10-K 1 dollargeneral10k2008.htm DOLLAR GENERAL 10-K FISCAL 2007 dollargeneral10k2008.htm


 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549
 
FORM 10-K
 
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended February 1, 2008

Commission file number: 001-11421

DOLLAR GENERAL CORPORATION
(Exact name of registrant as specified in its charter)

TENNESSEE
(State or other jurisdiction of
incorporation or organization)
61-0502302
(I.R.S. Employer
Identification No.)
 
100 MISSION RIDGE
GOODLETTSVILLE, TN  37072
(Address of principal executive offices, zip code)
 
Registrant’s telephone number, including area code:  (615) 855-4000
 
Securities registered pursuant to Section 12(b) of the Act: None
 
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 [  ]   No [X]

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.  Yes [   ] No [X]

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 [   ] No [X]

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. [X]
 
 

 



Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer [  ]    Accelerated filer [  ]
       
Non-accelerated Filer [X]  Smaller reporting company [  ]
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes [  ]  No [X]

The aggregate fair market value of the registrant’s common stock outstanding and held by non-affiliates as of August 3, 2007 was $663,400, all of which was owned by employees of the registrant and not traded on a public market. For this purpose, directors, executive officers and greater than 10% record shareholders are considered the affiliates of the registrant.

The registrant had 555,481,897 shares of common stock outstanding on March 17, 2008.


INTRODUCTION

General

This report contains references to years 2008, 2007, 2006, 2005, 2004 and 2003, which represent fiscal years ending or ended January 30, 2009, February 1, 2008, February 2, 2007, February 3, 2006, January 28, 2005, and January 30, 2004, respectively.  All of the discussion and analysis in this report should be read with, and is qualified in its entirety by, the Consolidated Financial Statements and related notes.

Forward Looking Statements

“Forward-looking statements” within the meaning of the federal securities laws are included throughout this report, particularly under the headings “Business” and “Management’s Discussion and Analysis of Financial Condition and Results of Operation,” among others. You can identify these statements because they are not solely statements of historical fact or they use words such as “may,” “will,” “should,” “expect,” “believe,” “anticipate,” “project,” “plan,” “expect,” “estimate,” “objective,” “forecast,” “goal,” “intend,” “will likely result,” or “will continue” and similar expressions that concern our strategy, plans or intentions. For example, all statements relating to our estimated and projected earnings, costs, expenditures, cash flows and financial results, our plans and objectives for future operations, growth or initiatives, or the expected outcome or impact of pending or threatened litigation are forward-looking statements.

All forward-looking statements are subject to risks and uncertainties that may change at any time, so our actual results may differ materially from those that we expected. We derive many of these statements from our operating budgets and forecasts, which are based on many detailed assumptions that we believe are reasonable. However, it is very difficult to predict the impact of known factors, and we cannot anticipate all factors that could affect our actual results. Important factors that could cause actual results to differ materially from the expectations expressed in our forward-looking statements are disclosed under “Risk Factors” in Part I, Item 1A and elsewhere in this document (including, without limitation, in conjunction with the forward-looking statements themselves and under the heading “Critical Accounting Policies and Estimates”). All written and oral forward-looking statements we make in the future are expressly qualified in their entirety by these cautionary statements as well as other cautionary statements that we make from time to time in our other SEC filings and public communications. You should evaluate all of our forward-looking statements in the context of these risks and uncertainties.

The important factors referenced above may not contain all of the material factors that are important to you. In addition, we cannot assure you that we will realize the results or developments we expect or anticipate or, even if substantially realized, that they will result in the consequences or affect us or our operations in the way we expect. The forward-looking statements included in this report are made only as of the date hereof. We undertake no obligation to publicly update or revise any forward-looking statement as a result of new information, future events or otherwise, except as otherwise required by law.

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PART I
 
ITEM 1.  BUSINESS
 
General

We are the largest discount retailer in the United States by number of stores, with 8,222 stores located in 35 states, primarily in the southern, southwestern, midwestern and eastern United States, as of February 29, 2008.  We serve a broad customer base and offer a focused assortment of everyday items, including basic consumable merchandise and other home, apparel and seasonal products.  A majority of our products are priced at $10 or less and approximately 30% of our products are priced at $1 or less.

We offer a compelling value proposition for our customers based on convenient store locations, easy in and out shopping and quality name brand and private label merchandise at highly competitive everyday low prices. We believe our combination of value and convenience distinguishes us from other discount, convenience and drugstore retailers, who typically focus on either value or convenience. Our business model is focused on strong and sustainable sales growth, attractive margins and limited maintenance capital expenditure and working capital needs, which results in significant cash flow from operations (before interest).

We were founded in 1939 as J.L. Turner and Son, Wholesale.  We opened our first dollar store in 1955, when we were first incorporated as a Kentucky corporation under the name J.L. Turner & Son, Inc.  We changed our name to Dollar General Corporation in 1968 and reincorporated as a Tennessee corporation in 1998.

We have expanded rapidly in recent years, increasing our total number of stores from 5,540 as of February 1, 2002, to 8,229 as of February 2, 2007, an 8.2% compounded annual growth rate (“CAGR”).  Over the same period, we grew our net sales from $5.3 billion to $9.2 billion (11.5% CAGR), driven by growth in number of stores as well as same store sales growth. In the fourth quarter of fiscal 2006, we announced our plans to slow new store growth in 2007 and to close approximately 400 stores in order to improve our profitability and to enable us to focus on improving the performance of existing stores. In 2007, we opened 365 new stores and closed 400 stores. We also relocated or remodeled 300 existing stores. We generated net sales in 2007 of $9.5 billion, an increase of 3.5% over 2006, including a same-store sales increase of 2.1%.

Merger with KKR

On July 6, 2007, we completed a merger (the “Merger”) in which our former shareholders received $22.00 in cash, or approximately $6.9 billion in total, for each share of our common stock held. In addition, fees and expenses related to the Merger and the related financing transactions totaling $102.6 million, principally consisting of investment banking fees, management fees, legal fees and stock compensation expense ($39.4 million), are reflected in the 2007 results of operations. As a result of the Merger, we are a subsidiary of Buck Holdings, L.P. (“Parent”), a Delaware limited partnership controlled by investment funds affiliated with Kohlberg Kravis Roberts & Co., L.P. (“KKR” or “Sponsor”). KKR, GS Capital Partners VI
 
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Fund, L.P. and affiliated funds (affiliates of Goldman, Sachs & Co.), Citi Private Equity, Wellington Management Company, LLP, CPP Investment Board (USRE II) Inc., and other equity co-investors (collectively, the “Investors”) indirectly own a substantial portion of our capital stock through their investment in Parent.

The Merger consideration was funded through the use of our available cash, cash equity contributions from the Investors, equity contributions of certain members of our management and the debt financings discussed below. Our outstanding common stock is now owned by Parent and certain members of management. Our common stock is no longer registered with the Securities and Exchange Commission (“SEC”) and is no longer traded on a national securities exchange.

We entered into the following debt financings in conjunction with the Merger:

·  
We entered into a credit agreement and related security and other agreements consisting of a $2.3 billion senior secured term loan facility, which matures on July 6, 2014 (the “Term Loan Facility”).
 
·  
We entered into a credit agreement and related security and other agreements consisting of a senior secured asset-based revolving credit facility of up to $1.125 billion (of which $432.3 million was drawn at closing and $132.3 million was paid down on the same day), subject to borrowing base availability, which matures July 6, 2013 (the “ABL Facility” and, with the Term Loan Facility, the “New Credit Facilities”).
   
·  We issued $1.175 billion aggregate principal amount of 10.625% senior notes due 2015, which mature on July 15, 2015, and $725 million aggregate principal amount of 11.875%/12.625% senior subordinated toggle notes due 2017, which mature on July 15, 2017. We repurchased $25 million of the 11.875%/12.625% senior subordinated toggle notes due 2017 in the fourth quarter of fiscal 2007.
 
Overall Business Strategy

Our mission is “Serving Others.” To carry out this mission, we have developed a business strategy of providing our customers with a focused assortment of everyday low priced merchandise in a convenient, small-store format.

Our Customers.  In general, we locate our stores and base our merchandise selection on the needs of households seeking value and convenience, with an emphasis on rural and small markets. However, much of our merchandise, intended to serve the basic consumable, household, apparel and seasonal needs of these targeted customers, also appeals to a much broader and higher income customer base.

Our Stores. The traditional Dollar General® store has, on average, approximately 6,900 square feet of selling space and generally serves customers who live within five miles of the store.  Of our 8,222 stores operating as of February 29, 2008, more than half serve communities
 
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with populations of 20,000 or less.  We believe that our target customers prefer the convenience of a small, neighborhood store with a focused merchandise assortment at value prices. Our Dollar General Market® stores are larger than the average Dollar General store, having on average approximately 17,000 square feet of selling space, and carry, among other items, an expanded assortment of grocery products and perishable items.  As of February 29, 2008, we operated 57 Dollar General Market stores.

Our Merchandise.  Our merchandising strategy combines a low-cost operating structure with a focused assortment of products, consisting of quality basic consumable, household, apparel and seasonal merchandise at competitive everyday low prices. Our strategic combination of name brands, quality private label products and other great value brands allows us to offer our customers a compelling value proposition. We believe our merchandising strategy and focused assortment generate frequent repeat customer purchases and encourage customers to shop at our stores for their everyday household needs.

Our Prices.  We distribute quality, consumable merchandise at everyday low prices.  Our strategy of a low-cost operating structure and a focused assortment of merchandise allows us to offer quality merchandise at competitive prices.  As part of this strategy, we emphasize even-dollar prices on many of our items.  In the typical Dollar General store, the majority of the products are priced at $10 or less, with approximately 30% of the products priced at $1 or less.

Our Cost Controls. We aggressively manage our overhead cost structure and typically seek to locate stores in neighborhoods where rental and operating costs are relatively low.  Our stores typically have low fixed costs, with lean staffing of usually two to three employees in the store at any time.  In 2005 and 2006, we implemented “EZstoreTM”, our initiative designed to improve inventory flow from our distribution centers, or DCs, to consumers. EZstore has allowed us to reallocate store labor hours to more customer-focused activities, improving the work content in our stores.

We also attempt to control operating costs by implementing new technology when feasible, including improvements in recent years to our store labor scheduling and store replenishment systems in addition to other improvements to our supply chain and warehousing systems.

Recent Strategic InitiativesProject Alpha.  In 2007, we executed strategic initiatives launched in the fourth quarter of 2006 aimed at improving our merchandising and real estate strategies, which we refer to collectively as “Project Alpha.” Project Alpha was based upon a comprehensive analysis of the performance of each of our stores and the impact of our inventory management model on our ability to effectively serve our customers.

The execution of this merchandising initiative has moved us away from our traditional inventory packaway model, where unsold seasonal, apparel and home products inventory items were stored on-site and returned to the sales floor to be sold year after year, until the items were eventually sold, damaged or discarded.  Project Alpha is an attempt to better meet our customers’ needs and to ensure an appealing, fresh merchandise selection. In connection with this initiative, in fiscal 2007 we began taking end-of-season markdowns on current-year non-replenishable
 
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merchandise. With limited and planned exceptions, we eliminated, through end-of-season and other markdowns, our seasonal, home products and basic clothing packaway merchandise and out of season current year merchandise by the end of fiscal 2007. In addition to allowing us to carry newer, fresher merchandise, particularly in our seasonal, apparel and home categories, we believe this strategy change has enhanced the appearance of our stores and will continue to positively impact customer satisfaction as well as our store employees’ ability to manage stores.

Project Alpha also encompassed significant improvements to our real estate practices. We are fully integrating the functions of site selection, lease renewals, relocations, remodels and store closings and have defined and are implementing rigorous analytical processes for decision-making in those areas. As a first step in our initiative to revitalize our store base, we performed a comprehensive real estate review resulting in the identification of approximately 400 underperforming stores, all of which we closed by mid-2007. These closings were in addition to stores that are typically closed in the normal course of business, which over the last 10 years constituted approximately 1% to 2% of our store base per year. We believe our rate of store closings should return to historic levels in 2008 and future years.  While we believe we have significant opportunities for future store growth, we have moderated our new store growth rate to enable us to focus on improving the performance of existing stores. Those efforts include increasing the number of store remodels and relocations in order to improve productivity and enhance the shopping experience for our customers.

As a result of opening new stores and remodeling existing stores, as of February 29, 2008, over 1,000 stores are operating in our racetrack format, which is designed with improved merchandise adjacencies and wider, more open aisles to enhance the overall guest shopping experience. We plan to continue to enhance this new store layout to further drive sales growth and margin enhancements through improved merchandising.

Our Industry

We compete in the deep discount segment of the U.S. retail industry. Our competitors include traditional “dollar stores,” as well as other retailers offering discounted convenience items. The “dollar store” sector differentiates itself from other forms of retailing in the deep discount segment by offering consistently low prices in a convenient, small-store format. Unlike other formats that have suffered with the rise of Wal-Mart and other discount supercenters, the “dollar store” sector has grown despite the presence of the discount supercenters.  We believe it is our substantial convenience advantage, at prices comparable to those of supercenters, that allows Dollar General to compete so effectively.
 
We believe that there is considerable room for growth in the “dollar store” sector. According to AC Nielsen, “dollar stores” have been able to increase their penetration across all income brackets in the last 6 years. Though traditional “dollar stores” have high customer penetration, according to Information Resources, Inc. “IRI,” the sector as a whole accounts for only approximately 1.2% of total consumer product goods spending, which we believe leaves ample room for growth. Our merchandising initiatives are aimed at increasing our stores’ share of customer spending.

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See “Our Competitive Strengths” and “Competition” below for additional information regarding our competitive situation.

Our Competitive Strengths

Market Leader in an Attractive Sector with a Growing Customer Base.  We are the largest discount retailer in the U.S. by number of stores, with 8,222 stores in 35 states as of February 29, 2008.  We are the largest player in the U.S. small box deep discount segment, with sales in excess of 1.4 times that of our nearest competitor in 2007.  We believe we are well positioned to further increase our market share as we continue to execute our business strategy and implement our operational initiatives.  Our target customers are those seeking value and convenience.  According to Nielsen Media Research as of mid-2007, approximately 64% of households shopped at least once at a discount store (up from 59% in 2001).

Consistent Sales Growth and Strong Cash Flow Generation. For 18 consecutive years, we have experienced positive annual same store sales growth.  Approximately two-thirds of our net sales come from the sale of consumable products, which are less susceptible to economic pressures (such as increased fuel costs and unemployment), with the remaining one-third comprised mainly of seasonal, basic clothing and home products which are subject to little trend or fashion risk.  We have a low cost operating model with attractive operating margins, low capital expenditures and low working capital needs, resulting in generation of significant cash flow from operations (before interest).

Differentiated Value Proposition. Our ability to deliver highly competitive everyday low prices in a convenient location and shopping format provides our customers with a compelling shopping experience and distinguishes us from other discount retailers, as well as convenience and drugstore retailers.

Compelling Unit Economics.  The traditional Dollar General store size, design and location requires an initial investment of approximately $250,000 including inventory. The low initial investment and maintenance capital expenditures, when combined with strong average unit volumes, provide for a quick recovery of store start-up costs.  The ability of our stores to generate strong cash flows with minimal investment results in a short payback period.

Efficient Supply Chain.  We believe our distribution network is an integral component of our efforts to reduce transportation expenses and effectively support our growth.  In recent years, we have made significant investments in technological improvements and upgrades which have increased our efficiency and capacity to support our merchandising and operations initiatives as well as future store growth.

Experienced and Motivated Management Team.  In January 2008, we hired Richard Dreiling, who has 38 years of retail experience, to serve as our Chief Executive Officer.  Over the past two years we strengthened our management team with the hiring of David Beré, our President and Chief Operating Officer. We also replaced a majority of our senior merchandising and real estate teams.  In connection with the Merger, we entered into agreements with certain
 
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members of management pursuant to which they elected to invest in Dollar General in an aggregate amount of approximately $10.4 million.

Seasonality

Our business is seasonal to a certain extent.  Generally, our highest sales volume occurs in the fourth quarter, which includes the Christmas selling season, and the lowest occurs in the first quarter.  In addition, our quarterly results can be affected by the timing of new store openings and store closings, the amount of sales contributed by new and existing stores, as well as the timing of certain holidays. We purchase substantial amounts of inventory in the third quarter and incur higher shipping costs and higher payroll costs in anticipation of the increased sales activity during the fourth quarter.  In addition, we carry merchandise during our fourth quarter that we do not carry during the rest of the year, such as gift sets, holiday decorations, certain baking items, and a broader assortment of toys and candy.

The following table reflects the seasonality of net sales, gross profit, and net income (loss) by quarter for each of the quarters of the current fiscal year as well as each of the quarters of the two most recent fiscal years. All of the quarters reflected below are comprised of 13 weeks with the exception of the fourth quarter of our fiscal year ended February 3, 2006, which was comprised of 14 weeks.

(in millions)
 
1st
Quarter
   
2nd
Quarter
   
3rd
Quarter
   
4th
Quarter
 
                         
Year Ended February 1, 2008(a)
                       
Net sales
  $ 2,275.3     $ 2,347.6     $ 2,312.8     $ 2,559.6  
Gross profit(b)
    633.1       623.2       646.8       740.4  
Net income (loss)(b)
    34.9       (70.1 )     (33.0 )     55.4  
                                 
Year Ended February 2, 2007
                               
Net sales
    2,151.4       2,251.1       2,213.4       2,554.0  
Gross profit(b)
    584.3       611.5       526.4       646.0  
Net income (loss)(b)
    47.7       45.5       (5.3 )     50.1  
                                 
Year Ended February 3, 2006
                               
Net sales
    1,977.8       2,066.0       2,057.9       2,480.5  
Gross profit
    563.3       591.5       579.0       730.9  
Net income
 
    64.9       75.6       64.4       145.3  
 
(a)
For comparison purposes, the 2nd quarter includes the results of operations for Buck Acquisition Corp. for the period prior to the Merger from March 6, 2007 (its formation) through July 7, 2007 (reflecting the change in fair value of interest rate swaps), and the 2nd quarter reflects the combination of pre-Merger and post-Merger results of Dollar General Corporation for the period from May 5, 2007 through August 3, 2007. We believe this presentation provides a more meaningful understanding of the underlying business.
(b)
Results for the 3rd and 4th quarters of 2006 and all quarters of 2007 reflect the impact of Recent Strategic Initiatives as discussed in further detail in “Management’s Discussion
and Analysis of Financial Condition and Results of Operations.”

 
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Merchandise

We separate our merchandise into the following four categories for reporting purposes: highly consumable, seasonal, home products, and basic clothing. Highly consumable consists of packaged food, candy, snacks and refrigerated products, health and beauty aids, home cleaning supplies and pet supplies; seasonal consists of seasonal and other holiday-related items, toys, stationery and hardware; and home products consists of housewares and domestics. The percentage of net sales of each of our four categories of merchandise for the period indicated below was as follows:

   
2007
   
2006
   
2005
 
Highly consumable
    66.5 %     65.7 %     65.3 %
Seasonal
    15.9 %     16.4 %     15.7 %
Home products
    9.2 %     10.0 %     10.6 %
Basic clothing
    8.4 %     7.9 %     8.4 %

Our home products and seasonal categories typically account for the highest gross profit margin, and the highly consumable category typically accounts for the lowest gross profit margin.

We currently maintain approximately 5,400 core stock-keeping units, or SKUs, per store and an additional 3,000 non-core SKUs that get rotated in and out of the store over the course of a year.  In 2007, we reduced the number of non-core SKUs.

We purchase our merchandise from a wide variety of suppliers. Approximately 12% of our purchases in 2007 were from The Procter & Gamble Company.  Our next largest supplier accounted for approximately 6% of our purchases in 2007.  We directly imported approximately 9% of our purchases at cost (15% at retail) in 2007.

The Dollar General Store

The average Dollar General store has approximately 6,900 square feet of selling space and is typically operated by a manager, an assistant manager and two or more sales clerks.  Approximately 47% of our stores are located in strip shopping centers, 51% are in freestanding buildings and 2% are in downtown buildings. We attempt to locate primarily in small towns or in neighborhoods of more densely populated areas where occupancy expenses are relatively low.

We generally have not encountered difficulty locating suitable store sites in the past, and management does not currently anticipate experiencing material difficulty in finding future suitable locations.
 

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Our recent store growth is summarized in the following table:
 
Year
Stores at
Beginning
of Year
Stores
Opened
Stores
Closed
Net
Store
Increase/(Decrease)
Stores at
End of Year
2005
7,320
734
125(a)
609
7,929
2006
7,929
537
237(b)
300
8,229
2007
8,229
365
400(b)
 (35)
8,194
 
(a) Includes 41 stores closed as a result of hurricane damage.
(b) Includes 128 stores in 2006 and 275 stores in 2007 closed as a result of certain recent strategic initiatives.
 
Employees

As of February 29, 2008, we employed approximately 71,500 full-time and part-time employees, including divisional and regional managers, district managers, store managers, and DC and administrative personnel.  Management believes our relationship with our employees is generally good, and we currently are not a party to any collective bargaining agreements.

Competition

We operate in the discount retail merchandise business, which is highly competitive with respect to price, store location, merchandise quality, assortment and presentation, in-stock consistency, and customer service.  We compete with discount stores and with many other retailers, including mass merchandise, grocery, drug, convenience, variety and other specialty stores. These other retail companies operate stores in many of the areas where we operate and many of them engage in extensive advertising and marketing efforts. Our direct competitors in the dollar store retail category include Family Dollar, Dollar Tree, Fred’s, 99 Cents Only and various local, independent operators. Competitors from other retail categories include Wal-Mart Walgreens, CVS, Rite Aid, Target and Costco, among others. Certain of our competitors have greater financial, distribution, marketing and other resources than we do.

The dollar store category differentiates itself from other forms of retailing by offering consistently low prices in a convenient, small-store format. We believe that our prices are competitive due in part to our low cost operating structure and the relatively limited assortment of products offered. Historically, we have minimized labor by offering fewer price points and a reliance on simple merchandise presentation. We maintain strong purchasing power due to our leadership position in the dollar store retail category and our focused assortment of merchandise.

Trademarks

Through our subsidiary, Dollar General Merchandising, Inc., we own marks that are registered with the United States Patent and Trademark Office, including the trademarks Dollar General®, Dollar General Market®, Clover Valley®, American Value®, DG Guarantee® and the Dollar General price point designs, along with certain other trademarks. We attempt to obtain registration of our trademarks whenever practicable and to pursue vigorously any infringement of those marks.  Our trademark registrations have various expiration dates; however, assuming that the trademark registrations are properly renewed, they have a perpetual duration.


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Available Information

Our Web site address is www.dollargeneral.com. We make available through this address, without charge, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after they are electronically filed or furnished to the SEC.
 
ITEM 1A. RISK FACTORS
 
Investing in our securities involves a degree of risk. Persons buying our securities should carefully consider the risks described below and the other information contained in this report and other filings that we make from time to time with the SEC, including our consolidated financial statements and accompanying notes. Any of the following risks could materially and adversely affect our business, financial condition or results of operations. In addition, the risks described below are not the only risks facing us. Additional risks and uncertainties not currently known to us or those we currently view to be immaterial also may materially and adversely affect our business, financial condition or results of operations. In any such case, the trading price of our securities could decline or we may not be able to make payments of principal and interest on our outstanding notes, and you may lose all or part of your original investment.

The fact that we have substantial debt could adversely affect our ability to raise additional capital to fund our operations, limit our ability to react to changes in the economy or our industry, expose us to interest rate risk to the extent of our variable rate debt and prevent us from meeting our obligations under our outstanding debt securities.

We have substantial debt which could have important consequences, including:

·  
making it more difficult for us to make payments on our outstanding debt;
 
·  
increasing our vulnerability to general economic and industry conditions;
 
·  
requiring a substantial portion of our cash flow from operations to be dedicated to the payment of principal and interest on our indebtedness, therefore reducing our ability
to use our cash flow to fund our operations, capital expenditures and future business opportunities;
 
·  
exposing us to the risk of interest rate fluctuations as certain of our borrowings bear interest based on market interest rates;
 
·  
limiting our ability to obtain additional financing for working capital, capital expenditures, debt service requirements, acquisitions and general corporate or other purposes; and
 
·  
limiting our ability to adjust to changing market conditions and placing us at a competitive disadvantage compared to our competitors who are less highly leveraged.

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In addition, the borrowings under our New Credit Facilities bear interest at variable rates and other debt we incur also could be variable-rate debt.  If market interest rates increase, variable-rate debt will create higher debt service requirements, which could adversely affect our cash flow.  While we have and may in the future enter into agreements limiting our exposure to higher interest rates, any such agreements may not offer complete protection from this risk.  We and our subsidiaries may be able to incur substantial additional indebtedness in the future, subject to the restrictions contained in our New Credit Facilities and the indentures governing our debt securities.  If new indebtedness is added to our current debt levels, the related risks that we now face could intensify.

Our debt agreements contain restrictions that limit our flexibility in operating our business.

Our New Credit Facilities and the indentures governing our debt securities contain various covenants that limit our ability to engage in specified types of transactions.  These covenants limit our and our restricted subsidiaries’ ability to, among other things:

·  
incur additional indebtedness, issue disqualified stock or issue certain preferred stock;
 
·  
pay dividends and make certain distributions, investments and other restricted payments;
 
·  
create certain liens or encumbrances;
 
·  
sell assets;
 
·  
enter into transactions with our affiliates;
 
·  
limit the ability of restricted subsidiaries to make payments to us;
 
·  
merge, consolidate, sell or otherwise dispose of all or substantially all of our assets; and
 
·  
designate our subsidiaries as unrestricted subsidiaries.

A breach of any of these covenants could result in a default under the agreement governing such indebtedness.  Upon our failure to maintain compliance with these covenants, the lenders could elect to declare all amounts outstanding thereunder to be immediately due and payable and terminate all commitments to extend further credit thereunder.  If the lenders under such indebtedness accelerate the repayment of borrowings, we cannot assure you that we will have sufficient assets to repay those borrowings, as well as our other indebtedness, including our outstanding debt securities.  We have pledged a significant portion of our assets as collateral under our New Credit Facilities.  If we were unable to repay those amounts, the lenders under our New Credit Facilities could proceed against the collateral granted to them to secure that indebtedness. Additional borrowings under the ABL Facility will, if excess availability under
 
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that facility is less than a certain amount, be subject to the satisfaction of a specified financial ratio.  Our ability to meet this financial ratio can be affected by events beyond our control, and we cannot assure you that we will meet this ratio and other covenants.

General economic factors may adversely affect our financial performance.

General economic conditions in one or more of the markets we serve may adversely affect our financial performance. A general slowdown in the economy, higher interest rates, higher than expected fuel and other energy costs, inflation, higher levels of unemployment, higher consumer debt levels, higher tax rates and other changes in tax laws, tightening of the credit markets, and other economic factors could adversely affect consumer demand for the products we sell, change our sales mix of products to one with a lower average gross profit and result in slower inventory turnover and greater markdowns on inventory. Higher interest rates, higher commodities rates, higher fuel and other energy costs, transportation costs, inflation, higher costs of labor, insurance and healthcare, foreign exchange rate fluctuations, higher tax rates and other changes in tax laws, changes in other laws and regulations and other economic factors increase our cost of sales and selling, general and administrative expenses, and otherwise adversely affect the operations and operating results of our stores.

Our plans depend significantly on initiatives designed to improve the efficiencies, costs and effectiveness of our operations, and failure to achieve or sustain these plans could affect our performance adversely.

We have had, and expect to continue to have, initiatives (such as those relating to marketing, merchandising, promotions, sourcing, shrink, private label, store operations and real estate) in various stages of testing, evaluation, and implementation, upon which we expect to rely to improve our results of operations and financial condition. These initiatives are inherently risky and uncertain, even when tested successfully, in their application to our business in general. It is possible that successful testing can result partially from resources and attention that cannot be duplicated in broader implementation. Testing and general implementation also can be affected by other risk factors described herein that reduce the results expected. Successful systemwide implementation relies on consistency of training, stability of workforce, ease of execution, and the absence of offsetting factors that can influence results adversely. Failure to achieve successful implementation of our initiatives or the cost of these initiatives exceeding management’s estimates could adversely affect our results of operations and financial condition.

Because our business is seasonal to a certain extent, with the highest volume of net sales during the fourth quarter, adverse events during the fourth quarter could materially affect our financial statements as a whole.

We generally recognize our highest volume of net sales during the Christmas selling season, which occurs in the fourth quarter of our fiscal year. In anticipation of this holiday, we purchase substantial amounts of seasonal inventory and hire many temporary employees. A seasonal merchandise inventory imbalance could result if for any reason our net sales during the Christmas selling season were to fall below either seasonal norms or expectations. If for any reason our fourth quarter results were substantially below expectations, our financial
 
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performance and operating results could be adversely affected by unanticipated markdowns, especially in seasonal merchandise. Lower than anticipated sales in the Christmas selling season would also negatively affect our ability to absorb the increased seasonal labor costs.

We face intense competition that could limit our growth opportunities and adversely impact our financial performance.

The retail business is highly competitive. We operate in the discount retail merchandise business, which is highly competitive with respect to price, store location, merchandise quality, assortment and presentation, in-stock consistency, and customer service. This competitive environment subjects us to the risk of adverse impact to our financial performance because of the lower prices, and thus the lower margins, required to maintain our competitive position. Also, companies operating in the discount retail merchandise sector (due to customer demographics and other factors) may have limited ability to increase prices in response to increased costs (including vendor price increases). This limitation may adversely affect our margins and financial performance. We compete for customers, employees, store sites, products and services and in other important aspects of our business with many other local, regional and national retailers. We compete with retailers operating discount, mass merchandise, grocery, drug, convenience, variety and other specialty stores. Certain of our competitors have greater financial, distribution, marketing and other resources than we do. These other competitors compete in a variety of ways, including aggressive promotional activities, merchandise selection and availability, services offered to customers, location, store hours, in-store amenities and price. If we fail to respond effectively to competitive pressures and changes in the retail markets, it could adversely affect our financial performance. See “Business—Our Industry, —Competitive Strengths, and —Competition” for additional discussion of our competitive situation.

Competition for customers has intensified in recent years as larger competitors have moved into, or increased their presence in, our geographic markets. We remain vulnerable to the marketing power and high level of consumer recognition of these larger competitors and to the risk that these competitors or others could venture into the “dollar store” industry in a significant way. Generally, we expect an increase in competition.

Natural disasters, unusually adverse weather conditions, pandemic outbreaks, boycotts and geo-political events could adversely affect our financial performance.
        
The occurrence of one or more natural disasters, such as hurricanes and earthquakes, unusually adverse weather conditions, pandemic outbreaks, boycotts and geo-political events, such as civil unrest in countries in which our suppliers are located and acts of terrorism, or similar disruptions could adversely affect our operations and financial performance. These events could result in physical damage to one or more of our properties, increases in fuel (or other energy) prices, the temporary or permanent closure of one or more of our stores or distribution centers, delays in opening new stores, the temporary lack of an adequate work force in a market, the temporary or long-term disruption in the supply of products from some local and overseas suppliers, the temporary disruption in the transport of goods from overseas, delay in the delivery of goods to our distribution centers or stores, the temporary reduction in the availability of products in our stores and disruption to our information systems. These events also can have
 
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indirect consequences such as increases in the costs of insurance following a destructive hurricane season. These factors could otherwise disrupt and adversely affect our operations and financial performance.

Risks associated with the domestic and foreign suppliers from whom our products are sourced could adversely affect our financial performance.
        
The products we sell are sourced from a wide variety of domestic and international suppliers. Approximately 12% of our purchases in 2007 were from The Procter & Gamble Company. Our next largest supplier accounted for approximately 6% of our purchases in 2007. We directly imported approximately 9% of our purchases at cost in 2007, but many of our domestic vendors directly import their products or components of their products. Political and economic instability in the countries in which foreign suppliers are located, the financial instability of suppliers, suppliers’ failure to meet our supplier standards, labor problems experienced by our suppliers, the availability of raw materials to suppliers, merchandise quality or safety issues, currency exchange rates, transport availability and cost, inflation, and other factors relating to the suppliers and the countries in which they are located or from which they import are beyond our control. In addition, the United States’ foreign trade policies, tariffs and other impositions on imported goods, trade sanctions imposed on certain countries, the limitation on the importation of certain types of goods or of goods containing certain materials from other countries and other factors relating to foreign trade are beyond our control. Disruptions due to labor stoppages, strikes or slowdowns, or other disruptions, involving our vendors or the transportation and handling industries also may negatively affect our ability to receive merchandise and thus may negatively affect sales. These and other factors affecting our suppliers and our access to products could adversely affect our financial performance. In addition, our ability to obtain indemnification from foreign suppliers may be hindered by the manufacturers’ lack of understanding of U.S. product liability or other laws, which may make it more likely that we may be required to respond to claims or complaints from customers as if we were the manufacturer of the products. As we increase our imports of merchandise from foreign vendors, the risks associated with foreign imports will increase.

We are dependent on attracting and retaining qualified employees while also controlling labor costs.

Our future performance depends on our ability to attract, retain and motivate qualified employees. Many of these employees are in entry-level or part-time positions with historically high rates of turnover. Availability of personnel varies widely from location to location. Our ability to meet our labor needs generally, including our ability to find qualified personnel to fill positions that become vacant at our existing stores and distribution centers, while controlling our labor costs, is subject to numerous external factors, including the level of competition for such personnel in a given market, the availability of a sufficient number of qualified persons in the work force of the markets in which we are located, unemployment levels within those markets, prevailing wage rates and changes in minimum wage laws, changing demographics, health and other insurance costs and changes in employment legislation. Increased turnover also can have significant indirect costs, including more recruiting and training needs, store disruptions due to management changeover and potential delays in new store openings or adverse customer
 
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reactions to inadequate customer service levels due to personnel shortages. Competition for qualified employees exerts upward pressure on wages paid to attract such personnel. In addition, to the extent a significant portion of our employee base unionizes, or attempts to unionize, our labor costs could increase. Our ability to pass along those costs is constrained.

Also, our stores are decentralized and are managed through a network of geographically dispersed management personnel. Our inability to effectively and efficiently operate our stores, including the ability to control losses resulting from inventory and cash shrinkage, may negatively affect our sales and/or operating margins.

Our planned future growth will be impeded, which would adversely affect sales, if we cannot open new stores on schedule or if we close a number of stores materially in excess of anticipated levels.

Our growth is dependent on both increases in sales in existing stores and the ability to open new stores. Our ability to timely open new stores and to expand into additional market areas depends in part on the following factors: the availability of attractive store locations; the absence of occupancy delays; the ability to negotiate favorable lease terms; the ability to hire and train new personnel, especially store managers; the ability to identify customer demand in different geographic areas; general economic conditions; and the availability of sufficient funds for expansion. In addition, many of these factors affect our ability to successfully relocate stores. Many of these factors are beyond our control. In addition, our substantial debt, particularly combined with the recent tightening of the credit markets, has made it more difficult for our real estate developers to obtain loans for our build-to-suit stores and to locate investors for those properties after they have been developed. If this trend continues, it could materially adversely impact our ability to open build-to-suit stores in desirable locations.

Delays or failures in opening new stores, or achieving lower than expected sales in new stores, or drawing a greater than expected proportion of sales in new stores from existing stores, could materially adversely affect our growth. In addition, we may not anticipate all of the challenges imposed by the expansion of our operations and, as a result, may not meet our targets for opening new stores or expanding profitably.

Some of our new stores may be located in areas where we have little or no meaningful experience. Those markets may have different competitive conditions, market conditions, consumer tastes and discretionary spending patterns than our existing markets, which may cause our new stores to be less successful than stores in our existing markets.

Some of our new stores will be located in areas where we have existing units. Although we have experience in these markets, increasing the number of locations in these markets may cause us to over-saturate markets and temporarily or permanently divert customers and sales from our existing stores, thereby adversely affecting our overall financial performance.
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We are dependent upon the smooth functioning of our distribution network, the capacity of our distribution centers, and the timely receipt of inventory.
 
We rely upon the ability to replenish depleted inventory through deliveries to our distribution centers from vendors and from the distribution centers to our stores by various means of transportation, including shipments by sea and truck. Labor shortages in the transportation industry and/or labor inefficiencies associated with certain “driver hours of service” regulations adopted by the Federal Motor Carriers Safety Administration could negatively affect transportation costs. In addition, long-term disruptions to the national and international transportation infrastructure that lead to delays or interruptions of service would adversely affect our business.

The efficient operation of our business is heavily dependent upon our information systems.

We depend on a variety of information technology systems for the efficient functioning of our business. We rely on certain software vendors to maintain and periodically upgrade many of these systems so that they can continue to support our business. The software programs supporting many of our systems were licensed to us by independent software developers. The inability of these developers or us to continue to maintain and upgrade these information systems and software programs would disrupt or reduce the efficiency of our operations if we were unable to convert to alternate systems in an efficient and timely manner. In addition, costs and potential problems and interruptions associated with the implementation of new or upgraded systems and technology or with maintenance or adequate support of existing systems could also disrupt or reduce the efficiency of our operations. We also rely heavily on our information technology staff. If we cannot meet our staffing needs in this area, we may not be able to fulfill our technology initiatives while continuing to provide maintenance on existing systems.

We are subject to governmental regulations, procedures and requirements. A significant change in, or noncompliance with, these regulations could have a material adverse effect on our financial performance.

Our business is subject to numerous federal, state and local regulations. Changes in these regulations, particularly those governing the sale of products, may require extensive system and operating changes that may be difficult to implement and could increase our cost of doing business. Untimely compliance or noncompliance with applicable regulations or untimely or incomplete execution of a required product recall can result in the imposition of penalties, including loss of licenses or significant fines or monetary penalties, in addition to reputational damage.

Our current insurance program may expose us to unexpected costs and negatively affect our financial performance.

Historically, our insurance coverage has reflected deductibles, self-insured retentions, limits of liability and similar provisions that we believe are prudent based on the dispersion of our operations. However, there are types of losses we may incur but against which we cannot be insured or which we believe are not economically reasonable to insure, such as losses due to acts of war, employee and certain other crime and some natural disasters. If we incur these losses, our business could suffer. Certain material events may result in sizable losses for the insurance industry and adversely impact the availability of adequate insurance coverage or result in
 
16

excessive premium increases. To offset negative insurance market trends, we may elect to self-insure, accept higher deductibles or reduce the amount of coverage in response to these market changes. In addition, we self-insure a significant portion of expected losses under our workers’ compensation, automobile liability, general liability and group health insurance programs. Unanticipated changes in any applicable actuarial assumptions and management estimates underlying our recorded liabilities for these losses, including expected increases in medical and indemnity costs, could result in materially different amounts of expense than expected under these programs, which could have a material adverse effect on our financial condition and results of operations. Although we continue to maintain property insurance for catastrophic events, we are effectively self-insured for losses up to the amount of our deductibles. If we experience a greater number of these losses than we anticipate, our financial performance could be adversely affected.

Litigation may adversely affect our business, financial condition and results of operations.

Our business is subject to the risk of litigation by employees, consumers, suppliers, shareholders, government agencies, or others through private actions, class actions, administrative proceedings, regulatory actions or other litigation. The outcome of litigation, particularly class action lawsuits and regulatory actions, is difficult to assess or quantify. Plaintiffs in these types of lawsuits may seek recovery of very large or indeterminate amounts, and the magnitude of the potential loss relating to these lawsuits may remain unknown for substantial periods of time. In addition, certain of these lawsuits, if decided adversely to us or settled by us, may result in liability material to our financial statements as a whole or may negatively affect our operating results if changes to our business operation are required. The cost to defend future litigation may be significant. There also may be adverse publicity associated with litigation that could negatively affect customer perception of our business, regardless of whether the allegations are valid or whether we are ultimately found liable. As a result, litigation may adversely affect our business, financial condition and results of operations. See Part I, Item 3 “Legal Proceedings” for further details regarding certain of these pending matters.

In addition, from time to time, third parties may claim that our trademarks or product offerings infringe upon their proprietary rights. Any such claim, whether or not it has merit, could be time-consuming and distracting for executive management, result in costly litigation, cause changes to our private label offerings or delays in introducing new private label offerings, or require us to enter into royalty or licensing agreements. As a result, any such claim could have a material adverse effect on our business, results of operations and financial condition.

The Investors control us and may have conflicts of interest with us now or in the future.

The Investors indirectly own, through their investment in Parent, a substantial portion of our common stock.  As a result, the Investors have control over our decisions to enter into any corporate transaction and have the ability to prevent any transaction that requires the approval of shareholders regardless of whether others believe that any such transactions are in our own best interests.  For example, the Investors could cause us to make acquisitions that increase the amount of indebtedness that is secured or that is senior to our outstanding debt securities or
 
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to sell assets, which may impair our ability to make payments under our outstanding debt securities.

Additionally, the Investors are in the business of making investments in companies and may from time to time acquire and hold interests in businesses that compete directly or indirectly with us.  The Investors may also pursue acquisition opportunities that may be complementary to our business and, as a result, those acquisition opportunities may not be available to us.  So long as the Investors, or other funds controlled by or associated with the Investors, continue to indirectly own a significant amount of the outstanding shares of our common stock, even if such amount is less than 50%, the Investors will continue to be able to strongly influence or effectively control our decisions.
 
ITEM 2. PROPERTIES
 
As of February 29, 2008, we operated 8,222 retail stores located in 35 states as follows:

State
Number of Stores
 
State
Number of Stores
Alabama
446
   
Nebraska
80
 
Arizona
51
   
New Jersey
22
 
Arkansas
224
   
New Mexico
42
 
Colorado
19
   
New York
223
 
Delaware
24
   
North Carolina
467
 
Florida
415
   
Ohio
465
 
Georgia
464
   
Oklahoma
271
 
Illinois
306
   
Pennsylvania
393
 
Indiana
302
   
South Carolina
316
 
Iowa
170
   
South Dakota
12
 
Kansas
144
   
Tennessee
403
 
Kentucky
300
   
Texas
969
 
Louisiana
326
   
Utah
9
 
Maryland
57
   
Vermont
3
 
Michigan
238
   
Virginia
243
 
Minnesota
16
   
West Virginia
149
 
Mississippi
256
   
Wisconsin
88
 
Missouri
309
         

Most of our stores are located in leased premises.  Individual store leases vary as to their terms, rental provisions and expiration dates.  The majority of our leases are relatively low-cost, short-term leases (usually with initial or primary terms of three to five years) often with multiple renewal options. We also have stores subject to build-to-suit arrangements with landlords, which typically carry a primary lease term of between 7 and 10 years with multiple renewal options. In recent years, an increasing percentage of our new stores have been subject to build-to-suit arrangements. In 2007, approximately 70% of our new stores were build-to-suit arrangements.
 
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As of February 29, 2008, we operated nine distribution centers, as described in the following table:
 
Location
Year
Opened
Approximate Square
Footage
 
Approximate Number
of Stores Served
Scottsville, KY
1959
720,000
   
948
 
Ardmore, OK
1994
1,310,000
   
1,147
 
South Boston, VA
1997
1,250,000
   
779
 
Indianola, MS
1998
820,000
   
885
 
Fulton, MO
1999
1,150,000
   
1,093
 
Alachua, FL
2000
980,000
   
735
 
Zanesville, OH
2001
1,170,000
   
1,113
 
Jonesville, SC
2005
1,120,000
   
728
 
Marion, IN
2006
1,110,000
   
794
 

We lease the distribution centers located in Oklahoma, Mississippi and Missouri and own the other six distribution centers. Approximately 7.25 acres of the land on which our Kentucky distribution center is located is subject to a ground lease. We lease additional temporary warehouse space as necessary to support our distribution needs.

Our executive offices are located in approximately 302,000 square feet of leased space in Goodlettsville, Tennessee.
 
ITEM 3.   LEGAL PROCEEDINGS
 
The information contained in Note 7 to the consolidated financial statements under the heading “Legal proceedings” contained in Part II, Item 8 of this report is incorporated herein by this reference.
 
ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
No matters were submitted to a vote of shareholders during the fourth quarter of 2007.

PART II

ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Market and Dividend Information.  Our outstanding common stock is privately held, and there is no established public trading market for our common stock. There were approximately 145 shareholders of record of our common stock as of March 17, 2008.

Our Board of Directors declared a quarterly dividend in the amount of $0.05 per share:

·  
payable on or before April 20, 2006 to common shareholders of record on April 6, 2006;
 
·  
payable on or before July 20, 2006 to common shareholders of record on July 6, 2006;

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·  
payable on or before October 19, 2006 to common shareholders of record on October 5, 2006;
 
·  
payable on or before January 18, 2007 to common shareholders of record on January 4, 2007; and
 
·  
payable on or before April 19, 2007 to common shareholders of record on April 5, 2007.

Our Board of Directors did not declare a dividend thereafter.  See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources” for a description of the restrictions on our ability to pay dividends.

Unregistered Sales of Equity Securities.  In connection with the Merger, our officer-level employees were offered the opportunity to roll over portions of their equity and/or stock options and to purchase additional equity of Dollar General.  In connection with such opportunity, on July 6, 2007 these individuals purchased a total of 635,207 shares of common stock having an aggregate value of approximately $3,176,035 and exchanged a total of 2,225,175 stock options outstanding prior to the Merger for 1,920,543 vested options to purchase shares of common stock (the “Rollover Options”) in the surviving company (the “Rollover”). The Rollover Options remain outstanding in accordance with the terms of the governing stock incentive plan and grant agreements pursuant to which the holder originally received the stock option grants. However, immediately after the Merger, the exercise price and number of shares underlying the Rollover Options were adjusted as a result of the Merger and the exercise price for all of the options was adjusted to $1.25 per option.

We subsequently offered certain other employees a similar investment opportunity to participate in our common equity.  As a result, on September 20, 2007 and October 5, 2007, we sold 15,000 shares and 558,000 shares, respectively, of our common stock to those employees for a purchase price of $5 per share.

In connection with the investment discussed above and the Merger, our Board of Directors adopted a new stock incentive plan pursuant to which certain of our officer-level and other employees also were granted, on July 6, 2007, September 20, 2007 and October 5, 2007, respectively, new non-qualified stock options to purchase 13,110,000 shares, 130,000 shares and 4,150,000 shares of our common stock at a per share exercise price of $5, which represented the fair market value of one share of our common stock on the grant date.  Effective January 21, 2008, our Board also granted to our CEO, Mr. Dreiling, non-qualified stock options to purchase 2.5 million shares of our common stock pursuant to the terms of the new stock incentive plan. All of these new options expire no later than 10 years following the grant date.  In addition, half of the options will vest ratably on each of the five anniversaries of July 6, 2007 solely based upon continued employment over that time period, while the other half of the options will vest based both upon continued employment and upon the achievement of predetermined performance annual or cumulative financial-based targets over time which coincide with our fiscal year. The options also have certain accelerated vesting provisions upon a change in control or initial public offering, as defined in the new incentive plan.

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Effective January 21, 2008, our Board also granted to Mr. Dreiling 890,000 shares of restricted common stock pursuant to the terms of the new stock incentive plan. The restricted stock will vest on the last day of our 2011 fiscal year if Mr. Dreiling remains employed by us through that date. The restricted stock also has certain accelerated vesting provisions upon a change in control, initial public offering, termination without cause or due to death or disability, or resignation for good reason, all as defined in Mr. Dreiling’s employment agreement.

The share issuances, the Rollover Options and the new option and restricted stock grants described above were effected without registration in reliance on (1) the exemptions afforded by Section 4(2) of the Securities Act of 1933, as amended (the “Securities Act”), because the sales did not involve any public offering, (2) Rule 701 promulgated under the Securities Act for shares that were sold under a written compensatory benefit plan or contract for the participation of our employees, directors, officers, consultants and advisors, and (3) Regulation S promulgated under the Securities Act relating to offerings of securities outside of the United States.
 
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ITEM 6.  SELECTED FINANCIAL DATA
 
The following table sets forth selected consolidated financial information of Dollar General Corporation as of the dates and for the periods indicated.  The selected historical statement of operations data and statement of cash flows data for the fiscal years ended February 1, 2008, February 2, 2007 and February 3, 2006, and balance sheet data as of February 1, 2008 and February 2, 2007 have been derived from our historical audited consolidated financial statements included elsewhere in this report. The selected historical statement of operations data and statement of cash flows data for the fiscal years ended January 28, 2005 and January 30, 2004 and balance sheet data as of February 3, 2006, January 28, 2005, and January 30, 2004 presented in this table have been derived from audited consolidated financial statements not included in this report.

As a result of the Merger, purchase accounting, and a new basis of accounting beginning on July 7, 2007, the 2007 financial reporting periods presented below include the 22-week Predecessor period of the Company from February 3, 2007 to July 6, 2007 and the 30-week Successor period, reflecting the merger of the Company and Buck Acquisition Corp. (“Buck”) from July 7, 2007 to February 1, 2008.  Buck’s results of operations for the period from March 6, 2007 to July 6, 2007 (prior to the Merger on July 6, 2007) are also included in the consolidated financial statements for the periods described above, where applicable, as a result of certain derivative financial instruments entered into by Buck prior to the Merger as further described below.  Other than these financial instruments, Buck had no assets, liabilities, or operations prior to the Merger. The fiscal years presented from 2003 to 2006 reflect the Predecessor.

Due to the significance of the Merger and related transactions that occurred in 2007, the 2007 Successor financial information may not be comparable to that of previous periods presented in the accompanying table.

The information set forth below should be read in conjunction with, and is qualified by reference to, the Consolidated Financial Statements and related notes included in Part II, Item 8 of this report and the Management’s Discussion and Analysis of Financial Condition and Results of Operations included in Part II, Item 7 of this report.
 
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(Amounts in millions, excluding number of stores and net sales per square foot)

     
Predecessor
 
         
   
Successor
         
Fiscal Year Ended
 
   
July 7, 2007 through
February 1,
2008 (1)
   
February 3, 2007
through
July 6, 2007
   
February 2,
2007 (2)
   
February 3,
2006 (3)
   
January 28,
2005
   
January 30,
2004
 
Statement of Operations Data:
                                   
Net sales
  $ 5,571.5     $ 3,923.8     $ 9,169.8     $ 8,582.2     $ 7,660.9     $ 6,872.0  
Cost of goods sold
    3,999.6       2,852.2       6,801.6       6,117.4       5,397.7       4,853.9  
Gross profit
    1,571.9       1,071.6       2,368.2       2,464.8       2,263.2       2,018.1  
Selling, general and administrative (4)
    1,324.5       960.9       2,119.9       1,903.0       1,706.2       1,510.1  
Transaction and related costs
    1.2       101.4       -       -       -       -  
Operating profit
    246.1       9.2       248.3       561.9       557.0       508.0  
Interest income
    (3.8 )     (5.0 )     (7.0 )     (9.0 )     (6.6 )     (4.1 )
Interest expense
    252.9       10.3       34.9       26.2       28.8       35.6  
Loss on interest rate swaps
    2.4       -       -       -       -       -  
Loss on debt retirement, net
    1.2       -       -       -       -       -  
Income (loss) before taxes
    (6.6 )     4.0       220.4       544.6       534.8       476.5  
Income tax expense (benefit)
    (1.8 )     12.0       82.4       194.5       190.6       177.5  
Net income (loss)
  $ (4.8 )   $ (8.0 )   $ 137.9     $ 350.2     $ 344.2     $ 299.0  
                                                 
Statement of Cash Flows Data:
                                               
Net cash provided by (used in):
                                               
Operating activities
  $ 239.6     $ 201.9     $ 405.4     $ 555.5     $ 391.5     $ 514.1  
Investing activities
    (6,848.4 )     (66.9 )     (282.0 )     (264.4 )     (259.2 )     (256.7 )
Financing activities
    6,709.0       25.3       (134.7 )     (323.3 )     (245.4 )     (43.3 )
Total capital expenditures
    (83.6 )     (56.2 )     (261.5 )     (284.1 )     (288.3 )     (140.1 )
Other Financial and Operating Data:
                                               
Same store sales growth
    1.9 %     2.6 %     3.3 %     2.2 %     3.2 %     4.0 %
Number of stores (at period end)
    8,194       8,205       8,229       7,929       7,320       6,700  
Selling square feet (in thousands at period end)
    57,376       57,379       57,299       54,753       50,015       45,354  
Net sales per square foot (5)
  $ 165.4     $ 163.9     $ 162.6     $ 159.8     $ 159.6     $ 157.5  
Highly consumable sales
    66.4 %     66.7 %     65.7 %     65.3 %     63.0 %     61.2 %
Seasonal sales
    16.3 %     15.4 %     16.4 %     15.7 %     16.5 %     16.8 %
Home product sales
    9.1 %     9.2 %     10.0 %     10.6 %     11.5 %     12.5 %
Basic clothing sales
    8.2 %     8.7 %     7.9 %     8.4 %     9.0 %     9.5 %
Rent expense
  $ 214.5     $ 150.2     $ 343.9     $ 312.3     $ 268.8     $ 232.0  
Balance Sheet Data (at period end):
                                               
Cash and cash equivalents and short-term investments
  $ 119.8             $ 219.2     $ 209.5     $ 275.8     $ 414.6  
Total assets
    8,656.4               3,040.5       2,980.3       2,841.0       2,621.1  
Total debt
    4,282.0               270.0       278.7       271.3       282.0  
Total shareholders’ equity
    2,703.9               1,745.7       1,720.8       1,684.5       1,554.3  
 
(1)
Includes the results of Buck for the period prior to the Merger with and into Dollar General Corporation from March 6, 2007 (its formation) through July 6, 2007 and the post-Merger results of Dollar General Corporation for the period from July 7, 2007 through February 1, 2008.
(2)
Includes the effects of certain strategic merchandising and real estate initiatives as further described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
(3)
The fiscal year ended February 3, 2006 was comprised of 53 weeks.
(4)
Penalty expenses of $10 million in fiscal 2003 are included in SG&A.
(5)
For the fiscal year ended February 3, 2006, net sales per square foot was calculated based on 52 weeks’ sales.
 
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ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

General

Accounting Periods.  The following text contains references to years 2008, 2007, 2006 and 2005, which represent fiscal years ending or ended January 30, 2009, February 1, 2008, February 2, 2007 and February 3, 2006, respectively. Our fiscal year ends on the Friday closest to January 31. Each of fiscal years 2007 and 2006 were and fiscal year 2008 will be 52-week accounting periods, while fiscal 2005 was a 53-week accounting period, which affects the comparability of certain amounts in the Consolidated Financial Statements and financial ratios between 2005 and the other fiscal years reflected herein.  As discussed below, we completed a merger transaction on July 6, 2007.  The 2007 52-week period presented includes the 22-week Predecessor period of Dollar General Corporation through July 6, 2007 reflecting the historical basis of accounting, and a 30-week Successor period, reflecting the impact of the business combination and associated purchase price allocation of the merger of Dollar General Corporation and Buck Acquisition Corp. (“Buck”), from July 7, 2007 to February 1, 2008.  For comparison purposes, the discussion of results of operations below is generally based on the mathematical combination of the Successor and Predecessor periods for the 52-week fiscal year ended February 1, 2008 compared to the Predecessor 2006 fiscal year ended February 2, 2007, which we believe provides a meaningful understanding of the underlying business.  Transactions relating to or resulting from the Merger are discussed separately.  The combined results do not reflect the actual results we would have achieved absent the Merger and should not be considered indicative of future results of operations.  This discussion and analysis should be read with, and is qualified in its entirety by, the Consolidated Financial Statements and the notes thereto. It also should be read in conjunction with the Forward-Looking Statements/Risk Factors disclosures set forth in the Introduction and in Item 1A of this report.

Purpose of Discussion. We intend for this discussion to provide the reader with information that will assist in understanding our company and the critical economic factors that affect our company. In addition, we hope to help the reader understand our financial statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles affect our financial statements.

Merger with KKR

On July 6, 2007, we completed a merger (the “Merger”) in which our former shareholders received $22.00 in cash, or approximately $6.9 billion in total, for each share of our common stock held. As a result of the Merger, we are a subsidiary of Buck Holdings, L.P. (“Parent”), a Delaware limited partnership controlled by investment funds affiliated with Kohlberg Kravis Roberts & Co., L.P. (“KKR” or “Sponsor”). KKR, GS Capital Partners VI Fund, L.P. and affiliated funds (affiliates of Goldman, Sachs & Co.), Citi Private Equity, Wellington Management Company, LLP, CPP Investment Board (USRE II) Inc., and other equity co-investors (collectively, the “Investors”) indirectly own a substantial portion of our capital stock through their investment in Parent.

24

The Merger consideration was funded through the use of our available cash, cash equity contributions from the Investors, equity contributions of certain members of our management and the debt financings discussed below. Our outstanding common stock is now owned by Parent and certain members of management. Our common stock is no longer registered with the Securities and Exchange Commission (“SEC”) and is no longer traded on a national securities exchange.

We entered into the following debt financings in conjunction with the Merger:

·  
We entered into a credit agreement and related security and other agreements consisting of a $2.3 billion senior secured term loan facility, which matures on July 6, 2014 (the “Term Loan Facility”).
 
·  
We entered into a credit agreement and related security and other agreements consisting of a senior secured asset-based revolving credit facility of up to $1.125 billion (of which $432.3 million was drawn at closing and $132.3 million was paid down on the same day), subject to borrowing base availability, which matures July 6, 2013 (the “ABL Facility” and, with the Term Loan Facility, the “New Credit Facilities”).
 
·  
We issued $1.175 billion aggregate principal amount of 10.625% senior notes due 2015, which mature on July 15, 2015, and $725 million aggregate principal amount of 11.875%/12.625% senior subordinated toggle notes due 2017, which mature on July 15, 2017.  During the fourth quarter of fiscal 2007, we repurchased $25 million of the 11.875%/12.625% senior subordinated toggle notes due 2017.

Executive Overview

We are the largest discount retailer in the United States by number of stores, with approximately 8,200 stores located in 35 states, primarily in the southern, southwestern, midwestern and eastern United States. We serve a broad customer base and offer a focused assortment of everyday items, including basic consumable merchandise and other home, apparel and seasonal products. A majority of our products are priced at $10 or less and approximately 30% of our products are priced at $1 or less. We seek to offer a compelling value proposition for our customers based on convenient store locations, easy in and out shopping and quality merchandise at highly competitive prices. We believe our combination of value and convenience distinguishes us from other discount, convenience and drugstore retailers, who typically focus on either value or convenience.

The nature of our business is seasonal to a certain extent.  Primarily because of sales of holiday-related merchandise, sales in the fourth quarter have historically been higher than sales achieved in each of the first three quarters of the fiscal year.  Expenses and, to a greater extent, operating income, vary by quarter.  Results of a period shorter than a full year may not be indicative of results expected for the entire year.  Furthermore, the seasonal nature of our business may affect comparisons between periods.

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In November 2006, we completed a strategic review of our inventory and real estate strategies and announced significant changes to existing company practices, which we refer to as “Project Alpha.” At that time, we announced our decision to close 403 stores which did not meet our recently developed store criteria, in addition to stores closed in the ordinary course of business, and to slow our new store growth rate. We made this decision to allow ourselves to focus on our merchandising efforts and improvements to our execution in the stores. At that time, we also announced the decision to eliminate, with limited exceptions, our “packaway” inventory strategy, which was our historical practice of storing unsold merchandise at the end of a season and carrying it over to the following year. All of the 403 stores identified for closing were closed by the end of July 2007, and all of our packaway inventory was eliminated by the end of the 2007 fiscal year. We believe that the elimination of packaway inventory, coupled with the completion in 2006 of the implementation of our EZstoreTM process (simplifying the way we stock new merchandise in our stores), contributed to our ability to show significant improvements in the shopability and manageability of our stores in 2007.  We believe these initiatives also led to our successful reduction of store employee turnover in 2007, including significant improvement at the critical store manager and district manager levels.

In addition to the initiatives noted above, during 2007 we worked closely with KKR to refine our strategic initiatives and set goals to improve our operational and financial performance. During this transition, we slowed our store growth, as planned, and we defined very specific operational and financial benchmarks to monitor and measure our progress against our goals. Specifically, in 2007, we focused on and made good progress on improving our merchandising and category management processes, refining our real estate processes and improving our distribution and transportation logistics. In addition, we accelerated our efforts to refine our pricing strategy, increase direct foreign sourcing and expand our private label offering. All of these initiatives are ongoing and we continue to expect them to positively impact our gross profit, sales productivity and capital efficiency in 2008 and beyond.

It is important for you to read our more detailed discussion of financial and operating results below under “Results of Operations.” Basis points or "bps" amounts referred to below are equal to 0.01 percent as a percentage of sales.  Some of the more significant highlights of the 2007 fiscal year are as follows:

·  
Total sales increased 3.5%, including a 2.1% increase in same-store sales compared with the prior year. The remaining sales increase resulted from new stores, partially offset by the impact of closed stores.
 
·  
Gross profit, as a percentage of sales, increased to 27.8% compared to 25.8% in 2006. This increase was the result of improved purchase markups, decreased markdowns, and leverage on distribution costs impacted by improved logistics.  The 2006 gross profit rate was significantly impacted by merchandise markdowns as a result of our inventory liquidation and store closing activities.
 
·  
SG&A, as a percentage of sales, increased to 24.1% compared to 23.1%. Several items of significance affected this comparison, including: the addition of leasehold intangibles amortization (non-cash) of 25 bps; an excess of Project Alpha-related
 
26

  SG&A expenses in 2007 over 2006 of 21 bps; an excess of 2007 incentive compensation resulting from meeting certain financial targets over 2006 discretionary bonuses of 18 bps;  the impact of hurricane-related insurance proceeds received in 2006 of 14 bps; an accrued loss relating to the restructuring of certain distribution center leases as a result of the Merger of 13 bps; and other SG&A relating to or resulting from the Merger.
   
·  
Other items affecting our 2007 results of operations, relating to or resulting from the Merger, as more fully described below, include transaction and related costs of $102.6 million and a significant increase in interest expense.
 
·  
As a result, we incurred a net loss for the 2007 combined periods of $12.8 million compared to net income for 2006 of $137.9 million. Cash flow from operating activities increased to $441.6 million in 2007 from $405.4 million in 2006.
 
·  
We opened 365 new stores, closed 400 stores (including 275 remaining from Project Alpha) and relocated or remodeled 300 stores. As of February 1, 2008, we operated 8,194 stores.
 
·  
We also reduced total inventories by $143.7 million, or 10.0%.

We made significant progress on our merchandising and operating initiatives in 2007, including clearing our stores of packaway inventories and closing our low-performing stores, giving us a strong foundation for further enhancements in 2008. These changes also contributed to a decrease in employee turnover and a dramatic improvement in the overall appearance of our stores. We moved forward with our pricing and private label initiatives and enhanced our merchandising analysis tools giving us a better platform for decision-making. We accomplished these goals while making a significant transition in the financial structure of the Company.

2008 Priorities. In 2008, under the leadership of our new CEO, we plan to continue to deliver value to our customers through our ability to deliver highly competitive prices in a convenient shopping format. Our stores provide our customers with a compelling shopping experience, low everyday prices on name brand and other quality items in a convenient, easy-to-shop format. We plan to continue to improve on this value/convenience model by implementing merchandising and operational improvements.

We are focused on further improving financial performance through:

·  
Productive sales growth, including emphasis on increasing shopper frequency, size of basket and productivity per square foot.
 
·  
Improving our gross margins through: decreasing inventory shrink, refining our pricing strategy, optimizing our merchandise offering, expanding and improving our private label offering and improving and expanding our foreign sourcing;

27

·  
Improving our operational processes, for example, through information technology and work management and leveraging those improvements to reduce costs.
 
·  
Strengthening and expanding our culture of serving others.

In addition, we plan to open approximately 200 new stores and to remodel or relocate approximately 400 stores.

Key Financial Metrics. We have identified the following as our most critical financial metrics for 2008:

·  
Same-store sales growth / sales per square foot
 
·  
Gross profit, as a percentage of sales
 
·  
Inventory turnover
 
·  
Cash flow
 
·  
Earnings before interest, taxes and depreciation and amortization (“EBITDA”)

Readers should refer to the detailed discussion of our operating results below for additional comments on financial performance in the current year periods as compared with the prior year periods.
 
28

Results of Operations

The following discussion of our financial performance is based on the Consolidated Financial Statements set forth herein. The following table contains results of operations data for the 2007, 2006 and 2005 fiscal years, and the dollar and percentage variances among those years.
 
                     
2007 vs. 2006
     
2006 vs. 2005
 
 
(amounts in millions)
 
2007 (a)
   
2006 (b)
   
2005 (c)
     
$
change
     
%
 change
     
$
change
   
%
change
 
                                           
                                           
Net sales by category:                                          
Highly consumable
  $ 6,316.8     $ 6,022.0     $ 5,606.5     $ 294.8       4.9 %   $ 415.5       7.4 %
% of net sales
    66.53 %     65.67 %     65.33 %                                
Seasonal
    1,513.2       1,510.0       1,348.8       3.2       0.2       161.2       12.0  
% of net sales
    15.94 %     16.47 %     15.72 %                                
Home products
    869.8       914.4       907.8       (44.6 )     (4.9 )     6.5       0.7  
% of net sales
    9.16 %     9.97 %     10.58 %                                
Basic clothing
    795.4       723.5       719.2       72.0       9.9       4.3       0.6  
% of net sales
    8.38 %     7.89 %     8.38 %                                
Net sales
  $ 9,495.2     $ 9,169.8     $ 8,582.2     $ 325.4       3.5 %   $ 587.6       6.8 %
Cost of goods sold
    6,851.8       6,801.6       6,117.4       50.2       0.7       684.2       11.2  
% of net sales
    72.16 %     74.17 %     71.28 %                                
Gross profit
    2,643.5       2,368.2       2,464.8       275.3       11.6       (96.6 )     (3.9 )
% of net sales
    27.84 %     25.83 %     28.72 %                                
Selling, general and administrative expenses
    2,285.4       2,119.9       1,903.0       165.5       7.8       217.0       11.4  
% of net sales
    24.07 %     23.12 %     22.17 %                                
Transaction and related costs
    102.6       -       -       102.6       100.0       -       -  
% of net sales
    1.08 %     -       -                       -       -  
Operating profit
    255.4       248.3       561.9       7.2       2.9       (313.6 )     (55.8 )
% of net sales
    2.69 %     2.71 %     6.55 %                                
Interest income
    (8.8 )     (7.0 )     (9.0 )     (1.8 )     26.3       2.0       (22.2 )
% of net sales
    (0.09 )%     (0.08 )%     (0.10 )%                                
Interest expense
    263.2       34.9       26.2       228.3       653.8       8.7       33.1  
% of net sales
    2.78 %     0.38 %     0.31 %                                
Loss on interest rate swaps, net
    2.4       -       -       2.4       100.0       -       -  
% of net sales
    0.03 %     -       -                                  
Loss on debt retirements, net
    1.2       -       -       1.2       100.0       -       -  
% of net sales
    0.01 %     -       -                                  
Income (loss) before income taxes
    (2.6 )     220.4       544.6       (222.9 )     (101.1 )     (324.3 )     (59.5 )
% of net sales
    (0.03 )%     2.40 %     6.35 %                                
Income taxes
    10.2       82.4       194.5       (72.2 )     (87.6 )     (112.1 )     (57.6 )
% of net sales
    0.11 %     0.90 %     2.27 %                                
Net income (loss)
  $ (12.8 )   $ 137.9     $ 350.2     $ (150.7 )     (109.3 )%   $ (212.2 )     (60.6 )%
 
(a)
The amounts in the 2007 column represent the mathematical combination of the Predecessor through July 6, 2007 and Successor from July 7, 2007 through February 1, 2008 as included in the consolidated financial statements. These results also include the operations of Buck for the period prior to the Merger from March 6, 2007 (Buck’s date of formation) through July 6, 2007 (reflecting the change in fair value of interest rate swaps.) This presentation does not comply with generally accepted accounting principles, but we believe this combination provides a meaningful method of comparison.
(b)
Includes the impacts of certain strategic initiatives as more fully described in the “Executive Overview” above.
(c)
The fiscal year ended February 3, 2006 was comprised of 53 weeks.
 
29

Net Sales.  Net sales increased $325.4 million, or 3.5%, in 2007, primarily representing a same-store sales increase of 2.1% for 2007 compared to 2006.  Same-store sales include stores that have been open for 13 months and remain open at the end of the reporting period. The increase in same-store sales accounted for $185.6 million of the increase in sales. Sales resulting from new store growth, including 365 new stores in 2007, were partially offset by the impact of store closings in 2007 and 2006. Increased sales of highly consumables accounted for $294.8 million of our total sales increase, resulting from successful changes over the past year to our consumables merchandising mix. Sales of seasonal merchandise and apparel increased slightly and were partially offset by a decrease in home products sales. To some extent, sales in these more discretionary categories were impacted by our efforts to eliminate our packaway strategy by the end of 2007 and to reduce overall inventory levels. In addition, we believe sales of seasonal merchandise, apparel and home products were negatively affected by continued economic pressures on our customers, particularly in the fourth quarter. The increase in same-store sales represents an increase in average customer purchase, offset by a slight decrease in customer traffic.

Increases in 2006 net sales resulted primarily from opening additional stores, including 300 net new stores in 2006, and a same-store sales increase of 3.3% for 2006 compared to 2005. The increase in same-store sales accounted for $265.4 million of the increase in sales, while new stores were the primary contributors to the remaining $322.2 million sales increase during 2006. The increase in same-store sales is primarily attributable to an increase in average customer purchase. We also believe that the strategic merchandising and real estate initiatives discussed above in the “Executive Overview” had a positive impact on net sales in the fourth quarter. By merchandise category, our sales increase in 2006 compared to 2005 was primarily attributable to the highly consumable category, which increased by $415.5 million, or 7.4%. An increase in sales of seasonal merchandise of $161.2 million, or 12.0%, also contributed to overall sales growth. We believe that our increased sales in 2006 were supported by additions to our product offerings and increased promotional activities, including the use of advertising circulars and clearance activities.

As discussed above, we monitor our sales internally by the following four major categories: highly consumable, seasonal, home products and basic clothing. The highly consumable category has a lower gross profit rate than the other three categories and has grown significantly over the past several years. We expect the move away from our packaway inventory strategy to have a positive impact on sales in our non-consumable merchandise categories. Because of the impact of sales mix on gross profit, we continually review our merchandise mix and strive to adjust it when appropriate. Maintaining an appropriate sales mix is an integral part of achieving our gross profit and sales goals.

Gross Profit.  The gross profit rate increased by 201 basis points in 2007 as compared with 2006 due to a number of factors, including: an increase in purchase markups, resulting primarily from a change in mix of items and higher vendor rebates; lower markdowns, including markdowns from retail and below cost markdowns (as discussed below, markdowns in 2006 included significant markdowns and below cost adjustments relating to the initial launch of Project Alpha); and improved leverage on distribution and transportation costs driven by
30

logistics efficiencies.  Offsetting the factors listed above was an increase in our shrink rate in 2007 as compared to 2006.

The gross profit rate decline in 2006 as compared with 2005 was due primarily to a significant increase in markdown activity as a percentage of sales, including below-cost markdowns, as a result of our inventory liquidation and store closing initiatives. While we believe these initiatives had a positive impact on sales, they had a negative impact on our gross profit rate in 2006. In total, our gross profit rate declined by 289 basis points to 25.8% in 2006 compared to 28.7% in 2005. Significantly impacting our gross profit rate, as a result of the related effect on cost of goods sold, were total markdowns of $279.1 million at cost taken during 2006, compared with total markdowns of $106.5 million at cost taken in 2005. The 2006 markdowns reflect $179.9 million at cost taken during the fourth quarter of 2006 compared to $39.0 million markdowns at cost taken during the fourth quarter of 2005. Other factors included, but were not limited to: a decrease in the markups on purchases, primarily attributable to purchases of highly consumable products (including nationally branded products, which generally have lower average markups); and an increase in our shrink rate.

Selling, General and Administrative (“SG&A”) Expense.  SG&A expense increased $165.5 million, or 7.8%, in 2007 from the prior year, and increased as a percentage of sales to 24.1% in 2007 from 23.1% in 2006. SG&A in 2007 includes: $23.4 million related to amortization of leasehold intangibles capitalized in connection with the revaluation of assets at the date of the Merger; $27.2 million of accrued administrative employee incentive compensation expense resulting from meeting certain financial targets (compared to $9.6 million of discretionary bonuses in 2006); approximately $54 million of expenses relating to the closing of stores and the elimination of our packaway inventory strategy (compared to approximately $33 million in 2006) and an accrued loss of approximately $12.0 million relating to the probable restructuring of certain distribution center leases. In addition, SG&A in 2007 includes approximately $4.8 million of KKR-related consulting and monitoring fees. SG&A expense in 2006 was partially offset by insurance proceeds of $13.0 million received during the year related to losses incurred due to Hurricane Katrina.

The increase in SG&A expense as a percentage of sales in 2006 as compared with 2005 was due to a number of factors, including increases in the following expense categories:  impairment charges on leasehold improvements and store fixtures totaling $9.4 million, including $8.0 million related to the planned closings of approximately 400 underperforming stores, 128 of which closed in 2006 and the remainder of which closed in 2007, lease contract terminations totaling $5.7 million related to these stores; higher store occupancy costs (increased 12.1%) due to higher average monthly rentals associated with our leased store locations; higher debit and credit card fees (increased 40.6%) due to the increased customer usage of debit cards and the acceptance of VISA credit and check cards at all locations; higher administrative labor costs (increased 29.9%) primarily related to additions to our executive team, particularly in merchandising and real estate, and the expensing of stock options; higher advertising costs (increased 198.3%) related primarily to the distribution of several advertising circulars in the year and to promotional activities related to the inventory clearance and store closing activities discussed above; and higher incentive compensation primarily related to the $9.6 million discretionary bonus authorized by the Board of Directors for the 2006 fiscal year.  These
31

increases were partially offset by insurance proceeds of $13.0 million received during the period related to losses incurred due to Hurricane Katrina, and depreciation and amortization expenses that remained relatively constant in fiscal 2006 as compared to fiscal 2005.

Transaction and Related Costs. The $102.6 million of expenses recorded in 2007 reflect $63.2 million of expenses related to the Merger, such as investment banking and legal fees as well as $39.4 million of compensation expense related to stock options, restricted stock and restricted stock units which were fully vested immediately prior to the Merger.

Interest Income.  Interest income in 2007 consists primarily of interest on short-term investments. The increase in 2007 from 2006 resulted from higher levels of cash and short term investments on hand, primarily in the first half of the year. The decrease in 2006 compared to 2005 was due primarily to the acquisition of the entity which held legal title to the South Boston distribution center in June 2006 and the related elimination of the note receivable which represented debt issued by this entity from which we formerly leased the South Boston distribution center.

Interest Expense. Interest expense increased by $228.3 million in 2007 as compared to 2006 due to interest on long-term obligations incurred to finance the Merger. See further discussion under “Liquidity and Capital Resources” below.  We had outstanding variable-rate debt of $787.0 million, after taking into consideration the impact of interest rate swaps, as of February 1, 2008. The remainder of our outstanding indebtedness at February 1, 2008 was fixed rate debt.

The increase in interest expense in 2006 was primarily attributable to increased interest expense of $6.5 million under a revolving credit agreement primarily due to increased borrowings, an increase in tax-related interest of $4.1 million, offset by a reduction in interest expense associated with the elimination of a financing obligation on the South Boston distribution center.

Loss on Interest Rate Swaps. During 2007, we recorded an unrealized loss of $4.1 million related to the change in the fair value of interest swaps prior to the designation of such swaps as cash flow hedges in October 2007. This loss is offset by earnings of $1.7 million under the contractual provisions of the swap agreements.

Loss on Debt Retirements, Net. During 2007, we recorded $6.2 million of expenses related to consent fees and other costs associated with a tender offer for certain notes payable maturing in June 2010 (“2010 Notes”). Approximately 99% of the 2010 Notes were retired as a result of the tender offer. The costs related to the tender of the 2010 Notes were partially offset by a $4.9 million gain resulting from the repurchase of $25.0 million of our 11.875%/12.625% Senior Subordinated Notes, due July 15, 2017.

Income Taxes.  The effective income tax rates for the Successor period ended February 1, 2008, and the Predecessor periods ended July 6, 2007, 2006 and 2005 were a benefit of 26.9% and expense of 300.2%, 37.4% and 35.7%, respectively.

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The income tax rate for the Successor period ended February 1, 2008 is a benefit of 26.9%.  This benefit is less than the expected U.S. statutory rate of 35% due to the incurrence of state income taxes in several of the group’s subsidiaries that file their state income tax returns on a separate entity basis and the election to include, effective February 3, 2007, income tax related interest and penalties in the amount reported as income tax expense.
 
The income tax rate for the Predecessor period ended July 6, 2007 is an expense of 300.2%.  This expense is higher than the expected U.S. statutory rate of 35% due principally to the non-deductibility of certain acquisition related expenses.
 
The 2006 income tax rate was higher than the 2005 rate by 1.7%.  Factors contributing to this increase include additional expense related to the adoption of a new tax system in the State of Texas; a reduction in the contingent income tax reserve due to the resolution of contingent liabilities that is less than the decrease that occurred in 2005; an increase in the deferred tax valuation allowance; and an increase related to a non-recurring benefit recognized in 2005 related to an internal restructuring.  Offsetting these rate increases was a reduction in the income tax rate related to federal income tax credits.  Due to the reduction in our 2006 income before tax, a small increase in the amount of federal income tax credits earned yielded a much larger percentage reduction in the income tax rate for 2006 versus 2005.
 
Effects of Inflation

We believe that inflation and/or deflation had a minimal impact on our overall operations during 2007, 2006 and 2005.

Liquidity and Capital Resources

Current Financial Condition / Recent Developments. During the past three years, we have generated an aggregate of approximately $1.4 billion in cash flows from operating activities. During that period, we expanded the number of stores we operate by approximately 12% (874 stores) and incurred approximately $685 million in capital expenditures. As noted above, we made certain strategic decisions which slowed our growth in 2007.

At February 1, 2008, we had total outstanding debt (including the current portion of long-term obligations) of $4.282 billion.  We also had an additional $769.2 million available for borrowing under our new senior secured asset-based revolving credit facility at that date.  Our liquidity needs are significant, primarily due to our debt service and other obligations.

Management believes our cash flow from operations and existing cash balances, combined with availability under the New Credit Facilities (described below), will provide sufficient liquidity to fund our current obligations, projected working capital requirements and capital spending for a period that includes the next twelve months.
 
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New Credit Facilities

Overview. On July 6, 2007, in connection with the Merger, we entered into two senior secured credit agreements, each with Goldman Sachs Credit Partners L.P., Citicorp Global Markets Inc., Lehman Brothers Inc. and Wachovia Capital Markets, LLC, each as joint lead arranger and joint bookrunner.  The CIT Group/Business Credit, Inc. is administrative agent under the senior secured credit agreement for the asset-based revolving credit facility and Citicorp North America, Inc. is administrative agent under the senior secured credit agreement for the term loan facility.

The New Credit Facilities provide financing of $3.425 billion, consisting of:

·  
$2.3 billion in a senior secured term loan facility; and
 
·  
a senior secured asset-based revolving credit facility of up to $1.125 billion (of which up to $350.0 million is available for letters of credit), subject to borrowing base availability.

The term loan credit facility consists of two tranches, one of which is a “first-loss” tranche, which, in certain circumstances, is subordinated in right of payment to the other tranche of the term loan credit facility.
 
We are the borrower under the term loan credit facility, the primary borrower under the asset-based credit facility and, in addition, certain subsidiaries of ours are designated as borrowers under this facility.  The asset-based credit facility includes borrowing capacity available for letters of credit and for short-term borrowings referred to as swingline loans.

The New Credit Facilities provide that we have the right at any time to request up to $325.0 million of incremental commitments under one or more incremental term loan facilities and/or asset-based revolving credit facilities. The lenders under these facilities are not under any obligation to provide any such incremental commitments and any such addition of or increase in commitments will be subject to our not exceeding certain senior secured leverage ratios and certain other customary conditions precedent.  Our ability to obtain extensions of credit under these incremental commitments will also be subject to the same conditions as extensions of credit under the New Credit Facilities.

The amount from time to time available under the senior secured asset-based credit facility (including in respect of letters of credit) shall not exceed the sum of the tranche A borrowing base and the tranche A-1 borrowing base. The tranche A borrowing base equals the sum of (i) 85% of the net orderly liquidation value of all our eligible inventory and that of each guarantor thereunder and (ii) 90% of all our accounts receivable and credit/debit card receivables and that of each guarantor thereunder, in each case, subject to a reserve equal to the principal amount of the 2010 Notes that remain outstanding at any time and other customary reserves and eligibility criteria. An additional 10% to 12% of the net orderly liquidation value of all our eligible inventory and that of each guarantor thereunder is made available to us in the form of a “last out” tranche in respect of which we may borrow up to a maximum amount of $125.0
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million. Borrowings under the asset-based credit facility will be incurred first under the last out tranche, and no borrowings will be permitted under any other tranche until the last out tranche is fully utilized. Repayments of the senior secured asset-based revolving credit facility will be applied to the last out tranche only after all other tranches have been fully paid down.

Interest Rate and Fees. Borrowings under the New Credit Facilities bear interest at a rate equal to an applicable margin plus, at our option, either (a) LIBOR or (b) a base rate (which is usually equal to the prime rate).  The applicable margin for borrowings is (i) under the term loan facility, 2.75% with respect to LIBOR borrowings and 1.75% with respect to base-rate borrowings and (ii) as of February 1, 2008 under the asset-based revolving credit facility (except in the last out tranche described above), 1.50% with respect to LIBOR borrowings and 0.50% with respect to base-rate borrowings and for any last out borrowings, 2.25% with respect to LIBOR borrowings and 1.25% with respect to base-rate borrowings.  The applicable margins for borrowings under the asset-based revolving credit facility (except in the case of last out borrowings) are subject to adjustment each quarter based on average daily excess availability under the asset-based revolving credit facility.

In addition to paying interest on outstanding principal under the New Credit Facilities, we are required to pay a commitment fee to the lenders under the asset-based revolving credit facility in respect of the unutilized commitments thereunder. At February 1, 2008 the commitment fee rate was 0.375% per annum. The commitment fee rate will be reduced (except with regard to the last out tranche) to 0.25% per annum at any time that the unutilized commitments under the asset-based credit facility are equal to or less than 50% of the aggregate commitments under the asset-based revolving credit facility. We must also pay customary letter of credit fees.

Prepayments. The senior secured credit agreement for the term loan facility requires us to prepay outstanding term loans, subject to certain exceptions, with:

·  
50% of our annual excess cash flow (as defined in the credit agreement) commencing with the fiscal year ending on or about January 31, 2008 (which percentage will be reduced to 25% and 0% if we achieve and maintain a total net leverage ratio of 6.0 to 1.0 and 5.0 to 1.0, respectively);
 
·  
100% of the net cash proceeds of all non-ordinary course asset sales or other dispositions of property in excess of $25.0 million in the aggregate and subject to our right to reinvest the proceeds; and
 
·  
100% of the net cash proceeds of any incurrence of debt, other than proceeds from debt permitted under the senior secured credit agreement.

The mandatory prepayments discussed above will be applied to the term loan facility as directed by the senior secured credit agreement.
 
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In addition, the senior secured credit agreement for the asset-based revolving credit facility requires us to prepay the asset-based revolving credit facility, subject to certain exceptions, with:

·  
100% of the net cash proceeds of all non-ordinary course asset sales or other dispositions of revolving facility collateral (as defined below) in excess of $1.0 million in the aggregate and subject to our right to reinvest the proceeds; and
 
·  
to the extent such extensions of credit exceed the then current borrowing base (as defined in the senior secured credit agreement for the asset-based revolving credit facility).

We may be obligated to pay a prepayment premium on the amount repaid under the term loan facility if the term loans are voluntarily repaid in whole or in part before July 6, 2009. We may voluntarily repay outstanding loans under the asset-based revolving credit facility at any time without premium or penalty, other than customary “breakage” costs with respect to LIBOR loans.
 
An event of default under the senior secured credit agreements will occur upon a change of control as defined in the senior secured credit agreements governing our New Credit Facilities.  Upon an event of default, indebtedness under the New Credit Facilities may be accelerated, in which case we will be required to repay all outstanding loans plus accrued and unpaid interest and all other amounts outstanding under the New Credit Facilities.
 
Letters of Credit. $350.0 million of our asset-based revolving credit facility is available for letters of credit.

Amortization. Beginning September 30, 2009, we are required to repay installments on the loans under the term loan credit facility in equal quarterly principal amounts in an aggregate amount per annum equal to 1% of the total funded principal amount at July 6, 2007, with the balance payable on July 6, 2014. There is no amortization under the asset-based revolving credit facility. The entire principal amounts (if any) outstanding under the asset-based revolving credit facility are due and payable in full at maturity, on July 6, 2013, on which day the commitments thereunder will terminate.

Guarantee and Security. All obligations under the New Credit Facilities are unconditionally guaranteed by substantially all of our existing and future domestic subsidiaries (excluding certain immaterial subsidiaries and certain subsidiaries designated by us under our senior secured credit agreements as “unrestricted subsidiaries”), referred to, collectively, as U.S. Guarantors.

All obligations and related guarantees under the term loan credit facility are secured by:

·  
a second-priority security interest in all existing and after-acquired inventory, accounts receivable, and other assets arising from such inventory and accounts receivable, of the Company and each U.S. Guarantor (the “Revolving Facility Collateral”), subject to certain exceptions;
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·  
a first priority security interest in, and mortgages on, substantially all of our and each U.S. Guarantor’s tangible and intangible assets (other than the Revolving Facility Collateral); and
 
·  
a first-priority pledge of 100% of the capital stock held by the Company, or any of our domestic subsidiaries that are directly owned by us or one of the U.S. Guarantors and 65% of the voting capital stock of each of our existing and future foreign subsidiaries that are directly owned by us or one of the U.S. Guarantors.
 
All obligations and related guarantees under the asset-based credit facility are secured by the Revolving Facility Collateral, subject to certain exceptions.
 
Certain Covenants and Events of Default. The senior secured credit agreements contain a number of covenants that, among other things, restrict, subject to certain exceptions, our ability to:
 
·  
incur additional indebtedness;
 
·  
sell assets;
 
·  
pay dividends and distributions or repurchase our capital stock;
 
·  
make investments or acquisitions;

·  
repay or repurchase subordinated indebtedness (including the senior subordinated notes discussed below) and the senior notes discussed below;
 
·  
amend material agreements governing our subordinated indebtedness (including the senior subordinated notes discussed below) or our senior notes discussed below; and
 
·  
change our lines of business.
 
The senior secured credit agreements also contain certain customary affirmative covenants and events of default.

At February 1, 2008, we had $102.5 million of borrowings, $28.8 million of commercial letters of credit, and $69.2 million of standby letters of credit outstanding under our asset-based revolving credit facility.

Senior Notes due 2015 and Senior Subordinated Toggle Notes due 2017

On July 6, 2007, we issued $1,175.0 million aggregate principal amount of 10.625% senior notes due 2015 (the “senior notes”) which mature on July 15, 2015 pursuant to an
37

indenture, dated as of July 6, 2007 (the “senior indenture”), and $725 million aggregate principal amount of 11.875%/12.625% senior subordinated toggle notes due 2017 (the “senior subordinated notes”), which mature on July 15, 2017, pursuant to an indenture, dated as of July 6, 2007 (the “senior subordinated indenture”). The senior notes and the senior subordinated notes are collectively referred to herein as the “notes.” The senior indenture and the senior subordinated indenture are collectively referred to herein as the “indentures.”
 
Interest on the notes is payable on January 15 and July 15 of each year, commencing January 15, 2008. Interest on the senior notes will be payable in cash. Cash interest on the senior subordinated notes will accrue at a rate of 11.875% per annum, and PIK interest (as that term is defined below) will accrue at a rate of 12.625% per annum. The initial interest payment on the senior subordinated notes will be payable in cash. For any interest period thereafter through July 15, 2011, we may elect to pay interest on the senior subordinated notes (i) in cash, (ii) by increasing the principal amount of the senior subordinated notes or issuing new senior subordinated notes (“PIK interest”) or (iii) by paying interest on half of the principal amount of the senior subordinated notes in cash interest and half in PIK interest. After July 15, 2011, all interest on the senior subordinated notes will be payable in cash.
 
The notes are fully and unconditionally guaranteed by each of the existing and future direct or indirect wholly owned domestic subsidiaries that guarantee the obligations under our New Credit Facilities.
 
We may redeem some or all of the notes at any time at redemption prices described or set forth in the indentures. We repurchased $25.0 million of the 11.875%/12.625% senior subordinated toggle notes in the fourth quarter of 2007.
 
Change of Control. Upon the occurrence of a change of control, which is defined in the indentures, each holder of the notes has the right to require us to repurchase some or all of such holder’s notes at a purchase price in cash equal to 101% of the principal amount thereof, plus accrued and unpaid interest, if any, to the repurchase date.

Covenants. The indentures contain covenants limiting, among other things, our ability and the ability of our restricted subsidiaries to (subject to certain exceptions):

·  
incur additional debt, issue disqualified stock or issue certain preferred stock;
 
·  
pay dividends on or make certain distributions and other restricted payments;
 
·  
create certain liens or encumbrances;
 
·  
sell assets;
 
·  
enter into transactions with affiliates;
 
·  
make payments to us;
 
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·  
consolidate, merge, sell or otherwise dispose of all or substantially all of our assets; and
 
·  
designate our subsidiaries as unrestricted subsidiaries.
 
Events of Default. The indentures also provide for events of default which, if any of them occurs, would permit or require the principal of and accrued interest on the notes to become or to be declared due and payable.

Registration Rights Agreement. On July 6, 2007, we entered into a registration rights agreement with respect to the notes.  In the registration rights agreement, we agreed to use commercially reasonable efforts to register with the SEC new senior notes having substantially identical terms as the senior notes and new senior subordinated notes having substantially identical terms as the senior subordinated notes.  We filed this registration statement with the SEC, and it was declared effective, in the fourth quarter of fiscal 2007.  We subsequently commenced the offer to exchange the new senior notes and the new senior subordinated notes for each of the outstanding senior notes and the outstanding senior subordinated notes, respectively. The exchange offer expired on March 17, 2008.  All of the outstanding senior notes and senior subordinated notes were tendered in the exchange offer.
 
Adjusted EBITDA

Under the New Credit Facilities and the indentures, certain limitations and restrictions could occur if we are not able to satisfy and remain in compliance with specified financial ratios. Management believes the most significant of such ratios is the senior secured incurrence test under the New Credit Facilities.  This test measures the ratio of the senior secured debt to Adjusted EBITDA. This ratio would need to be no greater than 4.25 to 1 to avoid such limitations and restrictions. As of February 1, 2008, this ratio was 3.4 to 1. Senior secured debt is defined as our total debt secured by liens or similar encumbrances less cash and cash equivalents.  EBITDA is defined as income (loss) from continuing operations before cumulative effect of change in accounting principle plus interest and other financing costs, net, provision for income taxes, and depreciation and amortization. Adjusted EBITDA is defined as EBITDA, further adjusted to give effect to adjustments required in calculating this covenant ratio under our New Credit Facilities. EBITDA and Adjusted EBITDA are not presentations made in accordance with GAAP, are not measures of financial performance or condition, liquidity or profitability, and should not be considered as an alternative to (1) net income, operating income or any other performance measures determined in accordance with GAAP or (2) operating cash flows determined in accordance with GAAP. Additionally, EBITDA and Adjusted EBITDA are not intended to be measures of free cash flow for management’s discretionary use, as they do not consider certain cash requirements such as interest payments, tax payments and debt service requirements and replacements of fixed assets.

Our presentation of EBITDA and Adjusted EBITDA has limitations as an analytical tool, and should not be considered in isolation or as a substitute for analysis of our results as reported under GAAP. Because not all companies use identical calculations, these presentations of EBITDA and Adjusted EBITDA may not be comparable to other similarly titled measures of
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other companies. We believe that the presentation of EBITDA and Adjusted EBITDA is appropriate to provide additional information about the calculation of this financial ratio in the New Credit Facilities. Adjusted EBITDA is a material component of this ratio. Specifically, non-compliance with the senior secured indebtedness ratio contained in our New Credit Facilities could prohibit us from being able to incur additional secured indebtedness, other than the additional funding provided for under the senior secured credit agreement and pursuant to specified exceptions, to make investments, to incur liens and to make certain restricted payments.
 
The calculation of Adjusted EBITDA under the New Credit Facilities is as follows:

 
(In millions)
 
Year Ended February 1,
2008
 
 
     
Net income (loss)
  $ (12.8 )
Add (subtract):
       
Interest income
    (8.8 )
Interest expense
    263.2  
Depreciation and amortization
    226.4  
Income taxes
    10.2  
EBITDA
    478.2  
         
Adjustments:
       
Transaction and related costs
    102.6  
Loss on debt retirements, net
    1.2  
Loss on interest rate swaps
    2.4  
Contingent loss on distribution center leases
    12.0  
Impact of markdowns related to inventory clearance activities, including LCM adjustments, net of purchase accounting adjustments
    5.7  
SG&A related to store closing and inventory clearance activities
    54.0  
Operating losses (cash) of stores to be closed
    10.5  
Monitoring and consulting fees to affiliates
    4.8  
Stock option and restricted stock unit expense
    6.5  
Indirect merger-related costs
    4.6  
Other
    1.0  
Total Adjustments
    205.3  
         
Adjusted EBITDA
  $ 683.5  

Other Considerations

Our inventory balance represented approximately 44% of our total assets exclusive of goodwill and other intangible assets as of February 1, 2008. Our proficiency in managing our inventory balances can have a significant impact on our cash flows from operations during a given fiscal year. We have made more efficient inventory management a strategic priority, as more fully discussed in the “Executive Overview” above.
 
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During 2006 and 2005, the Predecessor’s Board of Directors authorized the repurchase of up to $500 million and 10 million shares, respectively, of the Predecessor’s outstanding common stock. These authorizations allowed purchases in the open market or in privately negotiated transactions from time to time, subject to market conditions. During 2006, we purchased approximately 4.5 million shares pursuant to the 2005 authorization at a total cost of $79.9 million. During 2005, we purchased approximately 15.0 million shares pursuant to the 2005 and a prior authorization at a total cost of $297.6 million.
 
We may seek, from time to time, to retire the notes (as defined above) through cash purchases on the open market, in privately negotiated transactions or otherwise. Such repurchases, if any, will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors. The amounts involved may be material.

The following table summarizes our significant contractual obligations and commercial commitments as of February 1, 2008 (in thousands):

 
Payments Due by Period
Contractual obligations
Total
 
< 1 yr
 
1-3 yrs
 
3-5 yrs
> 5 yrs
Long-term debt obligations
$
4,293,718
 
$
-
   
$
36,223
   
$
46,000
 
$
4,211,495
Capital lease obligations
 
10,268
   
3,246
     
1,957
     
526
   
4,539
Interest (a)
 
2,817,237
   
382,587
     
762,872
     
756,070
   
915,708
Self-insurance liabilities (b)
 
203,600
   
68,613
     
89,815
     
26,612
   
18,560
Operating leases (c)
 
1,614,215
   
335,457
     
524,363
     
357,418
   
396,977
Monitoring agreement (d)
 
24,903
   
5,250
     
10,763
     
8,890
   
-
Subtotal
$
8,963,941
 
$
795,153
   
$
1,425,993
   
$
1,195,516
 
$
5,547,279
                                 
 
Commitments Expiring by Period
Commercial commitments (e)
 
Total
   
< 1 yr
     
1-3 yrs
     
3-5 yrs
   
> 5 yrs
Letters of credit
$
28,778
 
$
28,778
   
$
-
   
$
-
 
$
-
Purchase obligations (f)
 
385,366
   
384,892
     
474
     
-
   
-
Subtotal
$
414,144
 
$
413,670
   
$
474
   
$
-
 
$
-
Total contractual obligations and commercial commitments
$
9,378,085
 
$
1,208,823
   
$
1,426,467
   
$
1,195,516
 
$
5,547,279

(a)
Represents obligations for interest payments on long-term debt and capital lease obligations, and includes projected interest on variable rate long-term debt, based upon 2007 year end rates.
(b)
We retain a significant portion of the risk for our workers’ compensation, employee health insurance, general liability, property loss and automobile insurance. As these obligations do not have scheduled maturities, these amounts represent undiscounted estimates based upon actuarial assumptions. Reserves for workers’ compensation and general liability which existed as of the Merger date were discounted in order to arrive at estimated fair value.  All other amounts are reflected on an undiscounted basis in our consolidated balance sheets.
(c) 
Operating lease obligations are inclusive of amounts included in deferred rent and closed store obligations in our consolidated balance sheets.
(d)
We entered into a monitoring agreement, dated July 6, 2007, with affiliates of certain of our Investors pursuant to which those entities will provide management and advisory services.  Such agreement has no contractual term and for purposes of this schedule is presumed to be outstanding for a period of five years.
(e)
Commercial commitments include information technology license and support agreements, supplies, fixtures, letters of credit for import merchandise, and other inventory purchase obligations.
(f)
Purchase obligations include legally binding agreements for software licenses and support, supplies, fixtures, and merchandise purchases excluding such purchases subject to letters of credit.

In 2007 and 2006, our South Carolina-based wholly owned captive insurance subsidiary, Ashley River Insurance Company (“ARIC”), had cash and cash equivalents and investments balances held pursuant to South Carolina regulatory requirements to maintain a specified percentage of ARIC’s liability and equity balances (primarily insurance liabilities) in the form of certain specified types of assets and, as such, these investments are not available for general corporate purposes. At February 1, 2008, these cash and cash equivalents balances and investments balances were $11.9 million and $51.5 million, respectively.
 
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During 2005, we incurred significant losses caused by Hurricane Katrina, primarily inventory and fixed assets, in the form of store fixtures and leasehold improvements. We reached final settlement of our related insurance claim in 2006 and received proceeds totaling $21.0 million due to these losses, including $13.0 million in 2006 and $8.0 million in 2005, and have utilized a portion of these proceeds to replace lost assets. Insurance proceeds related to fixed assets are included in cash flows from investing activities and proceeds related to inventory losses and business interruption are included in cash flows from operating activities.

Legal actions, claims and tax contingencies. As described in Note 7 to the Consolidated Financial Statements, we are involved in a number of legal actions and claims, some of which could potentially result in material cash payments.  Adverse developments in those actions could materially and adversely affect our liquidity.  As discussed in Note 5 we also have certain income tax-related contingencies as more fully described below under “Critical Accounting Policies and Estimates.” Future negative developments could have a material adverse effect on our liquidity.

Considerations regarding distribution center leases. The Merger and certain of the related financing transactions may be interpreted as giving rise to certain trigger events (which may include events of default) under our three distribution center leases. In that event, our additional cost of acquiring the underlying land and building assets could approximate $112 million.  At this time, we do not believe such issues would result in the purchase of these distribution centers; however, the payments associated with such an outcome would have a negative impact on our liquidity. To minimize the uncertainty associated with such possible interpretations, we are negotiating the restructuring of these leases and the related underlying debt. We have concluded that a probable loss exists in connection with the restructurings and have recorded associated SG&A expenses in the Successor financial statements for the period ended February 1, 2008 totaling $12.0 million. The ultimate resolution of these negotiations may result in changes in the amounts of such losses, which changes may be material.

Credit ratings.  On June 12, 2007 Standard & Poor’s revised our long-term debt rating to B, and left our long-term debt ratings on negative watch.  Moody’s revised our long-term debt rating to B3 with a stable outlook.  These current ratings are considered non-investment grade.  Our current credit ratings, as well as future rating agency actions, could (1) negatively impact our ability to obtain financings to finance our operations on satisfactory terms; (2) have the effect of increasing our financing costs; and (3) have the effect of increasing our insurance premiums and collateral requirements necessary for our self-insured programs.

Cash flows

The discussion of the cash flows from operating, investing and financing activities included below for 2007 is generally based on the combination of the Predecessor and Successor for the 52-week period ended February 1, 2008, which we believe provides a more meaningful understanding of our liquidity and capital resources for the time period presented.
 
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Cash flows from operating activities.  Cash flows from operating activities for 2007 compared to 2006 increased by $36.2 million, notwithstanding a decline in net income (loss) of $150.8 million, as described in detail under “Results of Operations” above, and which is partially attributable to $102.6 million of Transaction and related costs in 2007. Other significant components of the change in cash flows from operating activities in 2007 as compared to 2006 were changes in inventory balances, which decreased by approximately 10% during 2007 compared to a decrease of approximately 3% during 2006. Inventory levels in the seasonal category declined by $84.5 million, or 24%, in 2007 compared to a $6.7 million, or 2%, increase in 2006. The highly consumable category declined by $42.4 million, or 6%, in 2007 compared to a $63.2 million, or 10%, increase in 2006. The home products category increased by $3.5 million, or 2%, in 2007 as compared to a $52.5 million, or 25%, decline in 2006. The basic clothing category decreased by $20.3 million, or 9%, in 2007 as compared to a $59.5 million, or 21%, decrease in 2006. In addition to inventory changes the decline in net income was a principal factor in the reduction in income taxes paid in 2007 as compared to 2006. Also offsetting the decline in net income were changes in accrued expenses in 2007 as compared to 2006, which increased primarily due to income tax related reserves, accrued interest, incentive compensation accrual, the accrued loss in connection with the ongoing negotiations to restructure our distribution center leases, and accruals for lease liabilities on closed stores.

Cash flows from operating activities for 2006 compared to 2005 declined by $150.1 million. The most significant component of the decline in cash flows from operating activities in 2006 as compared to 2005 was the reduction in net income, as described in detail under “Results of Operations” above. Partially offsetting this decline are certain noncash charges included in net income, including below-cost markdowns on inventory balances and property and equipment impairment charges totaling $78.1 million, and a $13.8 million increase in noncash depreciation and amortization charges in 2006 as compared to 2005. In addition, the reduction in 2006 year end inventory balances reflect the effect of below-cost markdowns and our efforts to sell through excess inventories, as compared with increases in 2005 and 2004.  Seasonal inventory levels increased by 2% in 2006 as compared to a 10% increase in 2005, home products inventory levels declined by 25% in 2006 as compared to a 2% increase in 2005, while basic clothing inventory levels declined by 21% in 2006 as compared to a 5% decline in 2005. Total merchandise inventories at the end of 2006 were $1.43 billion compared to $1.47 billion at the end of 2005, a 2.9% decrease overall, and a 6.4% decrease on a per store basis, reflecting both our focus on liquidating packaway merchandise and the effect of below-cost markdowns.

Cash flows from investing activities. The Merger, as discussed in more detail above, required cash payments of approximately $6.7 billion, net of cash acquired of $350 million. Significant components of property and equipment purchases in 2007 included the following approximate amounts: $60 million for improvements, upgrades, remodels and relocations of existing stores; $45 million for new stores; and $30 million for distribution and transportation-related capital expenditures. During 2007, we opened 365 new stores and remodeled or relocated 300 stores.
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During 2007 we purchased a secured promissory note for $37.0 million which represents debt issued by a third-party entity from which we lease our distribution center in Ardmore, Oklahoma. Purchases and sales of short-term investments in 2007, which equaled net sales of $22.1 million, primarily reflect our investment activities in our captive insurance subsidiary, and all purchases of long-term investments are related to the captive insurance subsidiary.

Cash flows used in investing activities totaling $282.0 million in 2006 were primarily related to capital expenditures and, to a lesser degree, purchases of long-term investments. Significant components of our property and equipment purchases in 2006 included the following approximate amounts: $66 million for distribution and transportation-related capital expenditures (including approximately $30 million related to our distribution center in Marion, Indiana which opened in 2006); $66 million for new stores; $50 million for the EZstoreTM project; and $38 million for capital projects in existing stores. During 2006 we opened 537 new stores and remodeled or relocated 64 stores.

Purchases and sales of short-term investments in 2006, which equaled net sales of $1.9 million, reflect our investment activities in tax-exempt auction rate securities as well as investing activities of our captive insurance subsidiary. Purchases of long-term investments are related to the captive insurance subsidiary.

Significant components of our purchases of property and equipment in 2005 included the following approximate amounts: $102 million for distribution and transportation-related capital expenditures; $96 million for new stores; $47 million related to the EZstoreTM project; $18 million for certain fixtures in existing stores; and $15 million for various systems-related capital projects. During 2005, we opened 734 new stores and relocated or remodeled 82 stores. Distribution and transportation expenditures in 2005 included costs associated with the construction of our new distribution centers in South Carolina and Indiana.

Net sales of short-term investments in 2005 of $34.1 million primarily reflect our investment activities in tax-exempt auction rate securities. Purchases of long-term investments are related to our captive insurance subsidiary.

Capital expenditures during 2008 are projected to be approximately $200 to $220 million.  We anticipate funding 2008 capital requirements with cash flows from operations and our revolving credit facility, if necessary. Significant components of the 2008 capital plan include growth initiatives as well as continued investment in our existing store base, plans for remodeling and relocating approximately 400 stores, additional investments in our supply chain, and leasehold improvements and fixtures and equipment for approximately 200 new stores. We plan to undertake these expenditures in order to improve our infrastructure and enhance our cash generated from operating activities.
 
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Cash flows from financing activities.  To finance the Merger, we issued long-term debt of approximately $4.2 billion and issued common stock in the amount of approximately $2.8 billion. We incurred costs associated with the issuance of Merger-related long-term debt of $87.4 million. As discussed above, we completed a cash tender offer for our 2010 Notes. Approximately 99% of the 2010 Notes were validly tendered resulting in repayments of long-term debt and related consent fees in the amount of $215.6 million. Borrowings, net of repayments, under our new asset-based revolving credit facility in 2007 totaled $102.5 million.
 
Cash flows used in financing activities during 2006 included the repurchase of approximately 4.5 million shares of our common stock at a total cost of $79.9 million, cash dividends paid of $62.5 million, or $0.20 per share, on our outstanding common stock, and $14.1 million to reduce our outstanding capital lease and financing obligations. These uses of cash were partially offset by proceeds from the exercise of stock options during 2006 of $19.9 million.

During 2005, we repurchased approximately 15.0 million shares of our common stock at a total cost of $297.6 million, paid cash dividends of $56.2 million, or $0.175 per share, on our outstanding common stock, and expended $14.3 million to reduce our outstanding capital lease and financing obligations. Also in 2005, we received proceeds of $14.5 million from the issuance of a tax increment financing in conjunction with the construction of our new distribution center in Indiana and proceeds from the exercise of stock options of $29.4 million.

The borrowings and repayments under the revolving credit agreements in 2007, 2006 and 2005 were primarily a result of activity associated with periodic cash needs.

Critical Accounting Policies and Estimates

The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect reported amounts and related disclosures.  In addition to the estimates presented below, there are other items within our financial statements that require estimation, but are not deemed critical as defined below. We believe these estimates are reasonable and appropriate. However, if actual experience differs from the assumptions and other considerations used, the resulting changes could have a material effect on the financial statements taken as a whole.

Management believes the following policies and estimates are critical because they involve significant judgments, assumptions, and estimates. Management has discussed the development and selection of the critical accounting estimates with the Audit Committee of our Board of Directors, and the Audit Committee has reviewed the disclosures presented below relating to those policies and estimates.
 
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Merchandise Inventories. Merchandise inventories are stated at the lower of cost or market with cost determined using the retail last-in, first-out (“LIFO”) method. Under our retail inventory method (“RIM”), the calculation of gross profit and the resulting valuation of inventories at cost are computed by applying a calculated cost-to-retail inventory ratio to the retail value of sales. The RIM is an averaging method that has been widely used in the retail industry due to its practicality. Also, it is recognized that the use of the RIM will result in valuing inventories at the lower of cost or market (“LCM”) if markdowns are currently taken as a reduction of the retail value of inventories.

Inherent in the RIM calculation are certain significant management judgments and estimates including, among others, initial markups, markdowns, and shrinkage, which significantly impact the gross profit calculation as well as the ending inventory valuation at cost. These significant estimates, coupled with the fact that the RIM is an averaging process, can, under certain circumstances, produce distorted cost figures. Factors that can lead to distortion in the calculation of the inventory balance include:

·  
applying the RIM to a group of products that is not fairly uniform in terms of its cost and selling price relationship and turnover;
 
·  
applying the RIM to transactions over a period of time that include different rates of gross profit, such as those relating to seasonal merchandise;
 
·  
inaccurate estimates of inventory shrinkage between the date of the last physical inventory at a store and the financial statement date; and
 
·  
inaccurate estimates of LCM and/or LIFO reserves.

Factors that reduce potential distortion include the use of historical experience in estimating the shrink provision (see discussion below) and recent improvements in the LIFO analysis whereby all SKUs are considered in the index formulation. As part of this process we also perform an inventory-aging analysis for determining obsolete inventory. Our policy is to write down inventory to an LCM value based on various management assumptions including estimated markdowns and sales required to liquidate such aged inventory in future periods. Inventory is reviewed on a quarterly basis and adjusted as appropriate to reflect write-downs determined to be necessary.

Factors such as slower inventory turnover due to changes in competitors’ tactics, consumer preferences, consumer spending and unseasonable weather patterns, among other factors, could cause excess inventory requiring greater than estimated markdowns to entice consumer purchases, resulting in an unfavorable impact on our consolidated financial statements. Sales shortfalls due to the above factors could cause reduced purchases from vendors and associated vendor allowances that would also result in an unfavorable impact on our consolidated financial statements.

We calculate our shrink provision based on actual physical inventory results during the fiscal period and an accrual for estimated shrink occurring subsequent to a physical inventory through the end of the fiscal reporting period. This accrual is calculated as a percentage of sales at each retail store, at a department level, and is determined by dividing the book-to-physical inventory adjustments recorded during the previous twelve months by the related sales for the same period for each store. To the extent that subsequent physical inventories yield different results than this estimated accrual, our effective shrink rate for a given reporting period will include the impact of adjusting the estimated results to the actual results. Although we perform physical inventories in virtually all of our stores on an annual basis, the same stores do not necessarily get counted in the same reporting periods from year to year, which could impact comparability in a given reporting period.
 
46

Goodwill and Indefinite-Lived Intangible Assets. Under SFAS 142, “Goodwill and Other Intangible Assets”, we are required to test goodwill and intangible assets with indefinite lives for impairment annually, or more frequently if impairment indicators occur. Significant judgments required in this testing process may include projecting future cash flows, determining appropriate discount rates and other assumptions. Projections are based on management’s best estimate given recent financial performance, market trends, strategic plans and other available information. Changes in these estimates and assumptions could materially affect the determination of fair value or impairment. Future indicators of impairment could result in an asset impairment charge.

Purchase Accounting. The Merger was accounted for as a reverse acquisition in accordance with the purchase accounting provisions of SFAS 141, “Business Combinations,” under which our assets and liabilities have been accounted for at their estimated fair values as of the date of the Merger. The aggregate purchase price was allocated to the tangible and intangible assets acquired and liabilities assumed, based upon an assessment of their relative fair values as of the date of the Merger. These estimates of fair values, the allocation of the purchase price and other factors related to the accounting for the Merger are subject to significant judgments and the use of estimates.

Property and Equipment. Property and equipment are recorded at cost. We group our assets into relatively homogeneous classes and generally provide for depreciation on a straight-line basis over the estimated average useful life of each asset class, except for leasehold improvements, which are amortized over the shorter of the applicable lease term or the estimated useful life of the asset. Certain store and warehouse fixtures, when fully depreciated, are removed from the cost and related accumulated depreciation and amortization accounts. The valuation and classification of these assets and the assignment of useful depreciable lives involves significant judgments and the use of estimates.

Impairment of Long-lived Assets. We review the carrying value of all long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. In accordance with Statement of Financial Accounting Standards (“SFAS”) 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” we review for impairment stores open more than two years for which current cash flows from operations are negative. Impairment results when the carrying value of the assets exceeds the undiscounted future cash flows over the life of the lease. Our estimate of undiscounted future cash flows over the lease term is based upon historical operations of the stores and estimates of future store profitability which encompasses many factors that are subject to variability and are difficult to predict. If a long-lived asset is found to be impaired, the amount recognized for impairment is equal to the difference between the carrying value and the asset’s fair value. The fair value is estimated based primarily upon future cash flows (discounted at our credit adjusted risk-free rate) or other reasonable estimates of fair market value.
 
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Insurance Liabilities. We retain a significant portion of the risk for our workers’ compensation, employee health insurance, general liability, property loss and automobile coverage. These costs are significant primarily due to the large employee base and number of stores. At the date of the Merger this liability was discounted in accordance with purchase accounting standards. Subsequent to the Merger, provisions are made to this insurance liability on an undiscounted basis based on actual claim data and estimates of incurred but not reported claims developed using actuarial methodologies based on historical claim trends. If future claim trends deviate from recent historical patterns, we may be required to record additional expenses or expense reductions, which could be material to our future financial results.

Contingent Liabilities – Income Taxes Income tax reserves are determined using the methodology established by the Financial Accounting Standards Board (“FASB”) Interpretation 48, Accounting for Uncertainty in Income Taxes – An Interpretation of FASB Statement 109 (“FIN 48”).  FIN 48, which we adopted on February 3, 2007, requires companies to assess each income tax position taken using a two step process.  A determination is first made as to whether it is more likely than not that the position will be sustained, based upon the technical merits, upon examination by the taxing authorities.  If the tax position is expected to meet the more likely than not criteria, the benefit recorded for the tax position equals the largest amount that is greater than 50% likely to be realized upon ultimate settlement of the respective tax position.  Uncertain tax positions require determinations and estimated liabilities to be made based on provisions of the tax law which may be subject to change or varying interpretation.  If our determinations and estimates prove to be inaccurate, the resulting adjustments could be material to our future financial results.

Contingent Liabilities - Legal Matters. We are subject to legal, regulatory and other proceedings and claims. We establish liabilities as appropriate for these claims and proceedings based upon the probability and estimability of losses and to fairly present, in conjunction with the disclosures of these matters in our financial statements and SEC filings, management’s view of our exposure. We review outstanding claims and proceedings with external counsel to assess probability and estimates of loss. We re-evaluate these assessments on a quarterly basis or as new and significant information becomes available to determine whether a liability should be established or if any existing liability should be adjusted. The actual cost of resolving a claim or proceeding ultimately may be substantially different than the amount of the recorded liability. In addition, because it is not permissible under GAAP to establish a litigation liability until the loss is both probable and estimable, in some cases there may be insufficient time to establish a liability prior to the actual incurrence of the loss (upon verdict and judgment at trial, for example, or in the case of a quickly negotiated settlement). See Note 7 to the Consolidated Financial Statements.

Lease Accounting and Excess Facilities. The majority of our stores are subject to short-term leases (usually with initial or primary terms of 3 to 5 years) with multiple renewal options
 
48

when available. We also have stores subject to build-to-suit arrangements with landlords, which typically carry a primary lease term of 10 years with multiple renewal options. Approximately half of our stores have provisions for contingent rentals based upon a percentage of defined sales volume. We recognize contingent rental expense when the achievement of specified sales targets is considered probable. We recognize rent expense over the term of the lease. We record minimum rental expense on a straight-line basis over the base, non-cancelable lease term commencing on the date that we take physical possession of the property from the landlord, which normally includes a period prior to store opening to make necessary leasehold improvements and install store fixtures. When a lease contains a predetermined fixed escalation of the minimum rent, we recognize the related rent expense on a straight-line basis and record the difference between the recognized rental expense and the amounts payable under the lease as deferred rent. We also receive tenant allowances, which we record as deferred incentive rent and amortize as a reduction to rent expense over the term of the lease. We reflect as a liability any difference between the calculated expense and the amounts actually paid. Improvements of leased properties are amortized over the shorter of the life of the applicable lease term or the estimated useful life of the asset.

For store closures (excluding those associated with a business combination) where a lease obligation still exists, we record the estimated future liability associated with the rental obligation on the date the store is closed in accordance with SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities.” Based on an overall analysis of store performance and expected trends, management periodically evaluates the need to close underperforming stores. Liabilities are established at the point of closure for the present value of any remaining operating lease obligations, net of estimated sublease income, and at the communication date for severance and other exit costs, as prescribed by SFAS 146. Key assumptions in calculating the liability include the timeframe expected to terminate lease agreements, estimates related to the sublease potential of closed locations, and estimation of other related exit costs. If actual timing and potential termination costs or realization of sublease income differ from our estimates, the resulting liabilities could vary from recorded amounts. These liabilities are reviewed periodically and adjusted when necessary.

Share-Based Payments. Our share-based stock option awards are valued on an individual grant basis using the Black-Scholes-Merton closed form option pricing model. The application of this valuation model involves assumptions that are judgmental and highly sensitive in the valuation of stock options, which affects compensation expense related to these options. These assumptions include the term that the options are expected to be outstanding, an estimate of the volatility of our stock price (which is based on a peer group of publicly traded companies), applicable interest rates and the dividend yield of our stock. Other factors involving judgments that affect the expensing of share-based payments include estimated forfeiture rates of share-based awards. If our estimates differ materially from actual experience, we may be required to record additional expense or reductions of expense, which could be material to our future financial results.
 
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Adoption of Accounting Standard

We adopted the provisions of FIN 48 effective February 3, 2007.  The adoption resulted in an $8.9 million decrease in retained earnings and a reclassification of certain amounts between deferred income taxes and other noncurrent liabilities to conform to the balance sheet presentation requirements of FIN 48.  As of the date of adoption, the total reserve for uncertain tax benefits was $77.9 million.  This reserve excludes the federal income tax benefit for the uncertain tax positions related to state income taxes which is now included in deferred tax assets.  As a result of the adoption of FIN 48, the reserve for interest expense related to income taxes was increased to $15.3 million and a reserve for potential penalties of $1.9 million related to uncertain income tax positions was recorded.  As of the date of adoption, approximately $27.1 million of the reserve for uncertain tax positions would impact our effective income tax rate if we were to recognize the tax benefit for these positions.  After the Merger and the related application of purchase accounting, no portion of the reserve for uncertain tax positions that existed as of the date of adoption would impact our effective tax rate but would, if subsequently recognized, reduce the amount of goodwill recorded in relation to the Merger.

Subsequent to the adoption of FIN 48, we elected to record income tax related interest and penalties as a component of the provision for income tax expense.

Accounting Pronouncements

In March 2008, the FASB issued Statement of Financial Accounting Standards ("SFAS") No. 161, “Disclosures about Derivative Instruments and Hedging Activities”, an amendment of FASB Statement No. 133. SFAS 161 applies to all derivative instruments and nonderivative instruments that are designated and qualify as hedging instruments pursuant to paragraphs 37 and 42 of SFAS 133 and related hedged items accounted for under SFAS 133. SFAS 161 requires entities to provide greater transparency through additional disclosures about how and why an entity uses derivative instruments, how derivative instruments and related hedged items are accounted for under SFAS 133 and its related interpretations, and how derivative instruments and related hedged items affect an entity’s financial position, results of operations, and cash flows. SFAS 161 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2008.  We currently plan to adopt SFAS 161 during our 2009 fiscal year.  No determination has yet been made regarding the potential impact of this standard on our financial statements.

In December 2007, the FASB issued SFAS No. 141(R), “Business Combinations”. The new standard establishes the requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any non-controlling interest (formerly minority interest) in an acquiree; provides updated requirements for recognition and measurement of goodwill acquired in the business combination or a gain from a bargain purchase; and provides updated disclosure requirements to enable users of financial statements to evaluate the nature and financial effects of the business combination. This Statement applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Early adoption is not allowed.  This standard is not expected to impact our financial statements unless a qualifying transaction is consummated subsequent to the effective date.
 
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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” (SFAS 159). SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value. It provides entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. SFAS 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. We currently plan to adopt SFAS 159 during our 2008 fiscal year.  We are in the process of evaluating the potential impact of this standard on our consolidated financial statements.

In September 2006, the FASB issued SFAS 157, “Fair Value Measurements.” SFAS 157 provides guidance for using fair value to measure assets and liabilities. The standard also requires expanded information about the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. The standard applies whenever other standards require (or permit) assets or liabilities to be measured at fair value. The standard does not expand the use of fair value in any new circumstances. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. For non-financial assets and liabilities, the effective date has been delayed to fiscal years beginning after November 15, 2008. We currently expect to adopt SFAS 157 during our 2008 and 2009 fiscal years. We are in the process of evaluating the potential impact of this standard on our consolidated financial statements.
 
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
Financial Risk Management

We are exposed to market risk primarily from adverse changes in interest rates. To minimize this risk, we may periodically use financial instruments, including derivatives. As a matter of policy, we do not buy or sell financial instruments for speculative or trading purposes and all derivative financial instrument transactions must be authorized and executed pursuant to approval by the Board of Directors. All financial instrument positions taken by us are intended to be used to reduce risk by hedging an underlying economic exposure. Because of high correlation between the derivative financial instrument and the underlying exposure being hedged, fluctuations in the value of the financial instruments are generally offset by reciprocal changes in the value of the underlying economic exposure. The financial instruments we use are straightforward instruments with liquid markets.

Interest Rate Risk

We manage our interest rate risk through the strategic use of fixed and variable interest rate debt and, from time to time, derivative financial instruments. Our principal interest rate exposure relates to outstanding amounts under our New Credit Facilities. Our New Credit Facilities provide for variable rate borrowings of up to $3,425.0 million including availability of $1,125.0 million under our senior secured asset-based revolving credit facility, subject to the borrowing base.  In order to mitigate a portion of the variable rate interest exposure under the New Credit Facilities, we entered into interest rate swaps with affiliates of Goldman, Sachs & Co., Lehman Brothers Inc. and Wachovia Capital Markets, LLC. Pursuant to the swaps, which became effective on July 31, 2007, we swapped three month LIBOR rates for fixed interest rates which will result in the payment of a fixed rate of 7.68% on a notional amount of $2,000.0 million which will amortize on a quarterly basis until maturity at July 31, 2012. At February 1, 2008, the notional amount was $1,630.0 million.
 
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A change in interest rates on variable rate debt impacts our pre-tax earnings and cash flows; whereas a change in interest rates on fixed rate debt impacts the economic fair value of debt but not our pre-tax earnings and cash flows.  Our derivatives qualify for hedge accounting as cash flow hedges.  Therefore, changes in market fluctuations related to the effective portion of these cash flow hedges do not impact our pre-tax earnings until the accrued interest is recognized on the derivatives and the associated hedged debt.  Based on our outstanding debt as of February 1, 2008 and assuming that our mix of debt instruments, derivative instruments and other variables remain the same, the annualized effect of a one percentage point change in variable interest rates would have a pretax impact on our earnings and cash flows of approximately $7.9 million.

The interest rate swaps are accounted for in accordance with SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities”, as amended and interpreted (collectively, “SFAS 133”).  SFAS 133 establishes accounting and reporting standards for derivative instruments and hedging activities. SFAS 133 requires that all derivatives be recognized as either assets or liabilities at fair value. Beginning October 12, 2007, we are accounting for the swaps described above as cash flow hedges and record the effective portion of changes in fair value of the swaps within accumulated other comprehensive income.

Subsequent to the 2007 fiscal year end, we entered into a $350.0 million step-down interest rate swap which became effective February 28, 2008 in order to mitigate an additional portion of the variable rate interest exposure under the New Credit Facilities.  We entered into the swap with Wachovia Capital Markets and we swapped one month LIBOR rates for fixed interest rates, which will result in the payment of a fixed rate of 5.58% on a notional amount of $350.0 million for the first year and $150.0 million for the second year.
 
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ITEM 8.   FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
Report of Independent Registered Public Accounting Firm

To the Board of Directors and Shareholders of
Dollar General Corporation

We have audited the accompanying consolidated balance sheets of Dollar General Corporation and subsidiaries as of February 1, 2008 (Successor) and February 2, 2007 (Predecessor), and the related consolidated statements of operations, shareholders' equity, and cash flows for the periods from March 6, 2007 to February 1, 2008 (Successor), February 3, 2007 to July 6, 2007 (Predecessor) and for the years ended February 2, 2007 and February 3, 2006 (Predecessor).  These financial statements are the responsibility of the Company's management.  Our responsibility is to express an opinion on these 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. We were not engaged to perform an audit of the Company's internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures  that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting.  Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Dollar General Corporation and subsidiaries at February 1, 2008 (Successor) and February 2, 2007 (Predecessor), and the consolidated results of their operations and their cash flows for the periods from March 6, 2007 to February 1, 2008 (Successor), February 3, 2007 to July 6, 2007 (Predecessor) and for the years ended February 2, 2007 and February 3, 2006 (Predecessor), in conformity with U.S. generally accepted accounting principles.

As discussed in Notes 1 and 9 to the consolidated financial statements, effective February 4, 2006, the Company changed its method of accounting for stock-based compensation in connection with the adoption of Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment”.

As discussed in Notes 1 and 5 to the consolidated financial statements, effective February 3, 2007, the Company changed its method of accounting for uncertain tax positions in connection with the adoption of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes”.
 
                                                                        /s/ Ernst & Young LLP

Nashville, Tennessee
March 25, 2008
 
53

CONSOLIDATED BALANCE SHEETS
(In thousands except per share amounts)
 
 
   
Successor
   
Predecessor
 
   
February 1,
2008
   
February 2,
2007
 
             
ASSETS
           
Current assets:
           
Cash and cash equivalents
  $ 100,209     $ 189,288  
Short-term investments
    19,611       29,950  
Merchandise inventories
    1,288,661       1,432,336  
Income taxes receivable
    32,501       9,833  
Deferred income taxes
    17,297       24,321  
Prepaid expenses and other current assets
    59,465       57,020  
Total current assets
    1,517,744       1,742,748  
Net property and equipment
    1,274,245       1,236,874  
Goodwill
    4,344,930       2,337  
Intangible assets, net
    1,370,557       86  
Other assets, net
    148,955       58,469  
Total assets
  $ 8,656,431     $ 3,040,514  
                 
LIABILITIES AND SHAREHOLDERS’ EQUITY
               
Current liabilities:
               
Current portion of long-term obligations
  $ 3,246     $ 8,080  
Accounts payable
    551,040       555,274  
Accrued expenses and other
    300,956       253,558  
Income taxes payable
    2,999       15,959  
Total current liabilities
    858,241       832,871  
Long-term obligations
    4,278,756       261,958  
Deferred income taxes
    486,725       41,597  
Other liabilities
    319,714       158,341  
Commitments and contingencies
               
Redeemable common stock
    9,122       -  
Shareholders’ equity:
               
Preferred stock, Shares authorized: 1,000,000
    -          
Series B junior participating preferred stock, stated
value $0.50 per share; Shares authorized:
10,000; Issued: None
            -  
Common stock; $0.50 par value, 1,000,000 shares authorized,
555,482 shares issued and outstanding at February 1, 2008 and
500,000 shares authorized, 312,436 shares issued and
outstanding at February 2, 2007, respectively.
    277,741       156,218  
Additional paid-in capital
    2,480,062       486,145  
Retained earnings (accumulated deficit)
    (4,818 )     1,103,951  
Accumulated other comprehensive loss
    (49,112 )     (987 )
Other shareholders’ equity
    -       420  
Total shareholders’ equity
    2,703,873       1,745,747  
Total liabilities and shareholders’ equity
  $ 8,656,431     $ 3,040,514  
 
The accompanying notes are an integral part of the consolidated financial statements.
54

CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands)
 
   
Successor
   
Predecessor
 
               
For the years ended
 
     
July 7, 2007
through
February 1, 2008 (a)
   
February 3, 2007 through
July 6, 2007
     
February 2,
2007
   
February 3,
2006
 
   
(30 weeks)
   
(22 weeks)
   
(52 weeks)
   
(53 weeks)
 
                         
                         
Net sales
  $ 5,571,493     $ 3,923,753     $ 9,169,822     $ 8,582,237  
                                 
Cost of goods sold
    3,999,599       2,852,178       6,801,617       6,117,413  
                                 
Gross profit
    1,571,894       1,071,575       2,368,205       2,464,824  
                                 
Selling, general and administrative
    1,324,508       960,930       2,119,929       1,902,957  
                                 
Transaction and related costs
    1,242       101,397       -       -  
                                 
Operating profit
    246,144       9,248       248,276       561,867  
                                 
Interest income
    (3,799 )     (5,046 )     (7,002 )     (9,001 )
                                 
Interest expense
    252,897       10,299       34,915       26,226  
                                 
Loss on interest rate swaps
    2,390       -       -       -  
                                 
Loss on debt retirement, net
    1,249       -       -       -  
                                 
Income (loss) before income taxes
    (6,593 )     3,995       220,363       544,642  
                                 
Income tax expense (benefit)
    (1,775 )     11,993       82,420       194,487