interest at floating rates. Therefore, our financial condition will be affected by changes in prevailing interest rates. On April 30, 2008, we entered into a hedging transaction through the acquisition of a "no cost collar." Under this arrangement, we capped our exposure on $210.0 million of LIBOR-based borrowings at a maximum LIBOR rate of 5.2%. In addition, we established a minimum "floor" LIBOR rate of 2.6%, in line with then current LIBOR rates. At December 27, 2008, the LIBOR rate in effect was approximately 1.9%, which was below the minimum rate specified under the "no cost collar." As a result, the "no cost collar" increased the effective annual interest rate on our LIBOR-based borrowings by approximately 0.4%. This hedging arrangement expires on December 15, 2010.

        The amended asset-based revolving loan facility contains a single fixed charge coverage requirement which only becomes applicable when borrowings exceed 90 percent of the borrowing base, as defined in the agreement governing the amended asset-based revolving loan facility. There are no credit ratings related triggers in the amended asset-based revolving loan facility that would impact the cost of borrowing, annual amortization of principal or related indebtedness maturity.

Debt

        Amended Asset-Based Revolving Loan Facility    Our amended asset-based revolving loan facility has a maximum borrowing capacity of $225.0 million, subject to a borrowing base calculation based on specified advance rates against the value of our inventory, pharmacy prescription files and accounts receivable. The asset-based revolving loan facility matures on July 21, 2011. The maturity date is subject to our refinancing or restructuring the aggregate principal amounts of our $210.0 million senior secured floating rate notes due 2010 and $195.0 million senior subordinated notes due 2011, in each case on terms reasonably acceptable to the administrative agent and at least 120 days prior to each series of notes' respective scheduled maturity date.

        The amended asset-based revolving loan facility includes a $50 million sub-limit for the issuance of letters of credit. Obligations under the revolving loan facility are collateralized by a first priority interest in inventory, receivables, pharmacy prescription files, deposit accounts and certain other current assets. Under the amended asset-based revolving loan facility, Duane Reade GP is the sole obligor. However, the amended asset-based revolving loan facility is guaranteed on a full and unconditional basis by us, Duane Reade Inc. and each of our other domestic subsidiaries other than the obligor.

        The amended asset-based revolving loan facility contains a single fixed charge coverage requirement which only becomes applicable when borrowings exceed 90 percent of the borrowing base, as defined in the agreement governing the amended asset-based revolving loan facility. Borrowings under the amended asset-based revolving loan facility have not exceeded 90 percent of the borrowing base and, as a result, the fixed charge covenant has not become applicable. There are no credit ratings related triggers in the amended asset-based revolving loan facility that would impact the cost of borrowing, annual amortization of principal or related indebtedness maturity.

        On September 28, 2007, the asset-based revolving loan facility was amended to exclude from the definition of "Capital Expenditures" any expenditure made with the proceeds of any equity securities issued or capital contributions received by us.

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        Revolving loans under the amended asset-based revolving loan facility, at our option, bear interest at either:

    a rate equal to LIBOR plus a margin of from 1.00% to 2.00%, determined based on levels of borrowing availability reset each fiscal quarter; or

    a rate equal to the prime rate of Banc of America Retail Group Inc. plus a margin of from 0.00% to 0.50%, determined based on levels of borrowing availability reset each fiscal quarter.

        Borrowings under the amended facility continue to be primarily LIBOR-based. At December 27, 2008 and December 29, 2007, the amended asset-based revolving loan facility bore interest at a weighted average annual rate of 3.51% and 6.72%, respectively.

        At December 27, 2008, there was $144.6 million outstanding under the amended asset-based revolving loan facility, and approximately $69.0 million of remaining availability, net of $6.3 million reserved for outstanding standby letters of credit. Obligations under this facility have been classified as current liabilities because cash receipts controlled by the lenders are used to reduce outstanding debt and we do not meet the criteria of SFAS No. 6, "Classification of Short-Term Obligations Expected to be Refinanced—An Amendment of ARB No. 43, Chapter 3A", to classify the debt as long-term. We intend to continue to utilize this facility for our working capital needs though the date of its maturity in July 2011.

        Senior Secured Floating Rate Notes due 2010    On December 20, 2004, we closed an offering of $160.0 million aggregate principal amount of senior secured floating rate notes due 2010. Using the net proceeds from that offering, together with approximately $2.2 million of borrowings under the amended asset-based revolving loan facility, we repaid all outstanding principal under the previously existing $155.0 million senior term loan facility, along with approximately $3.6 million of early repayment premium and accrued but unpaid interest through December 20, 2004. On August 9, 2005, we issued a further $50.0 million of senior secured notes. These new notes were issued under the same indenture as the December 2004 notes, although they do not trade fungibly with those December 2004 notes.

        The senior secured notes bear interest at a floating rate of LIBOR plus 4.50%, reset quarterly. Interest on the senior secured notes is payable quarterly on each March 15, June 15, September 15, and December 15. The senior secured notes mature on December 15, 2010. At December 27, 2008, the senior secured notes bore interest at an annual rate of 6.42%.

        On April 30, 2008, we entered into a hedging transaction through the acquisition of a "no cost collar." Under this arrangement, we capped our exposure on $210.0 million of LIBOR-based borrowings at a maximum LIBOR rate of 5.2%. In addition, we established a minimum "floor" LIBOR rate of 2.6%, in line with then current LIBOR rates. The changes in the fair value of the hedge agreement are reflected on the Consolidated Statements of Stockholder's Equity (Deficit) and Comprehensive Income (Loss) included within the financial statements. At December 27, 2008, the LIBOR rate in effect was approximately 1.9%, which was below the minimum rate specified under the "no cost collar." As a result, the "no cost collar" increased the effective annual interest rate on our LIBOR-based borrowings by approximately 0.4%. This hedging arrangement expires on December 15, 2010.

        We guarantee the senior secured notes on a full and unconditional, senior secured basis. Duane Reade Inc. and Duane Reade GP are co-obligors under the senior secured notes. The senior secured notes rank equally in right of payment with any of our, Duane Reade Inc.'s or Duane Reade GP's unsubordinated indebtedness and senior in right of payment to any of our, Duane Reade Inc.'s or Duane Reade GP's subordinated or senior subordinated indebtedness. All obligations under the senior secured notes are guaranteed on a senior basis by each of our existing subsidiaries, other than Duane Reade Inc. and Duane Reade GP, and will be guaranteed by future subsidiaries of Duane Reade Inc. and Duane Reade GP except certain foreign and certain domestic subsidiaries. The senior secured notes and the guarantees are collateralized by a first priority interest in substantially all of our assets other than those assets in which the lenders under the amended asset-based revolving loan facility have

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a first priority interest and certain excluded assets, as defined within the indenture. The senior secured notes and the guarantees are also collateralized by a second priority interest in all collateral pledged on a first priority basis to lenders under the amended asset-based revolving loan facility.

        Upon the occurrence of specified change of control events, we will be required to make an offer to repurchase all of the senior secured notes at 101% of the outstanding principal amount of the senior secured notes plus accrued and unpaid interest to the date of repurchase. The indenture governing the senior secured notes contains certain affirmative and negative covenants that limit the ability of Duane Reade Inc., Duane Reade GP and their restricted subsidiaries, as defined, to incur additional indebtedness, pay dividends, make repayments on indebtedness that is subordinated to the senior secured notes and to make certain other restricted payments, incur certain liens, use proceeds from sales of assets, enter into business combination transactions (including mergers, consolidations and asset sales), enter into sale-leaseback transactions, enter into transactions with affiliates and permit restrictions on the payment of dividends by restricted subsidiaries. The indenture governing the senior secured notes contains customary events of default, which, if triggered, may result in the acceleration of the indebtedness outstanding under the indenture. There are no credit ratings related triggers in the indenture governing the senior secured notes that would impact the cost of borrowing, annual amortization of principal or related indebtedness maturity. The indenture governing the senior secured notes does not contain financial maintenance covenants.

        At December 27, 2008, the weighted average combined interest rate in effect on all variable rate debt outstanding, including the effect of the "no cost collar," was 5.23%.

        Senior Subordinated Notes due 2011    On July 30, 2004, upon completion of the Acquisition, Duane Reade Inc. and Duane Reade GP co-issued $195.0 million of 9.75% senior subordinated notes due 2011. The senior subordinated notes mature on August 1, 2011 and bear interest at 9.75% per annum payable in semi-annual installments on February 1 and August 1. The senior subordinated notes are uncollateralized obligations and subordinated in right of payment to all of our, Duane Reade Inc.'s and Duane Reade GP's existing and future unsubordinated indebtedness, including borrowings under the amended asset-based revolving loan facility and the senior secured notes. The senior subordinated notes will rank equally with any future senior subordinated indebtedness and senior to any future subordinated indebtedness. The senior subordinated notes are guaranteed on an uncollateralized, senior subordinated basis by us and all of Duane Reade Inc.'s existing direct and indirect domestic subsidiaries other than Duane Reade GP, which is a co-obligor under the senior subordinated notes. Upon the occurrence of specified change of control events, we will be required to make an offer to repurchase all of the senior subordinated notes at 101% of the outstanding principal amount of the senior subordinated notes plus accrued and unpaid interest to the date of repurchase. The indenture governing the senior subordinated notes contains certain affirmative and negative covenants that limit the ability of Duane Reade Inc., Duane Reade GP and their restricted subsidiaries to incur additional indebtedness, pay dividends, make repayments on indebtedness that is subordinated to the senior subordinated notes and to make certain other restricted payments, incur certain liens, use proceeds from sales of assets, enter into business combination transactions (including mergers, consolidations and asset sales), enter into transactions with affiliates and permit restrictions on the payment of dividends by restricted subsidiaries. The indenture governing the senior subordinated notes contains customary events of default, which, if triggered, may result in the acceleration of the indebtedness outstanding under the indenture. There are no credit ratings related triggers in the indenture governing the senior subordinated notes that would impact the cost of borrowing, annual amortization of principal or related indebtedness maturity.

Other Factors Influencing our Liquidity

        Ten of our stores, which generated approximately 4.3% of our net sales for fiscal 2008, have leases scheduled to expire before the end of fiscal 2010. While none of these leases have options to extend the term of the lease, we believe that we will be able to renew the expiring leases on economically favorable terms or, alternatively, find other economically attractive locations to lease. During the first

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quarter of fiscal 2009, we entered into new leases for two of the four leases that were scheduled to expire in 2009.

        As of December 27, 2008, approximately 5,000 of our approximately 6,800 employees were represented by various labor unions and were covered by collective bargaining agreements. Pursuant to the terms of the collective bargaining agreements covering these employees, we are required, in some instances, to pay specified annual increases in salary and benefits contributions relating to the member employees. We do not believe that these increases will have a material impact on our liquidity or results of operations. Our collective bargaining agreements with the RWDSU/Local 338 and Local 340A unions, who, on a combined basis represent approximately 4,600 of our employees in all of our stores, expire on March 31, 2009. We are currently engaged in negotiations to renew these collective bargaining agreements. Approximately 400 of our employees in our two distribution centers in Maspeth, Queens, NY and North Bergen, NJ are represented by Local 210, International Brotherhood of Teamsters, Chauffeurs and Warehousemen, under a collective bargaining agreement that expires on August 31, 2011.

        In June 2005, the appraisal panel in the World Trade Center insurance claim litigation determined the amount of our business interruption loss as a result of the events of September 11, 2001. This determination by the panel is subject to existing appeals and potentially additional appeals, and on June 22, 2005, the Second Circuit Court of Appeals affirmed the decision of the trial court, with modifications, including modifications to certain of the legal tests on which the appraisal panel's decision was based. Based on this decision and related modifications, the appraisal panel revised its previously issued determination to require an additional $5.6 million payment from the carrier in addition to the $9.9 million previously paid by the insurance carrier in 2002. As a result of the insurer's refusal to pay this amount and also as a result of the Second Circuit Court of Appeals' interpretation of our insurance policy, in January 2007, we commenced another action in the U.S. District Court for the Southern District of New York to recover both the appraisal panel's award and additional amounts under the policy. In August 2007, the District Court entered judgment in the amount of $0.8 million plus interest, and both parties appealed. The appeals have been briefed and oral argument in the Second Circuit Court of Appeals has been held. However, due to the inherent uncertainty of litigation, there can be no assurance that this appeal will be successful. Please see "Item 3. Legal Proceedings" for a more detailed explanation of this matter.

        The following tables provide information with respect to our commitments and obligations as at December 27, 2008:

 
  Payments due by Period  
Contractual Cash Obligations
  Total   Within
1 year
  Within
2-3 years
  Within
4-5 years
  After
5 years
 
 
  (dollars in thousands)
 

Long-Term Debt(1)

  $ 405,033   $   $ 405,000   $   $ 33  

Asset-Based Revolving Loan Facility(2)

    144,642         144,642          

Capital Lease Obligations(3)

    5,977     4,485     1,492          

Operating Leases(4)

    1,602,254     145,772     290,147     275,236     891,099  

Closed Store Costs(5)

    8,154     4,718     1,399     662     1,375  

Fixed Interest Payments(6)

    57,038     19,013     38,025          

Severance Payments(7)

    585     467     16     15     87  

Redeemable Preferred Stock(8)

    39,400                 39,400  

Redeemable Preferred Stock Dividends(8)

    89,496                 89,496  
                       

Total Contractual Cash Obligations

  $ 2,352,579   $ 174,455   $ 880,721   $ 275,913   $ 1,021,490  
                       

(1)
These amounts include $195.0 million of outstanding senior subordinated notes, $210.0 million of outstanding senior secured floating rate notes and $33,000 outstanding under the senior convertible

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    notes due in 2022. For more information about the terms of the indebtedness described above, please see "—Debt," above.

(2)
At December 27, 2008, approximately $144.6 million was outstanding under our amended asset-based revolving loan facility. Obligations under this facility have been classified as current liabilities because cash receipts controlled by the lenders are used to reduce outstanding debt and we do not meet the criteria of SFAS No. 6, "Classification of Short-Term Obligations Expected to be Refinanced—An Amendment of ARB No. 43, Chapter 3A," to classify the debt as long-term; however this is not an indication that this credit facility is expected to be retired within the next year. We intend to continue to use this facility for our working capital needs through the date of its maturity in July 2011.

(3)
Note 12 to the consolidated financial statements provides further detail on our Capital Lease obligations.

(4)
Note 18 to the consolidated financial statements provides further detail on Operating Lease obligations.

(5)
In the normal course of its business, we will close store locations and establish reserves for costs anticipated to be incurred in connection with such store closings. The balance of the reserve is expected to be utilized primarily for occupancy-related costs in the closed stores.

(6)
Reflects interest payable on $195.0 million of the senior subordinated notes.

(7)
Includes amounts owed to former employees and also reflects future health insurance premium payments specified under the employment contract with Mr. Cuti which are required to be made by us in connection with his replacement on November 21, 2005. In an ongoing arbitration between Mr. Cuti and us (explained in more detail in "Item 3. Legal Proceedings"), we are seeking, among other forms of relief, rescission of employment agreements entered into between us and Mr. Cuti, the return of all compensation paid under the employment agreements, including the benefits described in this footnote, and other monetary damages.

(8)
The Series A redeemable preferred stock has a 12-year mandatory redemption date from the issuance date and provides for an annual cash dividend of 10% payable quarterly, subject to being declared by our Board of Directors. To the extent the dividends are not paid in cash, the dividends will cumulate on a quarterly basis to the extent not paid quarterly. The dividends are currently restricted under the agreements governing our outstanding indebtedness, so we have reflected the dividends in the table above as not being payable until the mandatory redemption date. Each of the 525,334 shares of Series A redeemable preferred stock is immediately redeemable without penalty, at our option prior to the mandatory redemption date, at a liquidation preference of $75.00 per share plus any accrued but unpaid dividends as of the redemption date.
 
   
  Amount of Commitment Expiration per Period  
Other Commercial Commitments
  Total Amounts
Committed
  Within 1 year   After 2-3 years   4-5 years   5 years  
 
  (dollars in thousands)
   
   
   
 

Standby Letters of Credit(1)

  $ 6,334   $ 6,334   $   $   $  
                       

Total Commercial Commitments

  $ 6,334   $ 6,334   $   $   $  
                       

(1)
Standby letters of Credit, primarily representing self-insured general liability claims and property lease security deposits, are renewed on an annual basis, unless otherwise requested by the beneficiary.

        We are party to multi-year, merchandise supply agreements in the normal course of business. The largest of these agreements is with AmerisourceBergen, our primary pharmaceutical supplier. Generally, these agreements provide for certain volume commitments and may be terminated by us, subject in some cases to specified termination payments, none of which we believe would constitute a material adverse effect on our financial position, results of operations or cash flows. It is the opinion of

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management that if any of these agreements were terminated or if any contracting party was to experience events precluding fulfillment of its obligations, we would be able to find a suitable alternative supplier.

        In connection with the November 21, 2005 replacement of Mr. Cuti as our CEO, Mr. Cuti's employment contract specified payments to Mr. Cuti in cash totaling up to $6.6 million. We have paid the full amount through December 27, 2008. In addition, the employment contract provides for continued health insurance coverage for Mr. Cuti during the 25-month period following termination and, upon expiration of that period, if Mr. Cuti is not otherwise eligible under another employer's comparable medical plan, lifetime retiree medical benefits at a cost not to exceed $50,000 annually. In an ongoing arbitration between Mr. Cuti and us (explained in more detail in "Item 3. Legal Proceedings"), we are seeking, among other forms of relief, rescission of employment agreements entered into between us and Mr. Cuti, the return of all compensation paid under the employment agreements, including the benefits described in this paragraph, and other monetary damages.

        In connection with the Acquisition, Mr. Cuti was granted equity interests in Duane Reade Shareholders and Duane Reade Holdings, Inc., consisting of options to purchase shares of our common stock and a profits interest in Duane Reade Shareholders. Mr. Cuti's employment contract provides that, as a result of his replacement on November 21, 2005, he had the right to require us to purchase for cash, to be paid over a two year period, all or a portion of these equity interests as he may designate, at a value determined in accordance with a formula. In connection with his replacement, we have treated all of his equity interests as having vested. The options have expired unexercised, and the profits interest will have no value unless the value of Duane Reade Shareholders and Duane Reade Holdings, Inc., respectively, appreciate following the Acquisition. Mr. Cuti's purchase right will be suspended at any time when the exercise of such purchase rights would result in a default under the financing arrangements of Duane Reade Shareholders, Duane Reade Holdings, Inc. or Duane Reade Inc. On December 21, 2005, Mr. Cuti provided notice to Duane Reade Inc. that he was exercising his repurchase right to cause us to repurchase 5% of his profits interest. Pursuant to the procedures outlined in the new employment agreement, Duane Reade Inc. has advised him that his profits interest as of December 21, 2005 was determined to have no value. The benefits described in this paragraph were all granted under an employment agreement between Mr. Cuti and us. In an ongoing arbitration between Mr. Cuti and us (explained in more detail in "Item 3. Legal Proceedings"), we are seeking, among other forms of relief, rescission of employment agreements entered into between us and Mr. Cuti and the return of all compensation paid under the employment agreements, including the benefits described in this paragraph. The determination that Mr. Cuti's profits interest as of December 21, 2005 had no value is also one of several subjects specifically at issue in the arbitration.

        In connection with the assignment of certain store leases to third parties during 2008 and 2007, we continue to provide secondary guarantees on the lease obligations for the assigned stores. The respective purchasers have assumed our obligations under these leases and are primarily liable for these obligations. Although we believe it to be unlikely, assuming that each respective purchaser became insolvent, management estimates that we could settle these obligations for amounts substantially less than the aggregate obligation of $27.8 million as of December 27, 2008. The obligations are for varying terms dependent upon the respective lease, the longest of which lasts through May 31, 2022.

Off-Balance Sheet Arrangements

        We are not a party to any agreements with, or commitments to, any special purpose entities that would constitute material off-balance sheet financing other than the items listed above.

Critical Accounting Policies

        Our discussion of results of operations and financial condition relies on our consolidated financial statements that are prepared based on certain critical accounting policies that require management to make judgments and estimates that are subject to varying degrees of uncertainty. We believe that investors need to be aware of these policies and how they impact our financial reporting to gain a more

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complete understanding of our consolidated financial statements as a whole, as well as our related discussion and analysis presented herein. While we believe that these accounting policies are grounded on sound measurement criteria, actual future events can and often do result in outcomes that can be materially different from these estimates or forecasts. The accounting policies and related risks described in the paragraphs below are those that depend most heavily on these judgments and estimates.

Receivables—Reserves for Uncollectible Accounts

        At December 27, 2008 and December 29, 2007, accounts receivable included $40.7 million and $37.7 million, respectively, representing amounts due from various insurance companies, pharmacy benefit management companies and governmental agencies under third party payment plans for prescription sales made prior to those dates. Our accounting policy, which is based on our past collection experience, is to fully reserve for all pharmacy receivables over 120 days old that are unpaid at the evaluation date and deemed uncollectible, as well as any other pharmacy receivables deemed potentially uncollectible. Pharmacy receivables other than New York Medicaid are adjudicated at the point of sale and do not generally have issues of collectability. There was approximately $0.1 million reserved for uncollectible pharmacy receivables at each of December 27, 2008 and December 29, 2007. Other receivables, which primarily consist of amounts due from vendors, are reserved for based upon a specific application of our historical collection experience to the total aged receivable balance. We have an aggregate allowance for doubtful accounts of approximately $1.7 million at December 27, 2008 and December 29, 2007.

Inventory Shrink Estimates

        We perform front-end and pharmacy physical inventories in all of our stores at least once per year on a staggered cycle basis and we cycle count inventories at our distribution centers throughout the year. Inventories are valued using the average specific item cost, last-in, first-out (LIFO) method reduced by estimated inventory shrink losses for the period between the last physical inventory in each store and the balance sheet date. These shrink estimates are based on the latest store trends. At December 27, 2008 and December 29, 2007, a change in this shrink estimate of 1.0% of front-end sales would impact year-to-date pre-tax earnings and related reserves by approximately $3.6 million and $3.3 million, respectively. To the extent that personal disposable income declines as a result of rising unemployment, higher taxes, reduced bonus income, falling housing prices, higher consumer debt levels, increased energy costs or other macroeconomic factors, we may encounter increased levels of shrink. Because most of our stores are located in the highly urbanized areas throughout New York City and the surrounding metropolitan area, our stores experience a higher rate of shrink than our national competitors.

Insurance Liabilities and Reserves

        At December 27, 2008 and December 29, 2007, there were $4.7 million and $4.8 million of accrued general liability claim costs, respectively, that primarily related to the gross amount payable for customer accident claims. Our policy is to recognize a liability for the estimated projected ultimate settlement value of these claims as well as a provision for incurred but unreported claims as of each balance sheet date. These estimates are made based on a review of the facts and circumstances of each individual claim using experienced third party claims adjustors. These estimates are also reviewed and monitored on an ongoing basis by management. For a majority of the claims, the maximum self-insured portion of any individual claim amounts to $250,000, although our historical claim settlement experience is significantly lower. We carry primary general liability insurance coverage (above the self-insured limit) of $15 million and also have a general liability umbrella policy that provides an additional $100 million of insurance coverage beyond the primary limit. At December 27, 2008, there were 234 outstanding claims with an average projected settlement value of approximately $20,274, as

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compared to 231 outstanding claims with an average projected settlement value of approximately $20,850 at December 29, 2007.

Impairment of Long-Lived Assets

        At December 27, 2008, we had net fixed assets of $186.6 million and other net intangible assets consisting of favorable leases and other lease acquisition costs of $66.6 million, customer lists of $29.0 million, capitalized software of $18.0 million and non-competition agreements of $0.3 million. Our policy is to evaluate our intangible and long-lived assets, exclusive of goodwill and indefinite-lived intangible assets, for impairment when circumstances indicate that impairment may have occurred. These circumstances include, but are not limited to, a significant adverse change in legal factors or in the business climate, adverse action or assessment by a regulator, unanticipated competition or the loss of key personnel. When evaluating long-lived assets for potential impairment, we first compare the carrying value of the asset to the asset's estimated future cash flows (undiscounted and without interest charges). If the estimated future cash flows are less than the carrying value of the asset, we calculate the amount of the impairment loss. The impairment loss calculation compares the carrying value of the asset to the asset's estimated fair value, which may be based on estimated future cash flows. We recognize an impairment loss if the amount of the asset's carrying value exceeds the asset's estimated fair value. Any such write downs would result in a non-cash operating loss. Our impairment loss calculations can be affected by uncertainties because they require management to make assumptions and to apply judgment to estimate future cash flows and asset fair values, including forecasting useful lives of the assets and selecting the discount rate that reflects the risk inherent in future cash flows. Using the impairment evaluation methodology described, we recorded long-lived asset impairment charges totaling $7.7 million and $0.9 million, in the aggregate, during fiscal 2008 and fiscal 2007, respectively. With respect to the testing of our long-lived assets for impairment, we may be required to record additional asset impairment charges in the future if the general economic downturn persists and if there is a prolonged period of economic weakness in the markets we serve.

Impairment of Goodwill and Intangible Assets

        At December 27, 2008, the carrying value of our goodwill and our trade name was approximately $69.5 million and $46.0 million, respectively. Goodwill and indefinite lived intangibles are not amortized but are evaluated annually as of the year end balance sheet date and between annual tests in certain circumstances as required under SFAS No. 142, "Goodwill and Other Intangible Assets." The process of evaluating our goodwill and our trade name for impairment involves the determination of fair value. Inherent in such fair value determinations are certain judgments and estimates, including a projection of future cash flows, the interpretation of economic indicators and market valuations, assumptions in our business plans and other quantitative and qualitative analyses.

        We assess our goodwill and our trade name for impairment annually at the end of its fiscal year and in interim periods if certain events occur indicating the carrying value may be impaired. We perform our analysis for potential impairment in accordance with SFAS No. 142, which requires that a two-step impairment test be performed on goodwill. In the first step, the fair value of the reporting unit is compared to its carrying value. If the fair value exceeds its carrying value, goodwill is not impaired, and no further testing is required. If the carrying value of the reporting unit exceeds its fair value, then a second step must be performed in order to determine the implied fair value of the goodwill and compare it to the carrying value of the goodwill. If the carrying value of goodwill exceeds its implied fair value then an impairment loss is recorded equal to the difference.

        Our most recent evaluation of goodwill and our trade name as of December 27, 2008 resulted in no impairment charge to these assets. We may be required to perform an additional interim impairment review if circumstances similar to those listed above, under the caption "Impairment of Long-Lived Assets," indicate that impairment may have occurred. We may be required to recognize an impairment charge at the time an interim or future annual impairment review is performed, depending in part on our estimated fair value. These types of analyses can be affected by uncertainties because

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they require management to make assumptions and to apply judgment to estimate future cash flows and to estimate industry economic factors, as well as the profitability of future business strategies and the selection of an appropriate discount rate that reflects the risk inherent in future cash flows. If actual results are not consistent with our estimates or assumptions, we may be exposed to an impairment charge that could be material.

Closed Store Reserve

        We occasionally vacate store locations prior to the expiration of the related lease. For vacated locations that are under long-term leases, we record an expense for the difference between our future lease payments and related costs (e.g., real estate taxes and common area maintenance) from the date of closure through the end of the remaining lease term, net of expected future sublease rental income. Our closed store reserve contains uncertainties because management is required to make assumptions and to apply judgment to estimate the duration of future vacancy periods, the amount and timing of future settlement payments, and the amount and timing of potential sublease rental income. When making these assumptions, management considers a number of factors, including historical settlement experience, the owner of the property, the location and condition of the property, the terms of the underlying lease, the specific marketplace demand and general economic conditions. At December 27, 2008 and December 29, 2007, we had a total closed store reserve of $8.2 million and $7.7 million, respectively. We may be required to recognize additional charges in our closed store reserve in a future period if we decide to vacate a store location prior to the expiration of the related lease.

Other Loss Contingencies

        Liabilities for loss contingencies are recorded when it is probable that a liability has been incurred and the amount of the loss is reasonably estimable. Loss contingencies often take years to resolve and can involve complicated litigation matters and potential regulatory actions, the outcomes of which are difficult to predict. Our estimates are developed in consultation with in-house and outside counsel, and are based upon our current litigation and settlement strategies. To the extent additional information arises or our strategies change, it is possible that our best estimate of the probable liability may also change. At December 27, 2008, we recorded loss contingencies for legal settlement costs of $3.8 million, of which $3.5 million relates to a litigation settlement for two class action lawsuits that was recorded in the fourth quarter of 2008. See "Item 3—Legal Proceedings" for further discussion of our legal proceedings at December 27, 2008.

Fair Value Measures

        We have certain financial instruments that are accounted for at fair value. Since the financial instruments are not traded, they are valued using valuation models that require judgment and inputs that are generally unobservable. Since judgment and unobservable inputs are involved in determining the fair value of these financial instruments, there is a risk that the carrying value of financial instruments may be overstated or understated. In 2007, we issued preferred stock and common stock warrants in connection with the acquisition of Gristedes store leases. In accordance with SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity," we have recorded the portion of the proceeds that are attributable to the preferred stock ($30.7 million) as a liability because of the mandatory redemption feature. The remaining amount of $8.4 million (net of $0.3 million of expenses) was ascribed to the warrants, based on a relative fair value basis, and is recorded within additional paid-in capital. At December 27, 2008 and December 29, 2007, we recorded a liability of $5.6 million and $3.2 million, respectively for the mandatory redemption feature of the preferred stock. The valuation of the mandatory redemption feature requires us to estimate the probability of events which may require the mandatory redemption of our preferred stock. Other significant financial instruments whose fair value is recorded within our consolidated financial statements include a liability for an interest rate collar, a liability for phantom stock, compensation expense for stock options granted by the Company and a liability for the profits interest of Mr. Cuti.

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        The valuations of these items contain uncertainties because they require management to make assumptions and to apply judgment to estimate industry economic factors and the profitability of future business strategies as well as selecting the appropriate discount rate. If actual results are not consistent with our estimates or assumptions, we may be required to record additional charges or reverse previously recorded charges that could be material. Additionally, there are inherent uncertainties in any fair value measurement technique, and changes in the underlying assumptions could materially affect the fair value measurement amounts. Due to the significant judgment applied in the valuation approaches, the valuations cannot be determined with precision, cannot be substantiated by comparison to quoted prices in active markets, and may not represent the amounts that would be realized in a current sale or immediate settlement of the asset or liability.

Seasonality

        The non-pharmacy business is seasonal in nature, with the Christmas holiday season generating a higher proportion of sales and earnings than other periods.

Inflation

        We believe that inflation has not had a material impact on our results of operations during the three years ended December 27, 2008.

Recently Issued Accounting Pronouncements

        In May 2008, the Financial Accounting Standards Board ("FASB") approved FASB Staff Position ("FSP") APB 14-1, "Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement)." FSP APB 14-1 clarifies that convertible debt instruments that may be settled in cash upon conversion (including partial cash settlement) are not addressed by paragraph 12 of APB Opinion No. 14, "Accounting for Convertible Debt and Debt issued with Stock Purchase Warrants." Additionally, FSP APB 14-1 specifies that issuers of such instruments should separately account for the liability and the equity components in a manner that will reflect the entity's nonconvertible debt borrowing rate when interest cost is recognized in subsequent periods, with the equity component being valued based on the difference between such non-convertible debt borrowing rate and the actual cash interest rate on such convertible debt. FSP APB 14-1 is effective for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years and must be applied retrospectively to all periods presented. We are evaluating the effect which the implementation of FSP APB 14-1 may have on our consolidated financial statements.

        In April 2008, the FASB issued FASB FSP No. FAS 142-3, "Determination of the Useful Life of Intangible Assets," which amends the factors that should be considered in developing renewal or extension assumptions used in determining the useful lives of recognized intangible assets. FSP No. FAS 142-3 is effective for fiscal years beginning after December 15, 2008, and interim periods within those years. We do not currently expect the adoption of FSP No. FAS 142-3 to have a material effect on our consolidated financial statements.

        In May 2008, the FASB issued SFAS No. 162, "The Hierarchy of Generally Accepted Accounting Principles." This standard is intended to improve financial reporting by identifying a consistent framework, or hierarchy, for selecting accounting principles to be used in preparing financial statements that are presented in conformity with generally accepted accounting principles in the United States for non-governmental entities. SFAS No. 162 is effective 60 days following approval by the SEC of the Public Company Accounting Oversight Board's amendments to AU Section 411, "The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles." We do not expect SFAS No. 162 to have a material impact on the preparation of our consolidated financial statements.

        In March 2008, the FASB issued SFAS No. 161, "Disclosures about Derivative Instruments and Hedging Activities—an Amendment of FASB Statement No. 133." The new standard is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced

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disclosures to enable investors to better understand the effects on an entity's financial position, financial performance, and cash flows. SFAS No. 161 is effective prospectively for periods beginning on or after November 15, 2008. The adoption of SFAS No. 161 is not currently expected to have a material effect on our consolidated financial statements.

        In December 2007, the FASB issued SFAS No. 160, "Noncontrolling Interests in Consolidated Financial Statements—An Amendment of ARB No. 51." SFAS No. 160 establishes accounting and reporting standards pertaining to ownership interests in subsidiaries held by parties other than the parent, the amount of net income attributable to the parent and to the noncontrolling interest, changes in a parent's ownership interest, and the valuation of any retained noncontrolling equity investment when a subsidiary is deconsolidated. This statement also establishes disclosure requirements that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. SFAS No. 160 is effective for fiscal years beginning on or after December 15, 2008. The adoption of SFAS No. 160 is not currently expected to have a material effect on our consolidated financial statements.

        In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115." This statement permits entities to choose to measure many financial instruments and certain other items at fair value. SFAS No. 159 was applicable for us as of December 30, 2007, the first day of fiscal 2008. The adoption of SFAS No. 159 did not have a material impact on our consolidated financial statements.

        In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements," which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 was applicable for us as of December 30, 2007, the first day of fiscal 2008. In February 2008, the FASB issued FASB Staff Position FAS 157-2 which deferred the effective date of SFAS No. 157 for certain nonfinancial assets and liabilities until fiscal 2009. We have adopted SFAS No. 157 to account for our financial assets and liabilities and such adoption did not have a material effect on our consolidated financial statements. The FASB Staff Position SFAS No. 157-2 defers the effective date of SFAS No. 157 for certain nonfinancial assets and liabilities until fiscal 2009, but we do not currently expect its adoption to have a material effect on our consolidated financial statements.

        In December 2007, the FASB issued SFAS No. 141(R), "Business Combinations." SFAS No. 141(R) requires the acquiring entity in a business combination to recognize the full fair value of assets acquired and liabilities assumed in the transaction (whether a full or partial acquisition), establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed, and requires the acquirer to disclose the information needed to evaluate and understand the nature and effect of the business combination. This statement applies to all transactions or other events in which the acquirer obtains control of one or more businesses, including those sometimes referred to as "true mergers" or "mergers of equals" and combinations achieved without the transfer of consideration, for example, by contract alone or through the lapse of minority veto rights. For new acquisitions made following the adoption of SFAS 141(R), significant costs directly related to the acquisition including legal, audit and other fees, as well as most acquisition-related restructuring, will have to be expensed as incurred rather than recorded to goodwill as is generally permitted under SFAS No. 141, "Business Combinations." Additionally, contingent purchase price arrangements (also known as earn-outs) will be re-measured to estimated fair value with the impact reported in earnings, whereas under present rules the contingent purchase consideration is recorded to goodwill when determined. Adoption of SFAS No. 141(R) is required for business combinations completed after December 15, 2008. Early adoption and retroactive application of SFAS No. 141(R) to fiscal years preceding the effective date are not permitted. The adoption of SFAS No. 141(R) is not currently expected to have a material effect on our consolidated financial statements.

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ITEM 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

        Our financial results are subject to risk from interest rate fluctuations on debt, which carries variable interest rates. Variable rate debt outstanding at December 27, 2008 included $144.6 million of borrowings under the amended asset-based revolving loan facility and $210.0 million under the senior secured floating rate notes. At December 27, 2008, the weighted average combined interest rate in effect on all variable rate debt outstanding was 5.2%. A 0.50% change in interest rates applied to the $354.6 million balance of floating rate debt would affect pre-tax annual results of operations by approximately $1.8 million. In addition, there were also $195.0 million of senior subordinated notes and $33,000 of senior convertible notes outstanding at December 27, 2008. The senior subordinated notes and senior convertible notes bear interest payable semi-annually at fixed rates of 9.75% and 3.75%, respectively, and are therefore not subject to risk from interest rate fluctuations.

        On April 30, 2008, we entered into a hedging transaction through the acquisition of a "no cost collar." Under this arrangement, we capped our exposure on $210.0 million of LIBOR-based borrowings at a maximum LIBOR rate of 5.2%. In addition, we established a minimum "floor" LIBOR rate of 2.6%, in line with then current LIBOR rates. The changes in the fair value of the hedge agreement are reflected on the Consolidated Statements of Stockholder's Equity (Deficit) and Comprehensive Income (Loss) included within the financial statements. At December 27, 2008, the LIBOR rate in effect was approximately 1.9%, which was below the minimum rate specified under the "no cost collar." As a result, the "no cost collar" increased the effective annual interest rate on our LIBOR-based borrowings by approximately 0.4%. The calculation of the fair value of the "no cost collar" resulted in a hedge liability of $4.7 million at December 27, 2008. This hedging arrangement expires on December 15, 2010.

        The principal objective of our investment management activities is to maintain acceptable levels of interest rate and liquidity risk to facilitate our funding needs. As part of our risk management, we may continue to use derivative financial products such as interest rate hedges and interest rate swaps in the future.

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ITEM 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA


DUANE READE HOLDINGS, INC

AUDITED FINANCIAL STATEMENTS

Index

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Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders of Duane Reade Holdings, Inc.:

        We have audited the accompanying consolidated balance sheets of Duane Reade Holdings, Inc. and subsidiaries (the "Company") as of December 27, 2008 and December 29, 2007, and the related consolidated statements of operations, stockholders' equity (deficit) and comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 27, 2008. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

        We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

        In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Duane Reade Holdings, Inc. and subsidiaries as of December 27, 2008 and December 29, 2007, and the results of their operations and their cash flows for each of the years in the three-year period ended December 27, 2008, in conformity with U.S. generally accepted accounting principles.

        As discussed in Note 1 to the consolidated financial statements, the Company adopted FASB Statement of Financial Accounting Standards No. 157, "Fair Value Measurements" as of December 30, 2007. Also as discussed in Note 1, the Company adopted FASB Statement of Financial Accounting Standards No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115" as of December 30, 2007.

/s/ KPMG LLP
New York, New York
March 23, 2009

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DUANE READE HOLDINGS, INC.

Consolidated Statements of Operations

(In thousands)

 
  Fiscal Year
Ended
December 27,
2008
  Fiscal Year
Ended
December 29,
2007
  Fiscal Year
Ended
December 30,
2006
 

Net sales

  $ 1,774,029   $ 1,686,752   $ 1,584,778  

Cost of sales (exclusive of depreciation and amortization shown separately below)

    1,227,129     1,176,376     1,108,727  
               

Gross profit

    546,900     510,376     476,051  

Selling, general & administrative expenses

    476,574     446,696     426,532  

Labor contingency income

            (18,004 )

Depreciation and amortization

    68,539     73,080     71,932  

Store pre-opening expenses

    797     600     305  

Gain on sale of pharmacy files

        (1,337 )    

Other (Note 16)

    16,808     15,948     14,747  
               

Operating loss

    (15,818 )   (24,611 )   (19,461 )

Interest expense, net

    54,915     60,977     56,947  
               

Loss before income taxes

    (70,733 )   (85,588 )   (76,408 )

Income tax expense

    2,045     2,192     2,956  
               

Net loss

  $ (72,778 ) $ (87,780 ) $ (79,364 )
               

See accompanying notes to consolidated financial statements.

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DUANE READE HOLDINGS, INC.

Consolidated Balance Sheets

(Dollars in thousands)

 
  December 27,
2008
  December 29,
2007
 

Assets

             

Current assets

             
 

Cash

  $ 1,430   $ 1,380  
 

Receivables, net

    55,783     55,707  
 

Inventories

    214,154     211,678  
 

Prepaid expenses and other current assets

    13,541     13,205  
           
 

Total current assets

    284,908     281,970  

Property and equipment, net

    186,560     195,740  

Goodwill

    69,510     70,099  

Other assets, net

    171,622     194,680  
           
 

Total assets

  $ 712,600   $ 742,489  
           

Liabilities and Stockholders' Deficit

             

Current liabilities

             
 

Accounts payable

  $ 88,238   $ 75,769  
 

Accrued interest

    8,597     9,158  
 

Accrued expenses

    52,262     43,086  
 

Current portion of long-term debt

    144,642     141,352  
 

Current portion of capital lease obligations

    4,485     3,994  
           
 

Total current liabilities

    298,224     273,359  

Long-term debt

    405,033     405,032  

Capital lease obligations, less current portion

    1,492     5,475  

Deferred income taxes

    28,440     27,423  

Redeemable preferred stock and accrued dividends

    36,775     31,786  

Deferred rent liabilities

    53,084     40,462  

Other non-current liabilities

    36,253     32,275  
           
 

Total liabilities

    859,301     815,812  
           

Commitments and contingencies (Note 18)

             

Stockholders' deficit

             
 

Preferred stock, $0.01 par; authorized 50,000 shares; issued and outstanding: zero shares at December 27, 2008 and December 29, 2007

         
 

Common stock, $0.01 par; authorized 4,205,600 shares at December 27, 2008 and December 29, 2007; issued and outstanding: 2,615,077 and 2,595,077 shares at December 27, 2008 and December 29, 2007, respectively

    26     26  
 

Paid-in capital

    255,867     251,716  
 

Accumulated other comprehensive income (loss)

    (4,747 )   4  
 

Accumulated deficit

    (397,847 )   (325,069 )
           
 

Total stockholders' deficit

    (146,701 )   (73,323 )
           
 

Total liabilities and stockholders' deficit

  $ 712,600   $ 742,489  
           

See accompanying notes to consolidated financial statements.

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DUANE READE HOLDINGS, INC.

Consolidated Statements of Cash Flows

(In thousands)

 
  Fiscal Year
Ended
December 27,
2008
  Fiscal Year
Ended
December 29,
2007
  Fiscal Year
Ended
December 30,
2006
 

Cash flows from operating activities:

                   

Net loss

  $ (72,778 ) $ (87,780 ) $ (79,364 )

Adjustments to reconcile net loss to net cash provided by operating activities:

                   

Depreciation and amortization

    72,191     76,733     75,882  

Deferred income taxes

    2,471     2,065     2,520  

Non-cash rent expense

    12,751     11,678     10,956  

Non-cash interest expense on redeemable preferred stock

    7,439     4,216      

Asset impairment charges

    7,662     868     10,202  

Reversal of labor contingency liability

            (18,004 )

Other non-cash charges (credits)

    (3,470 )   (4,379 )   382  

Changes in operating assets and liabilities (net of effect of acquisitions):

                   

Receivables

    (76 )   1,474     (800 )

Inventories

    (2,476 )   7,246     12,654  

Prepaid expenses and other current assets

    (336 )   12,454     4,255  

Accounts payable

    12,469     (7,641 )   10,699  

Accrued expenses

    2,460     (5,270 )   (8,827 )

Other assets and liabilities, net

    6,010     7,607     (8,939 )
               

Net cash provided by operating activities

    44,317     19,271     11,616  
               

Cash flows from investing activities:

                   

Capital expenditures

    (33,125 )   (26,050 )   (25,112 )

Lease acquisition, customer files and other costs

    (14,401 )   (19,206 )   (6,458 )

Proceeds on sales of assets

    525     3,335     2,500  
               

Net cash used in investing activities

    (47,001 )   (41,921 )   (29,070 )
               

Cash flows from financing activities:

                   

Borrowings from revolving credit facility

    2,067,969     1,982,406     1,850,549  

Repayments of revolving credit facility

    (2,064,678 )   (1,998,178 )   (1,829,120 )

Issuance of preferred stock and warrants

        39,150      

Issuance of common stock

    2,000          

Capital contributions

    1,454     2,467      

Deferred financing costs

    (1 )   (5 )   (755 )

Proceeds from exercise of stock options

        10      

Repayment of capital lease obligations

    (4,010 )   (3,215 )   (3,187 )
               

Net cash provided by financing activities

    2,734     22,635     17,487  
               

Net increase (decrease) in cash

    50     (15 )   33  

Cash at beginning of year

    1,380     1,395     1,362  
               

Cash at end of year

    1,430   $ 1,380   $ 1,395  
               

Supplementary disclosures of cash flow information:

                   

Cash paid for interest

  $ 44,384   $ 53,006   $ 52,518  

Cash paid for taxes on income, net of refunds received

  $ 109   $ 281   $ 198  

Property acquired under capital lease financing

  $ 518   $ 2,377   $  

See accompanying notes to consolidated financial statements.

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DUANE READE HOLDINGS, INC.

Consolidated Statements of Stockholders' Equity (Deficit) and Comprehensive Income (Loss)

(Dollars in thousands)

 
  Preferred Stock   Common Stock    
   
  Accumulated
Other
Comprehensive
Income (Loss)
   
   
 
 
  Paid-in
Capital
  Accumulated
Deficit
   
  Comprehensive
Income (Loss)
 
 
  Shares   Amount $   Shares   Amount $   Total  

Balance, January 1, 2006

      $     2,594,977   $ 26   $ 239,472   $ (157,925 ) $ 260   $ 81,833        

Grant and recognition of stock option expense

                    335             335   $  

Interest rate hedge

                            (67 )   (67 )   (67 )

Net loss

                        (79,364 )       (79,364 )   (79,364 )
                                       

Balance, December 30, 2006

      $     2,594,977   $ 26   $ 239,807   $ (237,289 ) $ 193   $ 2,737   $ (79,431 )
                                       

Grant and recognition of stock option expense

                    982             982   $  

Interest rate hedge

                            (189 )   (189 )   (189 )

Capital contribution

                    2,467             2,467      

Issuance of common stock warrants

                    8,450             8,450      

Exercise of stock options

            100         10             10      

Net loss

                        (87,780 )       (87,780 )   (87,780 )
                                       

Balance, December 29, 2007

      $     2,595,077   $ 26   $ 251,716   $ (325,069 ) $ 4   $ (73,323 ) $ (87,969 )
                                       

Grant and recognition of stock option expense

                    697             697   $  

Interest rate hedge

                            (4,751 )   (4,751 )   (4,751 )

Capital contribution

                    1,454             1,454      

Issuance of common stock

            20,000         2,000             2,000      

Net loss

                        (72,778 )       (72,778 )   (72,778 )
                                       

Balance, December 27, 2008

      $     2,615,077   $ 26   $ 255,867   $ (397,847 ) $ (4,747 ) $ (146,701 ) $ (77,529 )
                                       

See accompanying notes to consolidated financial statements.

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DUANE READE HOLDINGS, INC

Notes to Consolidated Financial Statements

1.     Organization and Summary of Significant Accounting Policies

        Duane Reade Holdings, Inc. was formed in December 2003 by Oak Hill Capital Partners, LP, a private equity firm ("Oak Hill") in order to acquire Duane Reade Inc. and its subsidiaries (the "Acquisition"). Approximately 99% of the common stock of Duane Reade Holdings, Inc. (the "Company") is owned by Duane Reade Shareholders, LLC, a parent entity also established to effectuate the Acquisition. The Acquisition was completed on July 30, 2004 through the merger of Duane Reade Acquisition (a wholly- owned subsidiary of Duane Reade Holdings, Inc.) into Duane Reade Inc. with Duane Reade Inc. being the surviving entity and a wholly-owned subsidiary of Duane Reade Holdings, Inc. after the merger transaction.

        The Company, along with certain of its subsidiaries, is a guarantor of the debt obligations of Duane Reade Inc. and Duane Reade, the New York general partnership that holds the operating assets and liabilities ("Duane Reade GP"). The Company has no assets or operations other than its investment in its subsidiaries. Accordingly, the Consolidated Financial Statements present the consolidated net assets and operations of the subsidiaries. The guarantees provided by the Company and its other subsidiaries under the debt obligations of Duane Reade Inc. and Duane Reade GP (described in more detail in Note 9) are full and unconditional, joint and several.

        The primary assets of Duane Reade Holdings, Inc. are its ownership of 100% of the outstanding common stock of Duane Reade Inc. Duane Reade Inc. owns 99% of the outstanding partnership interest of Duane Reade GP, and 100% of all of the outstanding common stock of DRI I Inc. DRI I Inc. owns the remaining 1% partnership interest in Duane Reade GP. Substantially all of the Company's operations of 251 drugstores located in the metropolitan New York market are conducted through Duane Reade GP. In August 1999, two new subsidiaries, Duane Reade International, Inc. and Duane Reade Realty, Inc., were established. Duane Reade GP distributed to Duane Reade Inc. and DRI I Inc. all rights, title, and interest in all its trademarks, trade names and all other intellectual property rights. In turn, Duane Reade Inc. and DRI I Inc. made a capital contribution of these intellectual property rights to Duane Reade International. This change created a controlled system to manage and exploit these intellectual property rights separate and apart from the retail operations. In addition, Duane Reade GP distributed some of its store leases to Duane Reade Inc. and DRI I Inc., which in turn made a capital contribution of these leases to Duane Reade Realty. Duane Reade Realty is the lessee under certain store leases entered into after its creation. Duane Reade Realty subleases to Duane Reade GP the properties subject to those leases.

        The Company has incurred losses since the Acquisition date due primarily to the additional depreciation and amortization expense relating to the stepped-up fair value of its assets on the Acquisition date, and increased interest expense on Acquisition indebtedness. The Company has an accumulated deficit of $397.8 million at December 27, 2008. The Company has generated positive net cash flows from operations of $44.3 million in fiscal 2008, $19.3 million in fiscal 2007 and $11.6 million in fiscal 2006. The Company has never been subject to the single quarterly fixed charge financial coverage requirement specified in the amended asset-based revolving loan facility agreement. The fixed charge financial covenant becomes applicable when borrowings exceed 90 percent of the borrowing base, as defined in the agreement. Historically, the Company's borrowings have never exceeded 90 percent of the borrowing base and the Company does not expect to exceed this threshold during 2009. If the fixed charge coverage ratio was in effect during fiscal 2008, the Company would have been in full compliance with the covenant.

        The Company intends to refinance its senior floating rate notes due 2010 and senior subordinated notes due 2011 in the amounts of $210 million and $195 million, respectively, prior to their maturity dates. There can be no assurance that such refinancing will actually take place.

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        Significant accounting policies followed in the preparation of the Consolidated Financial Statements are as follows:

        Reporting year:    The fiscal year for the Company is the 52 or 53 week reporting period ending on the last Saturday in December. The 2008, 2007 and 2006 fiscal years contain 52 weeks.

        Principles of consolidation:    The Consolidated Financial Statements include the accounts of the Company and its subsidiaries. All significant intercompany transactions and balances have been eliminated.

        Reclassification:    Certain prior year balances have been reclassified to conform to the current year's presentation.

        Cash:    Cash consists of cash on hand at our store locations.

        Receivables:    Receivables consist primarily of amounts due from various insurance companies, pharmacy benefit management companies and governmental agencies under third party payment plans for prescription sales and amounts due from vendors, a majority of which relate to promotional programs. The Company's accounting policy, which is based on its past collection experience, is to fully reserve for all pharmacy receivables over 120 days old that are unpaid at the evaluation date and deemed uncollectible, as well as any other pharmacy receivables deemed potentially uncollectible. Pharmacy receivables other than New York Medicaid are adjudicated at the point of sale and do not generally have issues of collectability. Other receivables, which primarily consist of amounts due from vendors, are reserved for based upon a specific application of the Company's historical collection experience to the total aged receivable balance. The Company has provided an aggregate allowance for doubtful accounts of $1.7 million at December 27, 2008 and December 29, 2007. The carrying value of the Company's receivables approximates fair value given the short-term maturity of these financial instruments.

        Inventories and cost of sales:    Inventories are stated at the lower of cost or market with cost determined using the specific item average cost last-in, first-out ("LIFO") method. When appropriate, provision is made for obsolete, slow-moving or damaged inventory. At December 27, 2008 and December 29, 2007, inventories would have been $2.4 million higher and $1.6 million lower, respectively, if they were valued at the lower of specific item average cost first-in, first-out cost or market. The lower specific item average cost first-in, first-out valuation at December 29, 2007 is due to an inventory purchase accounting step-up at July 30, 2004. The Company's primary pharmaceutical supplier provides $30.0 million of inventory on a consignment basis. Prescription drug inventory over the consignment limit is owned. As of December 27, 2008 and December 29, 2007, there was approximately $41.4 million and $38.9 million, respectively, of prescription drug inventory over the $30.0 million consignment limit included in the Company's consolidated balance sheets. Included within cost of sales are all warehouse expenses and distribution costs, except for depreciation and amortization expense, which is shown separately. The Company reflects promotional allowances from vendors as a reduction of inventory or advertising expense, depending on the nature of the allowance, when such inventory is sold or advertising or promotions have been completed and the related allowances have been earned.

        Property and equipment:    Property and equipment are stated at cost. Depreciation and amortization are calculated using the straight-line method over the estimated useful lives of assets as follows:

Buildings and improvements

  30 years

Furniture, fixtures and equipment

  3-10 years

Computer equipment

  5-7 years

Leasehold improvements

  Life of lease or, if shorter, remaining useful life

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        Other assets:    Deferred financing costs are amortized over the term of the underlying debt. Individual pharmacy customer files are amortized on a straight-line basis over their useful lives, generally the lesser of seven years or the remaining life of the store lease. Favorable leases are amortized on a straight-line basis over the remaining life of the lease. Non-competition contracts are amortized on a straight-line basis over the life of the respective agreements, which are normally three years.

        In accordance with Statement of Position 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use," the Company capitalizes certain costs incurred in the development of internal-use software. The Company capitalized $6.1 million, $4.7 million and $4.1 million of computer software during fiscal 2008, fiscal 2007 and fiscal 2006, respectively. These capitalized costs are amortized over the useful life of the software, generally seven years.

        Impairment:    The carrying values of intangible assets subject to amortization and long-lived assets are reviewed and evaluated for impairment by the Company when events and circumstances indicate that the carrying amount of these assets may not be recoverable. For these intangible and long-lived assets, this evaluation is generally based on the future undiscounted operating cash flows of the related assets. Should such evaluation result in the Company concluding that the carrying amount of intangibles or long-lived assets has been impaired, an appropriate write-down to fair value based on discounted cash flows would be recorded. Using the impairment methodology evaluation described, the Company recorded impairment charges in fiscal 2008 of approximately $7.7 million for stores whose asset carrying values were greater than their undiscounted expected cash flows. The Company recorded impairment charges of $0.9 million in fiscal 2007 and $10.2 in fiscal 2006 for stores whose asset carrying values were greater than their undiscounted expected cash flows. With respect to the testing of its long-lived assets for impairment, the Company may be required to record additional asset impairment charges in the future if the general economic downturn persists and if there is a prolonged period of economic weakness in the markets it serves.

        Goodwill and indefinite lived intangibles that are not amortized are evaluated for impairment annually as of the year end balance sheet date and between annual tests in certain circumstances as required under SFAS No. 142, "Goodwill and Other Intangible Assets". The process of evaluating the Company's goodwill and indefinite lived intangibles for impairment involves the determination of fair value. Inherent in such fair value determinations are certain judgments and estimates, including a projection of future cash flows, the interpretation of economic indicators and market valuations, assumptions in the Company's business plans and other quantitative and qualitative analyses. The Company assesses its goodwill and trade name for impairment annually at the end of its fiscal year and in interim periods if certain events occur indicating the carrying value may be impaired. The Company performs its analysis for potential impairment of goodwill in accordance with SFAS No. 142, which requires that a two-step impairment test be performed on goodwill. In the first step, the fair value of the reporting unit is compared to its carrying value. If the fair value exceeds its carrying value, goodwill is not impaired, and no further testing is required. If the carrying value of the reporting unit exceeds its fair value, then a second step must be performed in order to determine the implied fair value of the goodwill and compare it to the carrying value of the goodwill. If the carrying value of goodwill exceeds its implied fair value then an impairment loss is recorded equal to the difference.

        The Company's evaluation of goodwill and the Company's trade name as of December 27, 2008 and as of December 29, 2007 resulted in no impairment charge to these assets.

        Closed Store Reserve:    The Company occasionally vacates store locations prior to the expiration of the related lease. For vacated locations that are under long-term leases, the Company records an expense for the difference between its future lease payments and related costs (e.g., real estate taxes and common area maintenance) from the date of closure through the end of the remaining lease term, net of expected future sublease rental income. The Company's closed store reserve can be affected by uncertainties because management is required to make assumptions and to apply judgment to estimate

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the duration of future vacancy periods, the amount and timing of future settlement payments, and the amount and timing of potential sublease rental income. When making these assumptions, management considers a number of factors, including historical settlement experience, the owner of the property, the location and condition of the property, the terms of the underlying lease, the specific marketplace demand and general economic conditions. At December 27, 2008 and December 29, 2007, the Company had a total closed store reserve of $8.2 million and $7.7 million, respectively. The Company may be required to recognize additional charges to the closed store reserve in a future period if it decides to vacate a store location prior to the expiration of the related lease.

        Revenue recognition:    The Company recognizes revenues from the sale of merchandise at the time that the merchandise is sold. The Company does not accrue for product returns because the amounts are de minimis.

        Advertising expenses:    Costs incurred to produce media advertising are charged to expense when the advertising takes place. For the 2008, the 2007 and 2006 fiscal years, advertising expense was $12.0 million, $12.6 million and $14.9 million, respectively.

        Pre-opening expenses:    Store pre-opening costs, other than capital expenditures, are expensed when incurred.

        Operating lease accounting:    Rent expense for operating leases is expensed over the current lease term on a straight line basis commencing from the date of possession or delivery of the underlying asset. Landlord allowances are deferred and amortized on a straight-line basis over the lease term.

        Sales taxes:    The Company reflects sales tax collected at the point-of-sale as a current liability, rather than as a component of revenue. Sales taxes collected in such a manner are remitted to the appropriate state authorities in accordance with their respective payment schedules.

        Income taxes:    Income taxes are accounted for under the asset and liability method prescribed by SFAS No. 109, "Accounting for Income Taxes." Deferred tax assets and liabilities are determined based on the difference between the financial statement carrying amount and tax bases of the respective assets and liabilities as well as for the deferred tax effects of tax credit carryforwards. Deferred tax assets and liabilities are measured using the enacted tax rates expected to apply to taxable income in the years in which these temporary differences are expected to be recovered or settled. Valuation allowances are established when management determines that it is more likely than not that a deferred tax asset will not be realized. For the fiscal years ended December 27, 2008 and December 29, 2007, the Company's balance sheet reflects valuation allowances of $142.9 million and $112.0 million, respectively. Please refer to Note 17 "Income Taxes" for additional information on this topic. The Company also establishes a reserve for costs of exposure on previously filed tax returns.

        Employee stock option plans:    The board of directors of Duane Reade Holdings, Inc. adopted the Duane Reade Holdings,  Inc. Management Stock Option Plan (the "2004 Option Plan") on July 30, 2004. The 2004 Option Plan is administered by the compensation committee of the board of directors. Any officer, employee, director or consultant of Duane Reade Holdings or any of its subsidiaries or affiliates is eligible to be designated a participant under the 2004 Option Plan. As of December 27, 2008, a maximum of 575,893 shares of the Company's common stock (on a fully diluted basis) may be granted under the 2004 Option Plan.

        Under the 2004 Option Plan, the compensation committee of Duane Reade Holdings, Inc. may grant awards of nonqualified stock options, incentive stock options, or any combination of the foregoing. A stock option granted under the 2004 Option Plan will provide a participant with the right to purchase, within a specified period of time, a stated number of shares of the Company's common stock at the price specified in the award agreement. Stock options granted under the 2004 Option Plan will be subject to such terms, including the exercise price and the conditions and timing of exercise, not

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inconsistent with the 2004 Option Plan, as may be determined by the compensation committee and specified in the applicable stock option agreement or thereafter.

        Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS No. 123(R), using the "modified" prospective transition method. Under that transition method, compensation expense recognized includes the vested portion of share-based payments granted on or after January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123(R). The Company has elected to recognize compensation expense on a straight-line basis over the vesting period of the respective options. Refer to Note 19 for additional information regarding stock option-based compensation expense.

        Use of estimates:    The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues, costs and expenses during the reporting period. These estimates and assumptions are based on management's best estimates and assumptions. Recent events, including illiquid credit markets, volatility in the debt and equity markets and declines in consumer spending have combined to increase the uncertainty inherent in such estimates and assumptions. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates. Changes in those estimates resulting from continuing changes in the economic environment will be reflected in the financial statements in future periods.

        Significant estimates used in the preparation of the consolidated financial statements included herein follow:

        Inventory shrink:    Inventory balances are presented net of the Company's estimated provision for shrink, which is based on the most recent store trends. The Company takes front-end and pharmacy physical inventories in all of its stores at least once per year on a staggered cycle basis and performs cycle counts of the inventories at the distribution centers throughout the year.

        General liability insurance claims:    Liabilities for the gross amount payable of general liability insurance claims are primarily related to customer accidents. The Company's policy is to recognize such liabilities based on estimates of the ultimate settlement value of these claims, as well as for estimated incurred but unreported claims as of each balance sheet date. For a majority of the claims, the Company's maximum self-insured portion of an individual claim does not exceed $250,000, although the Company's historical claim settlement experience is significantly lower. The Company carries primary general liability insurance coverage (above the self-insured limit) of $15 million and also has a general liability umbrella policy that provides an additional $100 million of insurance coverage beyond the primary limit. At December 27, 2008 and December 29, 2007, the Company has recorded a liability of $4.7 million and $4.8 million, respectively, reflecting the estimated gross self-insured settlement value of its general liability claims.

        Other loss contingencies:    Liabilities for loss contingencies are recorded when it is probable that a liability has been incurred and the amount of the loss is reasonably estimable.

        Fair value measures:    The Company has certain financial instruments that are accounted for at fair value. Since the financial instruments are not traded, they are valued using valuation models that require judgment and inputs that are generally unobservable. The significant financial instruments recorded within the Company's consolidated financial statements at fair value include a liability for an interest rate collar, non-current liabilities for the mandatory redemption feature of its preferred stock, a liability for phantom stock, compensation expense for stock options granted by the Company and a liability for the profits interest of Mr. Cuti. The valuations of these items contain uncertainties because they require management to make assumptions about the probability of future events, to apply

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judgment to estimate industry and economic factors and the profitability of future business strategies as well as selecting the appropriate discount rate. Therefore, the valuations cannot be determined with precision, cannot be substantiated by comparison to quoted prices in active markets, and may not represent the amounts that would be realized in a current sale or immediate settlement of the asset or liability. Additionally, there are inherent uncertainties in any fair value measurement technique, and changes in the underlying assumptions could materially affect the fair value measurement amounts.

        Significant vendor relationships:    The Company is party to multi-year, merchandise supply agreements in the normal course of business. The largest of these agreements is with AmerisourceBergen, the Company's primary pharmaceutical supplier. Generally, these agreements provide for certain volume commitments and may be terminated by the Company, subject in some cases to specified termination payments, none of which, in management's opinion, would constitute a material adverse effect on the Company's results of operations, financial position or cash flows. It is the opinion of management that if any of these agreements were terminated or if any contracting party was to experience events precluding fulfillment of its obligations, the Company would be able to find a suitable alternative supplier.

        Recently issued accounting standards:    In May 2008, the Financial Accounting Standards Board ("FASB") approved FASB Staff Position ("FSP") APB 14-1, "Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement)." FSP APB 14-1 clarifies that convertible debt instruments that may be settled in cash upon conversion (including partial cash settlement) are not addressed by paragraph 12 of APB Opinion No. 14, "Accounting for Convertible Debt and Debt issued with Stock Purchase Warrants." Additionally, FSP APB 14-1 specifies that issuers of such instruments should separately account for the liability and the equity components in a manner that will reflect the entity's nonconvertible debt borrowing rate when interest cost is recognized in subsequent periods, with equity component being valued based on the difference between such non-convertible debt borrowing rate and the actual cash interest rate on such convertible debt. FSP APB 14-1 is effective for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years and must be applied retrospectively to all periods presented. The Company is evaluating the effect which the implementation of FSP APB 14-1 may have on the consolidated financial statements.

        In April 2008, the FASB issued FASB FSP No. FAS 142-3, "Determination of the Useful Life of Intangible Assets," which amends the factors that should be considered in developing renewal or extension assumptions used in determining the useful lives of recognized intangible assets. FSP No. FAS 142-3 is effective for fiscal years beginning after December 15, 2008, and interim periods within those years. The Company does not currently expect the adoption of FSP No. FAS 142-3 to have a material effect on the Company's consolidated financial statements.

        In May 2008, the FASB issued SFAS No. 162, "The Hierarchy of Generally Accepted Accounting Principles." This standard is intended to improve financial reporting by identifying a consistent framework, or hierarchy, for selecting accounting principles to be used in preparing financial statements that are presented in conformity with generally accepted accounting principles in the United States for non-governmental entities. SFAS No. 162 is effective 60 days following approval by the U.S. Securities and Exchange Commission ("SEC") of the Public Company Accounting Oversight Board's amendments to AU Section 411, "The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles." The Company does not expect SFAS No. 162 to have a material impact on the preparation of the Company's consolidated financial statements.

        In March 2008, the FASB issued SFAS No. 161, "Disclosures about Derivative Instruments and Hedging Activities—an Amendment of FASB Statement No. 133." The new standard is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand the effects on an entity's financial position, financial performance, and cash flows. SFAS No. 161 is effective prospectively for periods beginning on

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or after November 15, 2008. The adoption of SFAS No. 161 is not currently expected to have a material effect on the Company's consolidated financial statements.

        In December 2007, the FASB issued SFAS No. 160, "Noncontrolling Interests in Consolidated Financial Statements—An Amendment of ARB No. 51." SFAS No. 160 establishes accounting and reporting standards pertaining to ownership interests in subsidiaries held by parties other than the parent, the amount of net income attributable to the parent and to the noncontrolling interest, changes in a parent's ownership interest, and the valuation of any retained noncontrolling equity investment when a subsidiary is deconsolidated. This statement also establishes disclosure requirements that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. SFAS No. 160 is effective for fiscal years beginning on or after December 15, 2008. The adoption of SFAS No. 160 is not currently expected to have a material effect on the Company's consolidated financial statements.

        In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115." This statement permits entities to choose to measure many financial instruments and certain other items at fair value. SFAS No. 159 is applicable for the Company as of December 30, 2007, the first day of fiscal 2008. The adoption of SFAS No. 159 did not have a material impact on the Company's consolidated financial statements.

        In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements," which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 is applicable for the Company as of December 30, 2007, the first day of fiscal 2008. In February 2008, the FASB issued FASB Staff Position FAS 157-2 which deferred the effective date of SFAS No. 157 for certain nonfinancial assets and liabilities until fiscal 2009. The Company has adopted SFAS No. 157 to account for its financial assets and liabilities and such adoption did not have a material effect on its consolidated financial statements. The FASB Staff Position SFAS No. 157-2 defers the effective date of SFAS No. 157 for certain nonfinancial assets and liabilities until fiscal 2009, but the Company does not currently expect its adoption to have a material effect on the Company's consolidated financial statements.

        In December 2007, the FASB issued SFAS No. 141(R), "Business Combinations." SFAS No. 141(R) requires the acquiring entity in a business combination to recognize the full fair value of assets acquired and liabilities assumed in the transaction (whether a full or partial acquisition), establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed, and requires the acquirer to disclose the information needed to evaluate and understand the nature and effect of the business combination. This statement applies to all transactions or other events in which the acquirer obtains control of one or more businesses, including those sometimes referred to as "true mergers" or "mergers of equals" and combinations achieved without the transfer of consideration, for example, by contract alone or through the lapse of minority veto rights. For new acquisitions made following the adoption of SFAS 141(R), significant costs directly related to the acquisition including legal, audit and other fees, as well as most acquisition-related restructuring, will have to be expensed as incurred rather than recorded to goodwill as is generally permitted under SFAS No. 141, "Business Combinations." Additionally, contingent purchase price arrangements (also known as earn-outs) will be re-measured to estimated fair value with the impact reported in earnings, whereas under present rules the contingent purchase consideration is recorded to goodwill when determined. Adoption of SFAS No. 141(R) is required for business combinations after December 15, 2008. Early adoption and retroactive application of SFAS No. 141(R) to fiscal years preceding the effective date are not permitted. The adoption of SFAS No. 141(R) is not currently expected to have a material effect on the Company's consolidated financial statements.

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2.     Completion of Audit Committee Investigations

    Investigation of Real Estate Transactions and Related Matters:

        As previously disclosed, the Audit Committee of the Company, with the assistance of independent counsel (which engaged forensic accountants), conducted a review and investigation concerning certain real estate transactions and related matters and whether the accounting for such transactions was proper. That review and investigation was completed in 2007.

        As a result of the completion of the review and investigation, the independent counsel of the Audit Committee determined that it would not be necessary to restate any previously-issued financial statements for any periods subsequent to fiscal year 2004. However, the independent counsel identified approximately $14.4 million of pre-tax income from real estate transactions and related matters that occurred during the 2000 through 2004 fiscal years (the "Real Estate Related Transactions") for which the Company's accounting was concluded by the Company to be improper. Based on the conclusions of the independent counsel relating to the Real Estate Related Transactions, as described in more detail below, the Audit Committee determined, on May 22, 2007, that a restatement of the Company's previously-issued financial statements as of and for the five months ended December 25, 2004, the seven months ended July 30, 2004 and the 2000 through 2003 fiscal years (collectively, the "Affected Periods") was required. The Company has filed all of the necessary restated financial statements for the Affected Periods. The restatements have had no material impact on the Company's financial statements for any periods during the 2006, 2007 or 2008 fiscal years.

        The independent counsel concluded that the Real Estate Related Transactions were orchestrated by Anthony J. Cuti, a former Chairman and CEO, who was replaced in November 2005, and were expressly designed to overstate the Company's income. The primary method used in the scheme was to make payments to certain entities that were ostensibly in respect of services provided by the entities and record the payments in connection with the Company's acquisition of various leases. The payments were therefore capitalized as part of the Company's lease acquisition costs and amortized over the lives of the related leases. These amounts were in turn paid back to the Company by the entities ostensibly for terminating operations in certain stores, not exercising certain real estate options and for taking other actions in respect of various leases (the "Company Actions"). The payments made to the Company were generally recorded as income at or about the time the agreements relating to the Company Actions were signed. According to the independent counsel's report, in order to accomplish the scheme, Mr. Cuti made certain false representations to the Company's Chief Financial Officer, other members of the management of the Company and the Company's independent accountants concerning the structure and economic substance of the Real Estate Related Transactions. The independent counsel concluded that the agreements for the Real Estate Related Transactions between the entities and the Company had not been negotiated at arm's length and that the purported consideration in those Real Estate Related Transactions was illusory and lacking in economic substance. The independent counsel therefore concluded that the circular payments to the entities by the Company and payments by the entities back to the Company should not have been made and should not have been reflected in the financial statements as originally reported. The restatement of the financial statements as of and for the Affected Periods included the adjustments required to properly reflect those circular payments and resulting adjustments to the related amortization originally recorded.

        The Audit Committee's conclusion that the financial statements for the Affected Periods should be restated was based on the conclusions of the independent counsel in the investigation and the accounting impact of the misstatements relating to real estate-related income, combined with the misstatements described below under "Investigation of Credits and Rebillings."

        The review and investigation of the independent counsel and the forensic accountants was completed on May 18, 2007. On May 22, 2007, the Company received a grand jury subpoena from the United States Attorney's Office for the Southern District of New York seeking documents related to

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the above matters. The Company is cooperating fully with that investigation. In the Company's arbitration proceeding against Mr. Cuti, on May 25, 2007, the United States Attorney's Office for the Southern District of New York filed an application requesting that the arbitrator stay further proceedings in the arbitration, including discovery, pending further developments in its criminal investigation of Mr. Cuti. Following briefing by the parties on the application, the arbitrator entered an order staying the arbitration proceedings. The stay has been extended from time to time.

        On October 9, 2008, the United States Attorney's Office for the Southern District of New York and the SEC announced the filing of criminal and civil securities fraud charges against Mr. Cuti and another former executive of the Company, William Tennant. In the criminal indictment, the government charges that Mr. Cuti and Mr. Tennant engaged in a scheme, involving the credits and rebillings and real estate-related transactions discussed above, to falsely inflate the income and reduce the expenses that the Company reported to the investing public and others. The SEC's complaint similarly alleges that Mr. Cuti and Mr. Tennant entered into a series of fraudulent transactions designed to boost reported income and enable the Company to meet quarterly and annual earnings guidance. Both proceedings are continuing. For more information regarding the arbitration proceeding, please see Note 18 to the audited financial statements contained within this report.

    Investigation of Credits and Rebillings:

        The Audit Committee of the Company, with the assistance of independent counsel, conducted and completed a review and investigation of the fiscal periods from 2000 through September 30, 2006, relating to arrangements originated by Mr. Cuti for the issuance of improper credits and the subsequent rebilling of such credits related to amounts paid to construction and other contractors at its stores and the related improper accounting. The Audit Committee completed its investigation prior to the filing of the Company's quarterly report on Form 10-Q for the quarter ended September 30, 2006 on January 10, 2007.

        The investigation focused principally on the accounting impact of approximately $5.8 million of credits from construction contractors that were improperly taken into the Company's income and offsetting rebillings which were improperly recorded as capital expenditures in subsequent quarters by the Company. The Audit Committee believes that all of such credits were subsequently rebilled by the contractors and that the Company paid the contractors such rebilled amounts.

        The credits had the effect of improperly offsetting SG&A expense (and improperly increasing net income) during the periods in which they were received. Amounts subsequently rebilled by the Company were generally capitalized as store improvements, improperly increasing the reported level of property and equipment as well as subsequent depreciation expense. The overstated net property and equipment that resulted from the credit/rebilling practice was also carried through the Acquisition-related purchase accounting process on a dollar-for-dollar basis.

        In the periods from fiscal 2000 through the seven months ended July 30, 2004, increased depreciation resulted in a partial offset and understatement of operating income and income before income taxes. In the periods subsequent to July 30, 2004, increased depreciation resulted in an overstatement of operating loss and loss before income taxes. Income tax expense may also have been reduced as a result, based on the tax impact of such depreciation expense. However, due to the valuation allowance being recorded during 2006, there would not be any impact on income tax expense for the 2006 period.

        Net income (loss) for all of the above-described periods would reflect the combined impact of the overstatement or understatement of income (loss) before income taxes and any related changes in income tax expense (benefit).

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        The credit/rebilling practice resulted in the overstatement of net property and equipment in all periods since the re-billings occurred. As a result of the overstatement of net property and equipment and related purchase accounting adjustments made in connection with the Acquisition, goodwill was also understated.

        In addition, as a part of its investigation, the Audit Committee also examined certain invoices from store maintenance and other contractors to determine whether the amounts paid to those contractors were accounted for properly. The Audit Committee concluded that any misstatements with respect to such invoices were inconsequential.

        The Company has filed the necessary restated financial statements for the Affected Periods.

3.     Pharmacy and Customer File Acquisitions

        During the fiscal year ended December 27, 2008, the Company acquired the individual pharmacy customer files and the operations, including certain lease-related assets, of two pharmacy establishments (each of the acquired pharmacies was operated as a new store). The Company acquired the individual pharmacy customer files and the operations, including certain lease-related assets, of one pharmacy establishment (which was operated as a new store) during the fiscal year ended December 29, 2007. We did not acquire any pharmacy establishments or customer files in fiscal 2006. The table below provides detail of these acquisitions (dollars in millions).

 
  Fiscal Year
Ended
December 27,
2008
  Fiscal Year
Ended
December 29,
2007
 

Pharmacy establishments acquired

    2     1  
           

Purchase price allocation:

             

Identifiable intangibles

  $ 1.1   $ 1.2  

Inventory

    0.4     0.3  

Other assets

    0.1     0.3  

Accruals and liabilities

    0.0     (0.2 )
           

Total

  $ 1.6   $ 1.6  
           

        The acquired pharmacies have been included in the consolidated statements of operations from the date of acquisition and did not have a material effect on the reported results of operations of the Company for any of the periods presented.

4.     Receivables

        Receivables are summarized as follows (in thousands):

 
  December 27,
2008
  December 29,
2007
 

Third party pharmacy plans

  $ 40,705   $ 37,694  

Due from vendors

    11,440     14,569  

Credit cards and other receivables

    5,342     5,202  
           

Subtotal

    57,487     57,465  

Less: allowance for doubtful accounts

    (1,704 )   (1,758 )
           

Total Receivables, net of allowances

  $ 55,783   $ 55,707  
           

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5.     Prepaid Expenses and Other Current Assets

        Prepaid expenses and other current assets are summarized as follows (in thousands):

 
  December 27,
2008
  December 29,
2007
 

Prepaid rent / real estate receivables

  $ 3,879   $ 2,433  

Insurance claims receivable

    1,693     1,674  

Prepaid insurance

    1,536     1,992  

Prepaid cigarette taxes

    159     525  

Prepaid equipment leases & maintenance contracts

    1,192     1,270  

Miscellaneous prepaids & receivables

    5,082     5,311  
           

Total Prepaid expenses and other current assets

  $ 13,541   $ 13,205  
           

6.     Property and Equipment

        Property and equipment are summarized as follows (in thousands):

 
  December 27,
2008
  December 29,
2007
 

Furniture, fixtures and equipment

  $ 146,109   $ 138,900  

Building and leasehold improvements including construction in progress

    169,231     162,307  
           

    315,340     301,207  

Less accumulated depreciation and amortization

    128,780     105,467  
           

Total Property and equipment, net

  $ 186,560   $ 195,740  
           

        Depreciation and amortization of property and equipment was $38.0 million, $35.7 million and $33.7 million in fiscal 2008, fiscal 2007 and fiscal 2006, respectively.

7.     Other Assets

        Other assets are summarized as follows (in thousands):

 
  December 27,
2008
  December 29,
2007
 

Favorable leases and other lease acquisition costs (net of accumulated amortization of $72,120 and $60,140)

  $ 66,567   $ 74,368  

Pharmacy customer lists (net of accumulated amortization of $75,702 and $61,465)

    28,957     42,445  

Trade name

    46,000     46,000  

Deferred financing costs (net of accumulated amortization of $16,958 and $13,307)

    8,451     12,102  

Software & systems development costs (net of accumulated amortization of $13,150 and $8,982)

    18,021     16,081  

Other

    3,626     3,684  
           

Total Other assets, net

  $ 171,622   $ 194,680  
           

        For the fiscal years ended December 27, 2008, December 29, 2007 and December 30, 2006, amortization of intangible assets was $30.5 million, $37.4 million and $38.3 million, respectively. Amortization expense includes amortization of software and system development costs amounting to

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$4.2 million, $3.4 million and $2.9 million, respectively. For the 2009 through 2013 fiscal years, the Company expects to incur annual expenses related to the amortization of existing intangible assets of $28.1 million, $24.3 million, $18.7 million, $11.2 million and $9.1 million, respectively.

8.     Accrued Expenses

        Other accrued expenses are summarized as follows (in thousands):

 
  December 27,
2008
  December 29,
2007
 

Accrued salaries and benefits

  $ 15,083   $ 15,798  

Hedge liability (see Note 10)

    4,747      

Insurance related claims costs

    4,744     4,810  

Closed store reserves

    4,718     2,624  

Expense payables

    4,664     5,168  

Accrued legal liabilities (see Note 18)

    3,789     606  

Deferred tax liability (see Note 17)

    3,289     1,835  

Accrued professional fees

    1,955     3,191  

Sales tax payable

    1,294     1,576  

Accrued rent

    587     994  

Other

    7,392     6,484  
           

Total Accrued expenses

  $ 52,262   $ 43,086  
           

9.     Debt

        Debt is summarized as follows (in thousands):

Description of Instrument
  December 27, 2008   December 29, 2007  

Current Debt:

             
 

Asset-based revolving loan facility(1)

  $ 144,642   $ 141,352  
           

Non-Current Debt:

             
 

Senior floating rate notes due 2010

    210,000     210,000  
 

9.75% Senior subordinated notes due 2011

    195,000     195,000  
 

2.1478% Senior convertible notes due 2022(2)

    33     32  
           

Total Long-term debt

    405,033     405,032  
           

Total Debt

  $ 549,675   $ 546,384  
           

(1)
At December 27, 2008, approximately $144.6 million was outstanding under the Company's asset-based revolving loan facility. Obligations under this facility have been classified as current liabilities because cash receipts controlled by the lenders are used to reduce outstanding debt and the Company does not meet the criteria of SFAS No. 6, "Classification of Short-Term Obligations Expected to be Refinanced—An Amendment of ARB No. 43, Chapter 3A", to classify the debt as long-term, however, this is not an indication that this credit facility is expected to be retired within the next year. The Company intends to continue to use this facility for its working capital needs through the date of its maturity in July 2011.

(2)
Increase is due to the accretion of the discount on the original issuance.

        Asset-Based Revolving Loan Facility.    On July 22, 2004, in connection with the Acquisition, the asset-based revolving loan facility was amended to increase the borrowing capacity to an aggregate

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principal amount of $250 million, subject to an adjusted borrowing base calculation based upon specified advance rates against the value of inventory, pharmacy prescription files and accounts receivable. The original maturity date of the amended asset-based revolving loan facility was July 21, 2008. In August 2005, in conjunction with the issuance of $50.0 million aggregate principal amount of senior secured floating rate notes due 2010, the Company permanently reduced the maximum availability under the amended asset-based revolving loan facility by $25.0 million to $225.0 million. On July 7, 2006, the Company entered into a further amendment to the amended asset-based revolving loan facility to extend its maturity from July 21, 2008 to July 21, 2011, subject to the requirement that the Company refinance or restructure the $210.0 million aggregate principal amount of the senior secured floating rate notes due 2010 and the $195.0 million aggregate principal amount of the 9.75% senior subordinated notes due 2011, in each case, on terms reasonably acceptable to the administrative agent and at least 120 days prior to each's respective scheduled maturity date. The Company fully intends to refinance or restructure the outstanding principal amounts of its senior secured floating rate notes and senior subordinated notes within the required timeframe, in accordance with the requirements of the third amendment.

        On September 28, 2007, the asset-based revolving loan facility was amended to exclude from the definition of Capital Expenditures any expenditure made with the proceeds of any equity securities issued or capital contributions received by the Company.

        The amended asset-based revolving loan facility includes a $50 million sub-limit for the issuance of letters of credit. Obligations under the revolving loan facility are collateralized by a first priority interest in inventory, receivables, pharmacy prescription files, deposit accounts and certain other current assets. Under the amended asset-based revolving loan facility, Duane Reade GP is the sole obligor. However, the amended asset-based revolving loan facility is guaranteed on a full and unconditional basis by the Company, Duane Reade Inc. and each of the Company's other domestic subsidiaries other than the obligor.

        The amended asset-based revolving loan facility contains a single fixed charge coverage requirement which only becomes applicable when borrowings exceed 90 percent of the borrowing base, as defined in the agreement governing the amended asset-based revolving loan facility. Borrowings under the amended asset-based revolving loan facility have not exceeded 90 percent of the borrowing base and, as a result, the fixed charge covenant has not become applicable. There are no credit ratings related triggers in the amended asset-based revolving loan facility that would impact the cost of borrowing, annual amortization of principal or related indebtedness maturity.

        Revolving loans under the amended asset-based revolving loan facility, at the Company's option, bear interest at either:

    a rate equal to LIBOR (the London Interbank Offered Rate) plus a margin of from 1.00% to 2.00%, determined based on levels of borrowing availability reset each fiscal quarter; or

    a rate equal to the prime rate of Banc of America Retail Group Inc. plus a margin of from 0.00% to 0.50%, determined based on levels of borrowing availability reset each fiscal quarter.

        Borrowings under the amended facility continue to be primarily LIBOR-based. At December 27, 2008 and December 29, 2007, the amended asset-based revolving loan facility bore interest at a weighted average annual rate of 3.51% and 6.72%, respectively.

        At December 27, 2008, there was $144.6 million outstanding under the amended asset-based revolving loan facility, and approximately $69.0 million of remaining availability, net of $6.3 million reserved for outstanding standby letters of credit. Obligations under this facility have been classified as current liabilities because cash receipts controlled by the lenders are used to reduce outstanding debt, and the Company does not meet the criteria of SFAS No. 6, "Classification of Short-Term Obligations

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Expected to be Refinanced—An Amendment of ARB No. 43, Chapter 3A," to classify the debt as long-term.

        Senior Secured Floating Rate Notes due 2010.    On December 20, 2004, the Company closed an offering of $160.0 million aggregate principal amount of senior secured floating rate notes due 2010. Using the net proceeds from that offering, together with approximately $2.2 million of borrowings under the amended asset-based revolving loan facility, the Company repaid all outstanding principal under its previously existing $155.0 million senior term loan facility, along with approximately $3.6 million of early repayment premium and accrued but unpaid interest through December 20, 2004. On August 9, 2005, the Company issued a further $50.0 million of senior secured notes. These new notes were issued under the same indenture as the senior secured notes issued in December 2004, although they do not trade fungibly with those notes.

        The senior secured notes bear interest at a floating rate of LIBOR plus 4.50%, reset quarterly. Interest on the senior secured notes is payable quarterly on each March 15, June 15, September 15, and December 15. The senior secured notes mature on December 15, 2010. At December 27, 2008, the senior secured notes bore interest at an annual rate of 6.42%.

        On April 30, 2008, the Company entered into a hedging transaction through the acquisition of a "no cost collar." Under this arrangement, the Company capped its exposure on $210.0 million of LIBOR-based borrowings at a maximum LIBOR rate of 5.2%. In addition, the Company established a minimum "floor" LIBOR rate of 2.6%, in line with then current LIBOR rates. The changes in the fair value of the hedge agreement are reflected on the Consolidated Statements of Stockholder's Equity (Deficit) and Comprehensive Income (Loss) included within the financial statements. At December 27, 2008, the LIBOR rate in effect was approximately 1.9%, which was below the minimum rate specified under the "no cost collar." As a result, the "no cost collar" increased the effective annual interest rate on the Company's LIBOR-based borrowings by approximately 0.4%. This hedging arrangement expires on December 15, 2010.

        The Company guarantees the senior secured notes on a full and unconditional, senior secured basis. Duane Reade Inc. and Duane Reade GP are co-obligors under the senior secured notes. The senior secured notes rank equally in right of payment with any of the Company's, Duane Reade Inc.'s or Duane Reade GP's unsubordinated indebtedness and senior in right of payment to any of the Company's, Duane Reade Inc.'s or Duane Reade GP's subordinated or senior subordinated indebtedness. All obligations under the senior secured notes are guaranteed on a senior basis by each of the Company's existing subsidiaries, other than Duane Reade Inc. and Duane Reade GP, and will be guaranteed by future subsidiaries of Duane Reade Inc. and Duane Reade GP except certain foreign and certain domestic subsidiaries. The senior secured notes and the guarantees are collateralized by a first priority interest in substantially all of Duane Reade Inc. and Duane Reade GP's assets other than those assets in which the lenders under the amended asset-based revolving loan facility have a first priority interest. The senior secured notes and the guarantees are also collateralized by a second priority interest in all collateral pledged on a first priority basis to lenders under the amended asset-based revolving loan facility.

        Upon the occurrence of specified change of control events, Duane Reade Inc. and Duane Reade GP will be required to make an offer to repurchase all of the senior secured notes at 101% of the outstanding principal amount of the senior secured notes plus accrued and unpaid interest to the date of repurchase. The indenture governing the senior secured notes contains certain affirmative and negative covenants that limit the ability of Duane Reade Inc., Duane Reade GP and their restricted subsidiaries, as defined, to incur additional indebtedness, pay dividends, make repayments on indebtedness that is subordinated to the senior secured notes and to make certain other restricted payments, incur certain liens, use proceeds from sales of assets, enter into business combination transactions (including mergers, consolidations and asset sales), enter into sale-leaseback transactions,

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enter into transactions with affiliates and permit restrictions on the payment of dividends by restricted subsidiaries. The indenture governing the senior secured notes contains customary events of default, which, if triggered, may result in the acceleration of the indebtedness outstanding under the indenture. There are no credit ratings related triggers in the indenture governing the senior secured notes that would impact the cost of borrowing, annual amortization of principal or related indebtedness maturity. The indenture governing the senior secured notes does not contain financial maintenance covenants.

        At December 27, 2008, the weighted average combined interest rate in effect on all variable rate debt outstanding, including the effect of the "no cost collar," was 5.23%.

        Senior Subordinated Notes due 2011.    On July 30, 2004, upon completion of the Acquisition, Duane Reade Inc. and Duane Reade GP co-issued $195.0 million of 9.75% senior subordinated notes due 2011. The senior subordinated notes mature on August 1, 2011 and bear interest at 9.75% per annum payable in semi-annual installments on February 1 and August 1. The senior subordinated notes are uncollateralized obligations and subordinated in right of payment to all of the Company's, Duane Reade Inc.'s and Duane Reade GP's existing and future unsubordinated indebtedness, including borrowings under the amended asset-based revolving loan facility and the senior secured notes. The senior subordinated notes will rank equally with any future senior subordinated indebtedness and senior to any future subordinated indebtedness. The senior subordinated notes are guaranteed on an uncollateralized, senior subordinated basis by the Company and all of Duane Reade Inc.'s existing direct and indirect domestic subsidiaries other than Duane Reade GP, which is a co-obligor under the senior subordinated notes. Upon the occurrence of specified change of control events, the Company will be required to make an offer to repurchase all of the senior subordinated notes at 101% of the outstanding principal amount of the senior subordinated notes plus accrued and unpaid interest to the date of repurchase. The indenture governing the senior subordinated notes contains certain affirmative and negative covenants that limit the ability of Duane Reade Inc., Duane Reade GP and their restricted subsidiaries to incur additional indebtedness, pay dividends, make repayments on indebtedness that is subordinated to the senior subordinated notes and to make certain other restricted payments, incur certain liens, use proceeds from sales of assets, enter into business combination transactions (including mergers, consolidations and asset sales), enter into transactions with affiliates and permit restrictions on the payment of dividends by restricted subsidiaries. The indenture governing the senior subordinated notes contains customary events of default, which, if triggered, may result in the acceleration of the indebtedness outstanding under the indenture. There are no credit ratings related triggers in the indenture governing the senior subordinated notes that would impact the cost of borrowing, annual amortization of principal or related indebtedness maturity.

        2.1478% Senior Convertible Notes due 2022.    On April 16, 2002, Duane Reade Inc. completed an offering of $381.5 million aggregate principal amount of senior convertible notes maturing on April 16, 2022 (the "Convertible Notes"). The Convertible Notes were issued at a price of $572.76 per note (57.276% of the principal amount at maturity) and paid cash interest at the rate of 2.1478% per year on the principal amount at maturity, payable semi-annually in arrears on April 16 and October 16 of each year beginning on October 16, 2002, until April 16, 2007. Since that date, interest has accrued on the notes as amortization of the original issue discount representing a yield to maturity of 3.75% per year, computed on a semi-annual bond equivalent basis. In December 2002, Duane Reade Inc. repurchased a total of $30.5 million principal value of the Convertible Notes at an average purchase price of $486.99 per $1,000 note, resulting in a remaining net outstanding balance of $201.0 million.

        In connection with the Acquisition, Duane Reade Inc. made a tender offer to repurchase all of the $351.0 million outstanding principal value of the Convertible Notes. Upon the closing of the tender offer, a total of $350.9 million principal value ($201.0 million issuance value) was tendered for repurchase, leaving only $55.0 thousand of principal value ($32.0 thousand of issuance value) outstanding. Duane Reade Inc. may redeem for cash all or a portion of the principal value of the outstanding Convertible Notes at any time after April 16, 2007, at a price equal to the sum of the issue price plus accrued original issue discount and accrued cash interest, if any, to the redemption date.

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        Debt Maturities.    At December 27, 2008, the aggregate maturities of debt are as follows (dollars in thousands):

2009

  $  

2010

    210,000  

2011

    339,642  

2012

     

2012

     

Thereafter

    33  
       

Total

  $ 549,675  
       

10.   Hedging Activity

        SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," as amended, establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. Under SFAS No. 133, all derivatives, whether designated in hedging relationships or not, are required to be recorded on the balance sheet at fair value. SFAS No. 133 defines requirements for designation and documentation of hedging relationships, as well as ongoing effectiveness assessments, which must be met in order to qualify for hedge accounting. For a derivative that does not qualify as a hedge, changes in fair value would be recorded in earnings immediately.

        At December 27, 2008, the Company's hedging activity consists of a "no cost" interest rate collar designed to hedge interest rate variability on portions of its LIBOR-based borrowings. The Company formally documents the relationship between the hedging instruments and the hedged items, as well as its risk management objectives and strategy for undertaking hedge transactions. This interest rate collar qualifies for hedge accounting as a cash flow hedge. Accordingly, the Company recognizes this derivative at fair value as either an asset or liability on the consolidated balance sheets. All changes in fair value are recorded in accumulated other comprehensive income and subsequently reclassified into earnings when the related interest expense on the underlying borrowing is recognized. The Company has not, and does not plan to, enter into any derivative financial instruments for trading or speculative purposes.

        On April 30, 2008, the Company entered into a hedging transaction through the acquisition of a "no cost collar." Under this arrangement, the Company capped its exposure on $210.0 million of LIBOR-based borrowings at a maximum LIBOR rate of 5.2%. In addition, the Company established a minimum "floor" LIBOR rate of 2.6%, in line with then current LIBOR rates. The changes in the fair value of the hedge agreement are reflected on the Consolidated Statements of Stockholder's Equity (Deficit) and Comprehensive Income (Loss) included within the financial statements. At December 27, 2008, the LIBOR rate in effect was approximately 1.9%, which was below the minimum rate specified under the "no cost collar." As a result, the "no cost collar" increased the effective annual interest rate on the Company's LIBOR-based borrowings by approximately 0.4%. This hedging arrangement expires on December 15, 2010.

        On May 25, 2005, the Company entered into a hedging transaction through the acquisition of a "no cost collar." Under this arrangement, the Company capped its exposure on $130.0 million of LIBOR-based borrowings under the senior secured floating rate notes at a maximum LIBOR rate of 5.30%. In addition, the Company established a minimum "floor" LIBOR rate of 3.45%, in line with then current LIBOR rates. This hedging arrangement expired on June 16, 2008.

        The fair value of the interest rate collars resulted in a hedge liability of $4.7 million and a hedge asset of $4.0 thousand, at December 27, 2008 and December 29, 2007, respectively.

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11.   Fair Value

        On December 30, 2007, the first day of fiscal 2008, the Company adopted SFAS No. 157 to account for its financial assets and liabilities. This standard defines fair value, provides guidance for measuring fair value and requires certain disclosures. This standard does not require any new fair value measurements; however, it applies to all other accounting pronouncements that require or permit fair value measurements. This standard does not apply to fair value measurements related to share-based payments, nor does it apply to fair value measurements related to inventory.

        SFAS No. 157 utilizes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy under SFAS No. 157 are described below:

    Level 1—Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;

    Level 2—Quoted prices in markets that are not considered to be active or financial instruments for which all significant inputs are observable, either directly or indirectly; and

    Level 3—Prices or valuations that require inputs that are both significant to the fair value measurement and unobservable.

        A financial instrument's level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement. The fair value estimates presented in the tables below are based on the information available to the Company as of December 27, 2008 and December 29, 2007.

Valuation Techniques

        The valuation approach used to calculate the fair value of the Series A preferred stock's mandatory redemption feature is a combination of future liquidity event probabilities, risk-adjusted returns, and a net present value analysis. The valuation methodology applied to the profits interest is based on a Monte Carlo simulation, which estimates the fair value of the profits interest based on several inputs, including the fair value of the Company's equity, future liquidity event probabilities and the expected volatility of the underlying equity value. The interest rate collar is valued using models that contain observable market data as well as models that have non-observable inputs, such as assumptions regarding the future performance of the underlying assets. The guarantees for assigned store leases are valued using a probability weighted net present value analysis which considers the probability of future events which may cause the Company to fulfill the guarantees.

        Due to the significant judgment applied in the valuation approaches, the valuations cannot be determined with precision, cannot be substantiated by comparison to quoted prices in active markets, and may not represent the amounts that would be realized in a current sale or immediate settlement of the asset or liability. Additionally, there are inherent uncertainties in any fair value measurement technique, and changes in the underlying assumptions could materially affect the fair value measurement amounts, causing the Company to record additional expenses in a future period or to reverse previously recorded expenses in a future period.

Fair Value on a Recurring Basis

        The assets and liabilities measured at fair value on a recurring basis are categorized in the tables below based upon the lowest level of significant input to the valuations. As required by SFAS No. 157, the assets and liabilities are classified in their entirety based on the lowest level of input that is

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significant to the fair value measurement (dollars in thousands). The amounts representing liabilities are denoted in parentheses in the tables below.

 
  Level 1   Level 2   Level 3   Total  

Series A Preferred stock—mandatory redemption feature

  $   $   $ (5,624 ) $ (5,624 )

Profits interest

                 

Interest rate collar

            (4,747 )   (4,747 )

Guarantees

            (504 )   (504 )
                   

Total

  $   $   $ (10,875 ) $ (10,875 )
                   

        The table presented below summarizes the change in balance sheet carrying values associated with the Company's Level 3 assets and liabilities recorded at fair value on a recurring basis during the year ended December 27, 2008 (dollars in thousands).

 
  Preferred Stock
Mandatory
Redemption
Feature(1)
  Profits
Interest(2)
  Interest Rate
Collars, net
  Guarantees(3)   Total  

Balance at December 29, 2007

  $ (3,173 ) $ (1,671 ) $ 4   $   $ (4,840 )
 

Gains/(Losses)—

                               
   

Included in net loss

    (2,451 )   1,671         (504 )   (1,284 )
   

Included in other comprehensive loss

            (4,751 )       (4,751 )
   

Transfers

                     
                       

Balance at December 27, 2008

  $ (5,624 ) $   $ (4,747 ) $ (504 ) $ (10,875 )
                       

The amount of gains/(losses) for the period included in net loss and attributable to the change in unrealized gains/(losses) for assets and liabilities still held at December 27, 2008. 

  $ (2,451 ) $ 1,671   $   $ (504 ) $ (1,284 )
                       

(1)
The unrealized losses for the year ended December 27, 2008 are included within interest expense.

(2)
The unrealized gain for the year ended December 27, 2008 is included within other expenses.

(3)
The unrealized losses for the year ended December 27, 2008 are included within selling, general and administrative expenses.

12.   Capital Lease Obligations

        The Company has entered into several capital lease agreements. The capital lease obligations are payable in monthly installments and bear interest at a weighted average rate of 10.8%. At

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December 27, 2008, the aggregate maturity of the capitalized lease obligations and the present value of the net minimum lease payments are as follows (in thousands):

2009

  $ 4,881  

2010

    935  

2011

    653  
       

    6,469  

Less amounts representing interest

    492  
       

    5,977  

Less current maturities

    4,485  
       

Total Capital lease obligations, less current portion

  $ 1,492  
       

        At December 27, 2008, assets acquired under capital leases and the corresponding accumulated amortization amounts were $18.0 million and $12.9 million, respectively. At December 29, 2007, assets acquired under capital leases and the corresponding accumulated amortization amounts were $17.5 million and $9.2 million, respectively.

13.   Other Non-current Liabilities

        Non-current liabilities consists of the following:

 
  December 27,
2008
  December 29,
2007
 

Deferred credits

  $ 25,975   $ 17,429  

Phantom stock liability

        1,589  

Closed store reserve

    3,437     5,079  

Preferred stock—mandatory redemption feature

    5,624     3,173  

Other

    1,217     5,005  
           

Total Other non-current liabilities

  $ 36,253   $ 32,275  
           

        Deferred credits primarily reflects landlord allowances that will be recognized on a straight-line basis over the lives of the respective lease agreements. The preferred stock mandatory redemption feature is discussed in Note 14.

        The phantom stock liability represents the value of shares of common stock pledged to certain of the Company's current and former Senior Vice Presidents in exchange for certain forfeited payments to which they were entitled in connection with the completion of the Acquisition. Based upon the December 27, 2008 valuation of the Company's equity fair value, the phantom shares are considered to have no value at December 27, 2008.

14.   Issuance of Preferred Stock and Common Stock Warrants in Connection with the Acquisition of Store Leases

        On February 20, 2007, the Company entered into an agreement to acquire up to eight leases from the Gristedes supermarket chain for certain locations in the borough of Manhattan, New York City. As of December 27, 2008, the Company had completed the lease acquisitions for six of the former Gristedes locations. The Company has opened stores at the six former Gristedes locations. The acquisition of these leases has been funded through a portion of the proceeds from the issuance of $39.4 million of preferred stock and common stock warrants. The Company's agreement with Gristedes has expired and the Company is not obligated to acquire the remaining two leases.

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        On March 27, 2007, certain affiliates of Oak Hill Capital Partners L.P. made an equity commitment of $39.4 million in the form of Series A preferred stock and warrants to acquire approximately 11% (on a fully diluted basis) of the Company's common stock at an exercise price of $75.00 per share. The proceeds from this capital infusion were used, in part, to acquire the Gristedes leases and to fund certain other capital expenditures. The funds raised through this commitment in excess of funds needed for the acquisition were used to fund the Company's normal capital spending, fund new store openings or to reduce the Company's outstanding debt. The first portion of this equity commitment, which amounted to $13.0 million, was funded on March 27, 2007 and the balance of the $39.4 million commitment, in which certain members of senior management also elected to participate, was funded on June 28, 2007. The preferred stock has a 12-year mandatory redemption date from the issuance date and provides for an annual cash dividend of 10% payable quarterly subject to being declared by the Board of Directors. To the extent the dividends are not paid in cash, the dividends will cumulate on a quarterly basis. The dividends are recorded within interest expense on the Statement of Operations. Under the agreements governing its indebtedness, the Company is not currently permitted to pay such dividends in cash. As of December 27, 2008 and December 29, 2007, the Company had accrued unpaid dividends of $6.7 million and $2.4 million, respectively.

        Each of the 525,334 shares of Series A preferred stock is immediately redeemable without penalty, at the Company's option prior to the mandatory redemption date, at a liquidation preference of $75.00 per share plus any accrued but unpaid dividends as of the redemption date. The Company has the right, at its option, immediately prior to an initial public offering (IPO), to require holders of the preferred stock to convert all (but not less than all) of such shares into a number of shares of the Company's common stock equal to the liquidation preference for such shares of preferred stock, divided by the price per share of the Company's common stock set forth in the final prospectus to be used in connection with the IPO. Upon the occurrence of a change in control, the Company will be required to redeem all outstanding shares of the Series A preferred stock at a redemption price per share of $75.00 per share plus accrued and unpaid dividends.

        The warrants are exercisable initially to purchase an aggregate of up to 384,174 shares of the Company's common stock. The purchase price for each share of the Series A preferred stock is $75.00 per share, and warrants are exercisable for the Company's common stock at a price per share of $75.00, subject to certain adjustments.

        In accordance with SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity," the Company has recorded the portion of the proceeds that are attributable to the Series A preferred stock ($30.7 million) as a liability because of the mandatory redemption feature. The remaining amount of $8.4 million (net of $0.3 million of expenses) was ascribed to the warrants, based on a relative fair value basis, and is recorded within additional paid-in capital. The Company has also recorded a liability for the Series A preferred stock's mandatory redemption feature, which is considered a derivative financial instrument. The recorded liability for the Series A preferred stock's mandatory redemption feature was $5.6 million and $3.2 million at December 27, 2008 and December 29, 2007, respectively. Such liability is included in "Other non-current liabilities" on the Consolidated Balance Sheet. See Note 13 for further discussion.

15.   Stockholders' Equity

    Common Stock of Duane Reade Holdings, Inc.

        At December 30, 2006, the Company's common stock consisted of 3,050,000 authorized shares. In fiscal 2007, the Company increased the number of authorized shares of common stock to 4,205,600. The par value of the common stock is $0.01 per share. There were 2,615,077 and 2,595,077 shares issued and outstanding at December 27, 2008 and December 29, 2007, respectively. Approximately 99% of the outstanding shares of Duane Reade Holdings, Inc. are beneficially owned by Duane Reade

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Shareholders, LLC. Oak Hill, together with the equity co-investors, owns on a fully diluted basis 100% of the outstanding membership interests in Duane Reade Shareholders, LLC.

        On July 28, 2008, the Company's CEO purchased 20,000 shares of Duane Reade Holdings, Inc. common stock at a price of $100 per share. The proceeds from the common stock issuance were used for general corporate purposes.

    Preferred Stock of Duane Reade Holdings, Inc.

        In conjunction with the issuance of preferred stock discussed in Note 14, the Company created a new class of preferred stock. At December 27, 2008, 550,000 shares of the Company's Series A preferred stock ($0.01 par value) were authorized to be issued, of which 525,334 shares were outstanding. With respect to dividends and distributions and upon any liquidation event, the Series A preferred stock ranks senior to all classes of common stock.

        At December 27, 2008, the Company is also authorized to issue an additional 50,000 shares of preferred stock ($0.01 par value), none of which were outstanding at December 27, 2008 or December 29, 2007.

    Stockholders and Registration Rights Agreement

        A stockholders and registration rights agreement was entered into among certain members of management and Duane Reade Shareholders. The stockholders and registration rights agreement contains, among other things, certain restrictions on the ability of the parties thereto to freely transfer the securities of Duane Reade Holdings, Inc. held by such parties. In addition, the stockholders and registration rights agreement provides that the holders of a majority of the membership interests in Duane Reade Shareholders may, under certain circumstances, compel a sale of all or a portion of the equity in Duane Reade Holdings, Inc. to a third party (commonly known as drag-along rights) and, alternatively, that stockholders of Duane Reade Holdings, Inc. may participate in certain sales of stock by holders of a majority of the common stock of Duane Reade Holdings, Inc. to third parties (commonly known as tag-along rights). The stockholders and registration rights agreement also contains certain corporate governance provisions regarding the nomination of directors and officers of Duane Reade Holdings, Inc. by the parties thereto. The stockholders and registration rights agreement also provides that Duane Reade Shareholders will have the ability to cause Duane Reade Holdings, Inc. to register common equity securities of Duane Reade Holdings, Inc. under the Securities Act, and provide for procedures by which certain of the equity holders of Duane Reade Holdings, Inc. and Duane Reade Shareholders may participate in such registrations.

    Preemptive Rights Agreement

        A preemptive rights agreement was entered into among certain Oak Hill entities, Duane Reade Shareholders, Duane Reade Holdings, Inc., Duane Reade Inc. and Mr. Cuti and certain current and former Senior Vice Presidents. The preemptive rights agreement contains, among other things, certain preemptive rights for management, providing that certain equity securities issued by Duane Reade Shareholders or any of its subsidiaries to the members of Duane Reade Shareholders (other than Mr. Cuti) must dilute the interests of all of the parties to the preemptive rights agreement on a proportionate basis. In connection with any such issuance of equity securities, each of Messrs. Cuti, Henry and Ray have the right to purchase from the issuing entity a percentage of equity securities being issued equal to their percentage interest (including phantom stock interest) in Duane Reade Holdings, Inc. as of such time (and, in the case of Mr. Cuti, taking into account his interest in Duane Reade Shareholders as of such time). To the extent any such members of management no longer maintain equity interests in Duane Reade Shareholders or any of its subsidiaries, they will cease to be beneficiaries of the preemptive rights agreement.

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    Issuance of Common Stock Warrants

        As discussed in Note 14, in conjunction with the issuance of preferred stock, the Company also issued warrants to purchase the Company's common stock. The warrants are convertible to the Company's common stock at a price per share of $75.00, subject to certain adjustments. In accordance with SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity" and Accounting Principles Board Opinion No. 14, "Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants," the Company has recorded the portion of the proceeds that was ascribed to the warrants, $8.4 million (net of $0.3 million of expenses), based on a relative fair value basis, within additional paid-in capital.

    Additional Capital Contributions

        Oak Hill reimburses the Company for a portion of the Company's legal costs incurred in connection with the arbitration proceedings relating to Mr. Cuti and discussed in Note 18. During fiscal 2008 and fiscal 2007, the reimbursements totaled approximately $1.5 million and $2.5 million, respectively. The amounts are recorded within additional paid-in capital.

16.   Other Expenses

        The table below provides detail of Other expenses for fiscal years 2008, 2007 and 2006 (dollars in thousands).

 
  Fiscal Year
Ended
December 27,
2008
  Fiscal Year
Ended
December 29,
2007
  Fiscal Year
Ended
December 30,
2006
 

Closed store costs

  $ 3,649   $ 4,351   $  

Asset impairment charges

    7,662     868     10,202  

Oak Hill management fee

    1,250     1,250     1,250  

Accounting investigations

        2,250     835  

Former CEO (Mr. Cuti) matters

    6,029     6,013     1,280  

Miscellaneous other

    (1,782 )   1,216     1,180  
               

Total Other expenses

  $ 16,808   $ 15,948   $ 14,747  
               

        When facts and circumstances indicate that the carrying values of long-lived assets may be impaired, an evaluation of recoverability is performed by comparing the carrying values of the assets to projected future cash flows in addition to other quantitative and qualitative analyses. During fiscal 2008, the Company recorded asset impairment charges of approximately $7.7 million for stores whose asset carrying values were greater than their undiscounted expected cash flows. The Company recorded impairment charges of $0.9 million in fiscal 2007 and $10.2 million in fiscal 2006 for stores whose asset carrying values were greater than their undiscounted expected cash flows.

        In the normal course of its business, the Company closes store locations. In accordance with the provisions of SFAS No. 146, "Accounting for the Costs Associated with Exit or Disposal Activities", the Company establishes reserves for closed store costs anticipated to be incurred in connection with such closings.

        See Note 2 and Note 18 for a discussion of the costs relating to accounting investigations and the proceedings relating to Mr. Cuti. The Oak Hill management fee is payable quarterly.

        Included within the miscellaneous other balance for 2008 are benefits resulting from fair value adjustments to reverse the excess liabilities for the phantom stock liability and the profits interest

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liability. These benefits are offset by additional benefit costs related to a March 2006 union contract settlement.

17.   Income Taxes

        The income tax provision for the 2008, 2007 and 2006 fiscal years consists of the following (in thousands):

 
  Fiscal Year
Ended
December 27,
2008
  Fiscal Year
Ended
December 29,
2007
  Fiscal Year
Ended
December 30,
2006
 

Current:

                   
 

Federal

  $   $   $  
 

State & Local

    (2 )   126     436  

Deferred:

                   
 

Federal

    1,881     1,866     1,881  
 

State & Local

    166     200     639  
               

Total Income tax expense

  $ 2,045   $ 2,192   $ 2,956  
               

        Deferred tax assets and liabilities are determined based on the difference between the financial statement carrying amount and tax bases of the respective assets and liabilities at December 27, 2008 and December 29, 2007 and are summarized as follows (in thousands):

 
  December 27,
2008
  December 29,
2007
 

Deferred tax assets (liabilities)—current:

             
 

Deferred income

  $ 951   $ 1,026  
 

Inventories

    (2,774 )   (2,823 )
 

Reserves

    11,483     10,138  
 

Other, net

    330     311  
           

    9,990     8,652  
 

Less: Valuation allowance

    (13,279 )   (10,487 )
           

Total Deferred income taxes—current liability

  $ (3,289 ) $ (1,835 )
           

Deferred tax assets (liabilities)—non-current:

             
 

Deferred rent

  $ 24,155   $ 18,396  
 

Deferred income

    10,932     6,893  
 

Long lived assets

    (59,084 )   (72,260 )
 

Labor contingency and other reserves

    3,491     4,166  
 

Alternative minimum tax credits

    1,668     1,668  
 

Wage-based and other tax credits

    8,003     9,024  
 

Net operating losses

    109,848     103,430  
 

Other, net

    2,118     2,771  
           

    101,131     74,088  
 

Less: Valuation allowance

    (129,571 )   (101,511 )
           

Total Deferred income taxes—non-current liability

  $ (28,440 ) $ (27,423 )
           

        As a result of the Company's significant losses incurred in 2008 and 2007 and its anticipated future performance based on recently completed projections, the Company evaluated the need to record a valuation allowance against its net deferred tax assets as part of the 2008 tax provision accounting procedures. The evaluation undertaken included a review of the individual deferred tax components

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and a corresponding analysis of the anticipated time period during which the temporary differences giving rise to deferred tax assets and liabilities would reverse. Based on the results of this analysis, the Company determined that except for two specific items, all other deferred tax assets and liabilities were expected to reverse within the same period. The non-reversing items total $31.7 million and include the deferred tax liability of $10.8 million associated with post-2004 goodwill and the deferred tax liability of $20.9 million associated with the trade name. Because these items are not amortized for financial statement purposes, a reversal of the corresponding deferred tax liability is not expected to occur within the expiration period of the Company's net operating losses.

        In fiscal 2008, fiscal 2007 and fiscal 2006, the Company generated net operating losses of approximately $6.8 million, $56.9 million and $45.4 million, respectively. The federal net operating losses can be carried forward 20 years and will begin to expire in fiscal year 2018. The New York State and New York City net operating losses can be carried forward for a period ranging between 15 and 20 years and began to expire in fiscal year 2007. The New Jersey net operating losses can be carried forward seven years and will begin to expire in fiscal year 2011. The federal and state tax effects of these net operating losses are reflected as a tax benefit in the deferred income tax provision.

        Additional deferred tax assets include federal, state and local tax credits totaling $9.7 million, and are composed of federal Work Opportunity Tax credits ($3.4 million), federal Alternative Minimum Tax credits ($1.7 million), New York State Zone Equivalent Area credits ($3.9 million) and New York City Unincorporated Business Tax ("UBT") credits ($0.7 million). The Work Opportunity Tax credits can be carried forward for a period of 20 years and the UBT credits begin to expire after 7 years. Each of the other tax credits can be carried forward indefinitely.

        Realization of these assets is dependent upon generating sufficient taxable income in future periods. Based on historical taxable income and projections of future taxable income over the periods that the deferred tax assets are deductible, management believes that it is more likely than not that the deferred tax assets will not be realized and has therefore established a valuation allowance against its deferred tax assets.

        At December 27, 2008, the Company has approximately $181.5 million of gross deferred tax assets and approximately $70.4 million of gross deferred tax liabilities, resulting in a net deferred tax asset of $111.1 million. After adjusting for the value of the deferred tax liabilities that do not reverse, the resulting cumulative valuation allowance amounts to $142.9 million, of which $30.9 million was recorded in 2008, compared to $43.5 million recorded in 2007 and $38.1 million recorded in 2006.

        The provision for income taxes for the 2008 fiscal year, the 2007 fiscal year and the 2006 fiscal year differs from the amounts of income tax determined by applying the applicable U.S. statutory federal income tax rate to pre-tax loss as a result of the following (dollars in thousands):

 
  Fiscal Year Ended
December 27, 2008
  Fiscal Year Ended
December 29, 2007
  Fiscal Year Ended
December 30, 2006
 

Pre-tax loss

  $ (70,733 )   100.0 % $ (85,588 )   100.0 % $ (76,408 )   100.0 %
                           

Statutory rate

    24,757     35.0     29,956     35.0     26,743     35.0  

State and local taxes, net of federal tax benefit

    6,714     9.5     8,430     9.8     8,112     10.6  

NOL and tax credit adjustments

        0.0     4,704     5.5         0.0  

Employment and other tax credits

    (702 )   (1.0 )       0.0     328     0.4  

Preferred stock dividend

    (2,604 )   (3.7 )   (1,491 )   (1.7 )       0.0  

Other

    642     0.9     (253 )   (0.3 )   (46 )   (0.1 )
                           

    28,807     40.7     41,346     48.3     35,137     46.0  

Change in valuation allowance

    (30,852 )   (43.6 )   (43,538 )   (50.9 )   (38,093 )   (49.9 )
                           

Income tax expense

  $ (2,045 )   (2.9 )% $ (2,192 )   (2.6 )% $ (2,956 )   (3.9 )%
                           

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        Employment tax credits represent the benefits earned by the Company for its participation in various federal and state hiring incentive programs. These benefits are generally based on the number of qualifying employees hired and retained by the Company for a specified time period. Employees qualify for these hiring programs primarily as a result of their enrollment in various economic assistance programs or based upon the duration of their employment at certain qualifying locations.

        In June 2008, the examination of Duane Reade Inc.'s New York State Franchise Tax filings for the 2001 through 2003 tax years was completed. The amounts paid to New York State in connection with this settlement were previously accrued and were not material to the Company's consolidated financial statements. In October 2008, a similar examination of Duane Reade Inc.'s New York State Franchise Tax filings for the period January 2004 through July 2004 was settled with no payments required.

        In September 2008, the Company was notified by the Internal Revenue Service that its Form 1120 filing for the 2006 tax year had been selected for examination. The examination is in its early stages and there have been no proposed adjustments to date.

        During 2008, there were no material changes to the Company's uncertain tax positions. The Company reflects interest charges incurred in connection with audit settlements as interest expense; however, if any tax-related penalties were to be incurred, such amounts would be recorded as a component of the income tax provision.

18.   Commitments and Contingencies

        Leases:    Duane Reade leases its facilities under operating lease agreements expiring on various dates through the year 2030. In addition to minimum rentals, certain leases provide for annual increases based upon real estate tax increases, maintenance cost increases and inflation. Generally, the Company obtains a free rent period during the construction of stores. Additionally, the Company's leases provide for escalations over the term of the lease. Rent expense, including deferred rent, real estate taxes and other rent-related costs and sub-lease income for the fiscal years ended December 27, 2008, December 29, 2007 and December 30, 2006 was $158.1 million, $149.6 million and $145.1 million, respectively.

        Minimum annual cash rent obligations under non-cancelable operating leases at December 27, 2008 (including obligations under new store leases entered into but not opened as of December 27, 2008) are as follows (in thousands):

2009

  $ 145,772  

2010

    146,810  

2011

    143,337  

2012

    140,042  

2013

    135,194  

Thereafter

    891,099  
       

Total

  $ 1,602,254  
       

        Amounts anticipated to be received during the periods shown above in connection with sub-lease arrangements existing at December 27, 2008 total $69.2 million.

        Purchase Commitments:    The Company is party to multi-year, merchandise supply agreements in the normal course of business. The largest of these agreements is with AmerisourceBergen, the Company's primary pharmaceutical supplier. Generally, these agreements provide for certain volume commitments and may be terminated by the Company, subject in some cases to specified termination payments, none of which, in management's opinion, would constitute a material adverse effect on the Company's results of operations, financial position or cash flows. It is the opinion of management that if any of these agreements were terminated or if any contracting party was to experience events precluding fulfillment of its obligations, the Company would be able to find a suitable alternative supplier.

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        Litigation:    The Company is party to legal actions arising in the ordinary course of business. Based on information presently available to the Company, it believes that the ultimate outcome of these actions will not have a material adverse effect on its financial position, results of operations or cash flows. In addition, the Company is a party to the following legal actions and matters:

        During 2002, the Company initiated a legal action against its former property insurance carrier, in an attempt to recover what the Company believed to be a fair and reasonable settlement for the business interruption portion of its claim originating from the September 11, 2001 World Trade Center terrorist attack, during which its single highest volume and most profitable store was completely destroyed. After a lengthy litigation and appraisal process, an appraisal panel awarded the Company approximately $5.6 million (in addition to the $9.9 million that was paid by the insurer to the Company in 2002). As a result of the insurer's refusal to pay this amount and also as a result of the Second Circuit Court of Appeals' interpretation of the Company's insurance policy, in January 2007, the Company commenced another action in the U.S. District Court for the Southern District of New York to recover both the appraisal panel's award and additional amounts under the policy. In August 2007, the District Court entered judgment in the amount of $0.8 million plus interest, and both parties appealed. The appeals have been briefed and are oral argument in the Second Circuit Court of Appeals has been held. However, due to the inherent uncertainty of litigation, there can be no assurance that this appeal will be successful.

        Accordingly, given the risks and uncertainties inherent in litigation, there can be no definitive assurance that the Company will actually receive any or all of the panel's appraised value of this claim, and the Company has not recognized any income related to this matter, other than $9.4 million of the original $9.9 million paid by the insurer in 2002. It should be noted that any payment to the Company that might be forthcoming as a result of this claim may also result in the incurrence of additional expenses that are contingent upon the amount of such insurance claim settlement. These expenses, if incurred, are not expected to exceed $4.0 million.

        In November 2004, the Company was served with a purported class action complaint, Damassia v. Duane Reade Inc. The lawsuit was filed in the U.S. District Court for the Southern District of New York. The complaint alleges that, from the period beginning November 1998, the Company incorrectly gave some employees the title "Assistant Manager," in an attempt to avoid paying these employees overtime, in contravention of the Fair Labor Standards Act and New York law. In May 2008, the court certified this case as a class action. In April 2006, the Company was served with a purported class action complaint, Chowdhury v. Duane Reade Inc. and Duane Reade Holdings, Inc. The complaint alleges that, from a period beginning March 2000, the Company incorrectly classified certain employees in an attempt to avoid paying overtime to such employees, thereby violating the Fair Labor Standards Act and New York law. In May 2008, the court certified this case as a class action. The complaint seeks an unspecified amount of damages. In January 2009, the Company announced that, without admitting liability, it has entered into a Memorandum of Understanding to settle these two class action cases for $3.5 million. The settlement is subject to the approval of the U.S. District Court for the Southern District of New York. While the Company believes that it can strongly defend itself against the matters involved in this litigation, it has agreed to this settlement so that it may avoid future defense costs and uncertainty surrounding this litigation. As a result of this settlement agreement, the Company recorded a $3.5 million one-time, pre-tax charge during the fourth quarter ended December 27, 2008.

        In November 2007, the Company was served with a subpoena from the Office of the Attorney General of the State of New York. The subpoena requested information regarding services to customers with limited English proficiency. The Company has cooperated with the Office of the Attorney General and believes this matter will be settled on terms acceptable to it. Should this matter not be settled, the Company believes it has valid defenses to any claims that may be made against it and will vigorously defend itself.

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        In January 2008, the Company was served with a subpoena from the Department of Health and Human Services, Office of the Inspector General. The subpoena seeks information relating to the operation of the Company's pharmacy kiosks and information relating to a business relationship that the Company had with Mobility Plus, a provider of durable medical equipment. In February 2008, the Company received an identical subpoena from the Office of the Attorney General of the State of New York, Medicaid Fraud Control Unit. The Company is in the process of responding to the information requests from both entities. While the Company believes that it has been in compliance with all applicable rules and regulations, at this stage, there can be no assurance as to the ultimate outcome of this matter.

Proceedings Relating to Anthony J. Cuti

        On September 1, 2006, Anthony J. Cuti, a former Chairman, President and Chief Executive Officer of the Company, initiated an arbitration before the American Arbitration Association against Duane Reade Inc., Duane Reade Holdings, Inc. and Duane Reade Shareholders, LLC, which are referred to as the "respondents." The arbitration relates to his termination in November 2005. Mr. Cuti asserts various claims including, with respect to his employment agreement, breach of contract relating to the notice of termination provision, failure to make certain payments toward his 1998 corporate-owned life insurance policy, relief from the non-competition and non-solicitation covenants, failure to provide adequate information relating to the valuation of his profits interest and breach of the covenant of good faith and fair dealing. Other claims relate to the patent rights for the Company's virtual pharmacy kiosk system and payment of an alleged deferred 2001 bonus based on any insurance recovery the Company may obtain on its business interruption claim in connection with the 2001 World Trade Center tragedy. On March 16, 2007, Mr. Cuti sought leave to file an amended demand asserting additional allegations in support of his claim for breach of contract for failure to comply with the notice of termination provision in his employment agreement, and a claim for defamation. On May 17, 2007, the arbitrator issued an order granting leave to file Mr. Cuti's amended demand. Mr. Cuti seeks monetary damages, declaratory relief, rescission of his employment agreement and the payment of his legal costs and fees associated with his termination and the arbitration.

        On November 22, 2006, the respondents filed counterclaims and affirmative defenses against Mr. Cuti in the arbitration, alleging that between 2000 and 2005, Mr. Cuti was responsible for improper practices involving invoice credits and rebillings for the construction of the Company's stores, that led to overstating the Company's publicly reported earnings, and that caused the Company to create and maintain inaccurate records and publish financial statements containing misstatements. These counterclaims were based on information uncovered as of that date by an investigation conducted by independent legal counsel and forensic accountants at the direction of the Audit Committee.

        In a press release dated April 2, 2007, the Company disclosed that, based on new information provided to the Company, the Audit Committee, with the assistance of independent counsel and forensic accountants, was conducting a review and investigation concerning the propriety of certain real estate transactions and related matters and whether the accounting for such transactions was proper. On April 9, 2007, the respondents sought leave to file proposed amended counterclaims based on that new information. On May 17, 2007, the arbitrator issued an order granting leave to file the amended counterclaims. The amended counterclaims seek rescission of employment agreements entered into between the Company and Mr. Cuti, return of all compensation paid under the employment agreements, other compensatory and punitive damages, and legal costs and fees associated with the Audit Committee's investigation and the arbitration.

        On May 18, 2007, the independent counsel and the forensic accountants completed their review and investigation. The independent counsel concluded that Mr. Cuti orchestrated certain real estate and other transactions that led to overstating the Company's publicly reported earnings, and that caused the Company to create and maintain inaccurate records and publish financial statements

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containing misstatements. On May 22, 2007, the Audit Committee determined, after considering the results of the review and investigation, that certain of the Company's previously-issued financial statements would have to be restated. The restatements and the results of the investigation are discussed more fully in Note 2.

        On May 22, 2007, the Company received a grand jury subpoena from the United States Attorney's Office for the Southern District of New York seeking documents relating to the allegations in the amended counterclaims discussed above. The Company is cooperating fully with the investigation. The SEC has also requested that the Company provide it with information related to this matter.

        On May 25, 2007, the United States Attorney's Office for the Southern District of New York filed an application requesting that the arbitrator stay further proceedings in the arbitration, including discovery, pending further developments in its criminal investigation of Mr. Cuti. Following briefing by the parties on the application, the arbitrator entered an order staying the arbitration proceedings. The stay has been extended from time to time.

        On October 9, 2008, the United States Attorney's Office for the Southern District of New York and the SEC announced the filing of criminal and civil securities fraud charges against Mr. Cuti and another former executive of the Company, William Tennant. In the criminal indictment, the government charges that Mr. Cuti and Mr. Tennant engaged in a scheme, involving the credits and rebillings and real estate-related transactions discussed above, to falsely inflate the income and reduce the expenses that the Company reported to the investing public and others. The SEC's complaint similarly alleges that Mr. Cuti and Mr. Tennant entered into a series of fraudulent transactions designed to boost reported income and enable the Company to meet quarterly and annual earnings guidance. Both proceedings are continuing.

        Management Agreements:    The Company has employment agreements with several of its executives providing, among other things, for employment terms of up to four years. Pursuant to the terms of such employment and related agreements, the Company may be obligated for certain compensation and benefits in the event of termination.

        Other Commitments:    In connection with the assignment of certain store leases to third parties during 2008 and 2007, the Company provides secondary guarantees on the lease obligations for the assigned stores. The respective purchasers have assumed the Company's obligations under these leases and are primarily liable for these obligations. Although the Company believes it to be unlikely, assuming that each respective purchaser became insolvent, management estimates that the Company could settle these obligations for amounts substantially less than the aggregate obligation of $27.8 million as of December 27, 2008. The obligations are for varying terms dependent upon the respective lease, the longest of which lasts through May 31, 2022.

19.    Benefit Plans

Management Stock Option Plan

        The board of directors of Duane Reade Holdings, Inc. adopted the Duane Reade Holdings, Inc. Management Stock Option Plan (the "2004 Option Plan"), which became effective on the date the Acquisition was completed. The 2004 Option Plan is administered by the compensation committee of the board of directors. Any officer, employee, director or consultant of Duane Reade Holdings or any of its subsidiaries or affiliates is eligible to be designated a participant under the 2004 Option Plan. As at December 27, 2008, a maximum of 575,893 shares of the Company's common stock (on a fully diluted basis) may be granted under the 2004 Option Plan.

        Under the 2004 Option Plan, the compensation committee of Duane Reade Holdings, Inc. may grant awards of nonqualified stock options, incentive stock options, or any combination of the foregoing. A stock option granted under the 2004 Option Plan will provide a participant with the right

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to purchase, within a specified period of time, a stated number of shares of the Company's common stock at the price specified in the award agreement. Stock options granted under the 2004 Option Plan will be subject to such terms, including the exercise price and the conditions and timing of exercise, not inconsistent with the 2004 Option Plan, as may be determined by the compensation committee and specified in the applicable stock option agreement or thereafter. Options granted under this plan will (i) be issued at an exercise price equal to or greater than the fair market value at the time of grant, (ii) generally vest ratably over five years and (iii) terminate after ten years.

        A summary of activity under the Stock Option Plan as of December 27, 2008, and changes during the three years ended December 27, 2008 are presented below:

 
  2004 Management Stock
Option Plan
 
 
  Total
Options
  Wtd. Avg
Exercise
Price
  Wtd. Avg
Fair
Value
 

Options outstanding, December 31, 2005

    367,797   $ 100.00   $ 24.94  

Options granted

    63,211   $ 100.00   $ 41.43  

Options forfeited

    (28,757 ) $ 100.00   $ 24.58  

Options cancelled

    (106,532 ) $ 100.00   $ 24.59  
                   

Options outstanding, December 30, 2006

    295,719   $ 100.00   $ 28.63  

Options granted

    178,000   $ 100.00   $ 5.59  

Options forfeited

    (4,172 ) $ 100.00   $ 24.55  

Options cancelled

    (14,542 ) $ 100.00   $ 18.55  

Options exercised

    (100 ) $ 100.00   $ 25.28  
                   

Options outstanding, December 29, 2007

    454,905              

Options granted

    265,000   $ 100.00   $ 11.14  

Options forfeited

    (77,508 ) $ 100.00   $ 22.63  

Options cancelled

    (172,263 ) $ 100.00   $ 19.90  

Options exercised

      $ 100.00   $  
                   

Options outstanding, December 27, 2008

    470,134              
                   

Weighted average remaining life

    8.3 years              

        As a result of the November 21, 2005 replacement of Mr. Cuti, all of Mr. Cuti's options had vested and were exercisable until March 21, 2006, on which date the options expired unexercised.

        At December 27, 2008, there are 104,687 options exercisable under the 2004 Option Plan, with a weighted-average remaining life of 6.1 years, a weighted-average exercise price of $100 and an aggregate intrinsic value of $0. The total intrinsic value of the 100 options exercised during 2007 was $0. There were no options exercised in either 2008 or 2006.

        For share-based payment grants on or after December 31, 2006, the Company estimated the fair value of such grants using a lattice-based option valuation model. Prior to December 31, 2006, the Company estimated the fair value of share-based payment awards using the Black-Scholes option pricing model. The Company believes the lattice-based option valuation model is a more accurate model for valuing employee stock options since it best models the terms of our options.

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        The fair value of each option grant issued during the years ended December 27, 2008 and December 29, 2007 was estimated on the date of grant using the lattice-pricing model with the following weighted-average assumptions:

 
  December 27,
2008
  December 29,
2007
 

Dividend yield

    0.0 %   0.0 %

Volatility

    41.2 %   35.0 %

Risk-free interest rate

    3.6 %   4.7 %

Post-vesting employment termination

    1.9 %   5.0 %

        For stock options granted prior to December 31, 2006, the fair value of stock options was estimated using the Black-Scholes option-pricing model. The following are weighted-average inputs for the Black-Scholes option-pricing model used for grants under our stock plans during fiscal 2006:

    Expected dividend yield: 0%—The Company has historically not paid any dividends, nor does it currently expect to pay dividends in the foreseeable future.

    Expected volatility: 32.0%—The volatility figure reflects the weighted-average 1, 5 and 10-year observed volatility of comparable industry participants.

    Risk-free interest rate: 4.38%—This reflects the rate portrayed on the Treasury Yield Curve for a period of time equivalent to the expected term.

    Expected term (years): 6.5—The expected life represents the period of time for which options granted are expected to be outstanding. This estimate was derived from historical share option exercise experience, which management believes provides the best estimate of the expected term.

        As of December 27, 2008, there was $2.6 million of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the stock-based compensation plan. That cost is expected to be recognized on a straight-line basis over a weighted-average period of 3.1 years. During the 2008, 2007 and 2006 fiscal years, the Company recognized compensation cost related to share-based payments of approximately $0.7 million, $1.0 million and $0.3 million, respectively.

        As of December 27, 2008, a total of 105,759 shares of common stock of the Company were reserved for the issuance of additional stock options. The Company expects to satisfy the exercise of stock options utilizing newly-issued shares.

        401(k) Profit-Sharing Plan—The Company maintains an employee savings plan, pursuant to Section 401(k) (the "401(k) Plan") of the Internal Revenue Code ("IRC"), which, prior to January 1, 2002, covered substantially all non-union employees other than key employees as defined by IRC, and, effective January 1, 2002, became available to certain union employees. Eligible participating employees may contribute up to 10% of their pre-tax salaries, subject to certain IRC limitations. The 401(k) Plan, as amended, provides for employer matching contributions at the discretion of the Company (to a maximum of 1% of eligible pre-tax salaries) and has a feature under which the Company may contribute additional discretionary amounts for all eligible employees. During the fiscal years ended December 27, 2008, December 29, 2007 and December 30, 2006, the Company incurred expenses of $0.8 million, $0.9 million and $0.6 million, respectively, related to employer matching contributions.

        Organized Labor Benefit Plans—Duane Reade Inc.'s collective bargaining agreements with RWDSU/Local 338, Local 340A New York Joint Board, UNITE AFL-CIO and the International Brotherhood of Teamsters, Chauffeurs and Warehousemen and Helpers of America, Local 815 require certain contributions to multi-employer pension and welfare benefit plans for certain of its employees. For the

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2008, 2007 and 2006 fiscal years, the expenses for such plans were $7.4 million, $5.3 million and $3.6 million, respectively.

20.    Related Party Transactions

Management Services Agreement

        Under a management services agreement between Oak Hill Capital Management, Inc. (an affiliate of Oak Hill Capital Partners, L.P.) and Duane Reade Acquisition, Oak Hill Capital Management, Inc. agreed to provide financial advisory and management services to the Company as Duane Reade Inc.'s Board of Directors may reasonably request following the Acquisition. In consideration of these services, Oak Hill Capital Management, Inc. receives an annual fee of $1.25 million, payable quarterly.

Tax Sharing Agreement

        Duane Reade Holdings, Inc. is the common parent of an affiliated group of corporations that includes Duane Reade Inc. and its subsidiaries. Duane Reade Holdings, Inc. elected to file consolidated federal income tax returns on behalf of the group. Accordingly, Duane Reade Holdings, Inc., Duane Reade Inc. and its subsidiaries entered into a tax sharing agreement, under which Duane Reade Inc. and its subsidiaries will make payments to Duane Reade Holdings, Inc. These payments will not be in excess of Duane Reade Inc.'s and its subsidiaries' tax liabilities, if these tax liabilities had been computed on a stand-alone basis.

Trucking Services

        The Company is party to a consulting agreement with Transportation Services International ("TSI"), an entity operated by Joseph Cuti, the brother of Mr. Cuti. TSI provides various trucking, logistical and warehousing consultative services to the Company. The Company's agreement with TSI was terminated in 2008. The Company's payments to TSI totaled approximately $0.1 million annually in fiscal years 2008, 2007 and 2006.

Service Agreement

        The Company is party to a service agreement with EXLService Holdings, Inc. ("EXL") an entity that is a partially owned by Oak Hill Capital Management, Inc. (an affiliate of Oak Hill Capital Partners, L.P.). EXL is engaged by the Company to perform internal audit and internal control testing. The Company's agreement with EXL is terminable by either party. The Company's payments to EXL totaled approximately $0.6 million, $0.6 million and $0.4 million in fiscal years 2008, 2007 and 2006, respectively.

21.    Condensed Consolidating Financial Information of Subsidiary Guarantors and Co-Obligors

        The 9.75% Senior Subordinated Notes due 2011 and the Senior Secured Floating Rate Notes due 2010 were co-issued by Duane Reade Inc. and Duane Reade GP, each of whom is considered a "co-obligor." The Company and each of its other subsidiaries, composed of DRI I Inc., Duane Reade International, Inc. and Duane Reade Realty, Inc., are guarantors of such notes. The guarantee of the Company and of each subsidiary guarantor is full and unconditional and joint and several.

        The following condensed consolidating financial information for the Company presents the financial information of Duane Reade Holdings, Inc., the co-obligors and the subsidiary guarantors, prepared on the equity basis of accounting. Such presentation is based on the Company's understanding and interpretation of Rule 3-10 under the Securities and Exchange Commission's Regulation S-X. Deferred income taxes have been allocated to individual entities according to the Company's income tax allocation methodology. Certain of the prior year information have been adjusted to conform its presentation to the current year. The financial information may not necessarily be indicative of results of operations or financial position had the subsidiary guarantors operated as independent entities.

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DUANE READE HOLDINGS, INC.

Condensed Consolidating Statement of Operations

For the fiscal year ended December 27, 2008

(in thousands)

 
  Duane Reade
Holdings, Inc.
  Duane
Reade Inc.
  Duane
Reade GP
  Subsidiary
Guarantors
  Consolidating
Adjustments
  Duane Reade
Holdings, Inc.
Consolidated
 

Net sales

  $   $   $ 1,774,029   $   $   $ 1,774,029  

Cost of sales (exclusive of depreciation and amortization shown separately below)

            1,227,129             1,227,129  
                           
 

Gross profit

            546,900             546,900  

Selling, general & administrative expenses

            476,109     465         476,574  

Depreciation and amortization

            68,539             68,539  

Store pre-opening expense

            797             797  

Gain on sale of pharmacy files

                         

Other

            16,808             16,808  
                           
 

Operating (loss) income

            (15,353 )   (465 )       (15,818 )

Equity earnings in affiliates

    72,778     72,778         723     (146,279 )    

Interest expense, net

            54,915             54,915  
                           
 

Income (loss) before income taxes

    (72,778 )   (72,778 )   (70,268 )   (1,188 )   146,279     (70,733 )

Income tax expense

            2,032     13         2,045  
                           
 

Net income (loss)

  $ (72,778 ) $ (72,778 ) $ (72,300 ) $ (1,201 ) $ 146,279   $ (72,778 )
                           

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DUANE READE HOLDINGS, INC.

Condensed Consolidating Statement of Operations

For the fiscal year ended December 29, 2007

(in thousands)

 
  Duane Reade
Holdings, Inc.
  Duane
Reade Inc.
  Duane
Reade GP
  Subsidiary
Guarantors
  Consolidating
Adjustments
  Duane Reade
Holdings, Inc.
Consolidated
 

Net sales

  $   $   $ 1,686,752   $ 40,687   $ (40,687 ) $ 1,686,752  

Cost of sales (exclusive of depreciation and amortization shown separately below)

            1,176,376             1,176,376  
                           
 

Gross profit

            510,376     40,687     (40,687 )   510,376  

Selling, general & administrative expenses

            513,919     453     (67,676 )   446,696  

Depreciation and amortization

            73,080             73,080  

Store pre-opening expense

            600             600  

Gain on sale of pharmacy files

            (1,337 )           (1,337 )

Other

            15,948             15,948  
                           
 

Operating (loss) income

            (91,834 )   40,234     26,989     (24,611 )

Equity earnings in affiliates

    87,780     87,780         1,567     (177,127 )    

Interest expense, net

            60,977     (26,989 )   26,989     60,977  
                           
 

Income (loss) before income taxes

    (87,780 )   (87,780 )   (152,811 )   65,656     177,127     (85,588 )

Income tax (benefit) expense

            3,914     (1,722 )       2,192  
                           
 

Net (loss) income

  $ (87,780 ) $ (87,780 ) $ (156,725 ) $ 67,378   $