10-K 1 d10k.htm FORM 10-K Form 10-K
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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


FORM 10-K

 

(Mark One)

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

 

For the fiscal year ended January 31, 2008

 

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

 

For the transition period from                      to                     

 

Commission file number 1-8978


LONGS DRUG STORES CORPORATION

(Exact name of registrant as specified in its charter)

 

Maryland   68-0048627

(State or other jurisdiction

of incorporation or organization)

 

(I.R.S. Employer

Identification No.)

141 North Civic Drive

Walnut Creek, California

  94596
(Address of principal executive offices)   (Zip Code)

 

Registrant’s telephone number, including area code: (925) 937-1170


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

 

Title of Each Class


 

Name of Each Exchange on which Registered


Common stock   New York Stock Exchange

 

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  x    No  ¨

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 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  x    No  ¨

 

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, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer    x                                Accelerated filer    ¨                                Non-accelerated filer    ¨

 

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

 

The aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was approximately $1,839,669,000 as of July 26, 2007, based on the closing price of the registrant’s common stock on the New York Stock Exchange. For purposes of this calculation, only executive officers and directors are deemed to be the affiliates of the registrant.

 

There were 36,252,520 shares of common stock outstanding as of February 28, 2008.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

The information required by Part III of this Annual Report on Form 10-K, to the extent not set forth herein, is incorporated by reference from specified portions of our definitive Proxy Statement for our 2008 Annual Meeting of Stockholders.

 


 


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CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

 

This annual report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Such statements relate to, among other things, our strategic initiatives; supply chain changes; Medicare prescription drug benefits; development of our pharmacy benefit services segment; merchandise and marketing efforts; operational improvements; safety improvements and workers’ compensation claims and costs; labor scheduling and forecasting; the number of store openings, closures and remodels; revenues; pharmacy reimbursements; gross profits and margin; operating and administrative expenses; depreciation and amortization; liquidity and cash requirements; level of capital expenditures; share repurchases; dividends; effective tax rates; contractual obligations; the effect of new accounting pronouncements; and factors affecting front-end sales in fiscal 2009 and are indicated by words or phrases such as “continuing,” “expects,” “estimates,” “believes,” “plans,” “anticipates,” “will” and other similar words or phrases.

 

These forward-looking statements are based on our current plans and expectations and involve risks and uncertainties that could cause actual events and results to vary materially from those included in or contemplated by forward-looking statements we make. These risks and uncertainties include, but are not limited to, those set forth below:

 

   

Our ability to execute our previously announced initiatives;

   

Our ability to successfully manage our prescription drug plans;

   

Our ability to improve our supply chain and distribution capabilities;

   

Our ability to successfully implement new technology, including an integrated demand forecasting and replenishment system;

   

Disruption in our supply chain due to system and vendor conversions;

   

The success of our merchandise and marketing strategies (including price reduction programs implemented in response to competitive pressures);

   

Our ability to improve the performance of underperforming stores;

   

The timing, number and overall impact of store openings, closures and remodels;

   

The effect of the Medicare prescription drug benefit on our retail drug store and pharmacy benefit services revenues and profitability;

   

Our ability to grow prescription volumes;

   

Our ability to develop and integrate our pharmacy, mail order and pharmacy benefit services capabilities to take advantage of future growth opportunities;

   

The frequency and rate of introduction of successful new prescription drugs;

   

The introduction of lower priced generic drugs, including the timing of introduction and cost structure associated with generic drugs;

   

The efforts of third-party health plans, including government-sponsored plans, to reduce pharmacy reimbursements;

   

Changes in economic conditions, including economic growth, unemployment levels, consumer preferences and purchasing power and spending patterns generally;

   

The impact of rising gasoline prices and mortgage payments on economic conditions and consumer spending;

   

The effects of war and terrorism on economic conditions and consumer spending;

   

The impact of state and federal budget deficits on government healthcare spending and on general economic conditions;

   

Competition from other drugstore chains, supermarkets, mass merchandisers, discount retailers, on-line retailers, other retailers, pharmacy benefit management companies and prescription drug plan providers;

   

The growth of mail order pharmacies, and changes in some third-party health plans requiring mail order fulfillment of certain medications;

   

Continued good relationships with our employees;


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Interest rate fluctuations and changes in capital market conditions or other events affecting our ability to obtain necessary financing on favorable terms;

   

Our relationships with our suppliers, especially AmerisourceBergen Drug Corporation;

   

Our ability to hire and retain pharmacists and other store and management personnel;

   

The availability and cost of real estate for new stores;

   

The impact of pending or future litigation or regulatory proceedings;

   

The effectiveness of workers’ compensation reform efforts, especially in California, and the effect of potential further changes to California’s workers’ compensation laws;

   

Changes in state or federal legislation or regulations affecting our businesses;

   

Our ability to make and integrate acquisitions;

   

Changes to accounting policies and practices or internal controls; and

   

Other factors discussed in this report under “Risk Factors” and elsewhere or in any of our other SEC filings.

 

In addition, because we do not have a comprehensive perpetual inventory system, our ability to accurately forecast and track our retail drug store gross profit and inventory levels during periods between our quarterly physical inventories is limited. Therefore, our actual retail drug store gross profit and inventory levels may vary materially from those included in or contemplated by forward-looking statements we make.

 

We assume no obligation to update our forward-looking statements to reflect subsequent events or circumstances.

 


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TABLE OF CONTENTS

 

          Page

PART I

         

Item 1

  

Business

   1

Item 1A

  

Risk Factors

   6

Item 1B

  

Unresolved Staff Comments

   12

Item 2

  

Properties

   12

Item 3

  

Legal Proceedings

   14

Item 4

  

Submission of Matters to a Vote of Security Holders

   14

PART II

         

Item 5

  

Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

   15

Item 6

  

Selected Financial Data

   17

Item 7

  

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

   19

Item 7A

  

Quantitative and Qualitative Disclosures of Market Risk

   33

Item 8

  

Financial Statements and Supplementary Data:

   34
    

Statements of Consolidated Income

    
    

For the Fiscal Years Ended January 31, 2008, January 25, 2007 and January 26, 2006

   34
    

Consolidated Balance Sheets

    
    

As of January 31, 2008 and January 25, 2007

   35
    

Statements of Consolidated Cash Flows

    
    

For the Fiscal Years Ended January 31, 2008, January 25, 2007 and January 26, 2006

   36
    

Statements of Consolidated Stockholders’ Equity

    
    

For the Fiscal Years Ended January 31, 2008, January 25, 2007 and January 26, 2006

   37
    

Notes to Consolidated Financial Statements

   38
    

Report of Independent Registered Public Accounting Firm

   61

Item 9

  

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

   63

Item 9A

  

Controls and Procedures

   63
    

Management’s Report on Internal Controls Over Financial Reporting

    

Item 9B

  

Other Information

   63

PART III

         

Item 10

  

Directors, Executive Officers and Corporate Governance

   64

Item 11

  

Executive Compensation

   64

Item 12

  

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters..

   64

Item 13

  

Certain Relationships and Related Transactions, and Director Independence

   64

Item 14

  

Principal Accountant Fees and Services

   64

PART IV

         

Item 15

  

Exhibits and Financial Statement Schedules

   65

Signatures

   69


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PART I

 

Item 1. Business.

 

Overview

 

Longs Drug Stores Corporation was founded in 1938 in Oakland, California by two brothers, Tom and Joe Long. Today, we operate in two business segments: retail drug stores and, through our RxAmerica subsidiary, pharmacy benefit services. For financial information about these segments, see Note 13, “Segment Information” in the accompanying notes to our consolidated financial statements. We operate on a 52/53-week fiscal year ending on the last Thursday in January. Our 2008 fiscal year contained 53 weeks of operations and ended on January 31, 2008. Our 2009 fiscal year will contain 52 weeks of operations and will end on January 29, 2009.

 

Through our retail drug store segment, we are one of the most recognized retail drug store chains on the West Coast of the United States and in Hawaii, with 510 stores as of January 31, 2008. Our retail drug stores have a long history of serving the health and well-being needs of customers through customer-oriented pharmacy services and convenient product offerings that focus on health and wellness, beauty and convenience. Our retail drug store segment also operates a mail order pharmacy business.

 

Our pharmacy benefit services segment provides a range of services related to pharmacy benefit management, including plan design and implementation, claims administration and formulary management to third-party health plans and other organizations. In addition, effective January 1, 2006, our pharmacy benefit services segment began offering prescription drug plans under Medicare Part D as established by the Medicare Prescription Drug, Improvement and Modernization Act of 2003. These plans will provide prescription drug benefits to an estimated 440,000 to 450,000 Medicare beneficiaries in all 50 states and the District of Columbia in the calendar 2008 plan year. RxAmerica has extensive experience in managed state plans and an established reputation for reducing health care costs. Fiscal 2007 was the first full year of results for our Medicare prescription drug plans.

 

Our corporate offices are located at 141 North Civic Drive, Walnut Creek, California 94596, telephone (925) 937-1170. Our common stock is listed on the New York Stock Exchange (“NYSE”) under the stock symbol “LDG.” General information, financial news releases and filings with the Securities and Exchange Commission, including annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to these reports are available free of charge on our website at www.longs.com as soon as reasonably practicable after we file them with the Securities and Exchange Commission. We have submitted our 2007 annual Section 12(a) CEO certification to the NYSE. The certification was not qualified in any respect. Additionally, we filed with the Securities and Exchange Commission as exhibits to our Form 10-K for the year ended January 25, 2007 the CEO and CFO certifications required under Section 302 of the Sarbanes-Oxley Act of 2002.

 

Initiatives

 

More than five years ago, we began working on the following broad categories of strategic initiatives designed to make Longs a stronger competitor and more profitable company:

 

   

Pharmacy profitability—The pharmacy industry is undergoing significant structural changes, including Medicare prescription drug benefits, declining third-party reimbursement levels, and mandatory mail order fulfillment of prescriptions by certain health plans. In this environment, we continue to make progress on improving our pharmacy efficiency and productivity through technology enhancements, streamlining our prescription fill processes, increasing our utilization of central fill and providing more management training opportunities. We will continue to pursue additional opportunities to improve our efficiencies in the pharmacy by increasing the amount of time our pharmacists have to educate and counsel their patients by decreasing their administrative burden. We believe this will help us improve patient service, control costs and increase our prescription volumes and market share.

 

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Front-end sales—We have implemented merchandise and marketing strategies that include enhanced and expanded assortments in our core categories focusing on health, wellness, beauty and convenience in an effort to emphasize our competitive differentiation. We have a larger, more developed front-end business than typical drug store chains and we believe this is a competitive advantage that can be further developed. We have increased the quality and assortment of our private brand merchandise and improved our in-stock positions and product adjacencies through better inventory management. We plan to make continued progress toward full realization of all of the benefits of our merchandising strategy through improved store execution, self-distribution and inventory management.

 

   

Supply Chain—The upgrade of our supply chain systems and processes has included centralization of our merchandise procurement and replenishment, increased self-distribution, implementation of new technology and improvements to many business processes. Our upgraded supply chain technology includes a distribution management system in our California and Hawaii front-end distribution centers, a retail merchandise system, a store ordering, receiving and inventory management system in all of our mainland stores (with installation in our Hawaii stores scheduled for fiscal 2009), and procurement and allocation systems that are more tightly integrated with one another than the systems they replaced. We plan to implement an integrated demand forecasting and replenishment system for front-end merchandise during fiscal 2009. We also completed construction of an 800,000 square foot front-end distribution center in Patterson, California in the summer of fiscal 2007, which has enabled us to increase our self-distribution to approximately 80% of our front-end merchandise on the mainland from 40% previously. We have reduced our distribution costs as a percent of shipments and expect to make continued progress on efficiency and productivity. We expect these changes to continue to yield benefits in the form of lower cost of sales and expenses related to procurement and distribution, improved merchandise replenishment, and increased real-time visibility into our in-stock position, merchandise mix, product movement and gross profit for our retail drug store segment.

 

   

Operational processes—We have developed new and more efficient operational processes to help us reduce expenses and increase our focus on superior customer service. These improvements include more efficient workflow processes, optimizing our labor, improved safety practices and increased training hours for store managers. Our supply chain systems improvements and increased self-distribution of front-end merchandise are well aligned with our goals to achieve improved control over our merchandise inventory and in-stock position. We continue to work toward faster replenishment of self-distributed goods and better alignment of our front-end distribution capabilities with our retail merchandise adjacencies for greater workflow efficiencies. We plan to install a labor scheduling and forecasting system in our stores and expect to complete this installation in all stores by the end of fiscal 2009. We are also streamlining our store remodeling process to cause less disruption both for our customers and our store operations.

 

   

Pharmacy benefit services—We have achieved significant growth in RxAmerica, our pharmacy benefit services subsidiary. RxAmerica began offering prescription drug plans for Medicare beneficiaries effective January 1, 2006. These plans will provide prescription drug benefits to an estimated 440,000 to 450,000 Medicare beneficiaries in all 50 states and the District of Columbia during the calendar 2008 plan year. During fiscal 2008, RxAmerica acquired a registered insurance company, subsequently renamed Accendo Insurance Company, with licenses to operate as an insurance company in 46 states. This will allow us to continue to offer prescription drug plans for Medicare through Accendo after the expiration of our insurance waivers from the Centers for Medicare and Medicaid Services (“CMS”) on January 1, 2009. RxAmerica has extensive experience in managed state plans and an established reputation for reducing health care costs. RxAmerica’s pharmacy benefit management business has also continued to grow.

 

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Products and Services

 

The following table summarizes our product and service types, as a percentage of our total consolidated revenues from continuing operations:

 

     Fiscal Year

 
     2008

    2007

    2006

 

Pharmacy sales

   47.7 %   47.2 %   48.0 %

Front-end sales

   45.1 %   46.4 %   50.8 %

Prescription drug plan revenues

   5.9 %   5.6 %   0.4 %

Pharmacy benefit management revenues

   1.3 %   0.8 %   0.8 %
    

 

 

Total consolidated revenues

   100.0 %   100.0 %   100.0 %
    

 

 

 

Our retail drug stores sell prescription drugs and a wide assortment of nationally advertised brand name and private brand general merchandise, which we refer to as “front-end” merchandise. Our core front-end categories include over-the-counter medications, health and beauty products, cosmetics, photo and photo processing, convenience food and beverage items and greeting cards. In addition, we sell merchandise in non-core front-end categories such as housewares, automotive and sporting goods. Our private brand offerings include over-the-counter, health and beauty, photo and other merchandise offered under various proprietary names, including “Longs,” “Bayside Basics,” “Pacific Living,” “Walnut Grove,” “Holiday Place,” and others. To enhance customer service and build customer loyalty, we seek to consistently maintain in-stock positions in all of our merchandise categories. We will continue to develop our mix of front-end merchandise in our stores in response to the changing needs and preferences of our customers. For enhanced customer convenience, 52 of our stores have drive-through pharmacies as of the end of fiscal 2008. We also offer a variety of immunizations and health screening services in many of our stores, such as blood, glucose, osteoporosis, stroke and cholesterol testing, and leased space to outside providers of in-store medical clinics or diagnostic labs in seventeen stores as of January 31, 2008. In addition, we offer educational information to our customers about their health and well-being concerns through the Wellness Center section of our website, www.longs.com.

 

Our RxAmerica subsidiary provides comprehensive pharmacy benefit management services nationwide including prescription benefit plan design and implementation, claims administration and formulary management to third-party health plans and other organizations. We have designed these services to help lower prescription benefit costs for plan providers while improving healthcare access, service and treatment for covered members. We manage prescription benefit plans covering approximately 8.7 million lives with a network of pharmacies in all 50 states as well as Puerto Rico and the Virgin Islands. Effective January 1, 2006, RxAmerica began offering prescription drug plans under Medicare Part D as established by the Medicare Prescription Drug, Improvement and Modernization Act of 2003. These plans will provide prescription drug benefits to an estimated 440,000 to 450,000 Medicare participants in all 50 states and the District of Columbia during the calendar 2008 plan year.

 

Purchasing and Distribution

 

As part of our supply chain initiative we have made significant progress in centralizing our merchandise procurement and replenishment over the past several years in order to achieve greater efficiencies and economies of scale. We now have a centralized purchasing and replenishment structure for a significant portion of our front-end merchandise.

 

We distribute centrally procured merchandise to our stores through our distribution centers in California and Hawaii, and other merchandise is delivered directly to our stores by our vendors. Store deliveries from our distribution centers take place primarily through a leased fleet and contract drivers.

 

As a result of our more centralized purchasing approach, we have substantially increased the volume of merchandise received and delivered through our distribution centers. During fiscal 2007 we completed construction of an 800,000 square-foot front-end distribution center in Patterson, California and transitioned

 

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distribution operations from our Lathrop distribution center to the new facility. The Patterson distribution center has allowed us to increase our self-distribution to approximately 80% of our mainland front-end merchandise.

 

Advertising

 

We advertise primarily through promotional advertisements and circulars in major daily newspapers and, to a lesser extent, advertisements on radio and television. We centrally manage the majority of our advertising efforts. Our approach is to regionalize our advertising and use the most efficient media mix within a geographic area. Vendors fund a significant portion of our total advertising spending.

 

Technology

 

We are upgrading technology throughout our company in an effort to improve our efficiency, productivity and profitability. All of our stores utilize pharmacy systems to facilitate filling prescriptions, analyze drug interactions and adjudicate third-party claims, which allows our pharmacists to fill prescriptions accurately and efficiently with reduced risk of error or adverse drug interaction. We route some of the prescriptions that we receive to our central prescription fill centers, which provide increased productivity and reduced prescription fill costs. We have also installed advanced pill-dispensing robotics in many of our high-volume pharmacies. The fill centers and robotic technology enable our pharmacists to spend more time with customers while maintaining high quality customer service standards.

 

Our stores also utilize computer-assisted ordering and replenishment systems for certain goods that track sales and merchandise on hand and plan orders as necessary, and point-of-sale systems that facilitate customer check-out and allow us to process a high volume of transactions efficiently. We also have digital photo technology systems in over 90% of our stores.

 

We are making extensive system changes as part of our efforts to upgrade our supply chain, including a distribution management system in our California and Hawaii front-end distribution centers, a retail merchandise system, a store ordering, receiving and inventory management system in all of our mainland stores (with installation in our Hawaii stores scheduled for fiscal 2009), and procurement and allocation systems that are more tightly integrated with one another than the systems they replaced. We also plan to implement an integrated demand forecasting and replenishment system for front-end merchandise during fiscal 2009.

 

Mail Order

 

We provide prescription drug mail order services to our retail drug store and pharmacy benefit services customers. We continue to develop our mail order capabilities to complement our in-store pharmacies as well as our pharmacy benefit services offerings.

 

Internet

 

Through our website, www.longs.com, our customers can access our company information and extensive health and wellness information, refill prescriptions, order digital photos, and purchase certain over-the-counter medications 24 hours a day, 7 days a week. Customers may have items mailed to them or may pick them up at their local store. We believe that this sales channel provides customers with added flexibility and convenience.

 

Our RxAmerica subsidiary’s website, www.rxamerica.com, provides information about our pharmacy benefit management services and prescription drug plans for members, plan sponsors, pharmacies and physicians.

 

Trademarks

 

We hold various trademarks, trade names (including, but not limited to, Longs, Longs Drugs, Longs Pharmacy, E-fills, RxAmerica and our various private label brands) and business licenses that are essential to the operation of our business. These trademarks and licenses have varying terms and are generally renewable indefinitely.

 

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Employees

 

As of January 31, 2008, we had approximately 21,900 employees, of which approximately 55% were part-time. We hire additional temporary employees as needed, especially during peak seasons. All of our employees are non-union, and we believe that our relationship with our employees is good.

 

Regulation

 

Our pharmacies and pharmacists are licensed by their respective state boards of pharmacy. Our pharmacies and distribution centers are also subject to the regulations of the Federal Drug Enforcement Administration. Applicable licensing and registration requirements necessitate our compliance with various state statutes, rules and regulations. We are also subject to numerous federal and state laws and regulations concerning the protection of confidential patient medical records and information, including the federal Health Insurance Portability and Accountability Act (“HIPAA”).

 

Our retail business is also subject to other laws and regulations including, but not limited to, regulations governing the sale of alcohol and tobacco, minimum wage requirements, working condition requirements, public accessibility requirements, citizenship requirements, gaming laws and other laws and regulations. The construction and maintenance of our stores is also subject to regulations relating to environmental matters, building construction, and zoning requirements.

 

As a provider of Medicare prescription drug plan benefits, RxAmerica is subject to various federal regulations promulgated by the Center for Medicare and Medicaid Services (“CMS”) under the Medicare Prescription Drug, Improvement, and Modernization Act of 2003. In addition, with the fiscal 2008 acquisition of Nutmeg Life Insurance Company, later renamed Accendo Insurance Company (see Note 4 to our consolidated financial statements), we are also subject to various state insurance laws and regulations in connection with our prescription drug plan business.

 

As a publicly traded corporation, we are subject to numerous federal securities laws and regulations, including the Securities Act of 1933 and the Securities Exchange Act of 1934, and related rules and regulations promulgated by the SEC, and the Sarbanes-Oxley Act of 2002. These laws and regulations impose significant requirements in the areas of accounting and financial reporting, corporate governance and insider trading, among others.

 

Competition

 

The retail drug store industry is highly competitive. We face intense competition with local, regional and national retailers, including other drug store chains, independent drug stores, on-line retailers, supermarket chains and mass merchandisers, many of which are aggressively expanding in markets we serve. In addition, competition from mail-order pharmacies is growing, and some third-party health plans require mail order fulfillment of certain medications. We compete on the basis of inclusion of our pharmacies in third-party health plan networks, quality of pharmacy services, price, front-end merchandise quality, product mix, convenience and customer service.

 

In the pharmacy benefit services industry, our competitors include large national and regional pharmacy benefit managers and insurance companies and managed care providers, some of which are owned by or have affiliations with our retail drug store competitors. We compete on the basis of our ability to facilitate the management of prescription drug costs for our customers and to provide low cost, high quality care for their members, as well as our experience in supporting managed state and other government programs.

 

Concentrations

 

All of our revenues are generated within the United States. We do not derive revenues from operations in foreign countries or exports. No single customer accounts for 10% or more of our total revenues. We do not believe that the loss of any one customer or group of customers under common control would have a material effect on our business.

 

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Over 90% of our pharmacy sales are covered by third-party health plans. Medicare and Medicaid together represented approximately 24% of our fiscal 2008 pharmacy sales. Any significant loss of third-party business, including Medicare and Medicaid, could have a material adverse effect on our revenues and profitability.

 

We purchase over 90% of our pharmaceuticals from a single supplier, AmerisourceBergen Drug Corporation (“AmerisourceBergen”), with whom we have a long-term supply contract. Any significant disruptions in our relationship with AmerisourceBergen could have a material adverse effect on us.

 

Our pharmacy benefit services segment offers prescription drug plans under Medicare Part D as established by the Medicare Prescription Drug, Improvement, and Modernization Act of 2003. These plans are subject to annual bidding and regulatory approval, and the majority of our enrollees are “dual-eligible” (qualified for both Medicare and Medicaid) who are automatically assigned to providers based on the outcome of the annual bidding process. If there are changes in legislative, regulatory or competitive conditions, or if we were to lose our contract with the Centers for Medicare and Medicaid Services (“CMS”), our ability to continue to offer prescription drug plans or to generate profitable prescription drug plan revenues could be adversely affected.

 

Our stores, mail order pharmacy operations, distribution centers and corporate offices are located in the western United States, with the majority of our stores in California. Risks prevalent in this region include, but are not limited to, the adverse economic effects of significant state budget deficits, legislative or other governmental actions reducing prescription reimbursement payments to us or increasing our liability with respect to workers’ compensation, major earthquakes, volatility in energy supplies and costs, and shipping and other transportation-related disruptions. Because of our geographic concentration, these risks could result in significant disruptions to our business or increased operating expenses.

 

Seasonality

 

Our retail drug store business is seasonal, peaking in the fourth fiscal quarter when front-end sales benefit from the holiday season. Pharmacy sales and over-the-counter medications also benefit in the fourth fiscal quarter from the winter cold and flu season.

 

The profitability of our Medicare prescription drug plan business is also seasonal, peaking in the second half of our fiscal year as a result of the Medicare Part D benefit design.

 

Item 1A. Risk Factors.

 

A description of the risk factors associated with our business is set forth below. The risks and uncertainties described below are not the only risks and uncertainties facing us. Our business is also subject to general risks and uncertainties that affect many other companies. Additional risks and uncertainties not presently known to us, or risks we currently consider immaterial, could also affect our business.

 

If we are unable to successfully execute our strategic initiatives and business development efforts, our future productivity and profitability may be adversely affected.

 

We are currently undertaking a series of strategic initiatives and business development efforts designed to make Longs a stronger competitor and more profitable company. These initiatives and efforts address several core elements of our operations, including our supply chain, front-end sales, pharmacy profitability, prescription drug plan business, customer service and operational processes. Our ability to successfully implement these changes, which are significant to our operations and business, is critical to our future profitability. If we are not successful, we may not achieve the expected benefits from these initiatives and efforts, despite having expended significant capital and human effort. Furthermore, we may encounter difficulties implementing this amount of change in our organization that could have a negative impact on our implementation plans and project budgets.

 

Changes in economic conditions could adversely affect consumer buying practices and reduce our revenues and profitability.

 

Our performance is affected by economic conditions such as overall economic growth and unemployment, especially in California, our primary market. Recently, slowing economic growth, rising sub-prime mortgage

 

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defaults and a related tightening of credit markets, and higher gasoline prices have had a significant impact on consumer spending in our markets. Deterioration in economic conditions, particularly in California, could adversely affect our revenues and profitability. For example, an increase in unemployment could cause consumers to lose their health insurance, which could in turn adversely affect our pharmacy sales. Further, a decrease in overall consumer spending as a result of changes in economic conditions could adversely affect our front-end sales and profitability.

 

The retail drug store industry is highly competitive and further increases in competition in our markets could adversely affect us.

 

We face intense and growing competition with local, regional and national companies, including other drug store chains, independent drug stores, on-line retailers, supermarket chains and mass merchandisers, many of which are aggressively expanding in markets we serve. In addition, competition from mail order pharmacies is growing, and some third-party health plans require mail order fulfillment of certain medications. Many of our competitors have substantially greater resources, including name recognition and capital resources, than we do. Some of these competitors may offer our key products, including prescription drugs, at prices below or near cost in order to gain market share and increase sales of other products they offer. The nature and extent of consolidation in the retail drug store and pharmacy benefit services industries could also affect our competitive position. As competition increases in the markets in which we operate, a significant increase in general pricing pressures could occur, which could require us to reduce prices, purchase more effectively and increase customer service to remain competitive. We may not be able to continue to compete effectively in our markets or increase our revenues or margins in response to further increased competition.

 

The pharmacy benefit services industry has become increasingly competitive, and this competition could impair our ability to attract and retain clients, which could adversely affect our business

 

Our ability to maintain growth rates in our pharmacy benefit services business is dependent upon our ability to attract new clients and retain existing clients. Some of our competitors may offer services and pricing terms we may not be able to offer. Our contracts with clients generally do not have terms longer than three years and, in some cases, are terminable by the client on relatively short notice. In addition, a relatively small number of contracts account for a significant portion of our total pharmacy benefit management profitability. This competition may make it difficult for us to attract new clients and retain existing profitable clients, which could materially adversely affect our business and financial results.

 

Over the last several years, competition in the marketplace has also caused many pharmacy benefit services companies, including us, to reduce the prices charged to clients for core services and share a larger portion of the formulary fees and related revenues received from pharmaceutical manufacturers with clients. This combination of lower pricing and increased revenue sharing, as well as increased demand for enhanced service offerings and higher service levels, has put pressure on operating margins. This pressure may continue, and we can give no assurance new services provided to clients will fully compensate for these reduced margins.

 

We believe the managed care industry is undergoing substantial consolidation, and another party that is not our client could acquire some of our managed care clients. In such case, the likelihood such client would renew its contract with us, as opposed to one of our competitors, could be reduced.

 

Reductions in third-party, including government, reimbursement levels for prescription drugs continue to impact our gross margins on pharmacy sales and could have a significant effect on our retail drug store sales and gross profits.

 

Third-party health plans cover more than 90% of all the prescription drugs that we sell. Pharmacy sales covered by third parties have lower gross margins than non-third-party pharmacy sales, and third-party health plans continue to reduce the levels at which they reimburse us for the prescription drugs that we provide to their members. Furthermore, government-sponsored health plans such as Medicare and Medicaid are making

 

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continuing efforts to reduce their costs, including prescription drug reimbursements, and the new Medicare prescription drug benefit resulted in lower reimbursement levels for prescription drugs provided to Medicare participants. In particular, increased utilization of generic pharmaceuticals (which normally yield a higher gross profit rate than equivalent brand named drugs) has resulted in pressure to decrease reimbursement payments to pharmacies for generic drugs, causing a reduction in generic profit margins. If third-party health plans, including government-sponsored plans, continue to reduce their reimbursement levels, our retail drug store sales and gross profits could be significantly adversely affected.

 

Changes in industry pricing benchmarks could adversely affect our financial performance.

 

Contracts in the prescription drug industry, including our contracts with third-party payors and pharmacy benefit management clients, generally use certain published benchmarks to establish pricing for prescription drugs. These benchmarks include average wholesale price (“AWP”) and wholesale acquisition cost (“WAC”). Recent events have raised uncertainties as to whether third-party payors, prescription benefit management providers and others in the prescription drug industry will continue to utilize AWP as it has previously been calculated or whether other pricing benchmarks, such as average manufacturer price (“AMP”), will be adopted for establishing prices within the industry. In certain circumstances, AMP may be below our prescription drug acquisition cost. We believe that third-party payors and prescription benefit management providers will begin to evaluate other pricing benchmarks as the basis for contracting for prescription drugs and benefit management services in the future. Changes to industry pricing benchmarks may have a material adverse effect on our financial performance, results of operations and financial condition in future periods.

 

The significant investments we are making in our stores may not increase our retail drug store profitability, which could adversely affect our results of operations, financial condition and cash flows.

 

We have recently made and are continuing to make significant investments in our retail drug stores in an effort to increase our sales and profitability. These investments include the construction of drive-through pharmacies, pharmacy and other technology, installation of new digital photo equipment, and remodels and other improvements to some existing stores. Some of these investments require significant capital expenditures and human effort. We are uncertain about consumer reaction to these changes and therefore these investments may not result in increased sales and profitability. A failure to increase our retail drug store sales and profitability would adversely affect our results of operations, financial condition and cash flows.

 

Our ability to grow our business may be constrained by our inability to find suitable new store locations at acceptable prices or by the expiration of our current leases.

 

Our ability to grow our business may be constrained if suitable new store locations cannot be identified with lease terms or purchase prices that are acceptable to us. We compete with other retailers and businesses for suitable locations for our stores. Local land use and other regulations applicable to the types of stores we desire to construct may impact our ability to find suitable locations and influence the cost of constructing our stores. The expiration of leases at existing highly profitable store locations may adversely affect us if the renewal terms of those leases are unacceptable to us, or are not available for renewal due to owner/developer plans for the property, and we are forced to close or relocate stores.

 

We may incur significant costs in connection with the closing of stores.

 

As we have in the past, we may close stores if we deem such a decision to be warranted and we can do so on what we determine is a cost effective basis. In fiscal 2008, we approved a plan to dispose of 31 stores, including all of the 23 stores located in Washington, Oregon and Colorado and eight stores in California. We may choose to close additional stores in the future. Closures may occur prior to lease expiration in which case we may be unable to assign such leases in a manner that allows us to avoid store lease costs. We may also incur costs associated with severance and related benefits for affected employees. These costs may be partially offset by proceeds from the disposition of owned properties and pharmacy prescription files. In addition, upon natural expiration of our leases we may be unable to find suitable locations nearby that allow us to retain the customer base we have developed.

 

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Our failure to effectively manage new store openings could lower our sales and profitability.

 

Our growth strategy is largely dependent upon opening new stores and operating them profitably. Our ability to open new stores and operate them profitably depends upon a number of factors, some of which may be beyond our control. These factors include:

 

   

the ability to identify new store locations, negotiate suitable leases and build out the stores in a timely and cost efficient manner;

 

   

the ability to hire and train skilled pharmacists and other employees;

 

   

the ability to integrate new stores into our existing operations and leverage existing infrastructure; and

 

   

the ability to increase sales at new store locations.

 

Our growth will also depend on our ability to process increased merchandise volume resulting from new store openings through our inventory management systems and distribution facilities in a timely manner. If we fail to manage new store openings in a timely and cost efficient manner, our growth may decrease.

 

If our insurance-related costs increase significantly, our financial position and results of operations could be adversely affected.

 

The costs of many types of insurance and self-insurance, especially workers’ compensation, employee health care and others, have been highly volatile in recent years. These conditions have been exacerbated by rising health care costs, legislative changes, economic conditions, terrorism and heightened scrutiny of insurance brokers and insurance providers. If our insurance-related costs increase significantly, or we are unable to renew our insurance policies or protect against all the business risks facing us, our financial position and results of operations could be adversely affected.

 

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

 

We purchase over 90% of our pharmaceuticals from a single supplier, AmerisourceBergen, with whom we have a long-term supply contract. Any significant disruptions in our relationship with AmerisourceBergen, deterioration in AmerisourceBergen’s financial condition, or industry-wide changes in wholesaler business practices, including those of AmerisourceBergen, could have a material adverse effect on us. There can be no assurance that we would be able to find a replacement supplier on a timely basis or that such supplier would be able to fulfill our demands on similar terms, which would have a material adverse effect on our results of operations, financial condition and cash flows.

 

Our ability to attract and retain pharmacy personnel and develop alternate fill sources is important to the continued success of our business.

 

The retail drug store industry is continuing to experience a shortage of licensed pharmacists in the markets in which we operate. If we are unable to attract and retain pharmacists, our business could be adversely affected. In order to mitigate this risk we have established centralized prescription fill centers and have also installed robotic prescription fill equipment in many of our pharmacies. The success of these efforts is important to our ability to address the shortage of pharmacists, but additional efforts may be necessary to address this business issue. Additional investment may be costly, and could adversely affect our results of operations, financial condition and cash flows.

 

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

 

Our retail drug store and pharmacy benefit services businesses are subject to numerous federal, state and local regulations, many of which are new and developing. These include, but are not limited to, local

 

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registrations and regulation of pharmacies in the states where our pharmacies are located or licensed, Medicare and Medicaid regulations applicable to our retail pharmacy and pharmacy benefit services businesses, state labor laws and regulations, and the requirements of the Health Insurance Portability and Accountability Act, or HIPAA, regarding the protection of confidential patient medical records and other information. We are also subject to various state insurance laws and regulations in connection with our prescription drug plan business. Failure to adhere to these and other applicable regulations could result in the imposition of civil and criminal penalties. Furthermore, any new federal or state regulations or reforms, including healthcare reform initiatives or pharmacy benefit management regulation, could adversely affect us.

 

Should a product liability issue arise, inadequate insurance coverage against such risks or inability to maintain such insurance may result in a material adverse effect on our business.

 

Pharmacies are exposed to risks inherent in the packaging and distribution of pharmaceuticals and other healthcare products, including with respect to improper filling of prescriptions, labeling of prescriptions and adequacy of warnings, and are significantly dependent upon suppliers to provide safe, government-approved and non-counterfeit products. We also sell a variety of non-pharmaceutical products that we purchase from a large number of suppliers, including some who operate in foreign countries, which could become subject to contamination, product tampering, mislabeling or other damage, or could otherwise fail to meet the various food and consumer health safety requirements under which we operate. While we maintain reasonable quality assurance practices, no program can provide complete assurance that a product liability issue will not arise. Should a product liability issue arise, the coverage limits under our insurance programs may not be adequate to protect us against future claims. In addition, we may not be able to maintain this insurance on acceptable terms in the future. Damage to our reputation in the event of a product liability issue could have an adverse effect on our business, financial condition or results of operations. Reestablishing any lost confidence on the part of our customers would be difficult and costly.

 

Our geographic concentration in the western United States presents certain risks that could adversely affect us.

 

Our stores, mail order pharmacy operations, distribution centers and corporate offices are located in the western United States, with the majority of our stores in California. Risks prevalent in this region include, but are not limited to, the adverse economic effects of significant state budget deficits, a significant planned reduction in state Medicaid pharmacy reimbursements, further legislative or other governmental actions reducing prescription reimbursement payments to us, significant new or increased income or property tax, or increasing our liability with respect to workers’ compensation, major earthquakes, volatility in energy supplies and costs, and shipping and other transportation-related disruptions. Because of our geographic concentration, these risks could result in significant disruptions to our business or increased operating expenses. In addition, we rely primarily on two centralized distribution centers, both in California, to ship most of our non-prescription products to our stores. If either distribution center was destroyed or shut down for any reason, we would incur significantly higher costs and delays associated with distribution of products during the time it takes us to reopen or replace the centers.

 

An adverse trend in sales during the cold and flu, allergy and/or holiday seasons could have a disproportionate effect on our operating results for the year.

 

Our business, like that of many retailers, is seasonal, with the major portion of our sales and operating profit realized during the fourth fiscal quarter, which includes the main holiday selling season and as well as the winter cold and flu season. As a result, our results for the entire year tend to be disproportionately dependant on the performance in the fourth quarter. The strength of the holiday selling season and the severity of the cold and flu season vary considerably each year. Seasonal variability could lead to unexpected and materially adverse effects on our results of operations.

 

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The success of our business depends on maintaining a well-secured technology infrastructure.

 

We are dependent on our infrastructure, including our information systems, for many aspects of our business operations. A fundamental requirement for our business is the secure storage and transmission of personal health information and other confidential data. Our business and operations may be harmed if we do not maintain our business processes and information systems, and the integrity of our confidential information. Although we have developed systems and processes that are designed to protect information against security breaches, failure to protect such information or mitigate any such breaches may adversely affect our operations. Malfunctions in our business processes, breaches of our information systems or the failure to maintain effective and up-to-date information systems could disrupt our business operations, result in customer and member disputes, damage our reputation, expose us to risk of loss or litigation, result in regulatory violations, increase administrative expenses or lead to other adverse consequences.

 

The availability of pharmacy drugs is subject to governmental regulations.

 

The continued conversion of various prescription drugs to over-the-counter medications may reduce our pharmacy sales and customers may seek to purchase such medications at non-pharmacy stores. Also, if the rate at which new prescription drugs become available slows or if new prescription drugs that are introduced into the market fail to achieve popularity, our pharmacy sales may be adversely affected.

 

We are subject to certain legal proceedings that may adversely affect our financial condition and results of operations.

 

We are involved in a number of legal proceedings, which include consumer, employment and other litigation. Certain of these legal proceedings, if decided adversely to us or settled by us, may result in liability material to our financial condition and results of operations. We discuss certain legal proceedings to which we are a party in greater detail under the caption “Item 3. Legal Proceedings.”

 

If our prescription drug plans do not generate the anticipated revenues or profitability or if we do not retain our plan members, our financial results could be adversely affected.

 

Effective January 1, 2006, through our pharmacy benefit management subsidiary, we began offering prescription drug plans that provide prescription drug benefits under the Medicare Prescription Drug, Improvement, and Modernization Act of 2003. Because this is a relatively new federally subsidized benefit and is subject to annual bidding, it is difficult to predict the revenues and profitability of these plans and the timing of the related cash flows. If the revenues we generate from providing these benefits are not sufficient to cover the related prescription drug costs, if we are unable to successfully control our gross drug costs, or if the timing of our prescription drug expenditures and related subsidy payments from the Centers for Medicare and Medicaid Services (“CMS”) differ significantly from our projections, our profitability and cash flows will be adversely affected. CMS performs an annual reconciliation of prescription drug expenditures and their related subsidy payments to prescription drug plan sponsors subsequent to each calendar plan year. If the outcome of this reconciliation process is significantly different than our current estimates, our financial results for this business could be adversely affected. Furthermore, these plans are subject to annual bidding and regulatory approval and the majority of our enrollees are “dual-eligible” (qualified for both Medicare and Medicaid coverage) who are automatically assigned to providers based on the outcome of the annual bidding process. If our annual bid is not successful, or if Congress were to change or eliminate the plans, our profitability could be adversely affected.

 

If RxAmerica does not become fully licensed as a risk bearing entity, our ability to offer prescription drug plans will be adversely affected.

 

The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 requires prescription drug plan sponsors to ultimately be licensed under state law as a risk-bearing entity, such as an insurer or health maintenance organization, eligible to offer health insurance or health benefits coverage in each state in which the applicant offers a prescription drug plan. We recently acquired a “shell” insurance company in connection with our plans to satisfy the licensure requirements. For the 2009 plan year and forward, in accordance with the federal

 

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statutory mandate, the insurance company will provide the Medicare prescription drug plans. Our ability to offer prescription drug plans in the future may be adversely affected if the insurance company is not fully operational and successful in its bids to CMS for 2009. Furthermore, while many state insurance laws are well-established, CMS continues to provide new guidance in an attempt to assist sponsors and state regulators in determining the appropriate applicability of state insurance laws in the context of the prescription drug plans. Uncertainty as to the applicability of state and federal laws could have an impact on RxAmerica’s ability to successfully offer products and services under the Medicare Prescription Drug, Improvement, and Modernization Act of 2003.

 

If RxAmerica loses relationships with one or more key pharmaceutical manufacturers or if the payments made or rebates provided by pharmaceutical manufacturers decline, its business and financial results could be adversely affected

 

RxAmerica maintains contractual relationships with numerous pharmaceutical manufacturers that may provide it with, among other things:

 

   

rebates based upon sales of drugs through pharmacies in its retail networks; and

 

   

administrative fees for managing rebate programs, including the development and maintenance of formularies which include the particular manufacturer’s products.

 

In addition, formulary fee programs have been the subject of debate in federal and state legislatures and various other public and governmental forums. Changes in existing laws or regulations or in interpretations of existing laws or regulations or the adoption of new laws or regulations relating to any of these programs may materially adversely affect the operating results of RxAmerica.

 

If RxAmerica loses relationships with one or more key pharmacy providers, or its relationship is modified in an unfavorable manner, our business could be impaired

 

RxAmerica’s contracts with retail pharmacies, which are non-exclusive, are generally terminable on relatively short notice by either party. If one or more of the other top pharmacy chains elects to terminate its relationship with RxAmerica, or attempts to renegotiate the terms of the relationship in a manner that is unfavorable to it, members’ access to retail pharmacies and the RxAmerica business could be materially adversely affected. The continued growth of PBMs owned by the competing pharmacy chains, or the acquisition of significant PBM operations by such chains could increase the likelihood of our relationships with such pharmacy chains being adversely affected.

 

Item 1B. Unresolved Staff Comments.

 

None.

 

Item 2. Properties.

 

Stores

 

     Fiscal Year

 
     2008

    2007

    2006

 

Number of stores, beginning of period

   509     476     472  

Stores opened

   20     16     5  

Stores acquired

   13     21     —    

Stores closed

   (32 )   (4 )   (1 )
    

 

 

Number of stores, end of period

   510     509     476  
    

 

 

Number of stores, end of period (continuing operations)

   510     486     453  

Stores relocated

   3     7     0  

Stores remodeled

   43     40     41  

 

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In February 2007, our board of directors approved a plan to dispose of 31 stores during fiscal 2008, including all of the 23 stores located in Washington, Oregon and Colorado and 8 stores in California. We closed 30 of these stores during fiscal 2008. One California store previously included in this disposition plan will remain open.

 

We plan to open or relocate approximately 20 to 30 stores and remodel 40 additional stores in fiscal 2009.

 

Our stores are located in the following states:

 

     January 31,
2008


   January 25,
2007


   January 26,
2006


California

   447    437    402

Hawaii

   37    32    31

Nevada

   24    17    17

Arizona

   2    —      —  

Washington

   —      12    15

Colorado

   —      9    9

Oregon

   —      2    2
    
  
  

Total

   510    509    476
    
  
  

 

We opened two stores in Arizona during fiscal 2008 to support a new pharmacy benefits management contract signed by our RxAmerica subsidiary.

 

Approximately 92% of our stores are full-service retail drug stores, averaging approximately 23,000 square feet, of which approximately 16,000 square feet is devoted to selling space. The remaining 8% of our stores are smaller pharmacy stores, with less than 4,000 selling square feet and averaging approximately 1,500 selling square feet. Our future growth plans include a mix of full-service retail drug stores and smaller pharmacy stores.

 

As of January 31, 2008, 59% of our stores are leased from third parties, 28% are company-owned buildings on company-owned land, and 13% are company-owned buildings on leased land.

 

Distribution Centers

 

We operate the following distribution centers:

 

Location


   Leased/
Owned

   Square
Feet

Patterson, California (front-end merchandise)

   Owned    800,000

Ontario, California (front-end merchandise)

   Owned    353,000

Ontario, California (pharmaceutical inventories)

   Leased    36,000

Honolulu, Hawaii (front-end merchandise)

   Owned    48,000

 

We also lease supplemental warehouse space as needed, especially during our high-volume seasonal periods.

 

Other Properties

 

We have two principal company-owned corporate office facilities in California, with a total of 142,000 square feet, and we lease an additional 61,000 square feet of office space, also in California. We also own a 26,000 square foot office facility and lease an additional 70,000 square feet of office space in Salt Lake City, Utah, for our pharmacy benefit services segment. In addition, we lease a 34,000 square foot pharmacy mail order and central fill facility in Sacramento, California, and an 11,000 square foot office facility in Las Vegas, Nevada, for our mail order call center operations. Our remaining properties are not material, either individually or in the aggregate.

 

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Item 3. Legal Proceedings.

 

Rankin v. Longs Drug Stores California, Inc. was filed in the Superior Court of California, San Diego County, in October 2004, and was subsequently certified as a class action. The lawsuit alleged that our employment application violated California Labor Code Section 432.8 by inquiring about criminal convictions within the last seven years, without providing an exception for misdemeanor marijuana convictions more than two years old. The plaintiff sought to recover statutory damages and attorneys’ fees for himself and all similarly situated individuals who applied for employment with us during the class period. Trial commenced on August 20, 2007 and concluded with a dismissal of plaintiff’s case by the court on September 26, 2007. The plaintiff filed a notice of appeal on December 4, 2007.

 

During the third quarter of fiscal 2007, we completed a self-audit of certain of our California drug stores located in three counties that was initiated at the request of the State of California Department of Industrial Relations (“DIR”). The audit related to compliance with California law relating to meal period requirements. We made compensatory payments resulting from this audit, which were not material to us, during the fourth quarter of fiscal 2007. The DIR has also requested that we conduct an audit related to meal period compliance for all of our California drug stores. At this time we cannot reasonably estimate the amount of possible payments that might be required as a result of an additional audit, if any.

 

In addition to the matters described above, we are subject to various lawsuits, claims and federal and state regulatory reviews and actions arising in the normal course of our businesses. We accrue amounts we believe are adequate to address the liabilities related to lawsuits and other proceedings that we believe will result in a probable loss if the loss can be reasonably estimated. However, the ultimate resolution of such matters is uncertain and outcomes are not predictable with assurance. It is possible that the matters described above or other proceedings brought against us could have a material adverse impact on our financial condition and results of operations.

 

Item 4. Submission of Matters to a Vote of Security Holders.

 

There were no matters submitted to a vote of stockholders during the fourth quarter of fiscal 2008.

 

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PART II

 

Item 5. Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

 

The New York Stock Exchange is the principal market for our common stock, which is traded under the symbol “LDG.” Our transfer agent is Wells Fargo Shareowner Services, P.O. Box 64854, St. Paul, MN 55164-0854. There were approximately 2,132 stockholders of record as of February 21, 2008.

 

Quarterly high and low sale prices for our common stock, based on the New York Stock Exchange composite transactions, are shown below:

 

     First Quarter

   Second Quarter

   Third Quarter

   Fourth Quarter

   Fiscal Year

     Low

   High

   Low

   High

   Low

   High

   Low

   High

   Low

   High

Fiscal 2008

   $ 42.57    $ 54.99    $ 48.70    $ 59.20    $ 45.17    $ 54.69    $ 41.51    $ 58.54    $ 41.51    $ 59.20

Fiscal 2007

   $ 34.00    $ 48.55    $ 39.75    $ 48.50    $ 38.76    $ 48.53    $ 40.40    $ 47.05    $ 34.00    $ 48.55

 

Quarterly dividends per share are summarized as follows:

 

     First
Quarter

   Second
Quarter

   Third
Quarter

   Fourth
Quarter

   Fiscal
Year

Fiscal 2008

   $ 0.14    $ 0.14    $ 0.14    $ 0.14    $ 0.56

Fiscal 2007

   $ 0.14    $ 0.14    $ 0.14    $ 0.14    $ 0.56

 

We made the following repurchases of our common stock during the quarter ended January 31, 2008:

 

Period


   Total
Number
of Shares
Purchased


   Average
Price Paid
per Share


   Shares
Purchased as
Part of Publicly
Announced Plans
or Programs (1)


   Approximate
Dollar Value of
Shares that May
Yet be Purchased
Under the Plans
or Programs


Month #1

                       

October 26, 2007—November 22, 2007

   —        —      —      $ 224.7 million

Month #2

                       

November 23, 2007—December 27, 2007

   255,000    $ 52.80    255,000    $ 211.2 million

Month #3

                       

December 28, 2007—January 31, 2008

   1,245,000    $ 44.15    1,245,000    $ 156.3 million
    
  

  
      

Total

   1,500,000    $ 45.62    1,500,000       

 

(1) These shares were repurchased under two separate programs authorized by our board of directors, in May 2005 and November 2007. In May 2005, our board of directors authorized the repurchase of up to $150 million of our outstanding common stock through May 2008. In November 2007, our board of directors authorized the additional repurchase of up to $200 million of our outstanding common stock through February 2011. We have completed the May 2005 share repurchase program. Under the November 2007 share repurchase program, we are authorized to repurchase additional shares of our common stock for a maximum additional expenditure of $156.3 million.

 

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The following graph shows a comparison of the five-year cumulative total return for our common stock, the Russell 2000 Index and the Russell 2000 Consumer Staples Index, each of which assumes an initial value of $100 and reinvestment of dividends. The Russell 2000 Index consists of the smallest 2,000 companies in the Russell 3000 Index in terms of market capitalization. The Russell 2000 Consumer Staples Index is a capitalization-weighted index of companies that provide products directly to consumers that are typically considered non-discretionary items based on consumer purchasing habits, and our common stock is included in this index. The past performance of our common stock is not an indication of future performance. This stock performance graph information is not “soliciting material” and shall not be deemed filed with the SEC and is not to be incorporated by reference into our filings under the Securities Act of 1933 or the Securities Exchange Act of 1934, whether made before or after the date of this annual report and irrespective of any general incorporation language therein.

 

LOGO

 

     1/30/03

   1/29/04

   1/27/05

   1/26/06

   1/25/07

   1/31/08

Longs Drug Stores Corporation

   100.00    107.55    131.06    176.03    219.88    238.62

Russell 2000

   100.00    158.03    171.73    204.17    225.49    203.42

Russell 2000 Consumer Staples

   100.00    133.60    145.49    155.82    209.15    201.04

 

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Table of Contents

Item 6. Selected Financial Data.

 

    Fiscal Year (1)

 
    2008
(53 weeks)

    2007
(52 weeks)

    2006
(52 weeks)

    2005
(52 weeks)

    2004
(52 weeks)

 
    Dollars in thousands except per share data  

Statement of Consolidated Income data:

       

Revenues:

                                       

Retail drug store sales

  $ 4,882,827     $ 4,652,940     $ 4,491,752     $ 4,444,002     $ 4,360,616  

Pharmacy benefit services revenues (2)

    379,738       320,356       53,457       32,822       27,430  
   


 


 


 


 


Total revenues

    5,262,565       4,973,296       4,545,209       4,476,824       4,388,046  

Costs and expenses:

                                       

Cost of retail drug store sales

    3,614,769       3,484,617       3,333,605       3,319,110       3,272,855  

Prescription drug plan benefit costs (2)

    263,608       229,179       12,232       —         —    

Operating and administrative expenses

    1,211,561       1,126,019       1,078,121       1,071,082       1,049,996  

Gain on sale of distribution center

    —         —         (11,049 )     —         —    

Provision for store closures and asset impairments, net

    8,495       2,778       2,397       974       7,329  

Legal settlements and other disputes, net

    (431 )     (930 )     —         10,773       (7,007 )
   


 


 


 


 


Operating income

    164,563       131,633       129,903       74,885       64,873  

Interest expense, net

    7,763       6,846       7,857       13,354       13,379  

Income taxes

    57,909       45,334       45,922       22,343       18,457  
   


 


 


 


 


Income from continuing operations

    98,891       79,453       76,124       39,188       33,037  
   


 


 


 


 


Loss from discontinued operations, net of tax (3)

    (2,690 )     (4,992 )     (2,237 )     (2,280 )     (3,273 )
   


 


 


 


 


Net income

  $ 96,201     $ 74,461     $ 73,887     $ 36,908     $ 29,764  
   


 


 


 


 


Per common share data:

                                       

Basic earnings per common share:

                                       

Income from continuing operations

  $ 2.65     $ 2.14     $ 2.04     $ 1.05     $ 0.89  

Loss from discontinued operations (3)

    (0.07 )     (0.14 )     (0.06 )     (0.06 )     (0.09 )
   


 


 


 


 


Net income

    2.58       2.00       1.98       0.99       0.80  
   


 


 


 


 


Diluted earnings per common share:

                                       

Income from continuing operations

    2.59       2.08       1.99       1.04       0.88  

Loss from discontinued operations (3)

    (0.07 )     (0.13 )     (0.06 )     (0.06 )     (0.09 )
   


 


 


 


 


Net income

    2.52       1.95       1.93       0.98       0.79  
   


 


 


 


 


Dividends per common share

  $ 0.56     $ 0.56     $ 0.56     $ 0.56     $ 0.56  
   


 


 


 


 


Consolidated Balance Sheet and Cash Flows data:

                                       

Total assets

  $ 1,846,716     $ 1,687,668     $ 1,495,329     $ 1,413,095     $ 1,442,112  

Long-term debt

    183,364       118,091       59,818       145,688       114,558  

Other long-term liabilities

    105,352       103,459       80,469       69,770       50,695  

Stockholders’ equity

    827,925       815,557       762,589       721,845       713,921  

Operating cash flows

    218,299       182,968       202,301       181,638       122,139  

Capital expenditures and acquisitions

    190,153       167,687       105,492       91,479       113,999  
   


 


 


 


 


Operating statistics:

                                       

Number of stores at year end

    510       509       476       472       470  

Number of stores at year end, continuing operations

    510       486       453       449       447  

Same-store sales growth (decline) (4)
(52-week basis)

    0.9 %     2.0 %     0.6 %     0.6 %     (0.2 )%

Selling square footage at year end (thousands) (5)

    7,571       7,402       7,300       7,277       7,240  

Average drug store sales per selling square foot
(52-week basis)
(5)

  $ 630     $ 622     $ 608     $ 605     $ 604  

Number of employees at year end

    21,900       21,900       21,800       22,000       22,900  
   


 


 


 


 


 

(1) We operate on a 52/53-week fiscal year ending on the last Thursday in January.

 

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(2) Beginning January 1, 2006, through our pharmacy benefit services segment, we began offering prescription drug plans under Medicare Part D as established by the Medicare Prescription Drug, Improvement and Modernization Act of 2003.

 

(3) In fiscal 2008, we closed 30 stores, including all of the 23 stores located in Washington, Oregon and Colorado and seven stores in California, pursuant to a plan approved by our board of directors in February 2007. The results of operations associated with the stores in Washington, Oregon and Colorado are classified as discontinued operations for all periods presented (see Note 3 to our consolidated financial statements).

 

(4) Same-store sales statistics serve as a measure of our sales growth excluding the effect of opening new stores or closing stores. We compute same-store sales growth on a monthly basis, by comparing sales in the current fiscal month with those of the same fiscal month of the previous fiscal year for those stores that have been open for at least 13 complete consecutive fiscal months. Relocated stores are not included in same-store sales until the new location has been open for at least 13 complete consecutive fiscal months. This computation has the effect of measuring sales increases or decreases each month only for those stores that were open during all of the same month of the previous fiscal year. We compute quarterly and annual same-store sales growth by accumulating the monthly same-store sales results for those quarterly and annual periods. Same-store sales results for fiscal 2008 versus fiscal 2007 are presented on a comparable 52-week basis. Sales for the 30 stores closed during fiscal 2008 pursuant to a plan approved by our board of directors in February 2007 (see (3) above) are excluded from same-store sales results in fiscal 2008.

 

(5) Selling square footage and average sales per selling square foot are based on continuing operations only.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read together with our consolidated financial statements and the related notes. This discussion contains forward-looking statements relating to, among other things, the matters set forth under “Cautionary Statement Regarding Forward-Looking Statements.” Our actual results and the timing of events could differ materially from those anticipated in these forward-looking statements as a result of many factors, including, but not limited to, those set forth in the following discussion, under “Cautionary Statement Regarding Forward-Looking Statements” and “Risk Factors” and elsewhere in this Form 10-K.

 

OVERVIEW

 

Our fiscal 2008 financial results reflect the progress we have made on our initiatives to make Longs a stronger competitor and more profitable company. We successfully realigned and upgraded our store base, increased our self-distribution of front-end merchandise, built a strong foundation for the continued growth of our pharmacy benefit services segment, and made continued progress on our long-term strategic initiatives.

 

In February 2007, we announced a plan to dispose of 31 stores during fiscal 2008, including all of our 23 stores located in Washington, Oregon and Colorado and eight stores in California. Most of the stores were located in markets we entered in the 1980s and 1990s that remained underdeveloped. Sufficiently developing our presence in these markets would have required significant investment that we believed would be better directed toward markets that offer greater opportunities for more satisfactory returns. We therefore decided to close the stores and market the assets. As of the end of fiscal 2008, we have closed 30 of these stores. One California store previously included in this disposition plan will remain open. Twenty-four of the store locations have been sold or sub-leased and the remainder are being actively marketed. This realignment has allowed us to direct more attention to the growth of our retail drug store and pharmacy benefit services segments.

 

Our store opening activities resulted in a net addition of 24 stores within continuing operations. We opened 20 new stores, relocated three stores and closed nine stores. We also acquired seven retail pharmacies during the year, which increased our portfolio of smaller retail pharmacies, many of which are close to the point of care, such as hospitals, clinics and medical office buildings. We also acquired six stores in the Reno, Nevada area from Rite Aid Corporation, further increasing our presence in the Reno area. Our future growth plans incorporate a mix of smaller pharmacies as well as our traditionally larger full-service retail drug stores.

 

We remodeled 43 additional stores during fiscal 2008, achieving our goal of bringing our new, updated look to 50% of our full-service retail drug stores as of the end of fiscal 2008. We plan to remodel up to an additional 40 stores in fiscal 2009.

 

We completed construction of an 800,000 square foot distribution center in Patterson, California during the summer of fiscal 2007, which has enabled us to increase our self-distribution to 80% of our mainland front-end merchandise during fiscal 2008, up from 40% previously. We have already reduced our distribution costs as a percent of shipments and expect to make continued progress on efficiency and productivity.

 

We achieved continued growth at RxAmerica during fiscal 2008, both in our prescription drug plans for Medicare beneficiaries as well as our pharmacy benefit management business. Our prescription drug plans will serve an estimated 440,000 to 450,000 beneficiaries in the calendar 2008 plan year, up from enrollment last year of approximately 240,000. During fiscal 2008, RxAmerica acquired a registered insurance company, subsequently renamed Accendo Insurance Company, with licenses to operate as an insurance company in 46 states. This will allow us to continue to offer prescription drug plans for Medicare through Accendo after the expiration of our insurance waivers from the Centers for Medicare and Medicaid Services (“CMS”) on January 1, 2009. Pharmacy benefit management revenues also increased in fiscal 2008 due to growth in our existing client base and the addition of new clients. RxAmerica managed prescription drug plans covering 8.7 million lives as of the end of fiscal 2008, up from 7.3 million lives as of a year ago.

 

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We have continued to work on the broad categories of strategic initiatives established more than five years ago to make Longs a stronger competitor and more profitable company: pharmacy profitability, front-end sales, supply chain, operational processes and pharmacy benefit services. The progress we have made on these initiatives to date has enabled us to improve our operating performance, develop the organizational competence for change and improvement, and build a foundation for more profitable growth.

 

We plan to make continued enhancements to our supply chain and distribution capabilities in an effort to improve our inventory management and in-stock position. During fiscal 2009, we plan to complete the installation of our system for store ordering, receiving and inventory management in our Hawaii stores, and to implement an integrated demand forecasting and replenishment system for front-end merchandise in our mainland stores. Our increased self-distribution of front-end merchandise gives us the opportunity to optimize our merchandise assortments, take further advantage of faster replenishment and increase our use of technology to improve our efficiency.

 

We also plan to make continued progress on improving our productivity through operational initiatives focused on performance measurements, standardized processes and technologies and growing our business to better leverage our costs. We plan to install a labor scheduling and forecasting system in all of our stores by the end of fiscal 2009. We are also streamlining our remodeling process in an effort to reduce disruption for our customers and store operations. We are also working to improve the profitability of our new stores at a faster rate.

 

We remain focused on our longer-term goal to reduce the gap between our operating margin and those of our largest competitors, and plan to continue our efforts to become a stronger competitor and more profitable company.

 

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RESULTS OF OPERATIONS

 

Revenues

 

     Fiscal Year

 
     2008

    2007

    2006

 
     Dollars in Thousands  

Retail drug store sales:

                        

Pharmacy sales

   $ 2,509,252     $ 2,344,602     $ 2,179,522  

Front-end sales

     2,373,575       2,308,338       2,312,230  
    


 


 


Total

   $ 4,882,827     $ 4,652,940     $ 4,491,752  
    


 


 


Pharmacy benefit services revenues:

                        

Prescription drug plan revenues

   $ 310,800     $ 280,719     $ 16,201  

Pharmacy benefit management revenues

     68,938       39,637       37,256  
    


 


 


Total

   $ 379,738     $ 320,356     $ 53,457  
    


 


 


Total revenues

   $ 5,262,565     $ 4,973,296     $ 4,545,209  
    


 


 


Retail drug store sales:

                        

Total sales growth over previous year

     4.9 %     3.6 %     1.1 %

Total sales growth, comparable 52-week basis

     3.0 %     3.6 %     1.1 %

Same-store sales growth, comparable 52-week basis

     0.9 %     2.0 %     0.6 %

Pharmacy sales growth

     7.0 %     7.6 %     3.7 %

Same-store pharmacy sales growth, comparable 52-week basis

     1.8 %     5.1 %     3.2 %

Pharmacy as a % of total retail drug store sales

     51.4 %     50.4 %     48.5 %

% of pharmacy sales covered by third party health plans

     95.0 %     94.4 %     92.6 %

Front-end sales growth (decline)

     2.8 %     (0.2 )%     (1.3 )%

Same-store front-end sales growth (decline), comparable 52-week basis

     0.1 %     (0.9 )%     (1.7 )%

Front-end as a % of total retail drug store sales

     48.6 %     49.6 %     51.5 %

Pharmacy benefit services revenues:

                        

Prescription drug plan revenue growth over previous year

     10.7 %     N/A       N/A  

Pharmacy benefit management revenue growth over previous year

     73.9 %     6.4 %     13.5 %

 

Fiscal 2008 versus Fiscal 2007

 

Total revenues increased 5.8% in fiscal 2008 over fiscal 2007. On a comparable 52-week basis (excluding the last week of fiscal 2008), total revenue increased 3.8% in fiscal 2008 over fiscal 2007.

 

Retail Drug Store Sales

 

Retail drug store sales were $4.9 billion, a 4.9% increase over fiscal 2007. On a comparable 52-week basis, total retail drug store sales increased 3.0% in fiscal 2008 over fiscal 2007. Same-store sales increased 0.9% on a comparable 52-week basis. Growth in the number of stores and higher mail order sales also contributed to total retail drug store sales growth.

 

Pharmacy sales increased 7.0% in fiscal 2008 over fiscal 2007, partially due to the impact of the 53rd week in fiscal 2008, with same-store pharmacy sales increasing 1.8% on a comparable 52-week basis. The increase in same-store pharmacy sales was primarily due to continued increases in average retail prescription prices. Average prescription prices increased due to pharmaceutical cost inflation and the continued introduction and utilization of newer and more expensive drugs. The increase in average prescription prices was mitigated in part by the increased utilization of lower-priced, high-volume generic drugs. We estimate that generic utilization

 

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negatively impacted our same-store pharmacy sales by approximately 4.5 to 4.7 percentage points. We expect that average retail prices for prescription drugs will continue to rise due to pharmaceutical cost inflation and the continued introduction and utilization of newer and more expensive drugs. We expect that the utilization of generic drugs will continue to increase through the first half of fiscal 2009.

 

Prescription volumes were relatively flat in fiscal 2008 compared with fiscal 2007 due in part to a weaker cold and flu season. We expect that several favorable industry trends will positively impact our prescription volumes over the long term. These trends include an aging U.S. population consuming a greater number of prescription drugs, the growing use of prescription drugs as preventive therapy by healthcare providers and the introduction of new drugs. Factors that could offset these favorable trends include increasing competition, including the growth of mail order pharmacies, and rising prescription drug costs, which could cause consumers to reduce their purchases of prescription drugs or third-party health plans to reduce their coverage of prescription drug costs for their members.

 

Pharmacy sales were 51.4% of total drug store sales in fiscal 2008, compared to 50.4% in fiscal 2007. We expect pharmacy sales to continue to increase as a percentage of total drug store sales as pharmacy sales continue to increase faster than front-end sales.

 

Third-party health plans covered 95.0% of our pharmacy sales in fiscal 2008, compared to 94.4% in fiscal 2007. We expect third-party sales to remain over 90% of our total pharmacy sales for the foreseeable future due to significant consumer participation in managed care and other third-party plans, including Medicare prescription drug plans.

 

Front-end sales increased 2.8% in fiscal 2008 from fiscal 2007, partially due to the impact of the 53rd week in fiscal 2008, with same-store front-end sales increasing 0.1% on a comparable 52-week basis. Our core categories of health, wellness, beauty and convenience continued to outperform our non-core categories as a result of our continuing merchandise strategy to improve our profitability by focusing on our core categories. More than 85% of our front-end sales were in our core categories during fiscal 2008.

 

Our front-end sales performance is affected by overall economic conditions, including growth and unemployment, especially in California, our primary market. We expect these factors to contribute to a difficult sales environment in the short term. Longer term, we expect our front-end sales to increase as a result of growth in the number of our stores and our continued efforts to expand and enhance our assortments of merchandise in our core categories.

 

Pharmacy Benefit Services Revenues

 

Pharmacy benefit services revenues were $379.8 million in fiscal 2008, an 18.5% increase over fiscal 2007. Pharmacy benefit management revenues increased $29.3 million, or 73.9%, while prescription drug plan revenues increased $30.1 million, or 10.7%. On a comparable 52-week basis, total pharmacy benefit services revenue increased 15.1% in fiscal 2008 over fiscal 2007.

 

RxAmerica’s Medicare prescription drug plan revenues increased $30.1 million, or 10.7% compared to fiscal 2007 due to an increase in the number of beneficiaries covered by our prescription drug plans. These plans will provide prescription drug benefits to an estimated 440,000 to 450,000 Medicare beneficiaries in all 50 states and the District of Columbia during the calendar 2008 plan year.

 

Revenues under the prescription drug plans include fixed monthly premiums paid by beneficiaries and by the federal Centers for Medicare & Medicaid Services (“CMS”), as well as a CMS risk share component. If the ultimate per member per month benefit costs of any Medicare Part D regional plan varies more than a certain amount (2.5 percentage points for the calendar 2006 and 2007 plan years and 5.0 percentage points for the calendar 2008 plan year) above or below the level estimated in the original bid submitted by the Company and

 

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approved by CMS, there is a risk share settlement with CMS subsequent to the end of the plan year. The risk share adjustment, if any, is recorded as an adjustment to premium revenues and accounts receivable or accounts payable.

 

Pharmacy benefit management revenues increased 73.9% to $68.9 million due to growth in our existing client base and the addition of new clients. The Medicare prescription drug benefit also contributed to the increase in our pharmacy benefit management revenues in fiscal 2008 over fiscal 2007, partially as a result of RxAmerica providing pharmacy benefit management services to Medicare Advantage prescription drug plans.

 

Fiscal 2007 versus Fiscal 2006

 

Total revenues increased 9.4% in fiscal 2007 over fiscal 2006. Retail drug store sales were $4.7 billion, a 3.6% increase over fiscal 2006, with same-store sales increasing 2.0%. Growth in the number of stores and higher mail order sales also contributed to total retail drug store sales growth. Pharmacy benefit services revenues were $320.4 million in fiscal 2007, compared to $53.5 million in fiscal 2006, primarily due to an increase of $264.5 million related to the prescription drug plans we began offering on January 1, 2006 under Medicare Part D.

 

Retail Drug Store Sales

 

Pharmacy sales increased 7.6% in fiscal 2007 over fiscal 2006, with same-store pharmacy sales increasing 5.1%. The increase in same-store pharmacy sales was primarily due to continued increases in average retail prescription prices, in addition to higher prescription volumes. Average prescription prices increased due to pharmaceutical cost inflation and the continued introduction and utilization of newer and more expensive drugs. The increase in average prescription prices was mitigated in part by the increased utilization of lower-priced, high-volume generic drugs. We estimate that generic utilization negatively impacted our same-store pharmacy sales by approximately 2.2 percentage points.

 

The increase in our same-store prescription volumes was primarily due to the new Medicare drug benefit and the success of our pharmacy marketing initiatives. These increases were partially offset by a weaker cold and flu season on the West Coast in fiscal 2007 compared to fiscal 2006. Pharmacy sales were 50.4% of total drug store sales in fiscal 2007, compared to 48.5% in fiscal 2006. Third-party health plans covered 94.4% of our pharmacy sales in fiscal 2007, compared to 92.6% in fiscal 2006.

 

Front-end sales decreased 0.2% in fiscal 2007 from fiscal 2006, with same-store front-end sales decreasing 0.9%. The decline in same-store front-end sales was primarily due to lower sales in our non-core categories and a continued industry-wide decline in photo processing sales due to consumers’ continued migration to digital photography technology.

 

Pharmacy Benefit Services Revenues

 

The increase in pharmacy benefit services revenues in fiscal 2007 was primarily due to an increase of $264.5 million related to the prescription drug plans we began offering on January 1, 2006 under Medicare Part D as established by the Medicare Prescription Drug, Improvement and Modernization Act of 2003. Fiscal 2007 represented the first full year of operations for these plans. Our plans covered approximately 220,000 Medicare beneficiaries in all 50 states and the District of Columbia as of the end of fiscal 2007.

 

The Medicare prescription drug benefit also contributed to the 6.4% increase in our pharmacy benefit management revenues in fiscal 2007 over the fiscal 2006, partially as a result of RxAmerica providing pharmacy benefit management services to Medicare Advantage prescription drug plans.

 

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Gross Profit

 

     Fiscal Year

 
     2008

    2007

    2006

 

Retail drug store gross profit (thousands)

   $ 1,268,058     $ 1,168,323     $ 1,158,147  

Retail drug store gross profit margin

     26.0 %     25.1 %     25.8 %

LIFO provision (thousands)

   $ 9,086     $ 12,750     $ 4,800  

Prescription drug plan gross profit (thousands)

   $ 47,192     $ 51,540     $ 3,969  

Prescription drug plan gross profit margin

     15.2 %     18.4 %     24.5 %

 

Fiscal 2008 versus Fiscal 2007

 

Retail Drug Stores

 

Retail drug store gross profit was 26.0% of retail drug store sales in fiscal 2008, compared with 25.1% in fiscal 2007. The increase was primarily due to the increased utilization of generic drugs, which generally have higher gross profit margins than name-brand drugs, lower distribution costs achieved through increased self-distribution, and improved inventory management.

 

Our LIFO provision, which is included in the cost of retail drug store sales, was $9.1 million in fiscal 2008 and $12.8 million in fiscal 2007. The decrease was primarily due to lower net inflation compared with last year. The LIFO provision fluctuates with inflation rates, inventory levels and merchandise mix.

 

We will continue to pursue gross profit improvements through our merchandise focus on core categories, private label brands, supply chain systems and self distribution. We also expect that the utilization of lower-priced, higher-margin generic drugs will continue to increase through the first half of fiscal 2009. We expect that continued efforts by third-party health plans, including Medicare and other government-sponsored plans, to reduce prescription drug reimbursement levels, will at least partially offset these favorable effects on our gross profit percentage.

 

In addition to the acquisition cost of inventory sold (net of merchandise rebates and allowances), we include in-bound freight, receiving, warehousing, purchasing and distribution costs, and advertising expenses (net of advertising rebates and allowances) in our cost of retail drug store sales. We classify store occupancy costs as a component of operating and administrative expenses. Our retail drug store gross profit margins may not be comparable to those of some other retailers who include distribution and advertising costs in their operating expenses, or store occupancy costs in their cost of sales.

 

Prescription Drug Plans (Pharmacy Benefit Services Segment)

 

Prescription drug plan benefit costs relate only to prescription drug plan revenues. Revenues generated from pharmacy benefit management services are reported net of reimbursements to participating pharmacies.

 

Prescription drug plan gross profit was 15.2% of prescription drug plan revenues in fiscal 2008 compared with 18.4% in fiscal 2007. The decrease was due to lower average premiums as a result of our bids for the calendar 2007 plan year compared with the calendar 2006 plan year. We began offering prescription drug plans through our pharmacy benefit services segment on January 1, 2006 under Medicare Part D as established by the Medicare Prescription Drug, Improvement and Modernization Act of 2003. Prescription drug plan benefit costs represent our portion of the cost of prescription drugs purchased by Medicare participants in one of our prescription drug plans. Such costs include benefit payments during the period to pharmacies, and an estimate for benefit costs incurred but not reported as of the end of the period, reduced by associated manufacturer rebates.

 

As a result of the Medicare Part D benefit design, the Company incurs a disproportionate amount of prescription drug plan benefit costs early in the contract year. For example, as of January 1, 2008, for most of its plans the Company is responsible for approximately 67% of a Medicare beneficiary’s drug costs up to $2,510,

 

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while the beneficiary is responsible for 100% of their drug costs from $2,510 up to $5,726. The Company is responsible for 15% of a beneficiary’s drug costs above $5,726.

 

We expect our prescription drug plan gross profit margin to decrease in fiscal 2009 as a result of our bids for the calendar 2008 plan year, which reflect our goal to grow the operating income by remaining a low-cost provider in a highly competitive industry.

 

Fiscal 2007 versus Fiscal 2006

 

Retail Drug Stores

 

Retail drug store gross profit was 25.1% of retail drug store sales in fiscal 2007, compared with 25.8% in fiscal 2006. The decrease was due to a number of factors including reductions in prescription drug reimbursement levels associated with the new Medicare prescription drug benefit, the pharmacy sales mix shift toward Medicare beneficiaries, the mix of pharmacy and front-end sales and a higher LIFO provision. These increases were partially offset by a more profitable merchandise mix through better buying, lower distribution costs and increased utilization of generic drugs, which generally have higher gross profit margins than name-brand drugs.

 

Our LIFO provision, which is included in the cost of retail drug store sales, was $12.8 million in fiscal 2007 and $4.8 million in fiscal 2006. The increase was primarily due to higher net inflation compared to last year as well as higher inventories. The LIFO provision fluctuates with inflation rates, inventory levels and merchandise mix.

 

Prescription Drug Plans (Pharmacy Benefit Services Segment)

 

Prescription drug plan gross profit was 18.4% of prescription drug plan revenues in fiscal 2007 compared with 24.5% in 2006. We began offering prescription drug plans through our pharmacy benefit services segment on January 1, 2006 under Medicare Part D.

 

Operating and Administrative Expenses

 

Operating and administrative expenses were 23.0% of revenues in fiscal 2008, compared with 22.6% in fiscal 2007 and 23.7% in fiscal 2006. The expense rate increased in fiscal 2008 compared with fiscal 2007 primarily due to new store openings and the continued growth of our pharmacy benefit services segment. The expense rate decreased in fiscal 2007 compared with fiscal 2006 due to better leverage on higher fiscal 2007 revenues, primarily as a result of our new prescription drug plans. Fiscal 2007 operating expenses included increased expenses related to our new prescription drug plans and increased new store opening activities, including the Network Pharmaceuticals, Inc., asset acquisition, as well as $4.6 million in stock option expense as a result of the adoption of SFAS No, 123R, Share Based Payment and $3.7 million of costs related to the transition to our new Patterson distribution center.

 

Provision for Store Closures and Asset Impairments

 

The provision for store closures and asset impairments of $8.5 million in fiscal 2008 primarily includes lease-related costs, net of estimated sublease income, related to the disposition of stores in California as announced in February 2007. We closed or sold seven of the eight stores during the first half of fiscal 2008, and one store previously included in this disposition plan will remain open. Additional charges or gains related to this disposition of stores may be incurred as a result of changes to management’s current estimates and assumptions regarding the disposition of the remaining store locations. The timing of future charges and gains related to this disposition are subject to significant uncertainty including the variability in future vacancy periods and sublease income. Costs related to the disposition of 23 stores in Washington, Oregon and Colorado pursuant to this disposition plan are included in discontinued operations. See Note 3 to our Condensed Consolidated Financial Statements and “Discontinued Operations” below for further information.

 

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The provision for store closures and asset impairments in fiscal 2007 included $2.3 million for asset impairment charges related to the disposition of stores in California as announced in February 2007.

 

Gain on Sale of Distribution Center

 

During fiscal 2006, we entered into a sale-leaseback transaction for our Northern California front-end distribution center located in Lathrop, California, for net proceeds of $21.5 million and a resulting net gain of $11.0 million. We vacated the Lathrop facility during the fourth quarter of fiscal 2007 when our newly constructed distribution center in Patterson, California, became fully operational.

 

Net Interest Expense

 

Net interest expense was $7.8 million in fiscal 2008, $6.8 million in fiscal 2007 and $7.9 million in fiscal 2006. The increase in fiscal 2008 net interest expense was due to higher average borrowings, lower capitalized interest and less invested cash.

 

Income Taxes

 

Our effective income tax rate varies based on the level of our pre-tax income and the amount of certain tax deductions and credits. Our effective income tax rates from continuing operations were 36.9% in fiscal 2008, 36.3% in fiscal 2007, and 37.6% in fiscal 2006. We expect that our effective income tax rate will be approximately 38% in fiscal 2009.

 

Discontinued Operations

 

In February 2007, we announced a plan to dispose of 31 stores during fiscal 2008, including all of the 23 stores located in Washington, Oregon and Colorado and eight stores in California. Most of the stores were located in markets we entered in the 1980s and 1990s that remained underdeveloped. Sufficiently developing our presence in these markets would have required significant investment that we believed would be better directed toward markets that offer greater opportunities for more satisfactory returns. As of January 31, 2008, we had closed 30 of these stores. One California store previously included in this disposition plan will remain open. Twenty-four of the store locations have been sold or sub-leased and the remainder are being actively marketed.

 

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, the stores located in Washington, Oregon and Colorado are reported as discontinued operations effective in fiscal 2008, and as such both current and prior year results for these stores are classified within discontinued operations on our statements of consolidated income. The stores located in California continue to be reported within continuing operations.

 

For the 23 stores located in Washington, Oregon and Colorado, we incurred a pre-tax net loss of $4.5 million ($2.7 million after tax) in discontinued operations during fiscal 2008. This pre-tax net loss included costs of $11.1 million for lease-related costs net of estimated sublease rental income and $3.2 million for employee severance, and pre-tax operating losses of $8.0 million, offset by $17.8 million of pre-tax gains on the sale of store properties and related assets. Additional charges or gains related to this disposition of stores may be incurred as a result of sales of property or changes to our current estimates and assumptions regarding the disposition of the remaining store locations. The timing of future transactions and charges related to this disposition are subject to significant uncertainty including the variability in future vacancy periods, sublease income and the timing of property sales.

 

Fiscal 2007 and 2006 losses from discontinued operations of $5.0 million and $2.2 million, respectively, represent the operating losses for the 23 stores located in Washington, Oregon and Colorado.

 

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LIQUIDITY AND CAPITAL RESOURCES

 

General

 

Our primary sources of liquidity are operating cash flows and availability on our line of credit. We use cash to provide working capital for our operations, finance capital expenditures and acquisitions, repay debt, repurchase shares of our common stock and pay dividends.

 

We have a secured revolving line of credit with a syndication of banks, which expires in January 2012 and accrues interest at LIBOR-based rates. On October 30, 2007, we exercised an option to increase the credit facility’s borrowing and letter of credit capacity from $325 million to $400 million. Borrowings on this line of credit are secured by inventory, accounts receivable and certain intangible assets. As of January 31, 2008, borrowings of $167 million with a weighted average interest rate of 5.29% were outstanding on the secured line of credit. The secured revolving line of credit agreement contains customary restrictions but no financial covenants and no limitations on capital expenditures or share repurchases if availability of credit remains above a minimum level. Borrowings on the line of credit do not require repayment until the expiration date but may be prepaid without penalty. We pay a commitment fee of 0.25% per annum on the unused portion of the line of credit.

 

Additionally, as of January 31, 2008, we had $53.1 million in outstanding privately placed promissory notes. These notes, which mature at various dates through 2014, bear interest at fixed rates ranging from 6.19% to 6.71%, and are secured on the same basis as the secured revolving line of credit. The notes include penalties for repayment prior to their scheduled maturities. Current maturities of $36.7 million as of January 31, 2008 constitute regularly scheduled principal payments due in the next twelve months, the majority of which will be paid in the third quarter of fiscal 2009.

 

The privately placed promissory notes contain various customary financial covenants and restrictions. Failure to comply with these covenants and restrictions, or with the restrictions included in our secured revolving line of credit, could result in higher interest costs and potentially accelerated repayment requirements, and could affect our liquidity. As of January 31, 2008, we were in compliance with the restrictions and limitations included in these provisions.

 

We believe that cash on hand, together with cash provided by operating activities and borrowings on our line of credit, will be sufficient to meet our working capital, capital expenditure and debt service requirements beyond the next 12 months.

 

Operating Cash Flows

 

Net cash provided by operating activities was $218.3 million in fiscal 2008 compared with $183.0 million in fiscal 2007, and $202.3 million in fiscal 2006. The increase in our operating cash flows in fiscal 2008 from fiscal 2007 was primarily due to higher net income adjusted for non-cash expenses, including the provision for store closures and asset impairments, stock-based compensation expense, and depreciation and amortization. The decrease in our operating cash flows in fiscal 2007 from fiscal 2006 was primarily due to changes in operating assets and liabilities, partially offset by increased net income after adjustments for non-cash items including the provision for store closures and asset impairments, stock-based compensation expenses and the fiscal 2006 gain on the sale of our distribution center.

 

Net changes in assets and liabilities and deferred taxes decreased our operating cash flows in fiscal 2008 by $8.6 million. Merchandise inventories increased $20.9 million primarily due to increased self distribution of front-end merchandise through our Patterson, California distribution center. Accounts receivable (excluding receivables for claims payments covered by CMS which are included in financing cash flows) increased $20.4 million primarily due to increased pharmacy benefit services receivables related to the continued growth of that business. Current and other liabilities increased $52.7 million as a result of higher accounts payable on higher

 

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inventory levels and growth in pharmacy benefit payables due to the continued growth of that business. The change in current liabilities and deferred taxes also includes cash payments for income taxes of $63.6 million during fiscal 2008, up $5.2 million from fiscal 2007 due to increased taxable income and the effects of tax planning and optimization projects that increased certain tax deductions in previous years.

 

Net changes in assets and liabilities and deferred taxes decreased our operating cash flows in fiscal 2007 by $12.5 million. Accounts receivable (excluding receivables for claims payments covered by CMS which are included in financing cash flows) increased $64.1 million primarily due to increased pharmacy benefit services receivables related to our new prescription drug plans, in addition to higher pharmacy sales. Merchandise inventories increased $26.4 million primarily due to increased self-distribution of front-end merchandise associated with the opening of our new distribution center in Patterson, California, and new store growth. Current and other liabilities increased $94.1 million primarily as a result of increased pharmacy benefit services payables related to our new prescription drug plans. The change in current liabilities and deferred taxes also includes cash payments for income taxes of $58.5 million during fiscal 2007, up $37.0 million from fiscal 2006 due to increased taxable income and the effects of tax planning and optimization projects that increased certain tax deductions in previous years.

 

Net changes in assets and liabilities and deferred taxes accounted for $31.7 million of our operating cash flows in fiscal 2006. Current and other liabilities increased $73.2 million primarily as a result of the $28.8 million increase in merchandise inventories and increased pharmacy benefit services payables related to our new prescription drug plans. Pharmacy and other receivables increased $24.9 million due to higher pharmacy sales and pharmacy benefit services revenues.

 

Investing Cash Flows

 

Net cash used in investing activities was $169.5 million in fiscal 2008 compared with $166.0 million in fiscal 2007 and $77.7 million in fiscal 2006. Capital expenditures and acquisitions increased $22.5 million in fiscal 2008 over fiscal 2007 due to increased new store construction, remodel costs and acquisitions of pharmacies, pharmacy prescription files and a registered insurance company (see Note 4 to our consolidated financial statements). These increases were largely offset by proceeds of $20.6 million from the dispositions of property and intangible assets, primarily related to the disposition of 30 stores pursuant to a plan approved by our board of directors in February 2007. The increase in fiscal 2007 over fiscal 2006 was primarily due to expenditures for the construction of our new front-end distribution center in Patterson, California, as well as increased new store construction activity. In addition, during the second quarter of fiscal 2007 we purchased the assets of Network Pharmaceuticals, Inc. including 21 retail pharmacies and one closed door pharmacy for approximately $12.8 million. During the first quarter of fiscal 2007, we also purchased AmerisourceBergen’s 50% interest in a joint venture through which we and AmerisourceBergen operated a central prescription fill center for approximately $3.8 million. In addition to the Network Pharmaceuticals acquisition, we also opened 16 new stores, closed four stores, and remodeled 40 stores during fiscal 2007. Fiscal 2006 net investing cash flows were also reduced by $27.8 million for proceeds from property dispositions, primarily including the sale-leaseback of our Lathrop front-end distribution center.

 

We plan to open or relocate approximately 20 to 30 stores and remodel up to 40 stores in fiscal 2009. We expect capital expenditures in fiscal 2009 to be between $150 million and $200 million. In addition, in the ordinary course of business we may acquire stores, store-related assets including pharmacy customer lists, or other complementary businesses.

 

Financing Cash Flows

 

Net cash used in financing activities was $49.3 million in fiscal 2008, compared with $64.0 million in fiscal 2007 and $103.8 million in fiscal 2006. Our financing activities primarily consist of long-term borrowings and repayments, repurchases of common stock, dividend payments, proceeds from the exercise of stock options, and Medicare Part D subsidy receipts and disbursements.

 

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Our borrowing levels on our revolving line of credit fluctuate based largely on the levels of our cash flows from operations, capital expenditures, net Medicare Part D subsidy receipts and disbursements, and stock repurchases. There were net borrowings of $102.0 million on our revolving line of credit during fiscal 2008, compared with net borrowings of $65.0 million in fiscal 2007 and net repayments of $40.0 million in fiscal 2006. We also made regularly scheduled principal payments of $6.7 million on our private placement notes in fiscal 2008, compared with payments of $45.9 million in fiscal 2007 and $8.9 million in fiscal 2006. We are scheduled to make additional principal payments of $36.7 million on our private placement notes in the next 12 months.

 

We repurchased 2,474,000 shares of our outstanding common stock in fiscal 2008 at a total cost of $119.8 million. In fiscal 2007, we repurchased 984,000 shares at a total cost of $44.1 million. In fiscal 2006, we repurchased 1.4 million shares at a total cost of $55.1 million. These shares were repurchased under two separate programs authorized by our board of directors, in November 2007 and May 2005. In May 2005, our board of directors authorized the repurchase of up to $150 million of our outstanding common stock through May 2008. In November 2007, our board of directors authorized the additional repurchase of up to $200 million of our outstanding common stock through February 2011. Under the November 2007 share repurchase program, we are authorized to repurchase additional shares of our common stock for a maximum additional expenditure of $156.3 million. We have completed the May 2005 share repurchase program. Any future repurchase of our common stock will be made in open market transactions from time-to-time depending on market conditions and the availability of funds.

 

Our board of directors makes decisions about the declaration of quarterly dividends based on, among other things, our results of operations and financial position. We paid regular quarterly dividends totaling $21.2 million, $21.0 million and $20.8 million in fiscal 2008, 2007 and 2006, respectively.

 

Financing cash flows include prescription drug plan disbursements covered by CMS, including reinsurance payments and low-income cost subsidies, net of amounts received from CMS for these payments. Differences between receipts and payments for these amounts depend on the timing and extent of the related claims from beneficiaries. In fiscal 2008, our payments for these claims exceeded reimbursements from CMS by $31.9 million, compared with $35.4 million in fiscal 2007. Final settlement of the outstanding balance with CMS is made subsequent to the end of the plan year.

 

Contractual Obligations

 

The following table summarizes our contractual obligations as of January 31, 2008:

 

     Payments due by period

     Total

   Less than
1 year

   1-3 years

   3-5 years

   More than
5 years


     Thousands

Long-term debt

   $ 226,501    $ 40,096    $ 7,143    $ 173,468    $ 5,794

Operating leases

     1,034,389      83,319      164,333      148,548      638,189

Capital lease obligations

     20,505      1,048      2,096      2,163      15,198

Purchase obligations

     5,493,453      2,197,039      3,296,414      —        —  

Other long-term liabilities

     —        —        —        —        —  
    

  

  

  

  

Total

   $ 6,774,848    $ 2,321,502    $ 3,469,986    $ 324,179    $ 659,181
    

  

  

  

  

 

See “Debt,” “Leases” and “Commitments and Contingencies” in the accompanying notes to our consolidated financial statements for further information about the above items.

 

Purchase obligations include merchandise purchase commitments under various long-term supply contracts, as well as outstanding commitments under purchase orders issued in the normal course of business. Purchase obligations include estimated amounts to purchase pharmaceutical inventories from AmerisourceBergen, our primary supplier, under a long-term contract. The contract includes a minimum purchase requirement over the contract term, which is effective for three to seven years depending on our actual purchase levels and various

 

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termination provisions. The amounts included for this contract in the above table represent our best estimate of purchase levels under the contract’s terms.

 

Our other long-term liabilities of $105.4 million as of January 31, 2008 consisted of deferred rent, deferred income taxes, store closure reserves, capital lease obligations, long-term taxes payable and deferred gains on sale-leaseback transactions. These items either are not contractual obligations, such as deferred rent, deferred income taxes and deferred gains on sale-leaseback transactions, or are included elsewhere in the above table, such as capital and closed store lease obligations. See further discussion of income taxes below.

 

We incur substantial cash requirements for the payment of interest and income taxes each year. Payments for interest fluctuate based on our borrowings and interest rates. Our cash payments for interest, net of amounts capitalized, were $8.6 million in fiscal 2008, $9.4 million in fiscal 2007 and $9.2 million in fiscal 2006. At January 31, 2008, $53.1 million of our outstanding debt bears interest at fixed rates. Scheduled interest payments on fixed-interest long-term debt are included in “Long-Term Debt” in the table above. Our unsecured revolving line of credit, on which borrowings of $167 million were outstanding as of January 31, 2008, bears interest at LIBOR-based rates, and therefore an increase in interest rates could increase our interest expense and cash payments for interest. We do not currently undertake any specific actions to cover our exposure to interest rate risk and we are not currently a party to any interest rate risk management transactions. We have not purchased and do not currently hold any derivative financial instruments. Depending on the interest rate environment and subject to approval by our board of directors, we may make use of derivative financial instruments or other interest rate management vehicles in the future.

 

Our cash payments for income taxes were $63.6 million in fiscal 2008, $58.5 million in fiscal 2007 and $21.4 million in fiscal 2006. Cash paid for income taxes increased $5.0 million in fiscal 2008 due to higher taxable income and the effects of tax planning and optimization projects that increased certain tax deductions in previous years. Payments for income taxes fluctuate based on our taxable income and the availability and timing of tax deductions and credits. Our liability for unrecognized tax benefits is not material, and the periods in which such unrecognized amounts will be settled cannot be estimated at this time. During fiscal 2008, the Internal Revenue Service commenced an examination of our federal income tax returns for the years ended January 29, 2004 and January 27, 2005. It is reasonably possible that the outcome of this examination could result in an adjustment to our unrecognized tax benefits in the next 12 months. However, the amount and timing of the adjustment, if any, cannot be estimated at this time.

 

We also incur obligations for contributions to our 401(k) plan. We match a portion of our employees’ voluntary contributions and, prior to January 1, 2008, provided profit sharing contributions to the plan in some years. Effective January 1, 2008, we discontinued the profit sharing benefit and added an enhanced 401(k) matching contribution. Our future contributions to the plan, which may be made in cash or in shares of our common stock, will fluctuate based on the level of participation in the plan by our employees. Our contributions to this plan were $13.6 million for fiscal 2008, $12.1 million for fiscal 2007, and $11.3 million for fiscal 2006, all of which we funded with shares of our common stock.

 

OFF-BALANCE SHEET ARRANGEMENTS

 

We do not make use of any off-balance sheet arrangements that currently have or that we expect are reasonably likely to have a material effect on our financial condition, results of operations or cash flows. We utilize operating leases for many of our store locations, and from time to time we engage in sale-leaseback arrangements for financing purposes. We do not use special-purpose entities in any of our leasing arrangements.

 

CRITICAL ACCOUNTING POLICIES

 

The preparation of our financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of our assets and liabilities, disclosure of contingent assets and liabilities and the reported amounts of revenues and

 

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expenses during the reporting period. Uncertainties regarding such estimates and assumptions are inherent in the preparation of our financial statements, and actual results may differ from those estimates and assumptions. We believe the following critical accounting policies require the most significant judgments and estimates used in the preparation of our consolidated financial statements:

 

Accounts Receivable and Reserves

 

Our accounts receivable primarily include amounts due from third-party providers (e.g. pharmacy benefit managers, insurance companies and governmental agencies) and vendors. We maintain an allowance for the amount of these receivables that we estimate to be uncollectible. Our estimates of uncollectible amounts are based on our historical collection experience, current economic and credit conditions and any information available to us indicating that specific accounts are unlikely to be collected. We have historically collected a relatively high percentage of our accounts receivable, especially pharmacy receivables, and our credit and collection losses have not materially adversely affected us. However, if the financial condition of our third-party providers or vendors deteriorates, we may increase the allowance for uncollectible accounts and our recovery of recorded receivables may be significantly affected.

 

The gross accounts receivable that are covered by this critical accounting policy were approximately $343 million as of January 31, 2008, $292 million as of January 25, 2007 and $189 million as of January 26, 2006. Our allowance for uncollectible accounts was $8.1 million as of January 31, 2008, $8.8 million as of January 25, 2007 and $5.8 million as of January 26, 2006. Our provisions for uncollectible accounts charged to expense have not been significant in any of the last three years, and we have recorded no significant adjustments related to these receivables or related reserves as a result of changes in our estimates or assumptions. While we do not currently anticipate significant future adjustments to our estimates and assumptions related to our allowance for uncollectible accounts, such amounts are subject to external factors outside of our control, such as the financial condition of our third-party providers and vendors. As such, we cannot predict the nature or magnitude of potential future changes in facts and circumstances that could cause us to record significant adjustments to our allowance for uncollectible accounts.

 

Our accounts receivable also include amounts due from the federal Centers for Medicare and Medicaid Services (CMS) for certain subsidies related to our prescription drug plan benefits, amounting to $82.3 million as of January 31, 2008 and $36.5 million as of January 25, 2007. These amounts include estimated amounts due from other Medicare prescription drug plans and state sponsored plans to be paid upon completion of an annual reconciliation by CMS of enrollment between and among plans. A final plan reconciliation occurs subsequent to each respective plan year. Although we did not record a significant adjustment to the receivable balance as of January 25, 2007, the first year of the new plan, due to the relatively new nature of these plans, the results of the plan reconciliations are uncertain. If the outcome of this reconciliation process is significantly different than our current estimates, we may need to record significant adjustments to the value of our receivables.

 

Impairment of Long-Lived Assets

 

We review long-lived tangible assets and intangible assets with finite useful lives for impairment whenever events or changes in circumstances indicate that their carrying values may not be recoverable. Using our best estimates based on reasonable assumptions and projections, we record an impairment loss to write the assets down to their estimated fair values if the carrying values of such assets exceed their related undiscounted expected future cash flows.

 

We review goodwill and other intangible assets with indefinite useful lives for impairment annually, or more frequently if events or changes in circumstances warrant. We perform our annual impairment testing during the fourth fiscal quarter, when updated financial projections are available. If the carrying values of such assets exceed their estimated fair values, we record an impairment loss to write the assets down to their estimated fair values.

 

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We generally evaluate store-specific long-lived tangible assets and intangible assets with finite useful lives at an individual store level, which is the lowest level at which independent cash flows can be identified. We evaluate corporate assets or other long-lived assets that are not store-specific at a consolidated entity or segment level as appropriate. We evaluate goodwill at a reporting unit level in accordance with SFAS No. 142, Goodwill and Other Intangible Assets. Geographic regional divisions within the retail drug store segment comprise our reporting units.

 

Since quoted market prices are not typically available for our long-lived tangible and intangible assets, we estimate fair values for most assets based on the expected present value of future cash flows. We estimate future cash flows based on store-level historical results, current trends and operating and cash flow projections. Our estimates are subject to substantial uncertainty and may be affected by a number of factors outside of our control, including general economic conditions, the competitive environment and regulatory changes. If actual results differ from our estimates, we may record significant additional impairment charges in the future.

 

The net book value of our long-lived assets, including goodwill and other intangible assets, covered by this critical accounting policy was approximately $876 million as of January 31, 2008, $800 million as of January 25, 2007 and $704 million as of January 26, 2006. We recorded asset impairment charges of $2.1 million and $2.4 million in income from continuing operations for fiscal years 2007 and 2006, respectively. We recorded no asset impairment charges in fiscal 2008. We also recorded asset impairment charges of $5.6 million in discontinued operations for fiscal year 2007 related to our disposition of 23 stores in Washington, Oregon and Colorado. Although we believe the estimates and assumptions on which we based our recorded impairment charges are reasonable, we cannot predict the nature or magnitude of potential future changes in facts or circumstances outside of our control, or in our future plans and activities related to our long-lived assets, that could cause us to record significant additional impairment charges.

 

Store Closure Reserves

 

We recognize a liability for costs associated with closing a store when the liability is incurred. We record the present value of estimated remaining future lease obligations (including future property taxes, common area maintenance and other charges, as applicable), net of estimated future sublease income, when the store is closed. We record severance and other employee-related costs in the period in which we communicate the closure and related severance packages to the affected employees.

 

Our initial calculation and subsequent evaluations of store closure reserves include significant estimates about the amounts and timing of future sublease income. These estimates are based on our historical experience, the condition and location of the property, the lease terms and current real estate leasing market conditions. Two of our leased closed store locations are not currently subleased, and many of our previously closed stores have long remaining lease terms, with the longest lease term ending February 2029. As a result, if actual results differ from our estimates, we may significantly adjust our store closure reserves in future periods.

 

Our total store closure reserves covered by this critical accounting policy were $11.5 million as of January 31, 2008, $3.5 million as of January 25, 2007 and $2.7 million as of January 26, 2006. These amounts are net of estimated future sublease income of $23.2 million, $11.4 million and $16.6 million, respectively. We recorded provisions for store closures of $8.5 million in fiscal 2008 and $0.7 million in fiscal 2007 in income from continuing operations. We also recorded store closure related gains of $3.5 million in discontinued operations for fiscal 2008. We recorded no provision for store closures in fiscal 2006. Changes in our estimates and assumptions about future sublease income and other lease related costs have not resulted in significant adjustments to our store closure reserves in any of the last three years.

 

Insurance Reserves

 

We maintain insurance coverage for significant exposures as well as those risks that are required to be insured by law. It is generally our policy to retain a significant portion of certain losses related to workers’

 

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compensation, general liability, property losses, pharmacist liability, business interruptions and employee health care. We record provisions for these items based on claims experience, regulatory changes, an estimate of claims incurred but not yet reported and other relevant factors. We discount reserves for workers’ compensation and general liability claims to their expected present value using an essentially risk-free interest rate. The projections involved in this estimate are subject to substantial uncertainty because of several unpredictable factors, including actual claims experience, regulatory changes, litigation trends and changes in inflation and interest rates. If actual claims or costs vary from our estimates, we may need to record significant adjustments to our reserves and expense.

 

Our self-insurance reserves covered by this critical accounting policy declined from $51.1 million as of January 26, 2006, to $46.4 million as of January 25, 2007, and to $36.5 million as of January 31, 2008, due to our focus on a safe work environment, combined with recent changes in California’s workers’ compensation laws. As the effects of these changes continue to become more established, and assuming no further changes to the state’s workers’ compensation laws that adversely affect workers’ compensation costs in the state, future changes in our insurance reserves will likely become less significant.

 

Litigation Reserves

 

We are involved in various lawsuits, claims and federal and state regulatory reviews and actions arising in the normal course of business on an on-going basis. We accrue our best estimate of the probable loss related to legal claims and other proceedings. Such estimates are developed in consultation with in-house and outside counsel, and are based upon a combination of litigation and settlement strategies. To the extent additional information arises or our strategies change, it is possible that our best estimate of the probable liability may also change, which could have a significant adverse impact on our financial condition and result of operations. Changes in our estimates and assumptions about probable losses have not resulted in significant adjustments to our litigation reserves in any of the last three years.

 

Other Significant Accounting Policies

 

The above policies are not intended to be a comprehensive list of all of our accounting policies. In many cases, generally accepted accounting principles specifically dictate the accounting treatment for a particular transaction. There are also certain areas in which management’s judgment in selecting any available alternative would not produce a materially different result. See the accompanying audited consolidated financial statements and notes thereto for a more complete discussion of our accounting policies and other disclosures required by generally accepted accounting principles.

 

NEW ACCOUNTING PRONOUNCEMENTS

 

See Note 2, “New Accounting Pronouncements,” in the accompanying notes to our consolidated financial statements included in Item 8 of this Form 10-K.

 

Item 7A. Quantitative and Qualitative Disclosures of Market Risk.

 

Our major market risk exposure is changing interest rates. We use debt financing in combination with operating cash flows to support capital expenditures, acquisitions, working capital needs, dividend payments, share repurchases and other general corporate purposes. Our revolving line of credit, on which $167 million in borrowings were outstanding as of January 31, 2008, bears interest at LIBOR-based rates, and therefore an increase in interest rates could increase our interest expense. A 10% change in interest rates (53 basis points on our floating-rate debt as of January 31, 2008) would have an immaterial effect on our earnings and cash flows and on the fair value of our fixed rate debt. We do not currently undertake any specific actions to cover our exposure to interest rate risk and we are not currently a party to any interest rate risk management transactions. We have not purchased and do not currently hold any derivative financial instruments. Depending on the interest rate environment and subject to approval by our board of directors, we may make use of derivative financial instruments or other interest rate management vehicles in the future.

 

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Item 8. Financial Statements and Supplementary Data.

 

LONGS DRUG STORES CORPORATION

 

STATEMENTS OF CONSOLIDATED INCOME

 

     For the Fiscal Year Ended

 
     January 31,
2008

    January 25,
2007

    January 26,
2006

 
     (53 weeks)     (52 weeks)     (52 weeks)  
     Thousands Except Per Share Amounts  

Revenues:

                        

Retail drug store sales

   $ 4,882,827     $ 4,652,940     $ 4,491,752  

Pharmacy benefit services revenues

     379,738       320,356       53,457  

Total revenues

     5,262,565       4,973,296       4,545,209  
    


 


 


Costs and expenses:

                        

Cost of retail drug store sales

     3,614,769       3,484,617       3,333,605  

Prescription drug plan benefit costs

     263,608       229,179       12,232  

Operating and administrative expenses

     1,211,561       1,126,019       1,078,121  

Provision for store closures and asset impairments, net

     8,495       2,778       2,397  

Legal settlements and other disputes, net

     (431 )     (930 )     —    

Gain on sale of distribution center

     —         —         (11,049 )
    


 


 


Operating income

     164,563       131,633       129,903  

Interest expense

     8,913       9,118       9,151  

Interest income

     (1,150 )     (2,272 )     (1,294 )
    


 


 


Income from continuing operations before income taxes

     156,800       124,787       122,046  

Income taxes

     57,909       45,334       45,922  
    


 


 


Income from continuing operations

     98,891       79,453       76,124  

Loss from discontinued operations, net of tax (Note 3)

     (2,690 )     (4,992 )     (2,237 )
    


 


 


Net income

   $ 96,201     $ 74,461     $ 73,887  
    


 


 


Earnings per common share:

                        

Basic:

                        

Income from continuing operations

   $ 2.65     $ 2.14     $ 2.04  

Loss from discontinued operations

     (0.07 )     (0.14 )     (0.06 )
    


 


 


Net income

   $ 2.58     $ 2.00     $ 1.98  
    


 


 


Diluted:

                        

Income from continuing operations

   $ 2.59     $ 2.08     $ 1.99  

Loss from discontinued operations

     (0.07 )     (0.13 )     (0.06 )
    


 


 


Net income

   $ 2.52     $ 1.95     $ 1.93  
    


 


 


Dividends per common share

   $ 0.56     $ 0.56     $ 0.56  

Weighted average number of shares outstanding:

                        

Basic

     37,294       37,201       37,332  

Diluted

     38,232       38,181       38,280  

 

See accompanying notes to consolidated financial statements.

 

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LONGS DRUG STORES CORPORATION

 

CONSOLIDATED BALANCE SHEETS

 

     January 31,
        2008        


   January 25,
        2007        


     Thousands Except Share Information
Assets              

Current Assets:

             

Cash and cash equivalents

   $ 27,019    $ 27,596

Accounts receivable, net

     334,972      282,728

Merchandise inventories, net

     510,482      491,295

Deferred income taxes

     64,500      60,153

Prepaid expenses and other current assets

     22,043      22,017

Assets held for sale (Note 3)

     4,173      —  
    

  

Total current assets

     963,189      883,789
    

  

Property:

             

Land

     116,564      116,171

Buildings and leasehold improvements

     725,930      668,800

Equipment and fixtures

     628,556      621,068
    

  

Total

     1,471,050      1,406,039

Less accumulated depreciation

     715,682      705,856
    

  

Property, net

     755,368      700,183
    

  

Goodwill

     84,394      84,450

Intangible assets, net

     32,240      14,904

Other non-current assets

     11,525      4,342
    

  

Total assets

   $ 1,846,716    $ 1,687,668
    

  

Liabilities and Stockholders’ Equity              

Current Liabilities:

             

Trade accounts payable

   $ 273,953    $ 230,754

Pharmacy benefits payable

     176,829      148,595

Accrued employee compensation and benefits

     120,458      131,088

Taxes payable

     58,998      59,715

Other accrued expenses

     63,110      73,682

Current maturities of debt

     36,727      6,727
    

  

Total current liabilities

     730,075      650,561
    

  

Long-term debt

     183,364      118,091

Other long-term liabilities

     105,352      103,459
    

  

Total liabilities

     1,018,791      872,111
    

  

Commitments and Contingencies

             

Stockholders’ Equity:

             

Common stock: par value $0.50 per share, 120,000,000 shares authorized, 36,204,000, and 37,406,000 shares outstanding

     18,102      18,703

Additional capital

     288,385      250,113

Retained earnings

     521,438      546,741
    

  

Total stockholders’ equity

     827,925      815,557
    

  

Total liabilities and stockholders’ equity

   $ 1,846,716    $ 1,687,668
    

  

 

See accompanying notes to consolidated financial statements.

 

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LONGS DRUG STORES CORPORATION

 

STATEMENTS OF CONSOLIDATED CASH FLOWS

 

     For the Fiscal Year Ended

 
     January 31,
2008

    January 25,
2007

    January 26,
2006

 
     (53 weeks)     (52 weeks)     (52 weeks)  
     Thousands  

Operating Activities:

                        

Net income

   $ 96,201     $ 74,461     $ 73,887  

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

                        

Depreciation and amortization

     96,618       88,563       83,539  

Gain on sale of distribution center

     —         —         (11,049 )

Provision for store closures and asset impairments, net

     4,986       8,363       2,397  

Deferred income taxes and other

     (19,475 )     (15,441 )     9,474  

Stock awards and options, net

     24,536       19,808       13,714  

Excess tax benefits related to stock awards and options

     (8,926 )     (4,339 )     —    

Common stock contribution to employee retirement plan

     13,435       10,669       8,104  

Changes in assets and liabilities:

                        

Accounts receivable

     (20,394 )     (64,082 )     (24,868 )

Merchandise inventories

     (20,887 )     (26,414 )     (28,750 )

Other assets

     (540 )     (2,681 )     2,658  

Current liabilities and other

     52,745       94,061       73,195  
    


 


 


Net cash provided by operating activities

     218,299       182,968       202,301  
    


 


 


Investing Activities:

                        

Capital expenditures

     (162,365 )     (149,734 )     (105,492 )

Acquisitions

     (27,788 )     (17,953 )     —    

Proceeds from dispositions of property and intangible assets

     20,618       1,685       27,794  
    


 


 


Net cash used in investing activities

     (169,535 )     (166,002 )     (77,698 )
    


 


 


Financing Activities:

                        

Proceeds from (repayments of) revolving line of credit borrowings, net

     102,000       65,000       (40,000 )

Repayments of private placement notes and other borrowings

     (6,727 )     (45,870 )     (8,870 )

Repurchase of common stock

     (119,788 )     (44,134 )     (55,129 )

Proceeds from exercise of stock options

     19,693       13,117       20,986  

Dividend payments

     (21,183 )     (20,953 )     (20,818 )

Medicare Part D subsidy disbursements, net

     (31,850 )     (35,433 )     —    

Excess tax benefits related to stock awards and options

     8,926       4,339       —    

Other

     (412 )     (98 )     —    
    


 


 


Net cash used in financing activities

     (49,341 )     (64,032 )     (103,831 )
    


 


 


Increase (decrease) in cash and cash equivalents

     (577 )     (47,066 )     20,772  

Cash and cash equivalents at beginning of year

     27,596       74,662       53,890  
    


 


 


Cash and cash equivalents at end of year

   $ 27,019     $ 27,596     $ 74,662  
    


 


 


Supplemental disclosure of cash flow information:

                        

Cash paid for interest, net of amounts capitalized

   $ 8,580     $ 9,435     $ 9,210  

Cash paid for income taxes

     63,644       58,471       21,441  

 

See accompanying notes to consolidated financial statements.

 

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LONGS DRUG STORES CORPORATION

 

STATEMENTS OF CONSOLIDATED STOCKHOLDERS’ EQUITY

 

     Common Stock

    Additional
Capital

    Retained
Earnings


    Total
Stockholders’
Equity

 
     Shares

    Amount

       
     Thousands  

Balance at January 27, 2005

   37,418     $ 18,709     $ 178,544     $ 524,592     $ 721,845  

Net income

                           73,887       73,887  

Dividends ($0.56 per share)

                           (20,818 )     (20,818 )

Stock contributions to employee retirement plan

   228       114       7,990               8,104  

Stock awards, net of forfeitures

   42       21       (336 )             (315 )

Stock-based compensation expense

                   6,996               6,996  

Stock options exercised

   948       474       20,512               20,986  

Tax benefit related to stock awards and stock options, net

                   7,033               7,033  

Repurchase of common stock

   (1,420 )     (710 )     (7,365 )     (47,054 )     (55,129 )
    

 


 


 


 


Balance at January 26, 2006

   37,216       18,608       213,374       530,607       762,589  
    

 


 


 


 


Net income

                           74,461       74,461  

Dividends ($0.56 per share)

                           (20,953 )     (20,953 )

Stock contributions to employee retirement plan

   258       129       10,540               10,669  

Stock awards, net of forfeitures

   340       170       (1,597 )             (1,427 )

Stock-based compensation expense

                   15,320               15,320  

Stock options exercised

   576       288       12,829               13,117  

Tax benefit related to stock awards and stock options, net

                   5,915               5,915  

Repurchase of common stock

   (984 )     (492 )     (6,268 )     (37,374 )     (44,134 )
    

 


 


 


 


Balance at January 25, 2007

   37,406       18,703       250,113       546,741       815,557  
    

 


 


 


 


Cumulative effect of accounting change (Note 2)

                           (526 )     (526 )

Net income

                           96,201       96,201  

Dividends ($0.56 per share)

                           (21,183 )     (21,183 )

Stock contributions to employee retirement plan

   278       139       13,296               13,435  

Stock awards, net of forfeitures

   144       72       (5,556 )             (5,484 )

Stock-based compensation expense

                   19,926               19,926  

Stock options exercised

   850       425       19,268               19,693  

Tax benefit related to stock awards and stock options, net

                   10,094               10,094  

Repurchase of common stock

   (2,474 )     (1,237 )     (18,756 )     (99,795 )     (119,788 )
    

 


 


 


 


Balance at January 31, 2008

   36,204     $ 18,102     $ 288,385     $ 521,438     $ 827,925  
    

 


 


 


 


 

See accompanying notes to consolidated financial statements.

 

37

 


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LONGS DRUG STORES CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

1. The Company and Significant Accounting Policies

 

The Company—Longs Drug Stores Corporation (“Longs” or the “Company”), through its wholly owned subsidiary, Longs Drug Stores California, Inc., operates retail drug stores on the West Coast of the United States and in Hawaii, primarily under the names Longs, Longs Drugs, Longs Drug Stores and Longs Pharmacy. In addition to prescription drugs, the Company’s core front-end merchandise categories include over-the-counter medications, health and beauty products, cosmetics, photo and photo processing, convenience food and beverage items and greeting cards. The Company also sells merchandise in non-core categories such as housewares, automotive and sporting goods. The Company also operates a mail order pharmacy business.

 

Longs Drug Stores California, Inc. also provides pharmacy benefit services through its wholly owned subsidiary, RxAmerica L.L.C. (“RxAmerica”). RxAmerica provides a range of pharmacy benefit management services, including plan design and implementation, claims administration and formulary management, to third-party health plans and other organizations. In addition, beginning January 1, 2006, RxAmerica began offering prescription drug plan benefits under Medicare Part D as established by the Medicare Prescription Drug, Improvement and Modernization Act of 2003. The Company provides prescription drug benefits to Medicare participants in all 50 states and the District of Columbia as of January 31, 2008.

 

Basis of Presentation—The consolidated financial statements include the Company and its wholly owned subsidiaries. Inter-company accounts and transactions have been eliminated.

 

Fiscal Year—The Company operates on a 52/53-week fiscal year ending on the last Thursday in January. The fiscal year ended January 31, 2008 (“fiscal 2008”) contained 53 weeks of operations. The fiscal years ended January 25, 2007 (“fiscal 2007”) and January 26, 2006 (“fiscal 2006”) each contained 52 weeks of operations.

 

Reclassifications have been made to certain prior year amounts to conform to the fiscal 2008 presentation. Depreciation and amortization expenses have been combined with operating and administrative expenses on the Company’s statements of consolidated income (depreciation expense related to the Company’s distribution center property is included in cost of retail drug store sales). In addition, the statements of consolidated income for fiscal 2007 and 2006 have been revised to present certain components as discontinued operations (see Note 3).

 

Use of Estimates—The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities and the reported amounts of revenues and expenses during the reporting period. Uncertainties regarding such estimates and assumptions are inherent in the preparation of the Company’s financial statements and actual results may differ from those estimates and assumptions. The Company’s significant accounting judgments and estimates include accounts receivable and reserves, impairment of long-lived assets, store closure reserves, insurance reserves and litigation reserves.

 

Concentrations—Over 90% of the Company’s pharmacy sales are covered by third-party health plans. Medicare and Medicaid together represented approximately 24% of fiscal 2008 pharmacy sales. Medicare also provides for the prescription drug plans offered by RxAmerica. The prescription drug plans are subject to annual bidding and regulatory approval.

 

The Company purchases over 90% of its pharmaceuticals from a single supplier, AmerisourceBergen Drug Corporation (“AmerisourceBergen”), with whom the Company has a long-term supply contract.

 

The Company’s stores, mail order pharmacy operations, distribution centers and corporate offices are located in the western United States, primarily in California and Hawaii.

 

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LONGS DRUG STORES CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Cash and cash equivalents include investments with original maturities of three months or less when purchased. Also included in cash and cash equivalents are credit card and debit card receivables from banks, which typically settle within three business days, of $9.1 million as of January 31, 2008 and $8.6 million as of January 25, 2007.

 

Accounts receivable primarily include amounts due from third-party providers (e.g., pharmacy benefit managers, insurance companies and governmental agencies) and vendors. As of January 31, 2008, and January 25, 2007, accounts receivable also include $82.3 million and $36.5 million, respectively, due from the Centers for Medicare and Medicaid Services (“CMS”) for certain subsidies related to the Company’s prescription drug plan benefits. Receivables are stated net of allowances for uncollectible accounts. Estimates of uncollectible amounts are based on the Company’s historical collection experience, current economic and credit conditions and any information available to the Company indicating that specific accounts are unlikely to be collected.

 

Activity in the allowance for uncollectible accounts is summarized as follows:

 

     Fiscal Year

 
     2008

    2007

    2006

 
     Thousands  

Allowances for uncollectible accounts, beginning of year

   $ 8,789     $ 5,779     $ 5,770  

Additions charged to expense

     2,034       3,283       2,115  

Deductions for accounts written off

     (2,770 )     (273 )     (2,106 )
    


 


 


Allowances for uncollectible accounts, end of year

   $ 8,053     $ 8,789     $ 5,779  
    


 


 


 

Merchandise inventories are stated at the lower of cost or market value. Cost is determined using the last-in, first-out (LIFO) method. The excess of current cost over LIFO values was $204.9 million as of January 31, 2008, and $195.9 million as of January 25, 2007. The liquidation of LIFO inventory layers did not have a material effect on net income in any of the last three fiscal years.

 

Prepaid expenses and other current assets include participant-directed investments, primarily in exchange-traded money market and mutual funds, of $9.9 million as of January 31, 2008, and $10.8 million as of January 25, 2007, designated to fund the Company’s non-qualified deferred compensation plan.

 

Assets held for sale include the net carrying value of closed store properties that the Company is actively marketing for sale.

 

Property includes the major categories of land, buildings and leasehold improvements, and equipment and fixtures. Property is recorded at its cost, which is its estimated fair value if the property was acquired as part of an acquisition. The Company capitalizes costs that relate to the application and infrastructure development stage of software development, and includes such costs in equipment and fixtures. Costs for improvements that enhance the usefulness or extend the useful life of an asset are capitalized, as is interest incurred during asset construction or development periods. The Company capitalized interest costs of $2.1 million in fiscal 2008, $2.6 million in fiscal 2007, and $1.2 million in fiscal 2006. Repairs and maintenance costs are expensed as incurred.

 

Property is depreciated using the straight-line method over its estimated useful life. Useful lives are estimated at ten to thirty-three years for buildings, the shorter of the estimated useful life or lease term for leasehold improvements and up to twenty years for equipment and fixtures. Depreciation expense related to the Company’s distribution center property is included in the cost of retail drug store sales.

 

Buildings and leasehold improvements include assets under capital leases of $10.6 million as of January 31, 2008 and January 25, 2007. The corresponding capital lease obligation is included in other current and long-term

 

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LONGS DRUG STORES CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

liabilities, depending on scheduled payment dates. The amount capitalized for assets under capital leases is the present value at the beginning of the lease term of the aggregate future minimum lease payments. The amortization of such assets is included in depreciation expense. Accumulated amortization on assets under capital leases was $2.8 million as of January 31, 2008 and $2.3 million as of January 25, 2007.

 

Goodwill represents the excess of acquisition cost over the fair value of the net assets of acquired entities. Goodwill is not amortized, but is subject to impairment testing annually, or more frequently if events and circumstances indicate there may be impairment.

 

Intangible assets consist primarily of purchased pharmacy prescription files, non-compete agreements and beverage licenses in the Company’s retail drug store segment, and, as of January 31, 2008, insurance licenses in the Company’s pharmacy benefit services segment (see Note 5). Intangible assets with indefinite useful lives are not amortized, but are subject to impairment testing annually, or more frequently if events and circumstances indicate there may be impairment. Intangible assets with finite useful lives are amortized over those useful lives.

 

Impairment of Long-Lived Assets—The Company reviews long-lived tangible assets and intangible assets with finite useful lives for impairment whenever events or changes in circumstances indicate that their carrying values may not be recoverable. Using its best estimates based on reasonable assumptions and projections, the Company records an impairment loss to write such assets down to their estimated fair values if the carrying values of the assets exceed their related undiscounted expected future cash flows.

 

Goodwill and other intangible assets with indefinite useful lives are reviewed for impairment annually, or more frequently if events or changes in circumstances warrant. The Company performs its annual impairment testing during the fourth fiscal quarter, when updated financial projections are available. If the carrying values of such assets exceed their estimated fair values, the Company records an impairment loss to write the assets down to their estimated fair values.

 

Store-specific long-lived tangible assets and intangible assets with finite useful lives are generally evaluated at an individual store level, which is the lowest level at which independent cash flows can be identified. Corporate assets or other long-lived assets that are not store-specific are evaluated at a consolidated entity or segment level as appropriate. Goodwill is evaluated at a reporting unit level in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142, Goodwill and Other Intangible Assets. Geographic regional divisions within the retail drug store segment comprise the Company’s reporting units.

 

Fair values of beverage licenses and insurance licenses are estimated based on recent market transactions. Fair values for all other long-lived assets are estimated based on the expected present value of future cash flows.

 

Other non-current assets include, as of January 31, 2008, United States treasury notes held as statutorily required deposits associated with the Company’s insurance licenses (see Note 4). These treasury notes have maturities of one to five years, an amortized cost of $6.5 million, gross unrealized holding gains of $0.3 million and fair value of $6.8 million. These securities are classified as held-to-maturity and measured at amortized cost in the Company’s consolidated financial statements, as management has the intent and ability to hold the notes until maturity.

 

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LONGS DRUG STORES CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Other long-term liabilities consisted of the following:

 

     January 31,
2008


   January 25,
2007


     Thousands

Deferred rent

   $ 65,627    $ 58,869

Deferred income taxes

     12,633      28,788

Store closure reserves

     11,525      3,456

Capital lease obligations, long-term portion

     9,952      10,120

Long-term taxes payable

     3,529      —  

Deferred gains on sale-leaseback transactions

     2,086      2,226
    

  

Total

   $ 105,352    $ 103,459
    

  

 

Store Closure Reserves—The Company recognizes a liability for costs associated with closing a store when the liability is incurred. The present value of expected future lease costs, net of estimated future sublease income, is recorded when the store is closed. Severance and other employee-related costs are recorded in the period that the closure and related severance packages are communicated to the affected employees. Accretion of the discounted present value of expected future costs is recorded in operating and administrative expenses. Store closure reserves are periodically reviewed and, if necessary, adjusted based on changes in estimates about the amounts and timing of future sublease income.

 

Fair Value of Financial Instruments—The carrying values of the Company’s cash and cash equivalents, receivables and payables approximate their estimated fair values due to their short-term nature. To estimate the fair value of long-term debt, the Company uses those interest rates that are currently available to it for issuance of debt with similar terms and remaining maturities. As of January 31, 2008 and January 25, 2007, the carrying values and estimated fair values of the Company’s long-term debt (including the current maturities) were as follows:

 

     January 31,
2008


   January 25,
2007


     Thousands

Carrying value of long-term debt

   $ 220,091    $ 124,818

Estimated fair value of long-term debt

     221,945      126,530

 

Revenue Recognition—The Company recognizes revenue from retail drug store sales, net of an allowance for estimated returns, at the time the merchandise is sold or services performed. The allowance for sales returns is estimated based on the Company’s historical experience. Sales taxes are presented on a net basis (excluded from revenues and costs).

 

Pharmacy benefit services revenues include amounts generated from pharmacy benefit management services and, beginning January 1, 2006, prescription drug plans. Pharmacy benefit management revenues, which include plan design and implementation, claims administration and formulary management, are recognized when the Company’s RxAmerica subsidiary has completed its service obligations under its contracts, including the approval or denial of the authorization request to the participating pharmacy. RxAmerica does not take title to prescription drug inventories, does not assume substantial risks and rewards of inventory ownership or receivable collection associated with the provision of pharmacy benefit management services, and, generally, is not obligated to pay the associated dispensing pharmacy until it has been paid by the plan sponsor. Accordingly, pharmacy benefit management revenues from third-party health plans are recognized net of the reimbursements due to participating pharmacies. The Company does not recognize co-payments made to participating pharmacies by health plan members. Certain rebate revenues related to pharmacy benefit management services are estimated based on the Company’s contractual terms, prescription drug utilization, and recent rebate trends.

 

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LONGS DRUG STORES CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Beginning January 1, 2006, the Company began offering prescription drug plans under Medicare Part D as established by the Medicare Prescription Drug, Improvement and Modernization Act of 2003. Revenues under the plans include fixed monthly premiums paid by beneficiaries and by the federal Centers for Medicare & Medicaid Services (“CMS”), as well as a CMS risk share component. If the ultimate per member per month benefit costs of any Medicare Part D regional plan varies more than a certain amount (2.5 percentage points for the calendar 2006 and 2007 plan years, and 5.0 percentage points for the calendar 2008 plan year) above or below the level estimated in the original bid submitted by the Company and approved by CMS, there is a risk share settlement with CMS subsequent to the end of the plan year. The fixed monthly premiums are recognized on a straight-line basis over the period of coverage. The risk share adjustment, if any, is recorded as an adjustment to premium revenues and accounts receivable or accounts payable.

 

CMS also pays the Company certain subsidies for claims payments for which the Company assumes no risk, including reinsurance payments and low-income cost subsidies. Reinsurance payments represent the CMS obligation to pay 80% of the cost incurred by individuals in excess of the annual out-of-pocket limit. Low-income cost subsidies represent reimbursements from CMS for some portion or all of the deductibles, coinsurance and co-payment amounts for qualifying low-income beneficiaries. The Company administers and pays these amounts on behalf of CMS, and CMS makes monthly payments to the Company for the estimated amounts of these subsidies, with a final settlement subsequent to the end of the plan year based on actual experience. The Company accounts for these subsidies as deposits, with receipt and payment totals accumulated and recorded as accounts receivable or accounts payable depending on the net balance at the end of the reporting period. Payments in excess of receipts for these subsidies of $31.9 million and $35.4 million during fiscal 2008 and 2007, respectively, are included in Financing Activities in the Company’s Statements of Consolidated Cash Flows. The Company does not recognize premium revenues or benefit costs for these subsidies.

 

Cost of retail drug store sales includes the acquisition cost of inventory sold (net of merchandise rebates and allowances), in-bound freight, receiving, warehousing, purchasing and distribution costs and advertising expenses (net of advertising rebates and allowances). Advertising costs are expensed as incurred and were $84.2 million, $80.6 million, and $75.8 million, exclusive of rebates and allowances, in fiscal years 2008, 2007 and 2006, respectively.

 

Prescription drug plan benefit costs represent the Company’s portion of the cost of prescription drugs purchased by Medicare participants in one of its prescription drug plans. Such costs include benefit payments during the period to pharmacies, and an estimate for benefit costs incurred but not reported as of the end of the period, reduced by associated manufacturer rebates. As of January 1, 2008, for most of its plans the Company is responsible for approximately 67% of a Medicare beneficiary’s drug costs up to $2,510, while the beneficiary is responsible for 100% of their drug costs from $2,510 up to $5,726. The Company is responsible for 15% of a beneficiary’s drug costs above $5,726.

 

Vendor rebates and allowances—The Company records merchandise rebates and allowances as a reduction of the cost of inventory and the benefit is recognized as a reduction of the cost of retail drug store sales when the related inventory is sold. Advertising rebates and allowances are recognized as a reduction of advertising expense, a component of the cost of retail drug store sales, when the related advertising expense is incurred or the required performance is completed. Merchandise rebates and allowances received from vendors in a lump sum in connection with a contractual purchase arrangement are deferred and recognized as a reduction of the cost of retail drug store sales over the contract term.

 

Operating and administrative expenses include costs for retail drug store, pharmacy benefit services and administrative payroll and benefits; facilities and occupancy; and other miscellaneous expenses.

 

Insurance—The Company maintains insurance coverage for significant exposures and those risks required to be insured by law. It is generally the Company’s policy to retain a significant portion of certain losses related

 

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Table of Contents

LONGS DRUG STORES CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

to workers’ compensation, general liability, property losses, pharmacist liability, business interruptions and employee health care. Provisions for these items are recorded based upon the Company’s estimates for claim costs incurred. The provisions are estimated based on claims experience, regulatory changes, an estimate of claims incurred but not yet reported and other relevant factors. Reserves for workers’ compensation and general liability claims are discounted to their expected present value using an essentially risk-free interest rate. Such reserves totaled $36.5 million as of January 31, 2008 and $46.4 million as of January 25, 2007.

 

New store opening costs, primarily labor, advertising and store supplies, are charged to expense as incurred.

 

Rent—Minimum rent, including fixed escalations, is recorded on a straight-line basis over the lease term. The lease term commences when the Company takes possession of the leased premises, and in most cases ends upon expiration of the initial non-cancelable term. Renewal option periods are included in the lease term if failure to renew the lease would impose a penalty on the Company in such amount that, at the inception of the lease, renewal appears to be reasonably assured. When a lease provides for fixed escalations of the minimum rental payments during the lease term, the difference between the recorded straight-line rent and the amount payable under the lease is recognized as deferred rent. Contingent rental payments, typically based on a percentage of sales, are recognized as an expense when incurred, based on actual and projected sales or other results during the measurement period. Rental costs incurred during a construction period are recognized as an expense when incurred.

 

Stock-based compensation expense—Prior to the adoption of Statement of Financial Accounting Standards (“SFAS”) No. 123R, Share Based Payment, effective January 27, 2006, the Company accounted for stock-based employee compensation using the intrinsic value method in accordance with the provisions of Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees as allowed by SFAS No. 123, Accounting for Stock Based Compensation. Stock awards were valued at fair market value at the date of grant, and recorded as compensation expense over the vesting period. Compensation expense for performance-based stock awards was estimated until the measurement date, which is the earliest date at which the Company could determine the number of shares an employee is entitled to receive under the performance-based stock award arrangement. No compensation expense was recognized for employee stock options, because it is the Company’s practice to grant stock options with an exercise price not less than 100% of the closing market price of the underlying common stock on the date of grant.

 

SFAS No. 123R revised SFAS No. 123 and superseded APB Opinion No. 25, and requires that the fair value of stock-based employee compensation, including stock options and stock awards, be recognized as expense as the related services are performed. The standard also modified the measurement of compensation expense for performance-based restricted stock awards. The Company adopted SFAS No. 123R using the modified prospective transition method. Under this method, compensation cost is recorded for awards issued subsequent to the adoption of SFAS No. 123R and the unvested portion of previously issued awards. The following table summarizes the amounts recognized for stock compensation expense (under SFAS No. 123R in fiscal 2008 and 2007 and under APB Opinion No. 25 in fiscal 2006):

 

     Fiscal Year

     2008

  2007

  2006

     Thousands

Stock compensation expenses, included in operating and
administrative expenses:

                  

Stock awards

   $ 16,290   $ 10,727   $ 6,996

Stock options

     3,636     4,593     —  
    

 

 

Total

     19,926     15,320     6,996

Recognized income tax benefit

     (7,897)     (6,158)     (2,799)
    

 

 

After-tax effect of stock compensation expenses on net income

     $12,029     $9,162     $4,197
    

 

 

 

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LONGS DRUG STORES CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

No amounts of stock-based compensation cost have been capitalized as part of the cost of an asset.

 

The following table illustrates the effect on net income and earnings per share for fiscal 2006 if the Company had applied the fair value recognition provisions of SFAS No. 123 to all stock-based employee compensation, including stock options (in thousands, except per share amounts):

 

     Fiscal Year
2006


 

Net income, as reported

   $ 73,887  

Add: Stock-based employee compensation expense included in reported net income, net of related tax effects

     4,197  

Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects

     (6,745 )
    


Pro forma net income

   $ 71,339  
    


Basic earnings per share:

        

As reported

   $ 1.98  

Pro forma

   $ 1.91  

Diluted earnings per share:

        

As reported

   $ 1.93  

Pro forma

   $ 1.86  

 

The estimated fair value of stock options, net of estimated forfeitures, is recorded as compensation expense on a straight-line basis over the vesting period. The Company estimates the fair value of stock option grants using the Black-Scholes option pricing model, with the following weighted average assumptions:

 

     Fiscal Year

 
     2008

    2007

    2006

 

Expected volatility

   36.6 %   37.5 %   38.7 %

Dividend yield

   1.2 %   1.3 %   2.3 %

Risk-free interest rate

   4.4 %   4.7 %   4.0 %

Expected life (years)

   5.8     6.0     5.2  

 

The Company estimated its expected volatility based on an analysis of the historical volatility of the Company’s common stock and that of comparable companies over a term consistent with its expected life, as well as the implied volatility of the traded options of the Company and of comparable companies. The estimated dividend yield is based on the Company’s historical dividend yields and estimated expected future dividends. The risk-free interest rate is determined based on Treasury rates for the expected term of the options at the date of grant. The Company estimated the expected life based on an analysis of historical exercise behaviors by the Company’s stock option award recipients and comparable companies’ expected life assumptions.

 

Stock awards are valued at the fair market value of the Company’s stock as of the grant date. Awards with only time-based vesting requirements are recorded, net of estimated forfeitures, as compensation expense on a straight-line basis over the vesting period. For awards with performance-based vesting requirements, interim estimates of compensation expense are recorded based on the Company’s best estimate of the number of shares to be issued based on the best estimates of performance levels to be achieved (e.g. projected earnings per share). Compensation expense for performance-based stock awards is recognized net of estimated forfeitures on a straight-line basis over the requisite service period for each separately vesting portion of the award.

 

Income taxes—The Company accounts for income taxes using the asset and liability method. Under this method, deferred income taxes are recorded based upon the differences between the financial statement and tax

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

basis of assets and liabilities. The benefits of tax positions are recognized when it is more likely than not that such positions will be sustained upon examination (see Note 2). Tax positions that meet this recognition threshold are measured at the largest amount of tax benefit that is cumulatively greater than 50% likely of being realized upon settlement with the taxing authority. The Company includes interest and penalties related to income taxes in income tax expense on the statement of consolidated income and in taxes payable (the non-current portion of which is included in other long-term liabilities) on the consolidated balance sheet. Such amounts are not material to any period presented.

 

Earnings per share—Basic earnings per share are computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted earnings per share are computed by dividing net income by the weighted average number of common shares and dilutive common equivalent shares (restricted stock awards and stock options) outstanding during the period. The following is a reconciliation of the number of shares used in the Company’s basic and diluted earnings per share computations:

 

     Fiscal Year

     2008

   2007

   2006

     Thousands

Basic weighted average number of shares outstanding

   37,294    37,201    37,332

Effect of dilution from:

              

Stock options

   658    786    818

Restricted stock awards

   280    194    130
    
  
  

Diluted weighted average number of shares outstanding

   38,232    38,181    38,280
    
  
  

 

The computations of diluted earnings per share excluded 0.1 million stock options for fiscal 2008, 0.3 million stock options for fiscal 2007, and 0.2 million stock options for fiscal 2006 because their inclusion would have been anti-dilutive.

 

Comprehensive income equals net income for all periods presented.

 

2. New Accounting Pronouncements

 

Effective January 26, 2007, the Company adopted Financial Accounting Standards Board (“FASB”) Interpretation No. (“FIN”) 48, Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109, which clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements. FIN 48 requires the recognition of tax positions when it is more likely than not that such positions will be sustained upon examination. Tax positions that meet this recognition threshold are measured at the largest amount of tax benefit that is cumulatively greater than 50% likely of being realized upon settlement with the taxing authority. The adoption of FIN 48 resulted in a $0.5 million decrease to retained earnings for the cumulative effect of the change in accounting principle as of January 26, 2007 (the first day of fiscal 2008).

 

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements, which establishes a standard definition for fair value, provides a framework under generally accepted accounting principles for measuring fair value, and expands disclosure requirements for fair value measurements. FASB Staff Position (“FSP”) No. FAS 157-b, Effective Date of FASB No 157, issued in December 2007, delays the effective date of SFAS No. 157 to annual reporting periods beginning after November 15, 2008 (the Company’s fiscal 2010) for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis. The remaining provisions of SFAS No. 157 are effective for annual reporting periods beginning after November 15, 2007 (the Company’s fiscal 2009). The adoption of SFAS No. 157 will require increased disclosures in the Company’s consolidated financial statements.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

In December 2007, the FASB issued SFAS No. 141(revised 2007), Business Combinations (“SFAS No. 141R”), which revises current purchase accounting guidance in SFAS No. 141, Business Combinations. SFAS No. 141R requires most assets acquired and liabilities assumed in a business combination to be measured at their fair values as of the date of acquisition. SFAS No. 141R also modifies the initial measurement and subsequent remeasurement of contingent consideration and acquired contingencies, and requires that acquisition related costs be recognized as expense as incurred rather than capitalized as part of the cost of the acquisition. SFAS No. 141R is effective for fiscal years beginning after December 15, 2008 (the Company’s fiscal 2010) and is to be applied prospectively to business combinations occurring after adoption. The impact of SFAS No. 141R on the Company’s consolidated financial statements will depend on the nature and extent of the Company’s future acquisition activities.

 

3. Store Dispositions

 

In February 2007, the Company’s board of directors approved a plan to dispose of 31 stores during fiscal 2008, including all of the 23 stores located in Washington, Oregon and Colorado and eight stores in California. Most of the stores were located in markets the Company entered in the 1980s and 1990s that remained underdeveloped. Sufficiently developing the Company’s presence in these markets would have required significant investment that management believed would be better directed toward markets that offer greater opportunities for more satisfactory returns. As of January 31, 2008, the Company had closed 30 of these stores. One California store previously included in this disposition plan will remain open. Twenty-four of the store locations have been sold or sub-leased and the remainder are being actively marketed.

 

Each of these 30 stores constitutes a “component” as defined in SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. The stores located in Washington, Oregon and Colorado are reported as discontinued operations effective in fiscal 2008 in accordance with SFAS No. 144, and as such both current and prior year results for these stores are classified within discontinued operations in the Company’s statements of consolidated income. Net property—primarily land and buildings which the Company expects to dispose of within the next fiscal year—of $4.2 million associated with these stores is classified in assets held for sale as of January 31, 2008. The stores located in California are reported within continuing operations.

 

The Company records the net costs associated with the disposition of these 30 stores as the stores are sold or closed and the related assets are disposed of, in accordance with SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. For the seven stores located in California, the Company incurred $8.5 million of pre-tax net costs, primarily for lease-related costs net of sublease income, and severance, during fiscal 2008. These costs are included in the provision for store closures and asset impairments within continuing operations. The Company also recorded provisions of $2.8 million in fiscal 2007 and $2.4 million in fiscal 2006 for store closures and asset impairments within continuing operations, primarily for asset impairments related to underperforming and closed stores.

 

For the 23 stores located in Washington, Oregon and Colorado, the Company incurred a pre-tax net loss of $4.5 million ($2.7 million after tax) in discontinued operations during fiscal 2008. This pre-tax net loss included costs of $11.1 million for lease-related costs net of estimated sublease rental income and $3.2 million for employee severance, and pre-tax operating losses of $8.0 million, offset by $17.8 million of pre-tax gains on the sale of store properties and related assets.

 

Additional charges or gains related to the disposition of stores may be incurred as a result of sales of property or changes to management’s current estimates and assumptions regarding the disposition of the remaining store locations. The timing of future transactions and charges related to this disposition are subject to significant uncertainty including the variability in future vacancy periods, sublease income and the timing of property sales.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Results from discontinued operations were as follows:

 

     Fiscal year

 
     2008

    2007

    2006

 
     Thousands  

Retail drug store sales

   $ 35,313     $ 123,756     $ 125,094  

Costs and expenses:

                        

Cost of retail drug store sales

     32,037       95,684       97,362  

Operating and administrative expenses

     11,244       30,835       31,472  

Provision for store closures and asset impairments, net

     (3,511 )     5,585       —    
    


 


 


Loss before income taxes

     (4,457 )     (8,348 )     (3,740 )

Income tax benefit

     1,767       3,356       1,503  
    


 


 


Loss from discontinued operations, net of tax

   $ (2,690 )   $ (4,992 )   $ (2,237 )
    


 


 


 

The following is a summary of the reserve for store closures, which is included in other long-term liabilities:

 

     Fiscal Year

 
     2008

    2007

   2006

 
     Thousands  

Reserve balance—beginning of year

   $ 3,456     $ 2,727    $ 7,011  

Provision for present value of noncancellable lease obligations of stores closed, net of estimated sublease income

     11,331       447      —    

Changes in assumptions about future sublease income and other lease related costs

     749       232      —    

Provision for severance

     3,201       —           
    


 

  


Total provision for store closures

     15,281       679      —    
    


 

  


Reserve accretion

     524       9      0  

Cash receipts (payments) for leases

     (4,535 )     41      (4,284 )

Cash payments for severance

     (3,201 )               
    


 

  


Reserve balance—end of year

   $ 11,525     $ 3,456    $ 2,727  
    


 

  


 

There was no reserve accretion in fiscal 2006, because all of the remaining stores included in the reserve at that time were closed prior to the adoption of SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which required that the initial provision for store closures be recorded at the estimated net present value, and accreted to the full undiscounted value, of the noncancellable lease obligation, net of estimated sublease income. Previous accounting standards required that such provisions be recorded at their full undiscounted values.

 

4. Acquisitions

 

During fiscal 2008, the Company purchased the assets of seven retail pharmacies, including four from PharMerica, Inc., a subsidiary of AmerisourceBergen Corporation, for a total of $12.8 million. These acquisitions increased the Company’s portfolio of smaller retail pharmacies, many of which are close to the point of care, such as hospitals, clinics and medical office buildings. Four of the acquired stores are located in California, and three are in Hawaii. The Company allocated the $12.8 million total acquisition cost to pharmacy prescription files ($10.6 million), inventory ($2.1 million) and property and equipment ($0.1 million). The results of operations of the acquired locations are included in the Company’s consolidated financial statements within the

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

retail drug store segment as of their various acquisition dates. During fiscal 2008, the Company also purchased an additional $2.4 million of pharmacy prescription files from retail pharmacies in various transactions, which were transferred to the Company’s existing store base.

 

In the second quarter of fiscal 2008, the Company acquired the assets of six stores in the Reno, Nevada area from Rite Aid Corporation (“Rite Aid”) and sold to Rite Aid assets of certain of the stores included in the Company’s disposition plans announced in February 2007 (see Note 3). This transaction increased the Company’s presence in the Reno area while accelerating the disposition of stores in Washington and Oregon. The Company accounted for this purchase and sale transaction based on the fair values of the net assets exchanged. The Company allocated the $4.2 million total fair value of net assets acquired to property and equipment ($4.4 million), inventory ($3.1 million) and pharmacy prescription files ($3.4 million), partially offset by under market lease obligations ($6.7 million). The results of operations of the acquired stores are included in the Company’s consolidated financial statements within the retail drug store segment as of their acquisition date.

 

In the third quarter of fiscal 2008, through its wholly-owned subsidiary, RxAmerica L.L.C. (“RxAmerica”), the Company acquired Nutmeg Life Insurance Company (“Nutmeg”), from Hartford Life Insurance Company. Nutmeg is a registered insurance company and has licenses to operate as an insurance company in 46 states where it also maintains related statutorily required deposits. Nutmeg has no existing insurance policies in force. The acquisition of Nutmeg will allow RxAmerica to continue to offer prescription drug plans under the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 after the expiration of its insurance waivers from the Centers for Medicare and Medicaid Services (“CMS”) on January 1, 2009. The Company allocated the $11.4 million total acquisition cost to marketable securities ($6.5 million) and insurance licenses ($4.9 million). Nutmeg’s results of operations primarily consist of interest income, and are included in the Company’s consolidated financial statements within the pharmacy benefit services segment as of the acquisition date. In the fourth quarter of fiscal 2008, Nutmeg was renamed Accendo Insurance Company (“Accendo”) and redomesticated from the state of Iowa to Utah.

 

In fiscal 2007, the Company purchased AmerisourceBergen Drug Corporation’s (“AmerisourceBergen”) 50% interest in a joint venture through which the Company and AmerisourceBergen operated a central prescription fill center. This acquisition gave the Company sole ownership and control of a business that serves to reduce prescription fill costs and to address an industry-wide shortage of pharmacists, while also providing fulfillment for a portion of the Company’s mail order business. The Company allocated the $3.8 million acquisition cost to property and equipment ($1.5 million) and goodwill ($2.3 million). The acquired goodwill is deductible for tax purposes. The results of operations of the acquired fill center are included in the Company’s consolidated financial statements within the retail drug store segment as of the acquisition date. Prior to the acquisition, the Company used the equity method of accounting for its 50% investment in the joint venture.

 

In fiscal 2007, the Company purchased the assets of Network Pharmaceuticals, Inc. (“Network”) including 21 retail pharmacies and one closed door pharmacy, all located in Southern California, for $12.8 million. This acquisition expanded the Company’s presence in Southern California through pharmacies that are close to the point of care, such as hospitals, clinics and medical office buildings. The Company allocated the $12.8 million acquisition cost to pharmacy customer lists ($8.9 million), property and equipment ($1.1 million) and inventory ($2.8 million). The results of operations of the acquired locations are included in the Company’s consolidated financial statements within the retail drug store segment as of the June 11, 2006 acquisition date.

 

The pro forma effects of these acquisitions on the Company’s consolidated financial statements for periods prior to the acquisitions are not significant, either individually or in the aggregate.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

5. Goodwill and Intangible Assets

 

All of the Company’s goodwill, pharmacy prescription files and non-compete agreements are included in the retail drug store segment. Insurance licenses are included in the pharmacy benefit services segment.

 

The Company’s intangible assets other than goodwill include the following:

 

    Estimated
Useful Lives

  Gross
Carrying
Value

  Accumulated
Amortization

    Net
Carrying
Value

    Thousands

As of January 31, 2008:

                       

Intangible assets subject to amortization:

                       

Pharmacy prescription files

  5 years   $ 27,811   $ (6,457 )   $ 21,354

Non-compete agreements and other

  5 years     675     (103 )     572
       

 


 

Total

        28,486     (6,560 )     21,926

Intangible assets not subject to amortization:

                       

Beverage licenses

  N/A     5,445     —         5,445

Insurance licenses

  N/A     4,869     —         4,869
       

 


 

Total

      $ 38,800   $ (6,560 )   $ 32,240
       

 


 

As of January 25, 2007:

                       

Intangible assets subject to amortization:

                       

Pharmacy prescription files

  1-5 years   $ 12,519   $ (2,699 )   $ 9,820

Non-compete agreements and other

  2-5 years     5     (4 )     1
       

 


 

Total

        12,524     (2,703 )     9,821

Intangible assets not subject to amortization:

                       

Beverage licenses

  N/A     5,083     —         5,083
       

         

Total

      $ 17,607   $ (2,703 )   $ 14,904
       

 


 

 

The increase in pharmacy prescription files was primarily due to the acquisition of 13 stores during fiscal 2008 (see Note 4). Insurance licenses as of January 31, 2008 are related to the Nutmeg/Accendo acquisition during the third quarter of fiscal 2008 (see Note 4).

 

Amortization expense for intangible assets with finite useful lives was $4.6 million in fiscal 2008, $1.7 million in fiscal 2007, and $0.7 million in fiscal 2006. Estimated future annual amortization expense on these intangibles is as follows (in thousands):

 

Fiscal year ending:

      

2009

     5,626

2010

     5,377

2011

     5,328

2012

     4,287

2013

     1,308
    

Total

   $ 21,926
    

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

6. Debt

 

Debt at January 31, 2008 and January 25, 2007 consisted of the following:

 

     January 31,
2008


   January 25,
2007


     Thousands

Revolving line of credit, variable interest (weighted average rate of 5.29% at January 31, 2008, expires January 2012)

   $ 167,000    $ 65,000

Private placement notes, fixed interest rates ranging from 6.19% to 6.71%, mature at various dates through 2014

     53,091      59,818
    

  

Total debt

     220,091      124,818

Less current maturities

     36,727      6,727
    

  

Long-term portion

   $ 183,364    $ 118,091
    

  

 

The Company has a secured revolving line of credit agreement with a syndication of banks. The agreement expires in January 2012 and accrues interest at LIBOR-based rates. Borrowings on this line of credit are secured by inventory, accounts receivable and certain intangible assets. The secured revolving line of credit agreement contains customary restrictions but no financial covenants and no limitations on capital expenditures or share repurchases if availability of credit remains above a minimum level. On October 30, 2007, the Company exercised an option to increase its secured revolving line of credit facility’s borrowing and letter of credit capacity from $325 million to $400 million, with no change to its existing covenant requirements. Borrowings on the line of credit do not require repayment until the expiration date but may be prepaid without penalty. Letters of credit totaling $30.4 million were outstanding under the agreement as of January 31, 2008. The Company pays a monthly commitment fee of 0.25% per annum on the unused portion of the line of credit ($203 million as of January 31, 2008).

 

The private placement notes are secured on the same basis as the secured revolving line of credit. The private placement notes may be redeemed at the Company’s option prior to their scheduled maturities, subject to an early payment premium.

 

The Company’s debt agreements contain customary restrictions, and the private placement notes also include various customary financial covenants. As of January 31, 2008, the Company was in compliance with the restrictions and limitations included in these provisions.

 

As of January 31, 2008, future minimum principal payments on long-term debt were as follows (in thousands):

 

Fiscal year ending:

      

2009

   $ 36,727

2010

     2,727

2011

     2,727

2012

     169,727

2013

     2,727

Thereafter

     5,456
    

Total

   $ 220,091
    

 

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LONGS DRUG STORES CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

7. Leases

 

The Company leases most of its store properties and certain of its distribution centers and corporate office facilities. Most store leases have original non-cancelable terms of 15 to 25 years and contain renewal options covering up to 30 additional years in 5-year to 10-year increments. Store leases normally provide for minimum annual rent with provisions for additional rent based on a percentage of sales, and may contain escalation clauses.

 

Net rental expense is summarized as follows:

 

     Fiscal Year

 
     2008

    2007

    2006

 
     Thousands  

Minimum rentals

   $ 87,438     $ 83,128     $ 78,755  

Contingent rentals

     10,624       10,445       10,655  
    


 


 


       98,062       93,573       89,410  

Less sublease income

     (3,247 )     (3,151 )     (2,948 )
    


 


 


     $ 94,815     $ 90,422     $ 86,462  
    


 


 


 

Minimum rental commitments for non-cancelable leases as of January 31, 2008 are as follows:

 

     Operating
Leases


   Capital
Leases


 
     Thousands  

Fiscal year ending:

               

2009

   $ 83,319    $ 1,048  

2010

     83,494      1,048  

2011

     80,839      1,048  

2012

     75,953      1,055  

2013

     72,595      1,108  

Thereafter

     638,189      15,198  
    

  


Total minimum lease payments

   $ 1,034,389    $ 20,505  
    

        

Less amounts representing interest

            (10,384 )
           


Present value of capital lease obligations

          $ 10,121  

Less current portion

            (169 )
           


Long-term portion

          $ 9,952  
           


 

Total minimum lease payments on operating leases have not been reduced by minimum future sublease rentals of $20.9 million under non-cancelable subleases.

 

During fiscal 2006, the Company entered into a sale-leaseback transaction for its Northern California front-end distribution center located in Lathrop, California, for net proceeds of $21.5 million. The Company vacated the Lathrop facility during the fourth quarter of fiscal 2007 when its newly constructed distribution center in Patterson, California, became fully operational. The sale-leaseback transaction transferred substantially all risks and rewards of ownership to the buyer-lessor, and there were no commitments, obligations, provisions or circumstances that required or resulted in the Company’s continuing involvement other than the normal leaseback terms. Further, the leaseback is considered “minor” as defined in SFAS No. 13 Accounting for Leases, and SFAS No. 28, Accounting for Sales with Leasebacks. Therefore, the $11.0 million gain on the transaction was recognized upon completion of the sale in fiscal 2006.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

8. Commitments and Contingencies

 

As of January 31, 2008, the Company had outstanding commitments to purchase approximately $5.5 billion of merchandise inventory at various dates over the next three years for use in the normal course of business. This amount primarily represents commitments to the Company’s primary supplier, AmerisourceBergen, under a long-term supply contract. The contract includes a minimum purchase requirement over the contract term, which is effective for three to seven years depending on the Company’s actual purchase levels and various termination provisions.

 

The Company has entered into agreements with its executive officers and other key employees that provide termination benefits in the event of certain change in control events. Total contingent termination benefits as of the end of fiscal 2008 were approximately $40.4 million, plus amounts covering any excise tax on these benefits for certain executive officers. In addition, the Company’s stock-based compensation arrangements include provisions for accelerated vesting upon a change in control. There have been no events that would trigger these benefits as of January 31, 2008.

 

Rankin v. Longs Drug Stores California, Inc. was filed in the Superior Court of California, San Diego County, in October 2004, and was subsequently certified as a class action. The lawsuit alleged that the Company’s employment application violated California Labor Code Section 432.8 by inquiring about criminal convictions within the last seven years, without providing an exception for misdemeanor marijuana convictions more than two years old. The plaintiff sought to recover statutory damages and attorneys’ fees for himself and all similarly situated individuals who applied for employment with us during the class period. Trial commenced on August 20, 2007 and concluded with a dismissal of plaintiff’s case by the court on September 26, 2007. The plaintiff filed a notice of appeal on December 4, 2007.

 

During the third quarter of fiscal 2007, the Company completed a self-audit of certain of its California drug stores located in three counties that was initiated at the request of the State of California Department of Industrial Relations (“DIR”). The audit related to compliance with California law relating to meal period requirements. The Company made compensatory payments resulting from this audit, which were not material, during the fourth quarter of fiscal 2007. The DIR has also requested that the Company conduct an audit related to meal period compliance for all of its California drug stores. At this time the Company cannot reasonably estimate the amount of possible payments that might be required as a result of an additional audit, if any.

 

In addition to the matters described above, the Company is subject to various lawsuits, claims and federal and state regulatory reviews and actions arising in the normal course of its businesses. The Company accrues amounts it believes are adequate to address the liabilities related to lawsuits and other proceedings that it believes will result in a probable loss if the loss can be reasonably estimated. However, the ultimate resolution of such matters is uncertain and outcomes are not predictable with assurance. It is possible that the matters described above or other proceedings brought against the Company could have a material adverse impact on its financial condition and results of operations.

 

9. Employee Compensation and Benefits

 

The Company had approximately 21,900 full-time and part-time employees as of January 31, 2008. Virtually all full-time employees are eligible for medical, dental and life insurance benefits paid primarily by the Company.

 

Employees who meet certain eligibility requirements are entitled to participate in the Longs Drug Stores California, Inc. 401(k) Plan. Participating employees may make voluntary contributions through pre-tax salary deferrals, which are partially matched by the Company. Prior to January 1, 2008, the plan also included a profit

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

sharing component, through which eligible participants received a profit sharing benefit, funded entirely by the Company, if profits for the fiscal year, as defined, called for a payment in excess of the 401(k) match. Effective January 1, 2008, the Company discontinued the profit sharing benefit and added an enhanced 401(k) matching contribution that satisfies the 401(k) safe harbor contribution requirements under the Internal Revenue Code. Company contributions to the plan may be made in cash or shares of Longs common stock. The portion of the plan that holds Longs common stock is an employee stock ownership plan (ESOP) as defined by the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code (IRC) of 1986.

 

Compensation expense for Company contributions to the 401(k) plan is measured based on the amount of the contribution called for in the period under the plan, and was $13.6 million in fiscal 2008, $12.1 million in fiscal 2007 and $11.3 million in fiscal 2006. The Company has historically funded these contributions in shares of Longs common stock. Dividends on ESOP shares are charged to retained earnings, and all shares held by the ESOP are treated as outstanding shares in computing earnings per share. There were 4.7 million shares of Longs common stock in the ESOP as of January 31, 2008 and 5.5 million shares as of January 25, 2007.

 

The Longs Drug Stores Corporation Deferred Compensation Plan of 1995 provided eligible employees with the opportunity to defer a specified percentage of their cash compensation. Resulting obligations will be payable on dates selected by the participants in accordance with the terms of the plan. The Company’s deferred compensation obligation was $9.9 million as of January 31, 2008 and $10.8 million as of January 25, 2007. As of February 1, 2004, current participants were no longer allowed to make contributions to the plan and no future participants will be admitted to the plan.

 

10. Stock-Based Compensation

 

The Company has two separate plans under which it may grant options to purchase shares of the Company’s common stock and other awards of common stock or common stock appreciation rights to key employees. The Amended and Restated 1995 Long-Term Incentive Plan authorized the issuance of 7,400,000 shares of common stock in the form of stock options and stock awards. The Non-Executive Long-Term Incentive Plan, as amended, authorized the issuance of 3,000,000 shares of common stock of the Company and contains similar provisions to those of the Amended and Restated 1995 Long-Term Incentive Plan, except that it does not allow for incentive stock options or grants to officers or directors of the Company. Each stock award granted from the Amended and Restated 1995 Long-Term Incentive Plan reduces the total number of available shares under the plan by 2.75 shares and each stock option granted reduces the total available by one share. For the Non-Executive Long-Term Incentive Plan, as amended, each stock award or stock option reduces available shares by one share. As of January 31, 2008, there were 3,682,736 shares of common stock available for grant under the two plans.

 

Stock Options

 

Stock options are granted with an exercise price not less than 100% of the closing market price on the date of the grant. The Company’s options vest in equal annual portions over a period of four years and have a maximum term of ten years. The Company’s stock option award plans contain provisions for accelerated vesting upon a change of control.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Following is a summary of stock option activity:

 

     Shares

    Weighted Average
Exercise Price


   Weighted Average
Remaining
Contractual Term


   Aggregate
Intrinsic
Value


                     Thousands

Outstanding at January 27, 2005

   4,150,525     $ 22.85            

Granted (weighted average fair value $12.34)

   345,400       37.77            

Exercised

   (948,464 )     22.13         $ 16,023

Forfeited

   (268,225 )     24.06            

Expired

   (60,335 )     22.22            
    

                 

Outstanding at January 26, 2006

   3,218,901     $ 24.56            

Granted (weighted average fair value $17.26)

   94,500       44.27            

Exercised

   (576,177 )     22.77         $ 12,683

Forfeited

   (77,145 )     31.11            

Expired

   (44,625 )     23.25            
    

                 

Outstanding at January 25, 2007

   2,615,454     $ 25.50            

Granted (weighted average fair value $19.96)

   60,800       53.04            

Exercised

   (850,164 )     23.16         $ 25,903

Forfeited

   (32,950 )     37.58            

Expired

   (13,145 )     22.54            
    

                 

Outstanding at January 31, 2008

   1,779,995     $ 27.37    5.80 years    $ 33,670
    

                 

Vested or expected to vest at January 31, 2008

   1,703,425     $ 26.95    5.71 years    $ 32,522
    

                 

Exercisable at January 31, 2008

   1,397,143     $ 24.79    5.31 years    $ 29,698
    

                 

 

The total fair value of stock options vesting during the year was $3.1 million in fiscal 2008, $6.9 million in fiscal 2007, and $7.0 million in fiscal 2006. As of January 31, 2008, there was $3.8 million of unrecognized compensation cost related to unvested stock options. This cost is expected to be recognized over a weighted average period of 2.0 years.

 

Proceeds from stock option exercises during fiscal 2008 were $19.7 million and the related tax benefit was $10.2 million. The Company’s practice is to issue new shares to satisfy stock option exercises, but the resulting dilution may be partially or wholly offset by Company’s share repurchases made in the ordinary course of business, subject to outstanding authorizations by the Company’s Board of Directors and depending on existing market conditions, the Company’s financial position and other capital requirements.

 

Stock Awards

 

Stock awards are granted with either time-based vesting requirements or a combination of time-based and performance-based vesting requirements, such as a target earnings per share. Recipients of stock awards with only time-based vesting requirements have voting rights to the shares and dividends are credited to the shares during the restriction period. However, transfer of ownership of the shares is dependent on continued employment for periods of one to four years. Shares are not granted under a performance-based stock award until such time as the performance objective has been met, subject to necessary approvals, at which point additional time-based vesting requirements apply and recipients have the same rights and restrictions as for stock awards with only time-based vesting requirements.

 

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LONGS DRUG STORES CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Following is a summary of stock award activity:

 

     Shares

    Weighted Average
Grant- Date Fair Value


Outstanding at January 27, 2005

   217,310        

Granted

   89,009     $ 37.34

Vested (total fair value $4.4 million)

   (134,429 )      

Forfeited

   (39,850 )      
    

     

Outstanding at January 26, 2006

   132,040        

Granted

   381,796       40.96

Vested (total fair value $6.1 million)

   (142,971 )      

Forfeited

   (10,281 )      
    

     

Outstanding at January 25, 2007

   360,584       32.83

Granted

   268,819       50.28

Vested (total fair value $11.3 million)

   (341,177 )     33.09

Forfeited

   (6,522 )     43.94
    

     

Outstanding at January 31, 2008

   281,704        
    

     

 

As of January 31, 2008, there was $20.3 million of unrecognized compensation cost related to unvested stock awards. This cost is expected to be recognized over a weighted average period of 1.9 years.

 

On March 3, 2008, the Company granted stock awards for 332,264 shares pursuant to its fiscal 2007 and fiscal 2008 performance-based stock award programs due to the achievement of pre-defined performance objectives related to fiscal 2008 operating results. The Company may also grant additional stock awards for up to 166,800 shares under existing performance-based awards, subject to achievement of pre-defined performance objectives.

 

11. Income Taxes

 

Income tax expense is summarized as follows:

 

     Fiscal Year

     2008

    2007

    2006

     Thousands

Current:

                      

Federal

   $ 64,309     $ 54,261     $ 28,308

State

     9,225       12,625       7,437
    


 


 

Total current

     73,534       66,886       35,745

Deferred:

                      

Federal

     (13,965 )     (17,868 )     8,387

State

     (1,660 )     (3,684 )     1,790
    


 


 

Total deferred

     (15,625 )     (21,552 )     10,177
    


 


 

Total

     57,909       45,334       45,922
    


 


 

 

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LONGS DRUG STORES CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The reconciliation between the federal statutory tax rate and the Company’s effective tax rates is as follows:

 

     Fiscal Year

 
     2008

    2007

    2006

 

Federal income taxes at statutory rate

   35.0 %   35.0 %   35.0 %

State income tax, net of federal benefits

   3.7 %   4.0 %   4.3 %

Benefits of tax credits

   (0.2 )%   (0.3 )%   (0.8 )%

Benefits of deductible dividends paid on employee stock ownership plan shares

   (0.6 )%   (0.9 )%   (1.0 )%

Other

   (1.0 )%   (1.5 )%   0.1 %
    

 

 

Effective income tax rate

   36.9 %   36.3 %   37.6 %
    

 

 

 

Significant components of the Company’s deferred tax assets and liabilities are as follows:

 

     January 31,
2008


   January 25,
2007


     Thousands

Deferred tax assets:

             

Employee compensation and benefits

   $ 44,172    $ 46,708

Deferred rent

     16,107      16,075

Pharmacy benefit services contract accruals

     15,848      12,437

Accounts receivable and related reserves

     5,507      3,649

Store closure reserves

     4,855      —  

Other

     7,756      5,604
    

  

       94,245      84,473
    

  

Deferred tax liabilities:

             

Property and depreciation

     24,172      42,864

Intangible assets

     13,285      3,836

Other

     4,921      6,408
    

  

       42,378      53,108
    

  

Net deferred tax asset

   $ 51,867    $ 31,365
    

  

 

The Company has state tax credits of $2.0 million that may be carried forward for an indefinite period of time to offset future state taxable income.

 

Uncertain tax positions—The Company’s total unrecognized tax benefits, including the portion that would affect the Company’s effective tax rate if recognized, are not material. The Company’s federal income tax returns for the years ended January 2004 and later are subject to examination by the Internal Revenue Service (“IRS”) under the federal statute of limitations. The Company’s California income tax returns for the years ended January 2004 and later are subject to examination by the California Franchise Tax Board under California’s statute of limitations. Income tax returns for the Company’s other major state jurisdictions are subject to examination by the respective state tax authorities for the years ended January 2005 and later. During fiscal 2008, the IRS commenced an examination of the Company’s federal income tax returns for the years ended January 29, 2004 and January 27, 2005. It is reasonably possible that the outcome of this examination could result in an adjustment to the Company’s unrecognized tax benefits in the next 12 months. However, the amount and timing of the adjustment, if any, cannot be estimated at this time.

 

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LONGS DRUG STORES CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

12. Stockholders’ Equity

 

Authorized capital stock consists of 120 million shares of common stock, $.50 par value, and 30 million shares of preferred stock.

 

In May 2005, the Company’s board of directors authorized the repurchase of up to $150 million of the Company’s outstanding common stock through May 2008. On November 13, 2007, the Company’s board of directors authorized the additional repurchase of up to $200 million of the Company’s outstanding common stock through February 2011. The Company repurchased shares of its outstanding common stock under these programs in each of the last three years, as follows:

 

     Fiscal Year

     2008

   2007

   2006

Shares repurchased

     2,474,000      984,000      1,420,000

Total cost (millions)

   $ 119.8    $ 44.1    $ 55.1

 

As of January 31, 2008, nothing further remains under the May 2005 repurchase program. Under the November 2007 share repurchase program, the Company is authorized to repurchase additional shares of its outstanding common stock for a maximum additional expenditure of $156.3 million.

 

13. Segment Information

 

The Company operates in two business segments: retail drug stores and pharmacy benefit services. These segments were identified based on their separate and distinct products and services, technology, marketing strategies and management reporting. Management evaluates the segments’ operating performance separately and allocates resources based on their respective financial condition, results of operations and cash flows. Inter-segment transactions and balances are eliminated in consolidation.

 

Pharmacy is the cornerstone of the retail drug store segment, complemented by such core front-end categories as cosmetics, over-the-counter medications, health and beauty products, photo and photo processing, and food and beverage items. As of January 31, 2008, the retail drug store segment operated 510 retail stores in the western United States primarily under the names Longs, Longs Drugs, Longs Drug Stores and Longs Pharmacy. The retail drug store segment also operates a mail order pharmacy business.

 

The pharmacy benefit services segment, operated through the Company’s subsidiary, RxAmerica, L.L.C., provides pharmacy benefit management services whereby RxAmerica contracts with third-party health plans, retail pharmacies and drug manufacturers to provide a range of services to third-party health plan members, including pharmacy benefit plan design and implementation, claims administration and formulary management. In addition, beginning January 1, 2006, the pharmacy benefit services segment operates prescription drug plans under Medicare Part D as established by the Medicare Prescription Drug, Improvement and Modernization Act of 2003. Fiscal 2007 was the first full year of results for the new prescription drug plans.

 

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LONGS DRUG STORES CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The following table summarizes significant financial information by segment:

 

     Fiscal Year

 
     2008

    2007

    2006

 
     Thousands  

Revenues:

                        

Retail Drug Stores

   $ 4,882,827     $ 4,652,940     $ 4,491,752  

Pharmacy Benefit Services

     379,738       320,356       53,457  
    


 


 


Consolidated Totals

   $ 5,262,565     $ 4,973,296     $ 4,545,209  
    


 


 


Operating Income:

                        

Retail Drug Stores

   $ 115,269     $ 92,423     $ 121,426  

Pharmacy Benefit Services

     49,294       39,210       8,477  
    


 


 


Consolidated Totals

   $ 164,563     $ 131,633     $ 129,903  
    


 


 


Total Assets:

                        

Retail Drug Stores

   $ 1,668,948     $ 1,568,619     $ 1,445,650  

Pharmacy Benefit Services

     304,502       223,342       126,704  

Inter-segment Eliminations

     (126,734 )     (104,293 )     (77,025 )
    


 


 


Consolidated Totals

   $ 1,846,716     $ 1,687,668     $ 1,495,329  
    


 


 


 

The retail drug store segment accounts for all or substantially all of the Company’s capital expenditures, depreciation and amortization, gain on sale of distribution center, provision for store closures and asset impairments, and legal settlements and other disputes.

 

Consolidated total revenues include the following product and service types:

 

     Fiscal Year

     2008

   2007

   2006

     Thousands

Pharmacy sales

   $ 2,509,252    $ 2,344,602    $ 2,179,522

Front-end sales

     2,373,575      2,308,338      2,312,230

Prescription drug plan revenues

     310,800      280,719      16,201

Pharmacy benefit management revenues

     68,938      39,637      37,256
    

  

  

Consolidated total revenues

   $ 5,262,565    $ 4,973,296    $ 4,545,209
    

  

  

 

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LONGS DRUG STORES CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

14. Selected Quarterly Information (Unaudited)

 

Summarized quarterly results of operations for the years ended January 31, 2008 and January 25, 2007 are as follows:

 

    First
Quarter


    Second
Quarter


    Third
Quarter


    Fourth
Quarter


    Fiscal
Year

 
    Thousands, except per share data  

Year ended January 31, 2008

                                       

Revenues:

                                       

Retail drug store sales

  $ 1,185,011     $ 1,195,591     $ 1,158,422     $ 1,343,803     $ 4,882,827  

Pharmacy benefit services revenues

    111,999       78,958       79,731       109,050       379,738  
   


 


 


 


 


Total revenues

    1,297,010       1,274,549       1,238,153       1,452,853       5,262,565  

Retail drug store gross profit

    303,952       314,473       300,789       348,844       1,268,058  

Prescription drug plan gross profit

    4,062       11,496       15,411       16,223       47,192  

Income from continuing operations

    16,026       25,738       19,292       37,835       98,891  

Income (loss) from discontinued operations

    (2,988 )     869       106       (677 )     (2,690 )
   


 


 


 


 


Net income

    13,038       26,607       19,398       37,158       96,201  
   


 


 


 


 


Earnings per common share:

                                       

Basic:

                                       

Income from continuing operations

  $ 0.43     $ 0.69     $ 0.52     $ 1.02     $ 2.65  

Income (loss) from discontinued operations

    (0.08 )     0.02       0.00       (0.01 )     (0.07 )
   


 


 


 


 


Net income

    0.35       0.71       0.52       1.01       2.58  
   


 


 


 


 


Diluted

                                       

Income from continuing operations

  $ 0.42     $ 0.67     $ 0.51     $ 1.00     $ 2.59  

Income (loss) from discontinued operations

    (0.08 )     0.02       0.00       (0.02 )     (0.07 )
   


 


 


 


 


Net income

    0.34       0.69       0.51       0.98       2.52  
   


 


 


 


 


Year ended January 25, 2007

                                       

Revenues:

                                       

Retail drug store sales

  $ 1,134,977     $ 1,161,870     $ 1,123,875     $ 1,232,218     $ 4,652,940  

Pharmacy benefit services revenues

    93,400       75,343       75,015       76,598       320,356  
   


 


 


 


 


Total revenues

    1,228,377       1,237,213       1,198,890       1,308,816       4,973,296  

Retail drug store gross profit

    283,053       293,409       280,098       311,763       1,168,323  

Prescription drug plan gross profit

    5,041       10,020       20,266       16,213       51,540  

Income from continuing operations

    16,329       19,355       13,337       30,432       79,453  

Loss from discontinued operations

    (545 )     (323 )     (632 )     (3,492 )     (4,992 )
   


 


 


 


 


Net income

    15,784       19,032       12,705       26,940       74,461  
   


 


 


 


 


Earnings per common share:

                                       

Basic:

                                       

Income from continuing operations

  $ 0.44     $ 0.52     $ 0.36     $ 0.82     $ 2.14  

Loss from discontinued operations

    (0.02 )     (0.01 )     (0.02 )     (0.09 )     (0.14 )
   


 


 


 


 


Net income

    0.42       0.51       0.34       0.73       2.00  
   


 


 


 


 


Diluted

                                       

Income from continuing operations

  $ 0.43     $ 0.51     $ 0.35     $ 0.80     $ 2.08  

Loss from discontinued operations

    (0.02 )     (0.01 )     (0.02 )     (0.09 )     (0.13 )
   


 


 


 


 


Net income

    0.41       0.50       0.33       0.71       1.95  
   


 


 


 


 


 

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Table of Contents

LONGS DRUG STORES CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Pharmacy benefit services revenues include pharmacy benefit management revenues and revenues for prescription drug plans under Medicare Part D as established by the Medicare Prescription Drug, Improvement and Modernization Act of 2003. Prescription drug plan gross profit is measured based on prescription drug plan benefit costs and prescription drug plan revenues. Pharmacy benefit management revenues are reported net of reimbursements to participating pharmacies.

 

Results for the fourth quarter of fiscal 2008 included a $1.1 million pre-tax net gain associated with the Company’s disposition of stores during fiscal 2008, of which a net gain of $1.8 million was recorded in continuing operations and a net charge of $0.7 million was recorded in discontinued operations. Results for the fourth quarter of fiscal 2007 included $6.3 million of pre-tax charges associated with this disposition plan, of which $0.7 million was recorded in continuing operations and $5.6 million was recorded in discontinued operations.

 

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Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors and Stockholders of

Longs Drug Stores Corporation

Walnut Creek, California

 

We have audited the accompanying consolidated balance sheets of Longs Drug Stores Corporation and subsidiaries (the “Company”) as of January 31, 2008 and January 25, 2007, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended January 31, 2008. We also have audited the Company’s internal control over financial reporting as of January 31, 2008, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on these financial statements and an opinion on the effectiveness of the Company’s internal control over financial reporting 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 and whether effective internal control over financial reporting was maintained in all material respects. Our audits of financial statements included 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. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

 

A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Longs Drug Stores Corporation and subsidiaries as of January 31, 2008 and January 25, 2007, and the results of their operations and their cash flows for each of the three years in the period ended

 

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Table of Contents

January 31, 2008, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of January 31, 2008, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

 

As discussed in Note 2 to the consolidated financial statements, the Company adopted the provisions of Financial Accounting Standards Board (“FASB”) Interpretation No. 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109, on January 26, 2007, and as discussed in Note 1 the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123(R), Share-Based Payment on January 27, 2006.

 

/s/ Deloitte & Touche LLP

San Francisco, California

March 18, 2008

 

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Table of Contents

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.

 

None.

 

Item 9A. Controls and Procedures.

 

Management’s Report on Internal Control Over Financial Reporting

 

Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control system was designed to provide reasonable assurance to our management and board of directors regarding the preparation and fair presentation of published financial statements in accordance with generally accepted accounting principles.

 

All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.

 

Our management assessed the effectiveness of our internal control over financial reporting as of January 31, 2008. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control—Integrated Framework. Based on our assessment we believe that, as of January 31, 2008, our internal control over financial reporting is effective based on those criteria.

 

Our independent registered public accounting firm, Deloitte & Touche LLP, has audited the Company’s internal control over financial reporting and their report is included herein.

 

Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures

 

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

 

As of January 31, 2008, the end of the period covered by this annual report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective and adequate to provide reasonable assurance that material information relating to the Company would be made known to them on a timely basis.

 

There have been no changes in our internal control over financial reporting that occurred during the fourth fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

Item 9B. Other Information.

 

No events have occurred which would require disclosure under this Item.

 

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PART III

 

Item 10. Directors, Executive Officers and Corporate Governance.

 

Information concerning this item will be in our definitive proxy statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934 for our 2008 annual meeting of stockholders and is incorporated herein by reference.

 

Item 11. Executive Compensation.

 

Information concerning this item will be in our definitive proxy statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934 for our 2008 annual meeting of stockholders and is incorporated herein by reference.

 

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.

 

Information concerning this item will be in our definitive proxy statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934 for our 2008 annual meeting of stockholders and is incorporated herein by reference.

 

Item 13. Certain Relationships and Related Transactions, and Director Independence.