10-K 1 f200610kfinal.htm Form 10-K

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934


For the fiscal year ended February 2, 2007


Commission file number: 001-11421


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


TENNESSEE
(State or other jurisdiction of
incorporation or organization)

61-0502302
(I.R.S. Employer
Identification No.)

 

100 MISSION RIDGE
GOODLETTSVILLE, TN  37072
(Address of principal executive offices, zip code)

 

Registrant’s telephone number, including area code:  (615) 855-4000

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

 

Title of each class


Common Stock

Series B Junior Participating
Preferred Stock Purchase Rights

Name of the exchange on which registered

New York Stock Exchange

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 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. 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 Exchange Act).  Yes [  ]  No [X]

The aggregate market value of the voting stock held by non-affiliates of the registrant, computed by reference to the closing price on the New York Stock Exchange as of August 4, 2006, was approximately $3.9 billion. The registrant has no non-voting common stock.  For purposes of this disclosure only, the registrant has assumed that its directors, executive officers, and beneficial owners of greater than 10% of the registrant’s common stock are the “affiliates” of the registrant.  

The registrant had 313,938,190 shares of common stock outstanding on March 20, 2007.







INTRODUCTION

General

This report contains references to years 2007, 2006, 2005, 2004, 2003 and 2002, which represent fiscal years ending or ended February 1, 2008, February 2, 2007, February 3, 2006, January 28, 2005, January 30, 2004 and January 31, 2003, respectively.  All of the discussion and analysis in this report should be read with, and is qualified in its entirety by, the Consolidated Financial Statements and the notes thereto.

Forward Looking Statements/Risk Factors

This Form 10-K contains “forward-looking statements.”  These statements may be found throughout this Form 10-K, particularly under the headings “Business” and “Management’s Discussion and Analysis of Financial Condition and Results of Operation,” among others. Forward-looking statements typically are identified by the use of terms such as “may,” “will,” “should,” “expect,” “believe”, “anticipate”, “project”, “plan”, “expect”, “estimate”, “objective”, “forecast”, “goal”, “intend”, “will likely result”, or “will continue” and similar expressions, although some forward-looking statements are expressed differently.  You should consider statements that contain these words carefully because they may express or imply projections of revenues or expenditures, plans and objectives for future operations, growth or initiatives, expected future economic performance, or the expected outcome or impact of pending or threatened litigation based on currently available information.  The factors listed below under the heading “Risk Factors”, in the other sections of this Form 10-K, including, but not limited to: Item 1 subsections “Overall Business Strategy”, “Seasonality” and “Competition”; Item 3; and Item 7 subsections “Executive Overview” and “Critical Accounting Policies and Estimates”, in our other filings with the Securities and Exchange Commission (“SEC”), press releases and other communications provide examples of risks, uncertainties and events that could cause our actual results to differ materially from the expectations expressed in our forward-looking statements.

The forward-looking statements made in this Form 10-K relate only to events as of the date on which the statements are made.  We undertake no obligation to publicly update or revise any forward-looking statement to reflect events or circumstances arising after the date on which it was made.




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PART I

ITEM 1.

BUSINESS

General

We are a leading value discount retailer of quality general merchandise at everyday low prices.  Through conveniently located stores, we offer a focused assortment of basic consumable merchandise including health and beauty aids, packaged food and refrigerated products, home cleaning supplies, housewares, stationery, seasonal goods, basic clothing and domestics.  Dollar General® stores serve primarily low-, middle- and fixed-income families.  

We were founded in 1939 as J.L. Turner and Son, Wholesale.  We opened our first dollar store in 1955, when we were first incorporated as a Kentucky corporation under the name J.L. Turner & Son, Inc.  We changed our name to Dollar General Corporation in 1968 and reincorporated as a Tennessee corporation in 1998.  As of March 2, 2007, we operated 8,260 stores in 35 states, primarily in the southern, southwestern, midwestern and eastern United States.

Proposed Merger

On March 11, 2007, we entered into an Agreement and Plan of Merger (the “Merger Agreement”) with Buck Holdings LP, a Delaware limited partnership (“Parent”), and Buck Acquisition Corp., a Tennessee corporation and wholly owned subsidiary of Parent (“Merger Sub”), pursuant to which Merger Sub will be merged with and into us (the “Merger”). We will continue as the surviving corporation and as a wholly owned subsidiary of Parent. Merger Sub and Parent are affiliates of Kohlberg Kravis Roberts & Co., L.P.

Pursuant to the Merger Agreement, at the effective time of the Merger, each outstanding share of our common stock, other than any such shares held by any of our wholly owned subsidiaries and any shares owned by us, Parent or Merger Sub, will be cancelled and converted into the right to receive $22.00 in cash, without interest (the “Merger Consideration”). In addition, immediately prior to the effective time of the Merger, all shares of our restricted stock and restricted stock units will, unless otherwise agreed by the holder and Parent, vest and be converted into the right to receive the Merger Consideration. All options to acquire shares of our common stock will vest immediately prior to the effective time of the Merger and holders of such options will, unless otherwise agreed by the holder and Parent, be entitled to receive an amount in cash equal to the excess, if any, of the Merger Consideration over the exercise price per share of our common stock subject to the option.

Our Board of Directors unanimously approved the Merger Agreement and amended our Shareholder Rights Plan to exempt the Merger from that Plan’s operation.

Consummation of the Merger is not subject to a financing condition but is subject to customary closing conditions, including approval of the Merger Agreement by our shareholders, regulatory approval and other customary closing conditions. The Merger Agreement places specified restrictions on certain of our business activities, including but not limited to:



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acquisitions or dispositions of assets, capital expenditures, modifications of debt, leasing activities, compensatory changes, dividend increases, investments and share repurchases.

Overall Business Strategy

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

Our Customers.  We serve the basic consumable needs of customers primarily in the low- and middle-income brackets and those on fixed incomes. According to AC Nielsen’s 2006 Homescan® data, in 2006 approximately 41% of our customers had gross income of less than $30,000 per year and approximately 24% had gross income of less than $20,000 per year.  Our merchandising and operating strategies are primarily designed to meet the need for basic consumable products of consumers in these lower income groups.

Our Stores.  The traditional Dollar General store has, on average, approximately 6,900 square feet of selling space and generally serves customers who live within five miles of the store.  Of our 8,260 stores operating as of March 2, 2007, approximately 4,750 serve communities with populations of 20,000 or less.  We believe that our target customers prefer the convenience of a small, neighborhood store.  We believe that our convenient discount store format will continue to attract customers and provide us with a competitive advantage.  

In 2003, we began testing a Dollar General Market® store concept.  Dollar General Markets are larger than the average Dollar General store and carry, among other items, an expanded assortment of grocery products and perishable items.  At March 2, 2007, our 8,260 total stores included 56 Dollar General Market stores with an average of approximately 17,250 square feet of selling space.

Our Merchandise.  We are committed to offering a focused assortment of quality, consumable merchandise in a number of core categories, such as health and beauty aids, packaged food and refrigerated products, home cleaning supplies, housewares, stationery, seasonal goods, basic clothing and domestics.  This focused merchandise assortment allows customers to shop at Dollar General stores for their everyday household needs.  In 2006, the average customer purchase was $9.31.

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

Our Cost Controls.  We emphasize aggressive management of our overhead cost structure. Additionally, we seek to locate stores in neighborhoods where rental and operating costs are relatively low. We attempt to control operating costs by implementing new technology where feasible. Examples of this strategy in recent years include the implementation of “EZstore”, our initiative designed to improve inventory flow from distribution centers (“DCs”) to consumers; other improvements to our supply chain and warehousing systems; an automatic



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inventory replenishment system at the store level; the implementation of a new merchandise planning system designed to assist our merchants with their purchasing and store allocation decisions; enhancements and improvements to the inventory replenishment and merchandise planning systems; and the reengineering of our open-to-buy inventory procurement process.

Recent Strategic Initiatives

In the fourth quarter of 2006, we launched certain strategic initiatives related to our merchandising and real estate strategies based upon a comprehensive analysis of the performance of each of our stores and the impact of our inventory model on our ability to effectively serve our customers.

With regard to merchandising, we reviewed our historic inventory management strategies, changes in recent years to those practices and the potential impact on future profitability of an acceleration of our transition away from some of those practices. Under our traditional inventory disposition strategy, we carried forward any remaining prior season inventory (“packaway”) and attempted to adjust future inventory purchases to account for the carryover product. Beginning in the fourth quarter of 2003, principally at the conclusion of the holiday selling season, we began taking end-of-season markdowns materially in excess of markdowns that had been taken historically to attempt to accelerate the disposition of certain holiday-related items, as well as certain other seasonal, home and basic clothing items that had not sold as expected. Although these increased end-of-season markdowns resulted in less packaway inventory, there continued to be a packaway component of our merchandising practices and a significant amount of merchandise from prior seasons remained in many stores. Based on our review, we decided to discontinue our traditional inventory packaway management model in an attempt to better meet our customers’ needs and to ensure an appealing, fresh merchandise selection. We are currently in the process of executing that initiative, as further discussed below under “Merchandising Initiatives”.


We made significant improvements to the policies, procedures and controls relating to our real estate practices during 2006. We have fully integrated the functions of site selection, lease renewals, relocations, remodels and store closings and have defined and implemented additional criteria for decision-making in those areas. We continue to analyze our real estate performance and to look for ways to further refine and improve our practices. As a first step in our initiative to revitalize our store base, we plan to close approximately 400 underperforming stores by the end of fiscal 2007, including 151 stores that have already been closed as of March 2, 2007. The closings are in addition to stores that might be closed in the normal course of business. We will continue to evaluate our store base for additional closing candidates as part of our revitalization efforts. We also are focusing on upgrading our existing store base with plans to decelerate our new store growth rate to enable us to remodel or relocate a number of stores to improve productivity and enhance the shopping experience for the customers in those stores. We expect that these actions will result in better disciplined inventory management and a more productive store base.




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Growth Strategy

We have experienced a rapid rate of expansion in recent years, increasing our number of stores from 5,540 as of February 1, 2002, to 8,260 as of March 2, 2007.  In addition to growth from new store openings, we recorded same-store sales increases of 3.3% and 2.0% in 2006 and 2005, respectively.  Same-store sales calculations for 2005 and prior include only those stores that were open both at the end of that period and at the beginning of the preceding fiscal year, based on the comparable calendar weeks in the prior year. As further described below in Part II, Item 7, 2006 was a 52-week accounting period while 2005 was a 53-week accounting period. Accordingly, the same store sales percentages discussed above exclude sales from the 53rd week in 2005 as there was no comparable week in 2006 or 2004. We will continue to seek to grow our business and believe that this future growth will come from a combination of new store openings, remodeled and relocated stores, infrastructure investments and merchandising initiatives, each as discussed more fully below.

New Store Growth.  We believe that our convenient, small-store format is adaptable to small towns and neighborhoods throughout the country.  The majority of our stores are located in these small towns (which we define as communities with populations of 20,000 or less).  In 2006, approximately half of our new stores were opened in small towns while the remainder were opened either in rural or in more densely populated areas.  We expect a similar mix of new store openings between small towns and other areas in 2007.  New store openings in 2007 will include our existing market area as well as certain other geographic areas where management believes we have the potential to expand our store base. As part of the strategic initiatives discussed above, we plan to decrease the number of new store openings and increase the number of remodeled or relocated stores in 2007. Opening or remodeling/relocating stores in our existing market area allows us to take advantage of brand awareness and to maximize our operating efficiencies.

In 2006, 2005 and 2004, we opened 537, 734 and 722 new stores, and remodeled or relocated 64, 82 and 80 stores, respectively.  In 2007, we plan to open approximately 300 new Dollar General stores and plan to remodel or relocate an additional 300 stores.

Infrastructure Investments. Our distribution network is an integral component of our efforts to reduce transportation expenses and effectively support our growth.  In recent years, we have made significant investments in our distribution network. As of March 2, 2007, we operated nine DCs, one of which opened during 2006. In recent years, we have expanded our DCs in South Boston, Virginia, and Ardmore, Oklahoma, by completing the conversion of these DCs from single to dual sortation systems, which enables them to serve more stores.

We also have invested in technological improvements and upgrades in recent years. In 2006, new systems for assortment planning, merchandise allocations and drop ship receiving were installed. We implemented improvements to our transportation, sales audit, loss prevention and planogram systems.   In addition, we completed store system enhancements for promotions and coupons. In 2005, we installed new systems for store operating statements, store labor scheduling, supplier communications and transportation and claims management. In addition, we enhanced our store systems to allow us to sell Dollar General gift cards.  In 2004, we added a merchandising data warehouse, completed the rollout of credit/debit and electronic benefit



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transfer capabilities and installed an automatic inventory replenishment system in all stores. In addition, we completed a new stock ledger and sales flash system. Also, for the first time, we equipped store district managers with personal computers to enable them to access daily merchandising information.

Merchandising Initiatives.  Our merchandising initiatives are designed to promote same-store sales increases.  We continually evaluate the performance of our merchandise mix and make adjustments when appropriate.  In recent years, we have increased our emphasis on the highly consumable category by adding items in the food, paper, pet products, household chemicals, and health and beauty aids categories. Also in recent years, we began offering perishable products, which include a selection of dairy products, luncheon meats, frozen foods and ice cream. Other recent initiatives include prepaid phone cards and branded apparel.

In the fourth quarter of 2006, we commenced execution of an initiative to discontinue our traditional inventory packaway management model in an attempt to better meet our customers’ needs and to ensure an appealing, fresh merchandise selection. With few exceptions, we plan to eliminate, through end-of-season and other markdowns, existing seasonal, home products and basic clothing packaway merchandise by the end of fiscal 2007. In addition, beginning in fiscal 2007, we plan to sell virtually all current-year non-replenishable merchandise by taking end-of-season markdowns, allowing for increased levels of newer, current-season merchandise. We believe this strategy change will enhance the appearance of our stores and will positively impact customer satisfaction as well as the store employees’ ability to manage stores, ultimately resulting in higher sales, increased gross profit, lower employee turnover, and decreased inventory shrink and damages. We also expect that this improved inventory management will result in more appropriate per store inventory levels.

We expect to increase our sales mix of merchandise categories with higher gross profit rates, such as home products, basic clothing and seasonal merchandise, as we become increasingly able to improve our merchandise assortments and stock our stores with more current inventory. Achievement of our goals is contingent upon this expected sales mix improvement as well as effective inventory management and reductions in inventory shrink and damages.

In 2006, we initiated a new store layout that we believed would drive sales and improve our merchandising mix.  The new layout was launched in a test mode in early 2006, was further developed during the year, and became our standard new store format by the end of 2006.  Through the process of opening new stores and re-formatting a limited number of existing stores there were approximately 359 stores operating in this new format as of March 2, 2007.  The results have been encouraging, as we have seen additional sales, including increased sales of higher margin goods.  Additionally, improved merchandise adjacencies and wider, more open aisles have enhanced the overall guest shopping experience.

Merchandise

Dollar General stores offer a focused assortment of quality merchandise in a number of core categories. We operate as one reportable segment and separate our merchandise into the following four categories for reporting purposes: highly consumable, seasonal, home products,



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and basic clothing. Detailed information on our net sales by product class can be found in Note 13 to the consolidated financial statements contained in Item 8 of this report.

 We maintain approximately 4,900 core stock-keeping units (“SKUs”) per store.

For the preceding three years, the percentage of total sales of each of the four categories we track is as follows:

 

2006

 

2005

 

2004

Highly consumable

65.7

%

 

65.3

%

 

63.0

%

Seasonal

16.4

%

 

15.7

%

 

16.5

%

Home products

10.0

%

 

10.6

%

 

11.5

%

Basic clothing

7.9

%

 

8.4

%

 

9.0

%


Of the four categories, the home products and seasonal categories typically account for the highest gross profit rates and the highly consumable category typically accounts for the lowest gross profit rate.  

We purchase our merchandise from a wide variety of suppliers. Approximately 11% of our purchases in 2006 were from The Procter & Gamble Company.  Our next largest supplier accounted for approximately 5% of our purchases in 2006.  We directly imported approximately 14% of our retail receipts in 2006.

Through 2005, we generally did not use advertising circulars widely throughout our network of stores. Instead we advertised to support new traditional store openings primarily with targeted circulars and in-store signage. In 2006, we used several advertising circulars in an attempt to increase sales and customer traffic. Additionally, during 2006 we advertised on both television and radio. Advertising expenses remained less than 1% of sales. In 2005, we initiated a marketing program as the sponsor of a National Association for Stock Car Auto Racing (“NASCAR”) Busch Series car, which continued in 2006. During 2005 and 2006, we participated in the Busch Series racing season, which ran from February to November and served as the title sponsor of the Dollar General 300 NASCAR Busch Series race at Lowe’s Motor Speedway in Concord, North Carolina.

Seasonality

Our business is modestly seasonal in nature.  We expect to continue to experience seasonal fluctuations, with a larger percentage of our net sales, operating profit and net income being realized in the fourth quarter. In addition, our quarterly results can be affected by the timing of new store openings and store closings, the amount of sales contributed by new and existing stores, as well as the timing of certain holidays. We purchase substantial amounts of inventory in the third quarter and incur higher shipping costs and higher payroll costs in anticipation of the increased sales activity during the fourth quarter.  In addition, we carry merchandise during our fourth quarter that we do not carry during the rest of the year, such as gift sets, holiday decorations, certain baking items, and a broader assortment of toys and candy.




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The following table reflects the seasonality of net sales, operating profit, and net income (loss) by quarter. All of the quarters reflected below are comprised of 13 weeks with the exception of the fourth quarter of the year ended February 3, 2006, which was comprised of 14 weeks.


 

1st
Quarter

 

2nd
Quarter

 

3rd
Quarter

 

4th
Quarter

Year Ended February 2, 2007

           

Net sales

23.5

%

 

24.5

%

 

24.1 

%

 

27.9

%

Operating profit (a)

32.7

%

 

32.5

%

 

1.3 

%

 

33.5

%

Net income (loss) (a)

34.5

%

 

33.0

%

 

(3.8)

%

 

36.3

%

            

Year Ended February 3, 2006

           

Net sales

23.0

%

 

24.1

%

 

24.0 

%

 

28.9

%

Operating profit

19.0

%

 

21.5

%

 

18.1 

%

 

41.3

%

Net income

18.5

%

 

21.6

%

 

18.4 

%

 

41.5

%

            

Year Ended January 28, 2005

           

Net sales

22.8

%

 

24.0

%

 

24.5 

%

 

28.7

%

Operating profit

20.6

%

 

19.4

%

 

20.5 

%

 

39.6

%

Net income

19.7

%

 

20.7

%

 

20.7 

%

 

38.9

%

            

(a)

Results for the 3rd and 4th quarters of 2006 reflect the impact of Recent Strategic Initiatives as discussed above and in further detail below under “Management’s Discussion and Analysis of Financial Condition and Results of Operations”.


The Dollar General Store

The typical Dollar General store is operated by a manager, an assistant manager and two or more sales clerks.  Approximately 49% of our stores are located in strip shopping centers, 49% are in freestanding buildings and 2% are in downtown buildings.  We generally have not encountered difficulty locating suitable store sites in the past, and management does not currently anticipate experiencing material difficulty in finding suitable locations.

Our recent store growth is summarized in the following table:

Year

Stores at
Beginning
of Year

Stores
Opened

Stores
Closed

Net
Store
Increase

Stores at
End of Year

2004

6,700

722

102

 

620

7,320

2005

7,320

734

125

(a)

609

7,929

2006

7,929

537

237

(b)

300

8,229


(a) Includes 41 stores closed as a result of hurricane damage.

(b) Includes 128 stores closed as a result of certain recent strategic initiatives



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Employees

As of March 2, 2007, we employed approximately 69,500 full-time and part-time employees, including divisional and regional managers, district managers, store managers, and DC and administrative personnel, compared with approximately 64,500 employees on March 3, 2006.  Management believes our relationship with our employees is generally good, and we are not a party to any collective bargaining agreements.

Competition

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

The dollar store category differentiates itself from other forms of retailing by offering consistently low prices in a convenient, small-store format.  We believe that our prices are competitive due in part to our low cost operating structure and the relatively limited assortment of products offered.  Historically, we have minimized labor by offering fewer price points and a reliance on simple merchandise presentation.  We attempt to locate primarily in second-tier locations, either in small towns or in the neighborhoods of more densely populated areas where occupancy expenses are relatively low.  We maintain a strong purchasing power position due to our leadership position in the dollar store retail category, which centers on a focused assortment of merchandise.

Trademarks

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

Available Information

Our website address is www.dollargeneral.com. We make available through this address, without charge, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after they are electronically filed or furnished to the SEC.



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ITEM 1A.

RISK FACTORS

Investing in our securities involves a degree of risk. Persons buying our securities should carefully consider the risks described below and the other information contained in this report and other filings that we make from time to time with the SEC, including our consolidated financial statements and accompanying notes. If any of the following risks actually occurs, our business, financial condition, results of operation or cash flows could be materially adversely affected. In any such case, the trading price of our securities could decline and you could lose all or part of your investment. The risks described below are not the only ones facing us and are not intended to be a complete discussion of all potential risks or uncertainties. Additional risks not presently known to us or that we currently deem immaterial may also impair our business operations.

Some of the statements in our reports are not statements of historical fact; instead, they are what are known as “forward-looking statements” that may or may not come to fruition. Certain of the discussions in this report and in the documents incorporated by reference into this report may express or imply projections of revenues or expenditures; plans and objectives for future operations, growth or initiatives (such as the proposed merger; expectations regarding certain planned real estate and merchandising strategic and operational changes and their related timing, charges and cost estimates and anticipated results and benefits; the expected number of new store openings, relocations and remodels; our gross profit rate; the expected sale of inventory and our plans with respect to product assortment, inventory levels and the impact of seasonality; and other potential initiatives and plans referred to in “Results of Operations – Executive Overview”); expected future economic performance; the expected outcome or impact of pending or threatened litigation; our anticipated effective tax rate; or the anticipated levels of borrowings under our amended credit facility and the expected use of those funds. These and similar statements regarding events or results which we expect will or may occur in the future are forward-looking statements concerning matters that involve risks and uncertainties that may cause actual results to differ materially from those projected. Forward-looking statements generally may be identified through the use of words such as “believe,” “anticipate,” “project,” “plan,” “expect,” “estimate,” “objective,” “forecast,” “goal,” “intend,” “will likely result,” or “will continue” and similar expressions.

Although when we make forward-looking statements we believe they are based on reasonable assumptions within the bounds of our knowledge of our business, a number of factors could cause our actual results to differ materially from those that are projected. Factors and risks that may cause actual results to differ from this forward-looking information include, but are not limited to, those described below, as well as other factors discussed throughout this document, including, without limitation, the factors described under “Critical Accounting Policies and Estimates” or, from time to time, in our SEC filings, press releases and other communications. We cannot assure you that the results or developments expected or anticipated by us will be realized or, even if substantially realized, that those results or developments will result in the expected consequences for us or affect us or our operations in the way that we expect.

We caution readers to evaluate all forward-looking information in the context of these risks and uncertainties and not to place undue reliance on forward-looking statements made in this document which speak only as of the document’s date. We have no obligation, and do



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not intend, to publicly update or revise any of these forward-looking statements to reflect events or circumstances occurring after the date of this document or to reflect the occurrence of unanticipated events. We advise you, however, to consult any further disclosures we may make on related subjects in the documents we file with or furnish to the SEC or in our other public disclosures. Investors should also be aware that while we do, from time to time, communicate with securities analysts and others, it is against our policy to selectively disclose to them any material nonpublic information or other confidential commercial information. Shareholders should not assume that we agree with any statement or report issued by any analyst regardless of the content of the statement or report. To the extent that reports issued by securities analysts contain any financial projections, forecasts or opinions, those reports are not our responsibility.

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

Our plans depend significantly on initiatives designed to improve the efficiencies, costs and effectiveness of our operations, and failure to achieve or sustain these plans could affect our performance adversely. We have had, and expect to continue to have, initiatives (such as those relating to marketing, advertising, merchandising, promotions and real estate) in various stages of testing, evaluation, and implementation, upon which we expect to rely to improve our results of operations and financial condition. These initiatives are inherently risky and uncertain, even when tested successfully, in their application to our business in general. It is possible that successful testing can result partially from resources and attention that cannot be duplicated in broader implementation. Testing and general implementation also can be affected by other risk factors described herein that reduce the results expected. Successful systemwide implementation relies on consistency of training, stability of workforce, ease of execution, and the absence of offsetting factors that can influence results adversely. Failure to achieve successful implementation of our initiatives or the cost of these initiatives exceeding management’s estimates could adversely affect our results of operations and financial condition. Please reference the discussion of the initiatives in the “Executive Overview” portion of Management’s Discussion and Analysis below.

Because our business is moderately seasonal, with the highest portion of sales occurring during the fourth quarter, adverse events during the fourth quarter could materially affect our financial statements as a whole. We generally recognize a significant portion of our net sales and net income during the Christmas selling season, which occurs in the fourth quarter of our fiscal year. In anticipation of this holiday, we purchase substantial amounts of seasonal



11



inventory and hire many temporary employees. A seasonal merchandise inventory imbalance could result if for any reason our net sales during the Christmas selling season were to fall below either seasonal norms or expectations. If for any reason our fourth quarter results were substantially below expectations, our profitability and operating results could be adversely affected by unanticipated markdowns, especially in seasonal merchandise. Lower than anticipated sales in the Christmas selling season would also negatively affect our ability to absorb the increased seasonal labor costs.

We face intense competition that could limit our growth opportunities and reduce our profitability. The retail business is highly competitive. We operate in the discount retail merchandise business, which is highly competitive with respect to price, store location, merchandise quality, assortment and presentation, in-stock consistency, and customer service. This competitive environment subjects us to the risk of reduced profitability because of the lower prices, and thus the lower margins, required to maintain our competitive position. Also, companies operating in the discount retail merchandise sector (due to customer demographics and other factors) have limited ability to increase prices in response to increased costs (including vendor price increases). This limitation may adversely affect our margins and profitability. We compete for customers, employees, store sites, products and services and in other important aspects of our business with many other local, regional and national retailers. We compete with retailers operating discount, mass merchandise, drug, convenience, variety and specialty stores, supermarkets and supercenter-type stores. Certain of our competitors have greater financial, distribution, marketing and other resources than we do. These other competitors compete in a variety of ways, including aggressive promotional activities, merchandise selection and availability, services offered to customers, location, store hours, in-store amenities and price. If we fail to respond effectively to competitive pressures and changes in the retail markets, it could adversely affect our financial performance. See “Business” in Item 1 above for additional discussion of our competitive situation.

Although the retail industry as a whole is highly fragmented, certain segments of the retail industry have recently undergone and continue to undergo some consolidation, which can significantly alter the competitive dynamics of the retail marketplace. This consolidation may result in competitors with greatly improved financial resources, improved access to merchandise, greater market penetration and other improvements in their competitive positions. These business combinations could result in the provision of a wider variety of products and services at competitive prices by these consolidated companies, which could adversely affect our financial performance. Competition for customers has intensified in recent years as larger competitors have moved into, or increased their presence in, our geographic markets. We remain vulnerable to the marketing power and high level of consumer recognition of these larger competitors and to the risk that these competitors or others could venture into the “dollar store” industry in a significant way. Generally, we expect an increase in competition.

Natural disasters, unusually adverse weather conditions, pandemic outbreaks, boycotts and geo-political events could adversely affect our financial performance. The occurrence of one or more natural disasters, such as hurricanes and earthquakes, unusually adverse weather conditions, pandemic outbreaks, boycotts and geo-political events, such as civil unrest in countries in which our suppliers are located and acts of terrorism, or similar disruptions could adversely affect our operations and financial performance. These events could result in physical



12



damage to one or more of our properties, increases in fuel (or other energy) prices, the temporary or permanent closure of one or more of our stores or DCs, delays in opening new stores, the temporary lack of an adequate work force in a market, the temporary or long-term disruption in the supply of products from some local and overseas suppliers, the temporary disruption in the transport of goods from overseas, delay in the delivery of goods to our DCs or stores, the temporary reduction in the availability of products in our stores and disruption to our information systems. These events also can have indirect consequences such as increases in the costs of insurance following a destructive hurricane season. These factors could otherwise disrupt and adversely affect our operations and financial performance.

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

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



13



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

Our planned future growth will be impeded, which would adversely affect sales, if we cannot open new stores on schedule or if we close a number of stores materially in excess of anticipated levels. Our growth is dependent on both increases in sales in existing stores and the ability to open new stores. Our ability to timely open new stores and to expand into additional market areas depends in part on the following factors: the availability of attractive store locations; the absence of occupancy delays; the ability to negotiate favorable lease terms; the ability to hire and train new personnel, especially store managers; the ability to identify customer demand in different geographic areas; general economic conditions; and the availability of sufficient funds for expansion. In addition, many of these factors affect our ability to successfully relocate stores. Many of these factors are beyond our control. Delays or failures in opening new stores, or achieving lower than expected sales in new stores, or drawing a greater than expected proportion of sales in new stores from existing stores, could materially adversely affect our growth. In addition, we may not anticipate all of the challenges imposed by the expansion of our operations and, as a result, may not meet our targets for opening new stores or expanding profitably.

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

Some of our new stores will be located in areas where we have existing units. Although we have experience in these markets, increasing the number of locations in these markets may cause us to over-saturate markets and temporarily or permanently divert customers and sales from our existing stores, thereby adversely affecting our overall profitability.

We are dependent upon the smooth functioning of our distribution network, the capacity of our DCs, and the timely receipt of inventory. We rely upon the ability to replenish depleted inventory through deliveries to our DCs from vendors and from the DCs to our stores by various means of transportation, including shipments by sea and truck. Labor shortages in the transportation industry could negatively affect transportation costs. In addition, long-term disruptions to the national and international transportation infrastructure that lead to delays or interruptions of service would adversely affect our business.

The efficient operation of our business is heavily dependent upon our information systems. We depend on a variety of information technology systems for the efficient functioning of our business. We rely on certain software vendors to maintain and periodically upgrade many of these systems so that they can continue to support our business. The software programs supporting many of our systems were licensed to us by independent software developers. The inability of these developers or us to continue to maintain and upgrade these information systems and software programs would disrupt or reduce the efficiency of our operations if we were unable to convert to alternate systems in an efficient and timely manner. In addition, costs and



14



potential problems and interruptions associated with the implementation of new or upgraded systems and technology or with maintenance or adequate support of existing systems could also disrupt or reduce the efficiency of our operations. We also rely heavily on our information technology staff. If we cannot meet our staffing needs in this area, we may not be able to fulfill our technology initiatives while continuing to provide maintenance on existing systems.

We are subject to governmental regulations, procedures and requirements. A significant change in, or noncompliance with, these regulations could have a material adverse effect on profitability. Our business is subject to numerous federal, state and local regulations. Changes in these regulations, particularly those governing the sale of products, may require extensive system and operating changes that may be difficult to implement and could increase our cost of doing business. Untimely compliance or noncompliance with applicable regulations or untimely or incomplete execution of a required product recall can result in the imposition of penalties, including loss of licenses or significant fines or monetary penalties.

Our current insurance program may expose us to unexpected costs and negatively affect our profitably. Historically, our insurance coverage has reflected deductibles, self-insured retentions, limits of liability and similar provisions that we believe are prudent based on the dispersion of our operations. However, there are types of losses we may incur but against which we cannot be insured or which we believe are not economically reasonable to insure, such as losses due to acts of war, employee and certain other crime and some natural disasters. If we incur these losses, our business could suffer. Certain material events may result in sizable losses for the insurance industry and adversely impact the availability of adequate insurance coverage or result in excessive premium increases. To offset negative insurance market trends, we may elect to self-insure, accept higher deductibles or reduce the amount of coverage in response to these market changes. In addition, we self-insure a significant portion of expected losses under our workers’ compensation, automobile liability, general liability and group health insurance programs. Unanticipated changes in any applicable actuarial assumptions and management estimates underlying our recorded liabilities for these losses, including expected increases in medical and indemnity costs, could result in materially different amounts of expense than expected under these programs, which could have a material adverse effect on our financial condition and results of operations. Although we continue to maintain property insurance for catastrophic events, we are effectively self-insured for losses up to the amount of our deductibles. If we experience a greater number of these losses than we anticipate, our profitability could be adversely affected.

Litigation may adversely affect our business, financial condition and results of operations. Our business is subject to the risk of litigation by employees, consumers, suppliers, shareholders, government agencies, or others through private actions, class actions, administrative proceedings, regulatory actions or other litigation. The outcome of litigation, particularly class action lawsuits and regulatory actions, is difficult to assess or quantify. Plaintiffs in these types of lawsuits may seek recovery of very large or indeterminate amounts, and the magnitude of the potential loss relating to these lawsuits may remain unknown for substantial periods of time. In addition, certain of these lawsuits, if decided adversely to us or settled by us, may result in liability material to our financial statements as a whole or may negatively affect our operating results if changes to our business operation are required. The cost to defend future litigation may be significant. There also may be adverse publicity associated



15



with litigation that could negatively affect customer perception of our business, regardless of whether the allegations are valid or whether we are ultimately found liable. As a result, litigation may adversely affect our business, financial condition and results of operations. Please see Note 8 to the consolidated financial statements for further details regarding certain of these pending matters.

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

Our credit facility and other debt instruments place financial and other restrictions on us. Our debt obligations and financings have certain financial covenants and limits on our ability to incur additional indebtedness, to sell assets and to make certain payments. The lender’s ongoing obligation to extend credit under these financings will depend upon our compliance with these and other covenants. In addition, we may need to incur additional indebtedness which may have important consequences, including placing us at a competitive disadvantage compared to our competitors that may have proportionately less debt, limiting our flexibility in planning for changes in our business and the industry and making us more vulnerable to economic downturns and adverse developments in our business.

Our profitability could decline if we substantially exceed our anticipated borrowings under our amended credit facility. The amount of borrowings under our amended credit facility may fluctuate materially, particularly given the seasonality of our business, depending on various factors, including the time of year, our need to acquire merchandise inventory, changes to our merchandising plans and initiatives, changes to our capital expenditure plans and the occurrence of other events or transactions that may require funding through the amended credit facility. If these borrowings under our amended credit facility exceed our anticipated levels, our interest expense would increase beyond our expectations and a decrease in our profitability could result.

Our annual and quarterly operating results may fluctuate significantly and could fall below the expectations of securities analysts and investors due to a number of factors, some of which are beyond our control, resulting in a decline in the price of our securities. Our annual and quarterly operating results may fluctuate significantly because of several factors, including those described above. Accordingly, results for any one quarter are not necessarily indicative of results to be expected for any other quarter or for any year, and revenues and net income for any particular future period may decrease. In the future, operating results may fall below the expectations of securities analysts and investors. In that event, the price of our securities could decrease.

Failure to complete the proposed merger could adversely affect us.  On March 11, 2007, we entered into a merger agreement with affiliates of Kohlberg Kravis Roberts & Co. L.P. (“KKR”).  There is no assurance that the merger agreement and the merger will be approved by our shareholders or that the other conditions to the completion of the merger will be satisfied.  The current market price of our common stock may reflect a market assumption that the merger



16



will be completed, and a failure to complete the merger could result in a decline in the market price of our common stock. Consummation of the merger is subject to the following risks:  

·

the occurrence of any event, change or other circumstances that could give rise to a termination of the merger agreement;

·

the outcome of any legal proceedings that have been or may be instituted against us, members of our Board of Directors and others relating to the merger agreement, including the terms of any settlement of such legal proceedings that may be subject to court approval;

·

the inability to complete the merger due to the failure to obtain shareholder approval or the failure to satisfy other conditions to consummation of the merger;

·

the failure by KKR or its affiliates to obtain the necessary debt financing arrangements set forth in the commitment letter received in connection with the merger; and

·

the failure of the merger to close for any other reason.

In addition, in connection with the merger we will be subject to several risks, including the following:

·

there may be substantial disruption to our business and a distraction of our management and employees from day-to-day operations, because matters related to the merger may require substantial commitments of their time and resources;

·

uncertainty about the effect of the merger may adversely affect our credit rating and our relationships with our employees, suppliers and other persons with whom we have business relationships;

·

certain costs relating to the merger, such as legal, accounting and financial advisory fees, are payable by us whether or not the merger is completed; and

·

under certain circumstances, if the merger is not completed we may be required to pay the buyer a termination fee of up to $225 million.

Provisions in our charter, Tennessee law and our shareholder rights plan may discourage potential acquirors of our company, which could adversely affect the value of our securities. Our charter contains provisions that may have the effect of making it more difficult for a third party to acquire or attempt to acquire control of our company. In addition, we are subject to certain provisions of Tennessee law that limit, in some cases, our ability to engage in certain business combinations with significant shareholders. Also, our shareholder rights plan may inhibit accumulations of substantial amounts of our common stock without the approval of our Board of Directors.

These provisions, either alone, or in combination with each other, give our current directors and executive officers a substantial ability to influence the outcome of a proposed



17



acquisition of our company. These provisions would apply even if an acquisition or other significant corporate transaction was considered beneficial by some of our shareholders. If a change-in-control or change in management is delayed or prevented by these provisions, the market price of our securities could decline.

ITEM 1B.

UNRESOLVED STAFF COMMENTS


None.


ITEM 2.

PROPERTIES

As of March 2, 2007, we operated 8,260 retail stores located in 35 states as follows:

State

Number of Stores

 

State

Number of Stores

Alabama

443

  

Nebraska

90

 

Arizona

60

  

New Jersey

24

 

Arkansas

222

  

New Mexico

41

 

Colorado

8

  

New York

231

 

Delaware

25

  

North Carolina

456

 

Florida

429

  

Ohio

452

 

Georgia

471

  

Oklahoma

281

 

Illinois

310

  

Pennsylvania

410

 

Indiana

290

  

South Carolina

306

 

Iowa

178

  

South Dakota

5

 

Kansas

148

  

Tennessee

409

 

Kentucky

291

  

Texas

958

 

Louisiana

327

  

Utah

4

 

Maryland

63

  

Vermont

1

 

Michigan

250

  

Virginia

252

 

Minnesota

13

  

West Virginia

151

 

Mississippi

254

  

Wisconsin

99

 

Missouri

308

     

Most of our stores are located in leased premises.  Individual store leases vary as to their terms, rental provisions and expiration dates.  The majority of our leases are relatively low-cost, short-term leases (usually with initial or primary terms of three to five years) often with multiple renewal options. We also have stores subject to build-to-suit arrangements with landlords, which typically carry a primary lease term of between 7 and 10 years with multiple renewal options. In recent years, an increasing percentage of our new stores have been subject to build-to-suit arrangements. In 2007, we expect approximately 70% of our new stores to be build-to-suit arrangements.



18



As of March 2, 2007, we operated nine DCs, as described in the following table:

Location

Year
Opened

Approximate Square
Footage

 

Approximate Number of Stores Served

Scottsville, KY

1959

720,000

  

871

 

Ardmore, OK

1994

1,310,000

  

1,144

 

South Boston, VA

1997

1,250,000

  

794

 

Indianola, MS

1998

820,000

  

854

 

Fulton, MO

1999

1,150,000

  

1,264

 

Alachua, FL

2000

980,000

  

698

 

Zanesville, OH

2001

1,170,000

  

1,281

 

Jonesville, SC

2005

1,120,000

  

783

 

Marion, IN

2006

1,110,000

  

571

 

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


Our executive offices are located in approximately 302,000 square feet of leased space in Goodlettsville, Tennessee.

ITEM 3.

LEGAL PROCEEDINGS

The information contained in Note 8 to the consolidated financial statements under the heading “Legal Proceedings” contained in Part II, Item 8 of this report is incorporated herein by this reference.


ITEM 4.

SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of shareholders during the fourth quarter of 2006.


PART II


ITEM 5.

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


Our common stock is traded on the New York Stock Exchange under the symbol “DG.”  The following table sets forth the range of the high and low sales prices of our common stock during each quarter in 2006 and 2005, as reported in the consolidated transaction reporting system, together with dividends.

2006

 

First
Quarter

 

Second
Quarter

 

Third
Quarter

 

Fourth
Quarter

High

 

$

18.32

  

$

17.26

  

$

14.80

  

$

17.88

 

Low

 

$

17.01

  

$

13.02

  

$

12.10

  

$

13.54

 

Dividends

 

$

.050

  

$

.050

  

$

.050

  

$

.050

 
                 



19






2005

 

First
Quarter

 

Second
Quarter

 

Third
Quarter

 

Fourth
Quarter

High

 

$

22.80

  

$

22.50

  

$

20.39

  

$

19.84

 

Low

 

$

19.83

  

$

19.35

  

$

17.75

  

$

16.47

 

Dividends

 

$

.040

  

$

.045

  

$

.045

  

$

.045

 


Our stock price at the close of the market on March 20, 2007 was $21.16.

There were approximately 11,584 shareholders of record of our common stock as of March 20, 2007.

We have paid cash dividends on our common stock since 1975. The Board of Directors regularly reviews our dividend plans to ensure that they are consistent with our earnings performance, financial condition, need for capital and other relevant factors.

The following table contains information regarding purchases of our common stock made during the quarter ended February 2, 2007 by or on behalf of Dollar General or any “affiliated purchaser,” as defined by Rule 10b-18(a)(3) of the Exchange Act:


 

Period

 

Total Number
of Shares Purchased (a)

 

Average Price Paid per Share

 

Total Number
of Shares Purchased as Part of Publicly Announced Plans or Programs (b)

 

Approximate Dollar Value of Shares that May Yet Be Purchased Under the Plans or Programs (b)

 
  

11/04/06-11/30/06

 

1,040

  

15.80

  

-

  

$

500,000,000

  
  

12/01/06-12/31/06

 

40

  

15.44

  

-

  

$

500,000,000

  
  

01/01/07-02/02/07

 

464

  

17.26

  

-

  

$

500,000,000

  
  

Total

 

1,544

  

16.23

  

-

  

$

500,000,000

  
                  
 

(a)  Shares purchased in open market transactions in satisfaction of our obligations under certain employee benefit plans.

 

(b)  On November 29, 2006, we announced that our Board of Directors had approved a share repurchase program of up to $500 million of outstanding shares of our common stock.  Under the authorization, purchases may be made in the open market or in privately negotiated transactions from time to time subject to market conditions. This repurchase authorization expires on December 31, 2008.




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ITEM 6.

SELECTED FINANCIAL DATA


The following table sets forth selected consolidated financial information for each of the five most recent fiscal years.  This information should be read in conjunction with the Consolidated Financial Statements and the notes thereto included in Part II, Item 8 of this report, Management’s Discussion and Analysis of Financial Condition and Results of Operations, included in Part II, Item 7 of this report, and the Forward-Looking Statement/Risk Factors disclosure contained in the Introduction and in Part I, Item 1A of this report.


(In thousands, except per share and operating data)

 

February 2, 2007 (a)

 

February 3, 2006 (b)

 

January 28,

2005

 

January 30,

2004

 

January 31,

2003

SUMMARY OF OPERATIONS:

              

Net sales

$

9,169,822 

 

$

8,582,237 

 

$

7,660,927 

 

$

6,871,992 

 

$

6,100,404 

Gross profit

$

2,368,205 

 

$

2,464,824 

 

$

2,263,192 

 

$

2,018,129 

 

$

1,724,266 

Penalty expense and litigation settlement (proceeds)

$

– 

 

$

– 

 

$

– 

 

$

10,000 

 

$

(29,541)

Income before income taxes

$

220,363 

 

$

544,642 

 

$

534,757 

 

$

476,523 

 

$

410,337 

Net income

$

137,943 

 

$

350,155 

 

$

344,190 

 

$

299,002 

 

$

262,351 

Net income as a % of sales

 

1.5%

  

4.1% 

  

4.5% 

  

4.4% 

  

4.3% 

               

PER SHARE RESULTS:

              

Basic earnings per share

$

0.44 

 

$

1.09 

 

$

1.04 

 

$

0.89 

 

$

0.79 

Diluted earnings per share

$

0.44 

 

$

1.08 

 

$

1.04 

 

$

0.89 

 

$

0.78 

Cash dividends per share of common stock

$

0.200 

 

$

0.175 

 

$

0.160 

 

$

0.140 

 

$

0.128 

Weighted average diluted shares

 

313,510 

  

324,133 

  

332,068 

  

337,636 

  

335,050 

               

FINANCIAL POSITION:

              

Total assets

$

3,040,514 

 

$

2,980,275 

 

$

2,841,004 

 

$

2,621,117 

 

$

2,303,619 

Long-term obligations

$

261,958 

 

$

269,962 

 

$

258,462 

 

$

265,337 

 

$

330,337 

Shareholders’ equity

$

1,745,747 

 

$

1,720,795 

 

$

1,684,465 

 

$

1,554,299 

 

$

1,267,445 

Return on average assets (c)

 

4.4%

  

12.1% 

  

12.7% 

  

12.3% 

  

10.9% 

Return on average equity (c)

 

8.0%

  

20.9% 

  

22.1% 

  

21.4% 

  

23.2% 

               

OPERATING DATA:

              

Retail stores at end of period

 

8,229 

  

7,929 

  

7,320 

  

6,700 

  

6,113 

Year-end selling square feet

 

57,299,000 

  

54,753,000 

  

50,015,000 

  

45,354,000 

  

41,201,000 

Highly consumable sales

 

65.7%

  

65.3% 

  

63.0% 

  

61.2% 

  

60.2% 

Seasonal sales

 

16.4%

  

15.7% 

  

16.5% 

  

16.8% 

  

16.3% 

Home products sales

 

10.0%

  

10.6% 

  

11.5% 

  

12.5% 

  

13.3% 

Basic clothing sales

 

7.9%

  

8.4% 

  

9.0% 

  

9.5% 

  

10.2% 

               
               

(a)

Includes the effects of certain strategic merchandising and real estate initiatives as further described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations”.

(b)

The fiscal year ended February 3, 2006 was comprised of 53 weeks.

(c)

Average assets or equity, as applicable, is calculated using the fiscal year-end balance and the four preceding fiscal quarter-end balances.





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ITEM 7.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS


General

Accounting Periods.  The following text contains references to years 2007, 2006, 2005 and 2004, which represent fiscal years ending or ended February 1, 2008, February 2, 2007, February 3, 2006 and January 28, 2005, respectively. Our fiscal year ends on the Friday closest to January 31. Fiscal years 2006 and 2004 were each 52-week accounting periods, while fiscal 2005 was a 53-week accounting period, which affects the comparability of certain amounts in the Consolidated Financial Statements and financial ratios between 2005 and the other fiscal years reflected herein. This discussion and analysis should be read with, and is qualified in its entirety by, the Consolidated Financial Statements and the notes thereto. It also should be read in conjunction with the Forward-Looking Statements/Risk Factors disclosure set forth in the Introduction and in Item I, Part 1A of this report.

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


Proposed Merger. On March 11, 2007, we entered into an Agreement and Plan of Merger (the “Merger Agreement”) with Buck Holdings LP (“Parent”) and Buck Acquisition Corp. (“Merger Sub”), whereby Merger Sub will be merged with and into us (the “Merger”). In the event the Merger is consummated, we will continue as the surviving corporation and as a wholly owned subsidiary of Parent.  For more information, see Note 14 to the Consolidated Financial Statements.


Executive Overview

Dollar General Corporation is the largest dollar store value discount retailer of consumable basics in the United States, with over 8,000 stores. We are committed to serving the needs of low-, middle- and fixed-income customers. However, we sell quality private label and national brand products that appeal to a wide range of customers. Our small box retail model provides a compelling combination of value and convenience. We believe many of our customers shop at our stores because they trust us to consistently stock quality merchandise at low prices and they are able to complete a shopping trip in a limited amount of time. Many of our stores are located in towns that many retailers may find too small to support their business model, which has allowed us to continue to increase our store count faster than most retailers.


We operate in the highly competitive retail industry and face strong sales competition from other retailers that sell general merchandise and food. We strive to keep operating costs as low as possible in order to support our every day low price strategy while seeking a strong return on our investment. This effort affects all expenses, but is particularly critical as we compete for retail site locations and for qualified talent to manage and operate our stores.



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Our management team continues to focus on making good investment decisions for our long-term growth and profitability. In an effort to better support sales efforts in our stores and to improve profitability, we have attempted to strengthen our senior leadership team over the last several years and to improve synergies between store operations, store development, merchandising, marketing and the supply chain.  We believe we now have a strong leadership team in place and are beginning to see the impact of its efforts throughout the organization. In particular, this team developed and has begun to implement significant new programs related to our merchandising and real estate strategies.


Early in the fiscal year, we made changes to address unexpected shortfalls in same-store sales performance and declining customer traffic that we experienced from September 2005 through March 2006. Our efforts to arrest the trend and generate higher sales included significant increases in our promotional efforts, utilizing advertising circulars and more promotional pricing beginning in the first quarter of 2006. We also added more national brands, which typically carry a lower gross profit rate, in several merchandise categories, including food, snacks and automotive. While these efforts did reverse the same-store sales trend and resulted in improved sales, the gross profit rate and selling, general and administrative expenses rate to sales were unfavorably impacted. Accordingly, we began to concentrate our efforts on increasing the sales in our higher gross profit categories, namely, home products, basic clothing and seasonal. The evaluation of our performance in these categories led us to challenge our long-time business practice of packing away end-of-season merchandise.


In November 2006, we announced a plan to minimize the amount of merchandise in the stores that is carried over to subsequent periods (“packaway”). We began a significant effort in the fourth quarter of fiscal 2006 to sell-through this inventory, eliminating over half of the targeted merchandise by the end of the fiscal year. With few exceptions, we plan to eliminate, through end-of-season and other markdowns, existing seasonal, home and apparel packaway inventories from the stores by the end of fiscal 2007, allowing for newer and fresher items and more appealing merchandise presentation as we move forward. To maximize the financial returns of this initiative while accelerating the sell-through of the targeted inventory, we developed a schedule for markdowns and established an oversight team to monitor our efforts. In addition, we are utilizing television and radio advertising to help increase awareness of this effort as well as to introduce potential customers to our brand and everyday product offerings.


Discontinuing our traditional inventory packaway management model is an attempt to better meet our customers’ needs and to ensure an appealing, fresh merchandise selection. In addition, beginning in fiscal 2007, we plan to sell virtually all current-year non-replenishable merchandise by taking end-of-season markdowns, allowing for increased levels of newer, current-season merchandise. We believe this strategy change will enhance the appearance of our stores and will positively impact customer satisfaction as well as the store employees’ ability to manage stores, ultimately resulting in higher sales, increased gross profit, lower employee turnover, and decreased inventory shrink and damages. We also expect that this improved inventory management will result in more appropriate per store inventory levels.


Also in November 2006, we announced significant changes to our real estate strategy.  After a comprehensive analysis of the performance of each of our stores, management



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recommended and the Board of Directors approved a plan to focus on upgrading our existing store base in order to enhance the store experience for customers. As part of this plan, we announced our intention to close, by the end of fiscal 2007, approximately 400 stores that do not meet our real estate criteria, to remodel or relocate approximately 300 stores in fiscal 2007, and to decelerate new store openings, with an expectation of opening 300 new stores in fiscal 2007. In fiscal 2006, we opened 537 new stores and closed 237 stores, including 128 store closings identified in this strategic review. We will continue to apply rigorous criteria to new and existing stores and will look for other enhancements to optimize our real estate strategy for profitable growth.


In connection with the accelerated implementation of our new inventory merchandising strategies to virtually eliminate packaway inventories and to sell through merchandise in the closing stores, we incurred substantially higher markdowns on inventory. While we believe these initiatives had a positive impact on sales, they had a negative impact on our gross profit rate in 2006. In total, our gross profit rate declined by 289 basis points to 25.8% in 2006 compared to 28.7% in 2005. Significantly impacting our gross profit rate, as a result of the related effect on cost of goods sold, were total markdowns of $279.1 million at cost taken during 2006, compared with total markdowns of $106.5 million at cost taken in 2005. The 2006 markdowns reflect $179.9 million at cost taken during the fourth quarter of 2006 compared to $39.0 million of markdowns at cost taken during the fourth quarter of 2005. Markdowns which were expected to reduce inventory below cost were considered in our lower of cost or market estimate and recorded at such time as the utility of the underlying inventory was deemed to be impaired. During the third quarter of fiscal 2006, we recorded a lower of cost or market inventory impairment estimate related to the initiatives discussed above, and this estimate was revised slightly in the fourth quarter such that the impact for fiscal 2006 was $70.2 million, which reduced 2006 gross profit by a corresponding amount. Markdowns which are not below cost impact our gross profit in the period in which such markdowns are taken. A portion of the total markdowns taken during the fourth quarter were related to the inventory included in our lower of cost or market estimate, thereby reducing our estimate of such inventory as of the end of fiscal 2006 to $49.2 million. This inventory is expected to be sold during 2007.


In addition, we currently estimate that we will recognize total pre-tax SG&A charges associated with these inventory and real estate initiatives of approximately $104.6 million. Of this total, approximately $33.4 million is reflected in our results of operations during 2006, as follows (in millions):


 

Estimated
Total

Incurred in
2006

Remaining

Lease contract termination costs

$

38.1

 

$

5.7

 

$

32.4

 

One-time employee termination benefits

 

1.4

  

0.3

  

1.1

 

Other associated store closing costs

 

9.0

  

0.2

  

8.8

 

Inventory liquidation fees

 

5.0

  

1.6

  

3.4

 

Asset impairment & accelerated depreciation

 

9.0

  

8.3

  

0.7

 

Other costs (a)

 

42.1

  

17.3

  

24.8

 
 

$

104.6

 

$

33.4

 

$

71.2

 
          

(a) Includes incremental store labor, advertising and other costs.




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The remaining costs outlined in the table above are currently expected to be incurred in 2007, however, the amount and timing of these costs and charges as well as the amount of below-cost inventory estimates and adjustments may vary materially depending on various factors, including timing in the execution of the plan, the outcome of negotiations with landlords and/or potential sublease tenants, the accuracy of assumptions used by management in developing these estimates, final inventory levels, the timing and adequacy of markdowns, and retail market conditions.


We expect markdowns from retail to continue at significantly higher than historical levels throughout 2007, which will impact our expected gross profit. Specifically, we expect the gross profit rate to sales to be in the low 27 percent range in fiscal 2007. We are targeting a gross profit rate to sales of approximately 28 percent for fiscal 2008 and 29 percent for fiscal 2009. We expect to increase our sales mix of merchandise categories with higher gross profit rates, such as home, apparel and seasonal merchandise, as we become increasingly able to improve our merchandise assortments and stock our stores with more current inventory. Achievement of our gross profit targets is contingent upon this expected sales mix improvement as well as effective inventory management and reductions in inventory shrink and damages.

In addition to these strategic efforts, we have made progress in the following operating initiatives outlined in our Annual Report on Form 10-K for the 2005 fiscal year:


·

We completed our implementation of the EZstore process in all of our stores and continue to be encouraged by our store managers’ response to the program and the opportunities to reduce costs in labor, workers’ compensation, and damages, among others.

·

We completed construction of our ninth distribution center (“DC”) in Marion, Indiana which commenced operations in August of 2006.

·

Our new store layout has been implemented in 359 of our most recent new, relocated or remodeled stores. Operating results of the new layout in these stores continue to be encouraging, and we plan to implement this new format in the majority of new stores to be opened or relocated in fiscal 2007.

·

We generated sufficient cash flow to allow us to repurchase approximately 4.5 million shares of our common stock for $79.9 million and to pay dividends of $62.5 million, an increase per share of 14 percent.


For the year ended February 2, 2007, we reported net income of  $137.9 million, or $0.44 per diluted share, compared to net income of $350.2 million, or $1.08 per diluted share, for the year ended February 3, 2006.


Total revenues for the year increased by 6.8% over the prior year, aided by new stores and a same-store sales increase of 3.3% (based on the comparable 52-week period). The extra week in fiscal 2005 accounted for sales of approximately $162.9 million. Our gross profit rate was 25.8% in 2006 compared to 28.7% in 2005, primarily due to our 2006 strategic initiatives as further discussed below under “Results of Operations”.  Operating expenses, as a rate to sales, were 23.1% in fiscal 2006 compared to 22.2% in fiscal 2005, resulting from charges directly related to the strategic store closings and a $29.9 million increase in advertising expenses, a



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portion of which can be attributed to the inventory liquidation and store closing initiatives. Additionally, administrative salaries, incentive bonuses and related payroll taxes (excluding benefits) increased by $25.0 million resulting from the approval of a $9.6 million discretionary bonus to approximately 7,000 administrative and DC employees and the addition of executives and staff to support our strategic efforts, particularly in merchandising and real estate. Partially offsetting these amounts were insurance proceeds of  $13.0 million received during 2006 related to losses we experienced due to Hurricane Katrina.


Readers should refer to the detailed discussion of operating results below for additional comments on financial performance in the 2006 fiscal year as compared with the prior year. While we are disappointed with our 2006 financial results, we are excited about and confident in our strategic decisions to accelerate our real estate strategies and the elimination of our packaway inventory model. We believe these actions will allow us to sharpen our focus on serving the demands of our customers and will ultimately result in improved financial performance.


While we provide no assurance that we will be successful or continue to be successful, as applicable, in executing any or all of these initiatives, and do not guarantee that their successful implementation would result in improved financial performance, management continues to believe that they are appropriate initiatives to consider for the long-term success of the business.


Company Performance Measures. Management uses a number of metrics, including those indicated on the table included in “Results of Operations” below, to assess its performance. The following are the more frequently discussed metrics:

 

·

Earnings per share (“EPS”) growth is an indicator of the increased returns generated for our shareholders. EPS of $0.44 in 2006 reflected a decrease of 59% from EPS of $1.08 in 2005. Significant elements of this decrease were discussed above.

·

Total net sales growth indicates, among other things, the success of our selection of new store locations and merchandising strategies. Total net sales increased 6.8% in 2006. Note that fiscal 2005 included a 53rd week.

·

Same-store sales growth indicates whether our merchandising strategies, store execution and customer service in existing stores have been successful in generating increased sales. Same-store sales increased 3.3% in 2006, with stronger same-store sales in the latter half of the year than the first half as a result of our promotional and strategic initiatives.

·

Operating margin rate (operating profit divided by net sales), which is an indicator of our success in leveraging our fixed costs and managing our variable costs, declined to 2.7% in 2006 versus 6.5% in 2005. The various components impacting this metric are fully discussed in “Results of Operations” below.

·

Inventory turns (cost of goods sold for the year divided by average inventory balances, at cost, measured at the end of the latest five fiscal quarters) is an indicator of how well we are managing the largest asset on our balance sheet. Inventory turns were 4.3 times in 2006 compared to 4.2 times in 2005, including the 53rd week.

·

Return on average assets (net income for the year divided by average total assets, measured at the end of the latest five fiscal quarters) is an overall indicator of our



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effectiveness in deploying our resources. Return on assets was 4.4% in 2006 and 12.1% in 2005.


Key Items for Fiscal 2007.  For 2007, we have established the following priorities and initiatives aimed at continuing our growth and improving our operating and financial performance while remaining focused on serving our customers:

·

Sell through or otherwise eliminate 100% of the targeted inventory to virtually eliminate the packaway strategy, allowing us to have fresher merchandise and cleaner, neater stores, enhancing the shopping experience for our customers and the work experience of our employees.

·

Close the remaining underperforming stores identified as part of our revitalization efforts.

·

Open 300 new stores and relocate or remodel 300 existing stores using our new real estate criteria.

·

Further develop merchandising capabilities and tools.

·

Increase the discipline in our merchandise planning, buying and allocation processes.


In addition, we intend to continue our efforts to significantly reduce inventory shrink and to develop a strategic roadmap to reduce store manager turnover.

We can provide no assurance that we will be successful in executing these initiatives, nor can we guarantee that the successful implementation of these initiatives will result in superior financial performance.




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Results of Operations

The following discussion of our financial performance is based on the Consolidated Financial Statements set forth herein. The following table contains results of operations data for the 2006, 2005 and 2004 fiscal years, and the dollar and percentage variances among those years.  

(amounts in millions, excluding per share amounts)

   2006 (a)

   2005 (b)

  2004

2006 vs. 2005

2005 vs. 2004

$

change

%

 change

$

change

 %

 change

     


 


Net sales by category:

    


 


Highly consumable

$ 6,022.0

$ 5,606.5

$ 4,825.1

$ 415.5

7.4%

$ 781.4

16.2%

% of net sales

65.67%

65.33%

62.98%

 


 


Seasonal

1,510.0

1,348.8

1,264.0

161.2

12.0

84.8

6.7

% of net sales

16.47%

15.72%

16.50%

 


 


Home products

914.4

907.8

879.5

6.5

0.7

28.4

3.2

% of net sales

9.97%

10.58%

11.48%

 


 


Basic clothing

723.5

719.2

692.4

4.3

0.6

26.8

3.9

% of net sales

7.89%

8.38%

9.04%

 


 


Net sales

$ 9,169.8

$ 8,582.2

$ 7,660.9

$ 587.6

6.8%

$ 921.3

12.0%

Cost of goods sold

6,801.6

6,117.4

5,397.7

684.2

11.2

719.7

13.3

% of net sales

74.17%

71.28%

70.46%

 


 


Gross profit

2,368.2

2,464.8

2,263.2

(96.6)

(3.9)

201.6

8.9

% of net sales

25.83%

28.72%

29.54%

 


 


Selling, general and administrative expenses

2,119.9

1,903.0

1,706.2

217.0

11.4

196.7

11.5

% of net sales

23.12%

22.17%

22.27%

 


 


Operating profit

248.3

561.9

557.0

(313.6)

(55.8)

4.9

0.9

% of net sales

2.71%

6.55%

7.27%

 


 


Interest income

(7.0)

(9.0)

(6.6)

2.0

(22.2)

(2.4)

36.9

% of net sales

(0.08)%

(0.10)%

(0.09)%

 


 


Interest expense

34.9

26.2

28.8

8.7

33.1

(2.6)

(8.9)

% of net sales

0.38%

0.31%

0.38%

 


 


Income before income taxes

220.4

544.6

534.8

(324.3)

(59.5)

9.9

1.8

% of net sales

2.40%

6.35%

6.98%

 


 


Income taxes

82.4

194.5

190.6

(112.1)

(57.6)

3.9

2.1

% of net sales

0.90%

2.27%

2.49%

 


 


Net income

$ 137.9

$ 350.2

$ 344.2

$ (212.2)

(60.6)%

$ 6.0

1.7%

% of net sales

1.50%

4.08%

4.49%

 


 


     


 


Diluted earnings per share

$ 0.44

$ 1.08

$ 1.04

$ (0.64)

(59.3)%

$ 0.04

3.8%

Weighted average diluted shares

313.5

324.1

332.1

(10.6)

(3.3)

(7.9)

(2.4)



(a)

Includes the impacts of certain strategic initiatives as more fully described in the “Executive Overview” above.

(b)

The fiscal year ended February 3, 2006 was comprised of 53 weeks.




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Net Sales.  Increases in 2006 net sales resulted primarily from opening additional stores, including 300 net new stores in 2006, and a same-store sales increase of 3.3% for 2006 compared to 2005. Same-store sales increases are calculated based on the comparable calendar weeks in the prior year.  Accordingly, the same store sales percentages discussed herein exclude sales from the 53rd week of 2005 as there was no comparable week in 2006 or 2004. The increase in same-store sales accounted for $265.4 million of the increase in sales, while stores opened since the beginning of 2006 were the primary contributors to the remaining $322.2 million sales increase during 2006. The increase in same-store sales is primarily attributable to an increase in average customer purchase. We also believe that the strategic merchandising and real estate initiatives discussed above in the “Executive Overview” had a positive impact on net sales.


We monitor our sales internally by the following four major categories: highly consumable, seasonal, home products and basic clothing. The highly consumable category has a lower gross profit rate than the other three categories and has grown significantly over the past several years. This shift is, in part, the result of our strategic efforts to broaden our consumable product offerings and add more recognizable national brands in order to attract customers. However, we believe the increase in consumables, as a percent of total sales, has also been affected by changes in customers’ needs and by economic pressures, such as higher gasoline and energy prices, which have resulted in reductions in the percentages of total sales of our home products and basic clothing categories. As noted above in the “Executive Overview”, we expect the move away from our packaway inventory strategy will have a positive impact on sales in our non-consumable merchandise categories. Because of the impact of sales mix on gross profit, we continually review our merchandise mix and strive to adjust it when appropriate. Maintaining an appropriate sales mix among the four categories is an integral part of achieving our gross profit and sales goals.


By merchandise category, our sales increase in 2006 compared to 2005 was primarily attributable to the highly consumable category, which increased by $415.5 million, or 7.4%. An increase in sales of seasonal merchandise of $161.2 million, or 12.0%, also contributed to overall sales growth. We believe that our increased sales by merchandise category were supported by recent additions to our product offerings and increased promotional activities, including the use of advertising circulars and clearance activities.


Increases in 2005 net sales resulted primarily from opening additional stores, including 609 net new stores in 2005, and a same-store sales increase of 2.0% for 2005 compared to 2004. The increase in same-store sales accounted for $144.2 million of the increase in sales.  Stores opened since the beginning of 2004, as well as the $162.9 million impact of the 53rd week of sales in fiscal year 2005 for all stores, were the primary contributors to the remaining $777.1 million sales increase during 2005.  The increase in same-store sales is primarily attributable to an increase in average customer purchase.


Same-store sales calculations for 2005 and prior include only those stores that were open both at the end of that period and at the beginning of the preceding fiscal year. Beginning in fiscal 2006, we revised and published our method for determining the stores that are included in our publicly released same-store sales calculations. The revised same-store sales calculations include those stores that have been open at least 13 full fiscal months and remain open at the end



29



of the reporting period. Using the revised methodology, the same-store sales increase in 2005 was 2.2%.


Gross Profit.  The gross profit rate decline in 2006 as compared with 2005 was due primarily to a significant increase in markdown activity as a percentage of sales, including below-cost markdowns, as a result of our inventory liquidation and store closing initiatives. While we believe these initiatives had a positive impact on sales, they had a negative impact on our gross profit rate in 2006. In total, our gross profit rate declined by 289 basis points to 25.8% in 2006 compared to 28.7% in 2005. Significantly impacting our gross profit rate, as a result of the related effect on cost of goods sold, were total markdowns of $279.1 million at cost taken during 2006, compared with total markdowns of $106.5 million at cost taken in 2005. The 2006 markdowns reflect $179.9 million at cost taken during the fourth quarter of 2006 compared to $39.0 million markdowns at cost taken during the fourth quarter of 2005. The fourth quarter 2006 change in merchandising strategy also resulted in our ending inventory being valued lower than under our historical practices as ending inventory on-hand as of February 2, 2007 reflects the immediate impact of the markdowns at the time such markdowns were taken rather than at the time such inventory is sold.  The impact of this reduction to inventory value approximated $30.7 million in the fourth quarter of 2006. Markdowns which were expected to reduce inventory below cost were considered in our lower of cost or market estimate and recorded at such time as the utility of the underlying inventory was deemed to be impaired. During the third quarter of fiscal 2006, we recorded a lower of cost or market inventory impairment estimate related to the initiatives discussed above, and this estimate was revised slightly in the fourth quarter such that the impact for fiscal 2006 was $70.2 million, which reduced 2006 gross profit by a corresponding amount. Markdowns which are not below cost impact our gross profit in the period in which such markdowns are taken. A portion of the total markdowns taken during the fourth quarter were related to the inventory included in our lower of cost or market estimate, thereby reducing our estimate of such inventory as of the end of fiscal 2006 to $49.2 million. This inventory is expected to be sold during 2007. Other factors included, but were not limited to: a decrease in the markups on purchases, primarily attributable to purchases of highly consumable products (including nationally branded products, which generally have lower average markups); and an increase in our shrink rate.


The gross profit rate declined by 82 basis points in 2005 as compared with 2004 due to a number of factors, including but not limited to: lower sales (as a percentage of total sales) in our seasonal, home products and basic clothing categories, which have higher than average markups; an increase in markdowns as a percentage of sales primarily as a result of our initiative to reduce per-store inventory; higher transportation expenses primarily attributable to increased fuel costs; an increase in our shrink rate; and an estimated $5.2 million reduction resulting from the expansion of the number of departments utilized for the gross profit calculation from 10 to 23, as further described below under “Critical Accounting Policies and Estimates.” These factors were partially offset by higher average mark-ups on our beginning inventory in 2005 as compared with 2004.

In 2006, 2005 and 2004, we experienced inventory shrinkage, stated as a percentage of sales, of 3.40%, 3.22% and 3.05%, respectively.



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Selling, General and Administrative (“SG&A”) Expense.  The increase in SG&A expense as a percentage of sales in 2006 as compared with 2005 was due to a number of factors, including but not limited to increases in the following expense categories:  impairment charges on leasehold improvements and store fixtures totaling $9.4 million, including $8.0 million related to the planned closings of approximately 400 underperforming stores, 128 of which closed in 2006 and the remainder of which are scheduled to close in 2007, as further discussed above in the “Executive Overview”; lease contract terminations totaling $5.7 million related to these stores; higher store occupancy costs (increased 12.1%) due to higher average monthly rentals associated with our leased store locations; higher debit and credit card fees (increased 40.6%) due to the increased customer usage of debit cards and the acceptance of VISA credit and check cards at all locations; higher administrative labor costs (increased 29.9%) primarily related to recent additions to our executive team, particularly in merchandising and real estate, and the expensing of stock options; higher advertising costs (increased 198.3%) related primarily to the distribution of several advertising circulars in the current year period and to promotional activities related to the inventory clearance and store closing activities discussed above; and higher incentive compensation primarily related to the $9.6 million discretionary bonus authorized by the Board of Directors for the current fiscal year.  These increases were partially offset by insurance proceeds of $13.0 million received during the current year period related to losses incurred due to Hurricane Katrina, and depreciation and amortization expenses that remained relatively constant in fiscal 2006 as compared to fiscal 2005.


The decrease in SG&A expense as a percentage of sales in 2005 as compared with 2004 was due to a number of factors, including but not limited to the following expense categories that either declined or increased less than the 12.0% increase in sales: employee incentive compensation expense (decreased 37.8%), based upon our fiscal 2005 financial performance; professional fees (decreased 32.3%), primarily due to the reduction of consulting fees associated with the EZstore project and 2004 fees associated with our initial Sarbanes-Oxley compliance effort; and employee health benefits (decreased 10.0%), due in part to a downward revision in claim lag assumptions based upon review and recommendation by our outside actuary and decreased claims costs as a percentage of sales. Partially offsetting these reductions in SG&A were current year increases in store occupancy costs (increased 17.6%), primarily due to rising average monthly rentals associated with our leased store locations, and  store utilities costs (increased 22.7%) primarily related to increased electricity and gas expense.


Interest Income. The decline in interest income in 2006 compared to 2005 is due primarily to the acquisition of the entity which held legal title to the South Boston DC in June 2006 and the related elimination of the notes receivable which represented debt issued by this entity from which we formerly leased the South Boston DC. The increase in interest income in 2005 compared to 2004 is due primarily to earnings on short-term investments due to increased interest rates on these investments.

Interest Expense. The increase in interest expense in 2006 is primarily attributable to increased interest expense of $6.5 million under our revolving credit agreement primarily due to increased borrowings, an increase in tax-related interest of $4.1 million principally due to the non-recurrence in 2006 of a 2005 reduction in accrued interest related to contingent tax liabilities, offset by a reduction in interest expense associated with the elimination of the financing obligation associated with the June 2006 acquisition of the entity which held legal title



31



to the South Boston DC as discussed above. The decrease in interest expense in 2005 is primarily attributable to a reduction in tax-related interest expense of $1.4 million, principally due to the reversal of interest accruals pertaining to certain income tax related contingencies that were resolved during 2005. We had variable-rate debt of $14.5 million as of February 2, 2007 and February 3, 2006. The remainder of our outstanding indebtedness at February 2, 2007 and February 3, 2006 was fixed rate debt.

Income Taxes.  The effective income tax rates for 2006, 2005 and 2004 were 37.4%, 35.7% and 35.6%, respectively.


The 2006 income tax rate was higher than the 2005 rate by 1.7%.  Factors contributing to this increase include additional expense of approximately $0.9 million related to the adoption of a new tax system in the State of Texas which resulted in the elimination of certain deferred tax assets that had been recorded in prior years; an increase of approximately $0.9 million in expense related to the Company’s current year tax liability under the revised State of Texas tax system; a reduction in the contingent income tax reserve due to the resolution of contingent liabilities that is $2.0 million less than the decrease that occurred in 2005; an increase in the deferred tax valuation allowance of approximately $3.2 million related to state income tax credits; and an increase of $2.6 million related to a benefit recognized in 2005 resulting from an internal restructuring.  Offsetting these rate increases was a reduction in the income tax rate related to federal income tax credits.  Due to the reduction in the Company’s 2006 income before tax, a small increase in the amount of federal income tax credits earned yielded a much larger percentage reduction in the income tax rate for 2006 versus 2005.

While the 2005 and 2004 rates were similar overall, the rates contained offsetting differences. Factors causing the 2005 tax rate to increase when compared to the 2004 tax rate include a reduction in federal jobs credits of approximately $1.0 million, additional net foreign income tax expense of approximately $0.8 million and a decrease in the contingent income tax reserve due to resolution of contingent liabilities that was $3.6 million less than the decrease that occurred in 2004. Factors causing the 2005 tax rate to decrease when compared to the 2004 tax rate include the recognition of state tax credits of approximately $2.3 million related to the construction of our DC in Indiana and a benefit of approximately $2.6 million related to an internal restructuring that was completed during 2005.  The overall effect of these items increased the 2005 effective tax rate by approximately 0.8%.

Effects of Inflation

We believe that inflation and/or deflation had a minimal impact on our overall operations during 2006, 2005 and 2004.

Liquidity and Capital Resources

Current Financial Condition / Recent Developments. During the past three years, we have generated an aggregate of approximately $1.35 billion in cash flows from operating activities. During that period, we expanded the number of stores we operate by approximately 23% (over 1,500 stores) and incurred approximately $834 million in capital expenditures, primarily to support this growth. Also during this three-year period, we expended approximately



32



$587 million for repurchases of our common stock and paid dividends of approximately $171 million.

Our inventory balance represented approximately 47% of our total assets as of February 2, 2007. Our proficiency in managing our inventory balances can have a significant impact on our cash flows from operations during a given fiscal year. We have made more efficient inventory management a strategic priority, as more fully discussed in the “Executive Overview” above.

As described in Note 8 to the Consolidated Financial Statements, we are involved in a number of legal actions and claims, some of which could potentially result in material cash payments.  Adverse developments in those actions could materially and adversely affect our liquidity.  We also have certain income tax-related contingencies as more fully described below under “Critical Accounting Policies and Estimates.” Estimates of these contingent liabilities are included in our Consolidated Financial Statements. However, future negative developments could have a material adverse effect on our liquidity. See Notes 5 and 8 to the Consolidated Financial Statements.

On November 29, 2006, September 30, 2005, and November 30, 2004, the Board of Directors authorized the repurchase of up to $500 million, 10 million shares and 10 million shares, respectively, of our outstanding common stock. These authorizations allow or allowed, as applicable, purchases in the open market or in privately negotiated transactions from time to time, subject to market conditions. The objective of our share repurchase initiative is to enhance shareholder value by purchasing shares at a price that produces a return on investment that is greater than our cost of capital. Additionally, share repurchases generally are undertaken only if such purchases result in an accretive impact on our fully diluted earnings per share calculation.  The 2006 authorization expires December 31, 2008. The 2005 and 2004 authorizations were completed prior to their expiration dates. During 2006, we purchased approximately 4.5 million shares pursuant to the 2005 authorization at a total cost of $79.9 million. During 2005, we purchased approximately 15.0 million shares pursuant to the 2005 and 2004 authorizations at a total cost of $297.6 million. During 2004, we purchased approximately 11.0 million shares pursuant to the 2004 and a 2003 authorization at a total cost of $209.3 million. Share repurchases affected diluted earnings per share by less than $0.01 in 2006.




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The following table summarizes our significant contractual obligations and commercial commitments as of February 2, 2007 (in thousands):


 

Payments Due by Period

Contractual obligations

Total

 

< 1 yr

 

1-3 yrs

 

3-5 yrs

 

> 5 yrs

Long-term debt obligations

$

214,473

  

$

-

  

$

-

  

$

199,978

  

$

14,495

 

Capital lease obligations

 

18,407

   

6,667

   

6,476

   

492

   

4,772

 

Financing obligations

 

37,304

   

1,413

   

2,466

   

2,233

   

31,192

 

Interest (a)

 

111,509

   

22,012

   

42,747

   

14,012

   

32,738

 

Self-insurance liabilities (b)

 

183,538

   

76,062

   

63,813

   

20,118

   

23,545

 

Operating leases (c)

 

1,489,581

   

304,567

   

460,456

   

309,295

   

415,263

 

Subtotal

$

2,054,812

  

$

410,721

  

$

575,958

  

$

546,128

  

$

522,005

 
                    
 

Commitments Expiring by Period

Commercial commitments (d)

 

Total

   

< 1 yr

   

1-3 yrs

   

3-5 yrs

   

> 5 yrs

 

Letters of credit

$

116,147

  

$

116,147

  

$

-

  

$

-

  

$

-

 

Purchase obligations (e)

 

459,289

   

458,864

   

425

   

-

   

-

 

Subtotal

$

575,436

  

$

575,011

  

$

425

  

$

-

  

$

-

 

Total contractual obligations and commercial commitments

$

2,630,248

  

$

985,732

  

$

576,383

  

$

546,128

  

$

522,005

 
 

(a)

Represents obligations for interest payments on long-term debt, capital lease and financing obligations and includes projected interest on $14.5 million of variable rate long-term debt issued in 2005, based upon 2006 effective interest rates.

(b)

We retain a significant portion of the risk for our workers’ compensation, employee health insurance, general liability, property loss and automobile insurance. As these obligations do not have scheduled maturities, these amounts represent undiscounted estimates based upon actuarial assumptions. These amounts are reflected on an undiscounted basis in our consolidated balance sheets.

(c)

Operating lease obligations are inclusive of amounts included in deferred rent and closed store obligations in our consolidated balance sheets.

(d)

Commercial commitments include advertising contracts, contractual commitments for DC improvements and equipment purchases, information technology license and support agreements, letters of credit for import merchandise, and other inventory purchase obligations.

(e)

Purchase obligations include legally binding agreements for advertising, DC capital expenditures, software licenses and support, and merchandise purchases excluding such purchases subject to letters of credit.


In 2006 and 2005, our South Carolina-based wholly owned captive insurance subsidiary, Ashley River Insurance Company (“ARIC”), had cash and cash equivalents and investments balances held pursuant to South Carolina regulatory requirements to maintain a specified percentage of ARIC’s liability and equity balances (primarily insurance liabilities) in the form of certain specified types of assets and, as such, these investments are not available for general corporate purposes. At February 2, 2007, these cash and cash equivalents balances and investments balances were $3.2 million and $49.7 million, respectively.


In June 2006, we amended our existing revolving credit facility. The amended credit facility has a maximum commitment of $400 million (with the ability to increase to $500 million upon our mutual agreement with the lenders) and expires in June 2011. In addition to revolving loans, the amended credit facility includes a $15 million swingline loan sub-limit and a $75 million letter of credit sub-facility. Outstanding swingline loans and letters of credit reduce the borrowing capacity under the amended credit facility. In December 2006, we further amended the revolving credit facility to lower the fixed charge coverage financial covenant for future



34



periods through fiscal 2008 to take into account the impact that the initiatives discussed above in the “Executive Overview” related to merchandising and real estate strategies may have on the ratio in those periods. At February 2, 2007, we had no outstanding borrowings or letters of credit outstanding under the amended credit facility, and were in compliance with all financial covenants contained in the amended credit facility.


We have $200 million (principal amount) of 8 5/8% unsecured notes due June 15, 2010. This indebtedness was incurred to assist in funding our growth. Interest on the notes is payable semi-annually on June 15 and December 15 of each year.  We may seek, from time to time, to retire the notes through cash purchases on the open market, in privately negotiated transactions or otherwise. Such repurchases, if any, will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors. The amounts involved may be material.


In July 2005, as an inducement for us to select Marion, Indiana as the site for construction of a new DC, the Economic Development Board of Marion approved a tax increment financing in the amount of $14.5 million, which matures February 1, 2035. Pursuant to this financing, proceeds from the issuance of certain revenue bonds were loaned to us in connection with the construction of this DC. The variable interest rate on this loan is based on the weekly remarketing of the bonds, which are supported by a bank letter of credit, and ranged from 4.60% to 5.43% in 2006, and from 3.52% to 4.60% in 2005.

Significant terms of our outstanding debt obligations could have an effect on our ability to incur additional debt financing.  The amended credit facility contains financial covenants, which include limits on certain debt to cash flow ratios, a fixed charge coverage test, and minimum allowable consolidated net worth.  The amended credit facility also places certain specified limitations on secured and unsecured debt.  Our outstanding notes discussed above place certain specified limitations on secured debt and place certain limitations on our ability to execute sale-leaseback transactions.

We have generated significant cash flows from operations during recent years. We had peak borrowings under the amended credit facility of $253.4 million during 2006, $100.3 million during 2005 and $73.1 million during 2004, all of which were repaid prior to February 2, 2007, February 3, 2006, and January 28, 2005, respectively. Therefore, we do not believe that any existing limitations on our ability to incur additional indebtedness will have a material impact on liquidity. Notes 6 and 8 to the Consolidated Financial Statements contain additional disclosures related to our debt and financing obligations.

At February 2, 2007 and February 3, 2006, we had commercial letter of credit facilities totaling $200.0 million and $195.0 million, respectively, of which $116.1 million and $85.1 million, respectively, were outstanding for the funding of imported merchandise purchases.

During 2005, we incurred significant losses caused by Hurricane Katrina, primarily inventory and fixed assets, in the form of store fixtures and leasehold improvements. We reached final settlement of our related insurance claim in 2006 and received proceeds totaling $21.0 million due to these losses, including $13.0 million in 2006 and $8.0 million in 2005, and have utilized a portion of these proceeds to replace lost assets. Insurance proceeds related to fixed



35



assets are included in cash flows from investing activities and proceeds related to inventory losses and business interruption are included in cash flows from operating activities.

We believe that our existing cash balances ($189.3 million at February 2, 2007), cash flows from operations ($405.4 million generated in 2006), the amended credit facility ($400 million available at February 2, 2007) and our anticipated ongoing access to the capital markets, if necessary, will provide sufficient financing to meet our currently foreseeable liquidity and capital resource needs.

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

Cash flows from operating activities for 2005 compared to 2004 increased by $164.0 million. The most significant component of the increase in cash flows from operating activities in the 2005 period as compared to the 2004 period was the change in inventory balances. Seasonal inventory levels increased by 10% in 2005 as compared to a 22% increase in 2004, home products inventory levels increased by 2% in 2005 as compared to a 16% increase in 2004, while basic clothing inventory levels declined by 5% in 2005 as compared to a 21% increase in 2004. Total merchandise inventories at the end of 2005 were $1.47 billion compared to $1.38 billion at the end of 2004, a 7.1% increase overall, but a 1% decrease on a per store basis, reflecting our 2005 focus on lowering our per store inventory levels.

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


Purchases and sales of short-term investments in 2006, which equaled net sales of $1.9 million, reflect our investment activities in tax-exempt auction rate securities as well as investing



36



activities of our captive insurance subsidiary. Purchases of long-term investments are related to the captive insurance subsidiary.

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


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

Cash flows used in investing activities of $259.2 million in 2004 were also primarily related to capital expenditures. Significant components of our purchases of property and equipment in 2004 included the following approximate amounts: $101 million for distribution and transportation-related capital expenditures; $82 million for new stores; $26 million for certain fixtures in existing stores; $26 million for various systems-related capital projects; and $23 million for coolers in existing stores, which allow the stores to carry refrigerated products. During 2004, we opened 722 new stores and relocated or remodeled 80 stores. Distribution and transportation expenditures in 2004 included costs associated with the construction of our new DC in South Carolina as well as costs associated with the expansion of the Ardmore, Oklahoma and South Boston, Virginia DCs.

Net sales of short-term investments in 2004 of $25.8 million primarily reflect our investment activities in tax-exempt auction rate securities.

Capital expenditures during 2007 are projected to be approximately $180 to $200 million.  We anticipate funding 2007 capital requirements with cash flows from operations and the amended credit facility, if necessary. Significant components of the 2007 capital plan include leasehold improvements and fixtures and equipment for approximately 300 new stores, continued investment in our existing store base, plans for remodeling and relocating approximately 300 stores, and additional investments in our supply chain.  We plan to undertake these expenditures in order to improve our infrastructure and provide support for our anticipated growth.

Cash flows used in financing activities.  Cash flows used in financing activities during 2006 included the repurchase of approximately 4.5 million shares of our common stock at a total cost of $79.9 million, cash dividends paid of $62.5 million, or $0.20 per share, on our outstanding common stock, and $14.1 million to reduce our outstanding capital lease and financing obligations. These uses of cash were partially offset by proceeds from the exercise of stock options during 2006 of $19.9 million.


During 2005, we repurchased approximately 15.0 million shares of our common stock at a total cost of $297.6 million, paid cash dividends of $56.2 million, or $0.175 per share, on our



37



outstanding common stock, and expended $14.3 million to reduce our outstanding capital lease and financing obligations. Also in 2005, we received proceeds of $14.5 million from the issuance of a tax increment financing in conjunction with the construction of our new DC in Indiana and proceeds from the exercise of stock options of $29.4 million.


During 2004, we repurchased approximately 11.0 million shares of our common stock at a total cost of $209.3 million, paid cash dividends of $52.7 million, or $0.16 per share, on our outstanding common stock and expended $16.4 million to reduce our outstanding capital lease and financing obligations. These uses of cash were partially offset by proceeds from the exercise of stock options during 2004 of $34.1 million.


The borrowings and repayments under the revolving credit agreement in 2006, 2005 and 2004 were primarily a result of activity associated with periodic cash needs.


Critical Accounting Policies and Estimates


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


Management believes the following policies and estimates are critical because they involve significant judgments, assumptions, and estimates. Management has discussed the development and selection of the critical accounting estimates with the Audit Committee of our Board of Directors, and the Audit Committee has reviewed the disclosures presented below relating to those policies and estimates.


Merchandise Inventories. Merchandise inventories are stated at the lower of cost or market with cost determined using the retail last-in, first-out (“LIFO”) method. Under our retail inventory method (“RIM”), the calculation of gross profit and the resulting valuation of inventories at cost are computed by applying a calculated cost-to-retail inventory ratio to the retail value of sales. The RIM is an averaging method that has been widely used in the retail industry due to its practicality. Also, it is recognized that the use of the RIM will result in valuing inventories at the lower of cost or market (“LCM”) if markdowns are currently taken as a reduction of the retail value of inventories.


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




38



·

applying the RIM to a group of products that is not fairly uniform in terms of its cost and selling price relationship and turnover;


·

applying the RIM to transactions over a period of time that include different rates of gross profit, such as those relating to seasonal merchandise;


·

inaccurate estimates of inventory shrinkage between the date of the last physical inventory at a store and the financial statement date; and


·

inaccurate estimates of LCM and/or LIFO reserves.


To reduce the potential of such distortions in the valuation of inventory, we expanded the number of departments we utilize for our gross profit calculation from 10 to 23 in 2005. Other factors that reduce potential distortion include the use of historical experience in estimating the shrink provision (see discussion below) and the utilization of an independent statistician to assist in the LIFO sampling process and index formulation. As part of this process we also perform an inventory-aging analysis for determining obsolete inventory. Our policy is to write down inventory to an LCM value based on various management assumptions including estimated markdowns and sales required to liquidate such aged inventory in future periods. Inventory is reviewed on a quarterly basis and adjusted as appropriate to reflect write-downs determined to be necessary. The estimated amount of the below-cost inventory write-downs for the strategic merchandising initiatives discussed above in the “Executive Overview” is based on management’s assumptions regarding the timing and adequacy of markdowns and the final adjustment may vary materially from the estimate depending on various factors, including timing of the execution of the plan, retail market conditions and the accuracy of assumptions used by management in developing these estimates.


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

 

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



39




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


Impairment of Long-lived Assets. We review the carrying value of all long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. In accordance with Statement of Financial Accounting Standards (“SFAS”) 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” we review for impairment stores open more than two years for which current cash flows from operations are negative. Impairment results when the carrying value of the assets exceeds the undiscounted future cash flows over the life of the lease. Our estimate of undiscounted future cash flows over the lease term is based upon historical operations of the stores and estimates of future store profitability which encompasses many factors that are subject to variability and difficult to predict. If a long-lived asset is found to be impaired, the amount recognized for impairment is equal to the difference between the carrying value and the asset’s fair value. The fair value is estimated based primarily upon future cash flows (discounted at our credit adjusted risk-free rate) or other reasonable estimates of fair market value.


In connection with the strategic real estate initiatives noted above, we performed a comprehensive review of all of our stores and recorded impairment charges in 2006 totaling approximately $9.4 million, including $8.0 million related to the approximately 400 underperforming stores targeted for closing by the end of 2007.


Insurance Liabilities. We retain a significant portion of the risk for our workers’ compensation, employee health insurance, general liability, property loss and automobile coverage. These costs are significant primarily due to the large employee base and number of stores. Provisions are made to this insurance liability on an undiscounted basis based on actual claim data and estimates of incurred but not reported claims developed by independent actuaries utilizing historical claim trends. If future claim trends deviate from recent historical patterns, we may be required to record additional expenses or expense reductions, which could be material to our future financial results.


Contingent Liabilities – Income Taxes. We are subject to routine income tax audits that occur periodically in the normal course of business. We estimate our contingent income tax liabilities based on our assessment of probable income tax-related exposures and the anticipated settlement of those exposures translating into actual future liabilities. The contingent liabilities are estimated based on both historical audit experiences with various state and federal taxing authorities and our interpretation of current income tax-related trends. The adoption of Financial Accounting Standards Board (“FASB”) Interpretation 48, Accounting for Uncertainty in Income Taxes – An Interpretation of FASB Statement 109, (“FIN 48”) in fiscal 2007 is expected to have an impact on our estimates of contingent income tax liabilities which has not yet been quantified.



40



If our income tax contingent liability estimates prove to be inaccurate, the resulting adjustments could be material to our future financial results.


Contingent Liabilities - Legal Matters. We are subject to legal, regulatory and other proceedings and claims. We establish liabilities as appropriate for these claims and proceedings based upon the probability and estimability of losses and to fairly present, in conjunction with the disclosures of these matters in our financial statements and SEC filings, management’s view of our exposure. We review outstanding claims and proceedings with external counsel to assess probability and estimates of loss. We re-evaluate these assessments each quarter or as new and significant information becomes available to determine whether a liability should be established or if any existing liability should be adjusted. The actual cost of resolving a claim or proceeding ultimately may be substantially different than the amount of the recorded liability. In addition, because it is not permissible under GAAP to establish a litigation liability until the loss is both probable and estimable, in some cases there may be insufficient time to establish a liability prior to the actual incurrence of the loss (upon verdict and judgment at trial, for example, or in the case of a quickly negotiated settlement). See Note 8 to the Consolidated Financial Statements.


Lease Accounting and Excess Facilities. The majority of our stores are subject to short-term leases (usually with initial or primary terms of 3 to 5 years) with multiple renewal options when available. We also have stores subject to build-to-suit arrangements with landlords, which typically carry a primary lease term of between 7 and 10 years with multiple renewal options. Approximately half of our stores have provisions for contingent rentals based upon a percentage of defined sales volume. We recognize contingent rental expense when the achievement of specified sales targets is considered probable. We recognize rent expense over the term of the lease. We record minimum rental expense on a straight-line basis over the base, non-cancelable lease term commencing on the date that we take physical possession of the property from the landlord, which normally includes a period prior to store opening to make necessary leasehold improvements and install store fixtures. When a lease contains a predetermined fixed escalation of the minimum rent, we recognize the related rent expense on a straight-line basis and record the difference between the recognized rental expense and the amounts payable under the lease as deferred rent. We also receive tenant allowances, which we record as deferred incentive rent and amortize as a reduction to rent expense over the term of the lease. We reflect as a liability any difference between the calculated expense and the amounts actually paid. Improvements of leased properties are amortized over the shorter of the life of the applicable lease term or the estimated useful life of the asset.


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



41



income differ from our estimates, the resulting liabilities could vary from recorded amounts. These liabilities are reviewed periodically and adjusted when necessary.


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


Adoption of Accounting Standard

Prior to February 4, 2006, we accounted for share-based payments using the intrinsic-value-based recognition method prescribed by Accounting Principles Board Opinion 25, “Accounting for Stock Issued to Employees” (“APB 25”). Because stock options were granted at an exercise price equal to the market value of the underlying common stock on the date of grant, employee compensation cost related to stock options generally was not reflected in our results of operations prior to the adoption of SFAS 123(R), “Share-Based Payment.” The Compensation Committee of our Board of Directors took action to accelerate the vesting, effective February 3, 2006, of most of our outstanding stock options granted prior to January 24, 2006. The Compensation Committee took this action primarily to reduce non-cash compensation expense to be recorded in future periods under the provisions of SFAS 123(R). However, the Committee also believed this decision benefited employees.

Effective February 4, 2006, we adopted SFAS 123(R) using the modified–prospective-transition method and began recognizing compensation expense for our share-based payments based on the fair value of the awards on the grant date. For the year ended February 2, 2007, the adoption of the fair value method of SFAS 123(R) resulted in additional share-based compensation expense (a component of SG&A expense) and a corresponding decrease in income before income taxes of $3.6 million, a decrease in net income of $2.2 million, and a reduction in basic and diluted earnings per share of approximately $0.01.

We estimate the fair value of stock options using the Black-Scholes-Merton option pricing model for all option grants. We estimate the expected term using a computation based on an assumption that outstanding options will be exercised approximately halfway through their contractual term, taking into consideration such factors as grant date, expiration date, weighted-average time-to-vest, actual exercises and post-vesting cancellations. We calculate volatility assumptions using actual historical changes in the market value of the stock and implied volatility based upon traded options, weighted equally. We believe that this methodology provides the best indicator of future volatility.



42



Accounting Pronouncements

In July 2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”), which will require companies to assess each income tax position taken using a two-step process. A determination is first made as to whether it is more likely than not that the position will be sustained, based upon the technical merits, upon examination by the taxing authorities. If the tax position is expected to meet the more likely than not criteria, the benefit recorded for the tax position equals the largest amount that is greater than 50% likely to be realized upon ultimate settlement of the respective tax position. The interpretation applies to income tax expense as well as any related interest and penalty expense.


FIN 48 requires that changes in tax positions recorded in a company’s financial statements prior to the adoption of this interpretation be recorded as an adjustment to the opening balance of retained earnings for the period of adoption. FIN 48 will generally be effective for public companies for the first fiscal year beginning after December 15, 2006. We anticipate adopting the provisions of this interpretation during the first quarter of fiscal 2007. No determination has yet been made regarding the materiality of the potential impact of this interpretation on our financial statements.


In September 2006, the FASB issued SFAS 157, “Fair Value Measurements.” SFAS 157 provides guidance for using fair value to measure assets and liabilities. The standard also requires expanded information about the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. The standard applies whenever other standards require (or permit) assets or liabilities to be measured at fair value. The standard does not expand the use of fair value in any new circumstances. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We currently expect to adopt SFAS 157 during our 2008 fiscal year. No determination has yet been made regarding the potential impact of this standard on our financial statements.


In September 2006, the FASB issued SFAS 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans,” which requires companies to recognize the overfunded or underfunded status of a defined benefit postretirement plan (other than a multiemployer plan) as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. This Statement also requires a company to measure the funded status of a plan as of the date of its year-end statement of financial position, with limited exceptions. A company with publicly traded equity securities is required to initially recognize the funded status of a defined benefit postretirement plan and to provide the required disclosures as of the end of the fiscal year ending after December 15, 2006, and we have complied with these provisions to the extent material. The second phase of SFAS 158 includes a requirement to measure plan assets and benefit obligations as of the date of a company’s fiscal year-end statement of financial position effective for fiscal years ending after December 15, 2008. No final determination has yet been made regarding the timing or adoption of the second phase of SFAS 158 on our consolidated financial statements, however, because we currently have one supplemental executive retirement plan with one executive participant, the impact, if any, is expected to be minimal.



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ITEM 7A.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Financial Risk Management

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

We have cash flow exposure relating to variable interest rates associated with our revolving line of credit and tax increment financing, and may periodically seek to manage this risk through the use of interest rate derivatives.  The primary interest rate exposure on variable rate obligations is based on the London Interbank Offered Rate (“LIBOR”).  We were not party to any interest rate derivatives in 2006 or 2005.

At February 2, 2007 and February 3, 2006, the fair value of our debt, excluding capital lease obligations, was approximately $265.7 million and $281.0 million, respectively, based upon the estimated market value of the debt at those dates. The February 3, 2006 amount is net of the fair value of a note receivable relating to the South Boston, Virginia DC of approximately $49.5 million, as further discussed in Note 8 to the Consolidated Financial Statements. Such fair value exceeded the carrying values of the debt at February 2, 2007 and February 3, 2006 by approximately $14.0 million and $24.2 million, respectively.

Based upon our variable rate borrowing levels, a 1% adverse change in interest rates would have resulted in a pre-tax reduction of earnings and cash flows on an annualized basis of approximately $1.3 million in 2006, $0.1 million in 2005 and less than $0.1 million in 2004. Based upon our outstanding indebtedness at February 2, 2007 and February 3, 2006, a 1% reduction in interest rates would have resulted in an increase in the fair value of our fixed rate debt of approximately $9.2 million and $12.2 million, respectively.




44



ITEM 8.

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA


Report of Independent Registered Public Accounting Firm


To the Board of Directors and Shareholders of

Dollar General Corporation

Goodlettsville, Tennessee


We have audited the accompanying consolidated balance sheets of Dollar General Corporation and subsidiaries as of February 2, 2007 and February 3, 2006, and the related consolidated statements of income, shareholders’ equity and cash flows for each of the three years in the period ended February 2, 2007.  These financial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinion on these financial statements based on our audits.


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


In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Dollar General Corporation and subsidiaries as of February 2, 2007 and February 3, 2006, and the consolidated results of their operations and their cash flows for each of the three years in the period ended February 2, 2007, in conformity with U.S. generally accepted accounting principles.


As discussed in Note 1 to the consolidated financial statements, the accompanying consolidated balance sheet as of February 3, 2006 has been restated.


As discussed in Notes 1 and 10 to the consolidated financial statements, effective February 4, 2006, the Company changed its accounting for stock-based compensation in connection with the adoption of Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment.”


We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Dollar General Corporation and subsidiaries’ internal control over financial reporting as of February 2, 2007, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 23, 2007 expressed an unqualified opinion thereon.


                                                                                           /s/ Ernst & Young LLP

Nashville, Tennessee

March 23, 2007



45



CONSOLIDATED BALANCE SHEETS

(In thousands except per share amounts)

 

February 2,
2007

 

February 3,
2006

   

Restated

(see Note 1)

ASSETS

     

Current assets:

     

Cash and cash equivalents

$

189,288 

 

$

200,609 

Short-term investments

 

29,950 

  

8,850 

Merchandise inventories

 

1,432,336 

  

1,474,414 

Income taxes receivable

 

9,833 

  

Deferred income taxes

 

24,321 

  

Prepaid expenses and other current assets

 

57,020 

  

51,339 

Total current assets

 

1,742,748 

  

1,735,212 

Net property and equipment

 

1,236,874 

  

1,192,172 

Other assets, net

 

60,892 

  

52,891 

Total assets

$

3,040,514 

 

$

2,980,275 

      

LIABILITIES AND SHAREHOLDERS’ EQUITY

     

Current liabilities:

     

Current portion of long-term obligations

$

8,080 

 

$

8,785 

Accounts payable

 

555,274 

  

508,386 

Accrued expenses and other

 

253,558 

  

242,354 

Income taxes payable

 

15,959 

  

43,706 

Deferred income taxes

 

  

7,267 

Total current liabilities

 

832,871 

  

810,498 

Long-term obligations

 

261,958 

  

269,962 

Deferred income taxes

 

41,597 

  

48,454 

Other liabilities

 

158,341 

  

130,566 

Commitments and contingencies

     

Shareholders’ equity:

     

Series B junior participating preferred stock, stated
value $0.50 per share; Shares authorized:
10,000; Issued:  None

 

 - 

  

Common stock, par value $0.50 per share;
Shares authorized: 500,000; Issued:
2006-312,436; 2005-315,679

 

156,218 

  

157,840 

Additional paid-in capital

 

486,145 

  

462,383 

Retained earnings

 

1,103,951 

  

1,106,165 

Accumulated other comprehensive loss

 

(987)

  

(794)

Other shareholders’ equity

 

420 

  

(4,799)

Total shareholders’ equity

 

1,745,747 

  

1,720,795 

Total liabilities and shareholders’ equity

$

3,040,514 

 

$

2,980,275 


The accompanying notes are an integral part of the consolidated financial statements.



46



CONSOLIDATED STATEMENTS OF INCOME

(In thousands except per share amounts)

 

For the years ended

 

February 2,
2007

 

February 3,
2006

 

January 28,
2005

 

(52 weeks)

 

(53 weeks)

 

(52 weeks)

            

Net sales

$

9,169,822 

  

$

8,582,237 

  

$

7,660,927 

 
            

Cost of goods sold

 

6,801,617 

   

6,117,413 

   

5,397,735 

 
            

Gross profit

 

2,368,205 

   

2,464,824 

   

2,263,192 

 
            

Selling, general and administrative

 

2,119,929 

   

1,902,957 

   

1,706,216 

 
            

Operating profit

 

248,276 

   

561,867 

   

556,976 

 
            

Interest income

 

(7,002)

   

(9,001)

   

(6,575)

 
            

Interest expense

 

34,915 

   

26,226 

   

28,794 

 
            

Income before income taxes

 

220,363 

   

544,642 

   

534,757 

 
            

Income taxes

 

82,420 

   

194,487 

   

190,567 

 
            

Net income

$

137,943 

  

$

350,155 

  

$

344,190 

 
            

Earnings per share:

           

Basic

$

0.44 

  

$

1.09 

  

$

1.04 

 
            

Diluted

$

0.44 

  

$

1.08 

  

$

1.04 

 
            

Weighted average shares:

           

Basic

 

312,556 

   

321,835 

   

329,376 

 
            

Diluted

 

313,510 

   

324,133 

   

332,068 

 
 


The accompanying notes are an integral part of the consolidated financial statements.



47



CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

(In thousands except per share amounts)

 

Common
Stock
Shares

Common
Stock

Additional
Paid-in
Capital

Retained
Earnings

Accumulated
Other
Comprehensive
Loss

Other
Shareholders’
Equity

Total

Balances, January 30, 2004

336,190 

$ 168,095 

$ 376,930 

$1,014,788 

$           (1,161)

$        (4,353)

$1,554,299 

Comprehensive income:

       

Net income

344,190 

344,190 

Reclassification of net loss on derivatives

188 

188 

Comprehensive income

      

344,378 

Cash dividends, $0.16 per common share

(52,682)

(52,682)

Issuance of common stock under stock incentive plans

2,875 

1,437 

32,691 

34,128 

Tax benefit from stock option exercises

9,657 

9,657 

Repurchases of common stock

(11,020)

(5,510)

(203,785)

(209,295)

Purchase of common stock by employee deferred compensation trust, net (25 shares)

(92)

(377)

(469)

Issuance of restricted stock and restricted stock units, net

128 

64 

2,398 

(2,462)

Amortization of unearned compensation on restricted stock and restricted stock units

1,779 

1,779 

Deferred compensation obligation

2,708 

2,708 

Other equity transactions

(1)

16 

(54)

(38)

Balances, January 28, 2005

328,172 

$ 164,086 

$ 421,600 

$1,102,457 

$           (973)

$        (2,705)

$1,684,465 

Comprehensive income:

       

Net income

350,155 

350,155 

Reclassification of net loss on derivatives

179 

179 

Comprehensive income

      

350,334 

Cash dividends, $0.175 per common share

(56,183)

(56,183)

Issuance of common stock under stock incentive plans

2,249 

1,125 

28,280 

29,405 

Tax benefit from stock option exercises

6,457 

6,457 

Repurchases of common stock

(14,977)

(7,489)

(290,113)

(297,602)

Sales of common stock by employee deferred compensation trust, net (42 shares)

95 

788 

883 

Issuance of restricted stock and restricted stock units, net

249 

125 

5,151 

(5,276)

Amortization of unearned compensation on restricted stock and restricted stock units

2,394 

2,394 

Acceleration of vesting of stock options (see Note 10)

938 

938 

Other equity transactions

(14)

(7)

(138)

(151)

(296)

Balances, February 3, 2006

315,679 

$ 157,840 

$ 462,383 

$1,106,165 

$           (794)

$        (4,799)

$1,720,795 

Comprehensive income:

       

Net income

137,943 

137,943 

Reclassification of net loss on derivatives

188 

188 

Comprehensive income

      

138,131 

Cash dividends, $0.20 per common share

(62,472)

(62,472)

Issuance of common stock under stock incentive plans

1,573 

786 

19,108 

19,894 

Tax benefit from share-based payments

2,513 

2,513 

Repurchases of common stock

(4,483)

(2,242)

(77,705)

(79,947)

Purchases of common stock by employee deferred compensation trust, net (3 shares)

(2)

40 

38 

Reversal of unearned compensation upon adoption of SFAS 123(R) (see Note 10)

(364)

 (182)

(4,997)

5,179 

Share-based compensation expense

7,578 

7,578 

Vesting of restricted stock and restricted stock units

149 

75 

(75)

Transition adjustment upon adoption of SFAS 158

(381)

(381)

Other equity transactions

(118)

(59)

(363)

20 

(402)

Balances, February 2, 2007

312,436 

$ 156,218 

$ 486,145 

$1,103,951 

$           (987)

$            420 

$1,745,747 


The accompanying notes are an integral part of the consolidated financial statements.



48



CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

  

February 2,
2007

February 3,
2006

January 28,
2005

   

(52 weeks)

  

(53 weeks)

  

(52 weeks)

 
           

Cash flows from operating activities:

          

Net income

 

137,943 

 

350,155 

 

344,190 

 

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

          

Depreciation and amortization

  

200,608 

  

186,824 

  

164,478 

 

Deferred income taxes

  

(38,218)

  

8,244 

  

25,751 

 

Noncash share-based compensation

  

7,578 

  

3,332 

  

1,779 

 

Tax benefit from stock option exercises

  

(2,513)

  

6,457 

  

9,657 

 

Noncash inventory adjustments and asset impairments

  

78,115 

  

  

 

Change in operating assets and liabilities:

          

Merchandise inventories

  

(28,057)

  

(97,877)

  

(219,396)

 

Prepaid expenses and other current assets

  

(5,411)

  

(10,630)

  

(3,352)

 

Accounts payable

  

53,544 

  

87,230 

  

22,258 

 

Accrued expenses and other liabilities

  

38,353 

  

40,376 

  

35,048 

 

Income taxes

  

(35,165)

  

(26,017)

  

23,793 

 

Other

  

(1,420)

  

7,391 

  

(12,691)

 

Net cash provided by operating activities

  

405,357 

  

555,485 

  

391,515 

 

Cash flows from investing activities:

          

Purchases of property and equipment

  

(261,515)

  

(284,112)

  

(288,294)

 

Purchases of short-term investments

  

(49,675)

  

(132,775)

  

(221,700)

 

Sales of short-term investments

  

51,525 

  

166,850 

  

247,501 

 

Purchases of long-term investments

  

(25,756)

  

(16,995)

  

 

Insurance proceeds related to property and equipment

  

1,807 

  

1,210 

  

 

Proceeds from sale of property and equipment

  

1,650 

  

1,419 

  

3,324 

 

Net cash used in investing activities

  

(281,964)

  

(264,403)

  

(259,169)

 

Cash flows from financing activities:

          

Borrowings under revolving credit facility

  

2,012,700 

  

232,200 

  

195,000 

 

Repayments of borrowings under revolving credit facility

  

(2,012,700)

  

(232,200)

  

(195,000)

 

Issuance of long-term obligations

  

  

14,495 

  

 

Repayments of long-term obligations

  

(14,118)

  

(14,310)

  

(16,417)

 

Payment of cash dividends

  

(62,472)

  

(56,183)

  

(52,682)

 

Proceeds from exercise of stock options

  

19,894 

  

29,405 

  

34,128 

 

Repurchases of common stock

  

(79,947)

  

(297,602)

  

(209,295)

 

Tax benefit of stock options

  

2,513 

  

  

 

Other financing activities

  

(584)

  

892 

  

(1,149)

 

Net cash used in financing activities

  

(134,714)

  

(323,303)

  

(245,415)

 

Net decrease in cash and cash equivalents

  

(11,321)

  

(32,221)

  

(113,069)

 

Cash and cash equivalents, beginning of year

  

200,609 

  

232,830 

  

345,899 

 

Cash and cash equivalents, end of year

 

189,288 

 

200,609 

 

232,830 

 

Supplemental cash flow information:

          

Cash paid during year for:

          

Interest

 

24,180 

 

25,747 

 

26,748 

 

Income taxes

 

155,825 

 

205,802 

 

133,100 

 



49






Supplemental schedule of noncash investing and financing activities:

          

Purchases of property and equipment awaiting processing for payment, included in Accounts payable

 

18,094 

 

24,750 

 

12,921 

 

Purchases of property and equipment under capital lease obligations

 

5,366 

 

7,197 

 

5,722 

 

Elimination of financing obligations (See Note 8)

 

46,608 

 

 

 

Elimination of promissory notes receivable (See Note 8)

 

46,608 

 

 

 

The accompanying notes are an integral part of the consolidated financial statements.



50



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.

Basis of presentation and accounting policies

Basis of presentation

These notes contain references to the years 2007, 2006, 2005 and 2004, which represent fiscal years ending or ended February 1, 2008, February 2, 2007, February 3, 2006 and January 28, 2005, respectively. Fiscal year 2007 will be, and each of 2006 and 2004 was, a 52-week accounting period while 2005 was a 53-week accounting period. The Company’s fiscal year ends on the Friday closest to January 31. The consolidated financial statements include all subsidiaries of the Company, except for its not-for-profit subsidiary the assets and revenues of which are not material.  Intercompany transactions have been eliminated.

The Company leases three of its distribution centers (“DCs”) from lessors, which meet the definition of a Variable Interest Entity (“VIE”) as described by Financial Accounting Standards Board (“FASB”) Interpretation 46, “Consolidation of Variable Interest Entities” (“FIN 46”), as revised. One of these DCs has been recorded as a financing obligation whereby the property and equipment, along with the related lease obligations, are reflected in the consolidated balance sheets.  The other two DCs, excluding the equipment, have been recorded as operating leases in accordance with Statement of Financial Accounting Standards (“SFAS”) 98, “Accounting for Leases.”  The Company is not the primary beneficiary of these VIEs and, accordingly, has not included these entities in its consolidated financial statements.

Business description

The Company sells general merchandise on a retail basis through 8,229 stores (as of February 2, 2007) located primarily in the southern, southwestern, midwestern and eastern United States.  The Company has DCs in Scottsville, Kentucky; Ardmore, Oklahoma; South Boston, Virginia; Indianola, Mississippi; Fulton, Missouri; Alachua, Florida; Zanesville, Ohio; Jonesville, South Carolina and Marion, Indiana.

The Company purchases its merchandise from a wide variety of suppliers. Approximately 11% of the Company’s purchases in 2006 were made from The Procter & Gamble Company. The Company’s next largest supplier accounted for approximately 5% of the Company’s purchases in 2006.

Restatement of previously issued consolidated financial statements

The Company has historically classified self-insurance and deferred rent liabilities within Accrued expenses and other, which is included in Total current liabilities on the Company’s consolidated balance sheets.  Management has concluded that a portion of these liabilities (including approximately $89.3 million and $23.0 million of self-insurance and deferred rent liabilities, respectively) and certain other assets of $15.8 million and liabilities of $18.3 million should be classified as noncurrent, along with the related deferred income tax impacts, where applicable.  As a result, the Company has restated the accompanying February 3, 2006 consolidated balance sheet to correct the prior presentation.



51



The following is a summary of consolidated balance sheet line items impacted by the classification adjustments:

 

As Previously Reported

 

Adjustments

 

As Restated

Prepaid expenses and other current assets

$

67,140

  

$

(15,801)

  

$

51,339

 

Deferred income tax asset – current

 

11,912

   

(11,912)

   

-

 

Total current assets

 

1,762,925

   

(27,713)

   

1,735,212

 

Other assets, net

 

37,090

   

15,801 

   

52,891

 

Accrued expenses and other

 

372,920

   

(130,566)

   

242,354

 

Deferred income tax liability – current

 

-

   

7,267 

   

7,267

 

Total current liabilities

 

933,797

   

(123,299)

   

810,498

 

Deferred income tax liability – noncurrent

 

67,633

   

(19,179)

   

48,454

 

Other liabilities

 

-

   

130,566 

   

130,566

 


Cash and cash equivalents

Cash and cash equivalents include highly liquid investments with insignificant interest rate risk and original maturities of three months or less when purchased.  Such investments primarily consist of money market funds, certificates of deposit and commercial paper.  The carrying amounts of these items are a reasonable estimate of their fair value due to the short maturity of these investments.

Payments due from banks for third-party credit card, debit card and electronic benefit transactions classified as cash and cash equivalents totaled approximately $11.6 million and $7.8 million at February 2, 2007 and February 3, 2006, respectively.

The Company’s cash management system provides for daily investment of available balances and the funding of outstanding checks when presented for payment.  Outstanding but unpresented checks totaling approximately $122.3 million and $124.2 million at February 2, 2007 and February 3, 2006, respectively, have been included in Accounts payable in the consolidated balance sheets.  Upon presentation for payment, these checks are funded through available cash balances or the Company’s existing credit facility.

The Company has certain cash and cash equivalents balances that, along with certain other assets, are being held as required by certain regulatory requirements and are therefore not available for general corporate purposes, as further described below under “Investments in debt and equity securities.”

Investments in debt and equity securities


The Company accounts for its investment in debt and marketable equity securities in accordance with SFAS 115, “Accounting for Certain Investments in Debt and Equity Securities,” and accordingly, classifies them as held-to-maturity, available-for-sale, or trading.  Debt securities categorized as held-to-maturity are stated at amortized cost.  Debt and equity securities categorized as available-for-sale are stated at fair value, with any unrealized gains and losses, net of deferred income taxes, reported as a component of Accumulated other comprehensive loss.  Trading securities (primarily mutual funds held pursuant to deferred compensation and supplemental retirement plans, as further discussed in Note 9) are stated at fair value, with



52



changes in fair value recorded in income as a component of Selling, general and administrative (“SG&A”) expense.


In general, the Company invests excess cash in shorter-dated, highly liquid investments such as money market funds, certificates of deposit, and commercial paper.  Depending on the type of securities purchased (debt versus equity) as well as the Company’s intentions with respect to the potential sale of such securities before their stated maturity dates, such securities have been classified as held-to-maturity or available-for-sale.  Given the short maturities of such investments (except for those securities described in further detail below), the carrying amounts approximate the fair values of such securities.


The Company may invest in tax-exempt auction rate securities, which are debt instruments having longer-dated (in some cases, many years) legal maturities, but with interest rates that are generally reset every 28-35 days under an auction system.  Because auction rate securities are frequently re-priced, they trade in the market like short-term investments.  As available-for-sale securities, these investments are carried at fair value, which approximates cost given that the average duration of such securities held by the Company is less than 40 days.  Despite the liquid nature of these investments, the Company categorizes them as short-term investments instead of cash and cash equivalents due to the underlying legal maturities of such securities.  However, they have been classified as current assets as they are generally available to support the Company’s current operations. There were no such investments outstanding as of February 2, 2007 or February 3, 2006.


In 2006 and 2005, the Company’s South Carolina-based wholly owned captive insurance subsidiary, Ashley River Insurance Company (“ARIC”), had investments in U.S. Government securities, obligations of Government Sponsored Enterprises, short- and long-term corporate obligations, and asset-backed obligations. These investments are held pursuant to South Carolina regulatory requirements to maintain certain asset balances in relation to ARIC’s liability and equity balances and as such, these investments are not available for general corporate purposes. The composition of these required asset balances changes periodically. At February 2, 2007, the total of these balances was $52.9 million and is reflected in the Company’s consolidated balance sheet as follows: cash and cash equivalents of $3.2 million, short-term investments of $30.0 million and long-term investments included in other assets of $19.7 million.


The Company’s investment in the secured promissory notes issued by the third-party entity from which the Company formerly leased its DC in South Boston, Virginia, was classified as a held-to-maturity security at February 3, 2006. The Company acquired the entity which held legal title to this DC in June 2006 as discussed in Note 8, thereby effectively eliminating these secured promissory notes and related financing obligations.


Historical cost information pertaining to investments in mutual funds by participants in the Company’s supplemental retirement and compensation deferral plans classified as trading securities is not readily available to the Company.



53



On February 2, 2007 and February 3, 2006, held-to-maturity, available-for-sale and trading securities consisted of the following (in thousands):

February 2, 2007

 

Cost

 

Gross Unrealized

 

Estimated
Fair Value

Gains

 

Losses

Held-to-maturity securities

                

Bank and corporate debt

 

$

100,386

  

$

2

  

$

80

  

$

100,308

 

U.S. Government securities

  

17,026

   

1

   

29

   

16,998

 

Obligations of Government Sponsored Enterprises

  

9,192

   

3

   

9

   

9,186

 

Asset-backed securities

  

2,833

   

4

   

10

   

2,827

 
   

129,437

   

10

   

128

   

129,319

 
                 

Available-for-sale securities

                

Equity securities

  

13,512

   

-

   

-

   

13,512

 
                 

Trading securities

                

Equity securities

  

13,591

   

-

   

-

   

13,591

 
                 

Total debt and equity securities

 

$

156,540

  

$

10

  

$

128

  

$

156,422

 
                 


February 3, 2006

 

Cost

 

Gross Unrealized

 

Estimated
Fair Value

Gains

 

Losses

Held-to-maturity securities

                

Bank and corporate debt

 

$

59,196

  

$

-

  

$

55

  

$

59,141

 

Obligations of Government Sponsored Enterprises

  

7,590

   

-

   

12

   

7,578

 

Asset-backed securities

  

3,847

   

5

   

6

   

3,846

 

Other debt securities

  

47,151

   

2,319

   

-

   

49,470

 
   

117,784

   

2,324

   

73

   

120,035

 
                 

Available-for-sale securities

                

Equity securities

  

16,300

   

-

   

-

   

16,300

 
                 

Trading securities

                

Equity securities

  

14,873

   

-

   

-

   

14,873

 
                 

Total debt and equity securities

 

$

148,957

  

$

2,324

  

$

73

  

$

151,208

 
                 




54



On February 2, 2007 and February 3, 2006, these investments were included in the following accounts in the consolidated balance sheets (in thousands):




February 2, 2007

Held-to-Maturity Securities

 

Available-
for-Sale Securities

 

Trading

Securities

Cash and cash equivalents

$

79,764

  

$

13,512

  

$

-

 

Short-term investments

 

29,950

   

-

   

-

 

Prepaid expenses and other current assets

 

-

   

-

   

1,090

 

Other assets, net

 

19,723

   

-

   

12,501

 
 

$

129,437

  

$

13,512

  

$

13,591

 


February 3, 2006


    

Cash and cash equivalents

$

44,870

  

$

16,300

  

$

-

 

Short-term investments

 

8,850

   

-

   

-

 

Prepaid expenses and other current assets

 

-

   

-

   

3,776

 

Other assets, net

 

16,913

   

-

   

11,097

 

Current portion of long-term obligations
(see Note 6)

 

1,108

   

-

   

-

 

Long-term obligations (see Note 6)

 

46,043

   

-

   

-

 
 

$

117,784

  

$

16,300

  

$

14,873

 


The contractual maturities of held-to-maturity and available-for-sale securities as of February 2, 2007 were as follows (in thousands):


 

Held-to-Maturity Securities

 

Available-for-Sale Securities

 

Cost

Fair Value

 

Cost

Fair Value

Less than one year

$

109,304

 

$

109,278

  

$

-

 

$

-

 

One to three years

 

17,300

  

17,214

   

-

  

-

 

Greater than three years

 

2,833

  

2,827

   

-

  

-

 

Equity securities

 

-

  

-

   

13,512

  

13,512

 
 

$

129,437

 

$

129,319

  

$

13,512

 

$

13,512

 


For the years ended February 2, 2007, February 3, 2006 and January 28, 2005, gross realized gains and losses on the sales of available-for-sale securities were not material.  The cost of securities sold is based upon the specific identification method.

Merchandise inventories

Inventories are stated at the lower of cost or market with cost determined using the retail last-in, first-out (“LIFO”) method. Under the Company’s retail inventory method (“RIM”), the calculation of gross profit and the resulting valuation of inventories at cost are computed by applying a calculated cost-to-retail inventory ratio to the retail value of sales.  The excess of current cost over LIFO cost was approximately $4.3 million at February 2, 2007 and $5.8 million at February 3, 2006. Current cost is determined using the retail first-in, first-out method.  LIFO reserves decreased $1.5 million, $0.5 million and $0.2 million in 2006, 2005 and 2004, respectively.  Costs directly associated with warehousing and distribution are capitalized into inventory.

In 2005, the Company expanded the number of inventory departments it utilizes for its gross profit calculation from 10 to 23. The impact of this change in estimate on the Company’s



55



consolidated 2005 results of operations was an estimated reduction of gross profit and a corresponding decrease to inventory, at cost, of $5.2 million.

Store pre-opening costs

Pre-opening costs related to new store openings and the construction periods are expensed as incurred.

Property and equipment

Property and equipment are recorded at cost.  The Company provides for depreciation and amortization on a straight-line basis over the following estimated useful lives:

 

Land improvements

20

 

Buildings

39-40

 

Furniture, fixtures and equipment

3-10


Improvements of leased properties are amortized over the shorter of the life of the applicable lease term or the estimated useful life of the asset.

Impairment of long-lived assets

When indicators of impairment are present, the Company evaluates the carrying value of long-lived assets, other than goodwill, in relation to the operating performance and future cash flows or the appraised values of the underlying assets. In accordance with SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the Company reviews for impairment stores open more than two years for which current cash flows from operations are negative. Impairment results when the carrying value of the assets exceeds the undiscounted future cash flows over the life of the lease. The Company’s estimate of undiscounted future cash flows over the lease term is based upon historical operations of the stores and estimates of future store profitability which encompasses many factors that are subject to variability and difficult to predict. If a long-lived asset is found to be impaired, the amount recognized for impairment is equal to the difference between the carrying value and the asset’s fair value. The fair value is estimated based primarily upon future cash flows (discounted at the Company’s credit adjusted risk-free rate) or other reasonable estimates of fair market value. Assets to be disposed of are adjusted to the fair value less the cost to sell if less than the book value.  


The Company recorded impairment charges, included in SG&A expense, of approximately $9.4 million in 2006, $0.6 million in 2005 and $0.2 million in 2004 to reduce the carrying value of certain of its stores’ assets as deemed necessary due to negative sales trends and cash flows at these locations. The majority of the 2006 charges were recorded pursuant to certain strategic initiatives discussed in Note 2.

Other assets

Other assets consist primarily of long-term investments, qualifying prepaid expenses, debt issuance costs which are amortized over the life of the related obligations, utility and security deposits, life insurance policies and goodwill.



56



Vendor rebates

The Company accounts for all cash consideration received from vendors in accordance with the provisions of Emerging Issues Task Force Issue (“EITF”) 02-16, “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor.” Cash consideration received from a vendor is generally presumed to be a rebate or an allowance and is accounted for as a reduction of merchandise purchase costs and recognized in the statement of operations at the time the goods are sold. However, certain specific, incremental and otherwise qualifying SG&A expenses related to the promotion or sale of vendor products may be offset by cash consideration received from vendors, in accordance with arrangements such as cooperative advertising, when earned for dollar amounts up to but not exceeding actual incremental costs. The Company recognizes amounts received for cooperative advertising on performance, “first showing” or distribution, consistent with its policy for advertising expense in accordance with the American Institute of Certified Public Accountants Statement of Position 93-7, “Reporting on Advertising Costs.”


Rent expense

Rent expense is recognized over the term of the lease.  The Company records minimum rental expense on a straight-line basis over the base, non-cancelable lease term commencing on the date that the Company takes physical possession of the property from the landlord, which normally includes a period prior to the store opening to make necessary leasehold improvements and install store fixtures.  When a lease contains a predetermined fixed escalation of the minimum rent, the Company recognizes the related rent expense on a straight-line basis and records the difference between the recognized rental expense and the amounts payable under the lease as deferred rent.  The Company also receives tenant allowances, which are recorded as deferred incentive rent and are amortized as a reduction to rent expense over the term of the lease.  Any difference between the calculated expense and the amounts actually paid are reflected as a liability, with the current portion in Accrued expenses and other and the long-term portion in Other liabilities in the consolidated balance sheets, and totaled approximately $30.4 million and $25.0 million at February 2, 2007 and February 3, 2006, respectively.

The Company recognizes contingent rental expense when the achievement of specified sales targets are considered probable, in accordance with EITF Issue 98-9, “Accounting for Contingent Rent.” The amount expensed but not paid as of February 2, 2007 and February 3, 2006 was approximately $8.6 million and $9.3 million, respectively, and is included in Accrued expenses and other in the consolidated balance sheets. (See Notes 4 and 8).

For store closures where a lease obligation still exists, the Company records the estimated future liability associated with the rental obligation on the date the store is closed in accordance with SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities.” Based on an overall analysis of store performance and expected trends, management periodically evaluates the need to close underperforming stores. Liabilities are established at the point of closure for the present value of any remaining operating lease obligations, net of estimated sublease income, and at the communication date for severance and other exit costs, as prescribed by SFAS 146. Key assumptions in calculating the liability include the timeframe expected to terminate lease



57



agreements, estimates related to the sublease potential of closed locations, and estimation of other related exit costs. Liabilities are reviewed periodically and adjusted when necessary.


Insurance liabilities

The Company retains a significant portion of risk for its workers' compensation, employee health, general liability, property and automobile claim exposures.  Accordingly, provisions are made for the Company's estimates of such risks.  Actuaries are utilized to determine the undiscounted future claim costs for the workers' compensation, general liability, and health claim risks.  To the extent that subsequent claim costs vary from those estimates, future results of operations will be affected. Ashley River Insurance Company (or ARIC, as defined above), a South Carolina-based wholly owned captive insurance subsidiary of the Company, charges the operating subsidiary companies premiums to insure the retained workers' compensation and non-property general liability exposures.  Pursuant to South Carolina insurance regulations, ARIC has cash and cash equivalents and investment balances that are not available for general corporate purposes, as further described above under “Investments in debt and equity securities.” ARIC currently insures no unrelated third-party risk. The Greater Cumberland Insurance Company, formerly a Vermont-based wholly owned captive insurance subsidiary of the Company, was liquidated in 2005.

Other liabilities

Other liabilities consist primarily of the noncurrent portion of insurance liabilities of $107.5 million in 2006 and $89.3 million in 2005, as well as the noncurrent portion of deferred rent, deferred gains, and liabilities related to the Company’s supplemental retirement and compensation deferral plans.

Fair value of financial instruments

The carrying amounts reflected in the consolidated balance sheets for cash, cash equivalents, short-term investments, receivables and payables approximate their respective fair values.  At February 2, 2007 and February 3, 2006, the fair value of the Company’s debt, excluding capital lease obligations, was approximately $265.7 million and $281.0 million, respectively, based upon the estimated market value of the debt at those dates.  The February 3, 2006 amount is net of the fair value of a note receivable on the South Boston, Virginia DC of approximately $49.5 million, as further discussed in Note 8. Such fair value exceeded the carrying values of the debt at February 2, 2007 and February 3, 2006 by approximately $14.0 million and $24.2 million, respectively. Fair values are based primarily on quoted prices for those or similar instruments.  A discussion of the carrying value and fair value of the Company’s derivative financial instruments is included in the section entitled “Derivative financial instruments” below.

Derivative financial instruments

The Company accounts for derivative financial instruments in accordance with the provisions of SFAS 133, “Accounting for Derivative Instruments and Hedging Activities”, as amended by SFAS 137, 138 and 149 and interpreted by numerous FASB Issues. These



58



statements require the Company to recognize all derivative instruments on the balance sheet at fair value, and contain accounting rules for hedging instruments, which depend on the nature of the hedge relationship.

The Company has historically used derivative financial instruments primarily to reduce its exposure to adverse fluctuations in interest rates and, to a much lesser extent, other market exposures.

As a matter of policy, the Company does not buy or sell financial instruments, including derivatives, for speculative or trading purposes and all financial instrument transactions must be authorized and executed pursuant to the approval of the Board of Directors. All financial instrument positions taken by the Company are used to reduce risk by hedging an underlying economic exposure and are structured as straightforward instruments with liquid markets. The Company primarily executes derivative transactions with major financial institutions.

The following table summarizes activity in Accumulated other comprehensive loss during 2006 related to derivative transactions used by the Company in prior periods to hedge cash flow exposures relating to certain debt transactions (in thousands):

 

Before-Tax

Amount

 

Income Tax

 

After-Tax

Amount

Accumulated net losses as of February 3, 2006

(1,253)

  

$

459 

  

(794)

 

Net losses reclassified from Other comprehensive loss into earnings

 

286 

   

(98)

   

188 

 

Accumulated net losses as of February 2, 2007

(967)

  

$

361 

  

(606)

 

The Accumulated other comprehensive loss balance at February 2, 2007 includes deferred losses realized in June 2000 on the settlement of an interest rate derivative that was designated and effective as a cash flow hedge of the Company’s forecasted issuance of its $200 million of fixed rate notes in June 2000 (see Note 6). This amount will be reclassified into earnings as an adjustment to the effective interest expense on the fixed rate notes through their maturity date in June 2010. The Company estimates that it will reclassify into earnings during the next twelve months approximately $0.2 million of the net amount recorded in Accumulated other comprehensive loss as of February 2, 2007.


Share-based payments

The Company has a shareholder-approved stock incentive plan under which stock options, restricted stock, restricted stock units and other equity-based awards may be granted to officers, directors and key employees. Effective February 4, 2006, the Company adopted SFAS 123 (Revised 2004) “Share Based Payment” and began recognizing compensation expense for share-based compensation based on the fair value of the awards on the grant date. SFAS 123(R) requires share-based compensation expense recognized since February 4, 2006 to be based on the following: (a) grant date fair value estimated in accordance with the original provisions of SFAS 123, “Accounting for Stock-Based Compensation,” for unvested options granted prior to the adoption date and (b) grant date fair value estimated in accordance with the provisions of SFAS 123(R) for unvested options granted subsequent to the adoption date. The



59



Company adopted SFAS 123(R) under the modified-prospective-transition method and, therefore, results from prior periods have not been restated.

Prior to February 4, 2006, the Company accounted for share-based payments using the intrinsic-value-based recognition method prescribed by Accounting Principles Board Opinion 25, “Accounting for Stock Issued to Employees” (“APB 25”), and had provided pro forma disclosures as permitted under SFAS 123. Because stock options were granted at an exercise price equal to the market price of the underlying common stock on the date of grant, compensation cost related to stock options was generally not required to be recorded as a reduction to net income prior to adopting SFAS 123(R).

Under SFAS 123(R), forfeitures are estimated at the time of valuation and reduce expense ratably over the vesting period. This estimate is adjusted periodically based on the extent to which actual forfeitures differ, or are expected to differ, from the previous estimate. The forfeiture rate is the estimated percentage of options granted that are expected to be forfeited or canceled before becoming fully vested. The Company bases this estimate on historical experience. An increase in the forfeiture rate will decrease compensation expense. Under SFAS 123, the Company elected to account for forfeitures when awards were actually forfeited.


SFAS 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required prior to the adoption of SFAS 123(R).


The fair value of each option grant is separately estimated. The fair value of each option grant is amortized into compensation expense on a straight-line basis between the grant date for the award and each vesting date. The Company has estimated the fair value of all stock option awards as of the date of the grant by applying the Black-Scholes-Merton option pricing valuation model. The application of this valuation model involves assumptions that are judgmental and highly sensitive in the determination of compensation expense.


The Company also accounts for nonvested restricted stock and restricted stock unit awards in accordance with the provisions of SFAS 123(R). The Company calculates compensation expense as the difference between the market price of the underlying stock on the date of grant and the purchase price, if any, and recognizes such amount on a straight-line basis over the period in which the recipient earns the nonvested restricted stock and restricted stock unit award. Under the provisions of SFAS 123(R), unearned compensation is not recorded within shareholders’ equity.


The Company has elected to determine its excess tax benefit pool upon adoption of SFAS 123(R) in accordance with the provisions of FASB Staff Position (“FSP”) 123(R)-3, “Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards.” Under the provisions of this FSP, the cumulative benefit of stock option exercises included in additional paid-in capital for the periods after the effective date of SFAS 123 is reduced by the cumulative income tax effect of the pro forma stock option expense previously disclosed in accordance with the requirements of SFAS 123. (The provision of this FSP applied only to options that were fully vested before the date of adoption of SFAS 123(R). The amount of any excess tax benefit for options that are either granted after the adoption of SFAS 123(R) or are partially vested on the



60



date of adoption were computed in accordance with the provisions of SFAS 123(R).) The amount of any excess deferred tax asset over the actual income tax benefit realized for options that are exercised after the adoption of SFAS 123(R) will be absorbed by the excess tax benefit pool. Income tax expense will be increased should the Company’s excess tax benefit pool be insufficient to absorb any future deferred tax asset amounts in excess of the actual tax benefit realized. The Company has determined that its excess tax benefit pool was approximately $68 million as of the adoption of SFAS 123(R) on February 4, 2006.


Revenue and gain recognition

The Company recognizes retail sales in its stores at the time the customer takes possession of merchandise.  All sales are net of discounts and estimated returns and are presented net of taxes assessed by governmental authorities that are imposed concurrent with those sales.  The liability for retail merchandise returns is based on the Company’s prior experience. The Company records gain contingencies when realized.

The Company began gift card sales in the third quarter of 2005.  The Company recognizes gift card sales revenue at the time of redemption.  The liability for the gift cards is established for the cash value at the time of purchase. The liability for outstanding gift cards was approximately $0.8 million and $0.5 million at February 2, 2007 and February 3, 2006, respectively, and is recorded in Accrued expenses and other. Through February 2, 2007, the Company has not recorded any breakage income related to its gift card program. The Company will continue to evaluate its current breakage policy as it continues to gain more sufficient company-specific customer experience.

Advertising costs

Advertising costs are expensed upon performance, “first showing” or distribution, and are reflected net of qualifying cooperative advertising funds provided by vendors in SG&A expenses. Advertising costs were $45.0 million, $15.1 million and $7.9 million in 2006, 2005 and 2004, respectively.  These costs primarily include promotional circulars, targeted circulars supporting new stores, in-store signage, and costs associated with the sponsorship of a National Association for Stock Car Auto Racing team. In addition, beginning in the fourth quarter of 2006, the Company also utilized television and radio advertising in conjunction with certain strategic initiatives as further discussed in Note 2. Vendor funding for cooperative advertising offset reported expenses by $7.9 million, $0.8 million and $1.0 million in 2006, 2005 and 2004, respectively.


Capitalized interest

To assure that interest costs properly reflect only that portion relating to current operations, interest on borrowed funds during the construction of property and equipment is capitalized.  Interest costs capitalized were approximately $2.9 million, $3.3 million and $3.6 million in 2006, 2005 and 2004, respectively.



61



Income taxes

The Company reports income taxes in accordance with SFAS 109, “Accounting for Income Taxes”.  Under SFAS 109, the asset and liability method is used for computing future income tax consequences of events that have been recognized in the Company’s consolidated financial statements or income tax returns.  Deferred income tax expense or benefit is the net change during the year in the Company’s deferred income tax assets and liabilities.

Management estimates

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods.  Actual results could differ from those estimates.

 Accounting pronouncements

In July 2006, the FASB issued Interpretation 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”), which will require companies to assess each income tax position taken using a two-step process. A determination is first made as to whether it is more likely than not that the position will be sustained, based upon the technical merits, upon examination by the taxing authorities. If the tax position is expected to meet the more likely than not criteria, the benefit recorded for the tax position equals the largest amount that is greater than 50% likely to be realized upon ultimate settlement of the respective tax position. The interpretation applies to income tax expense as well as any related interest and penalty expense.


FIN 48 requires that changes in tax positions recorded in a company’s financial statements prior to the adoption of this interpretation be recorded as an adjustment to the opening balance of retained earnings for the period of adoption. FIN 48 will generally be effective for public companies for the first fiscal year beginning after December 15, 2006. The Company anticipates adopting the provisions of this interpretation during the first quarter of fiscal 2007. No determination has yet been made regarding the materiality of the potential impact of this interpretation on the Company’s financial statements.


In September 2006 the FASB issued SFAS 157, “Fair Value Measurements”, which provides guidance for using fair value to measure assets and liabilities. The standard also requires expanded information about the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. The standard applies whenever other standards require (or permit) assets or liabilities to be measured at fair value. The standard does not expand the use of fair value in any new circumstances. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company currently expects to adopt SFAS 157 during the 2008 fiscal year. No determination has yet been made regarding the potential impact of this standard on the Company’s financial statements.



62



In September 2006 the FASB issued SFAS 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans,” which will require companies to recognize the overfunded or underfunded status of a defined benefit postretirement plan (other than a multiemployer plan) as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. This Statement also requires a company to measure the funded status of a plan as of the date of its year-end statement of financial position, with limited exceptions. A company with publicly traded equity securities is required to initially recognize the funded status of a defined benefit postretirement plan and to provide the required disclosures as of the end of the fiscal year ending after December 15, 2006, and the Company has complied with these provisions to the extent material. The second phase of SFAS 158 includes a requirement to measure plan assets and benefit obligations as of the date of the Company’s fiscal year-end statement of financial position, and is effective for fiscal years ending after December 15, 2008. No final determination has yet been made regarding the timing or expected impact of adoption of the second phase of SFAS 158 on the Company’s consolidated financial statements, however, because the Company currently has one supplemental executive retirement plan with one executive participant, the impact, if any, is expected to be minimal.


Reclassifications

Certain reclassifications of the 2005 and 2004 amounts have been made to conform to the 2006 presentation.

2.

Strategic initiatives


In its Quarterly Report on Form 10-Q for the quarterly period ended August 4, 2006, the Company announced it was considering modifying its historical inventory management model and accelerating its recently enhanced real estate strategy. The outcome of these deliberations is set forth below.


Inventory management

In November 2006, the Company’s Board of Directors approved management’s recommendation to discontinue the Company’s historical inventory packaway model by the end of fiscal 2007. With few exceptions, the Company plans to eliminate, through end-of-season and other markdowns, existing seasonal, home products and basic clothing packaway merchandise by the close of fiscal 2007 to allow for increased levels of newer, current-season merchandise.  In connection with this strategic change, the Company incurred substantially higher markdowns and writedowns on inventory in the third and fourth quarters of 2006. The Company recorded total markdowns of $279.1 million at cost taken during 2006, compared with total markdowns of $106.5 million at cost taken in 2005. Markdowns which were expected to reduce inventory below cost were considered in the Company’s lower of cost or market estimate and recorded at such time as the utility of the underlying inventory was deemed to be impaired. During the third quarter of fiscal 2006, the Company recorded a lower of cost or market inventory impairment estimate of $63.5 million, increasing the balance to $69.4 million as of November 3, 2006. This estimate was reduced by $23.7 million during the remainder of 2006, reflecting the Company’s estimate of the below-cost markdowns that were taken during that period, resulting in a balance



63



of approximately $45.6 million as of February 2, 2007. This inventory is expected to be sold during 2007. Markdowns which are not below cost impact the Company’s gross profit in the period in which such markdowns are taken. The amount of the below-cost inventory adjustment is based on management’s assumptions regarding the timing and adequacy of markdowns and the final adjustment may vary materially from the amount recorded depending on various factors, including timing of the execution of the plan, retail market conditions and the accuracy of assumptions used by management in developing these estimates.


Exit and disposal activities

In November 2006, the Company’s Board of Directors approved management’s recommendation to close, in addition to those stores that might be closed in the ordinary course of business, approximately 400 stores by the end of fiscal 2007 (approximately 128 of which have been closed as of February 2, 2007), and expects to incur the following pretax costs associated with the closing of these stores (in millions):


(Unaudited)

Estimated Total

Incurred in 2006

Remaining

Lease contract termination costs

$

38.1 

 

$

5.7 

 

$

32.4 

 

One-time employee termination benefits

 

1.4 

  

0.3 

  

1.1 

 

Other associated store closing costs

 

9.0 

  

0.2 

  

8.8 

 

Inventory liquidation fees

 

5.0 

  

1.6 

  

3.4 

 

Asset impairment & accelerated depreciation

 

9.0 

  

8.3 

  

0.7 

 

Inventory markdowns below cost

 

10.5 

  

6.7 

  

3.8 

 

Total

$

73.0 

 

$

22.8 

 

$

50.2 

 


Other associated store closing costs as listed in the table above primarily include the removal of any usable assets as well as real estate consulting and other services.


Liability balances related to activities discussed above for stores closed during 2006 are as follows (in millions):


 

Balance,
February 3,
2006

2006 Initial
Expenses

2006 Payments
and Other

Balance,
February 2,
2007

Lease contract termination costs

$

 

$

5.7 

 

$

0.7

 

$

5.0

 

One-time employee termination benefits

 

  

0.3 

  

-

  

0.3

 

Other associated store closing costs

 

  

0.2 

  

-

  

0.2

 

Inventory liquidation fees

 

  

1.6 

  

1.3

  

0.3

 

Total

$

 

$

7.8 

 

$

2.0

 

$

5.8

 


In addition, non-cash costs and charges of approximately $15.0 million associated with this decision have been recognized in 2006, comprised of $8.0 million of property and equipment impairment and $0.3 million of accelerated depreciation included in SG&A, and $6.7 million of below-cost inventory adjustments included in cost of goods sold. The Company recorded an estimated below-cost inventory reserve for closing stores of $7.8 million during the third quarter of 2006, which was reduced by $4.2 million during the remainder of 2006, reflecting the Company’s $3.1 million estimate of the below-cost markdowns that were taken during that



64



period and a $1.1 million reduction of the original estimate, resulting in a balance of approximately $3.6 million for inventory owned as of February 2, 2007.


All expenses associated with exit and disposal activities are included in SG&A expenses with the exception of the below-cost inventory adjustments, which are included in cost of goods sold in the consolidated statement of income for 2006. As noted above, the Company expects to incur additional charges in future periods when the related expenses are incurred. The estimated amount and timing of these future costs and charges are dependent on various factors, including timing of the execution of the plan, the outcome of negotiations with landlords and/or potential sublease tenants, and final inventory levels.


3.

Property and equipment

Property and equipment is recorded at cost and summarized as follows:

(In thousands)

2006

 

2005

Land and land improvements

$

147,447 

 

$

147,039 

Buildings

 

437,368 

  

381,460 

Leasehold improvements

 

212,078 

  

209,701 

Furniture, fixtures and equipment

 

1,617,163 

  

1,437,324 

Construction in progress

 

16,755 

  

46,016 

  

2,430,811 

  

2,221,540 

Less accumulated depreciation and amortization

 

1,193,937 

  

1,029,368 

Net property and equipment

$

1,236,874 

 

$

1,192,172 


Depreciation expense related to property and equipment was approximately $199.6 million, $186.1 million and $163.1 million in 2006, 2005 and 2004, respectively. Amortization of capital lease assets is included in depreciation expense.

4.

Accrued expenses and other

Accrued expenses and other consist of the following:

(In thousands)

2006

 

2005

Restated

(see Note 1)

Compensation and benefits

$

41,957 

 

$

41,460 

Insurance

 

76,062 

  

65,376 

Taxes (other than taxes on income)

 

50,502 

  

58,967 

Other

 

85,037 

  

76,551 

 

$

253,558 

 

$

242,354 


Other accrued expenses primarily include the current portion of liabilities for deferred rent, freight expense, contingent rent expense, interest, electricity, and common area maintenance charges.



65



5.

Income taxes

The provision (benefit) for income taxes consists of the following:

(In thousands)

  2006

 

  2005

 

2004

Current:

        

Federal

$

101,919 

 

$

175,344 

 

$

155,497 

Foreign

 

1,200 

  

1,205 

  

1,169 

State

 

17,519 

  

9,694 

  

8,150 

  

120,638 

  

186,243 

  

164,816 

Deferred:

        

Federal

 

(34,807)

  

8,479 

  

21,515 

Foreign

 

13 

  

17 

  

21 

State

 

(3,424)

  

(252)

  

4,215 

  

(38,218)

  

8,244 

  

25,751 

 

$

82,420 

 

$

194,487 

 

$

190,567 


A reconciliation between actual income taxes and amounts computed by applying the federal statutory rate to income before income taxes is summarized as follows:

(Dollars in thousands)

  2006

 

  2005

 

  2004

U.S. federal statutory rate
on earnings before

income taxes

$

77,127 

 

35.0 

%

 

$

190,625 

 

35.0 

%

 

$

187,165 

 

35.0 

%

State income taxes, net of federal income tax benefit

 

5,855 

 

2.7 

   

6,223 

 

1.1 

   

8,168 

 

1.5 

 

Jobs credits, net of federal income taxes

 

(5,008)

 

(2.3)

   

(4,503)

 

(0.8)

   

(5,544)

 

 (1.0)

 

Increase (decrease) in valuation allowances

 

3,211 

 

1.5 

   

(88)

 

(0.0)

   

(106)

 

 (0.0)

 

Other

 

1,235 

 

0.5 

   

2,230 

 

0.4 

   

884 

 

0.1 

 
 

$

82,420 

 

37.4 

%

 

$

194,487 

 

35.7 

%

 

$

190,567 

 

35.6 

%


The 2006 income tax rate was higher than the 2005 rate by 1.7%.  Factors contributing to this increase include additional expense of approximately $0.9 million related to the adoption of a new tax system in the State of Texas which resulted in the elimination of certain deferred tax assets that had been recorded in prior years; an increase of approximately $0.9 million related to the Company’s current year tax liability under the revised State of Texas tax system; a reduction in the contingent income tax reserve due to the resolution of contingent liabilities that is $2.0 million less than the decrease that occurred in 2005; an increase in the deferred tax valuation allowance, as discussed below, of approximately $3.2 million; and an increase of $2.6 million related to a benefit recognized in 2005 related to an internal restructuring.  Offsetting these rate increases was a reduction in the income tax rate related to federal income tax credits.  Due to the reduction in the Company’s 2006 income before tax, a small increase in the amount of federal income tax credits earned yielded a much larger percentage reduction in the income tax rate for 2006 versus 2005.



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While the 2005 and 2004 rates were similar overall, the rates contained offsetting differences. Factors causing the 2005 tax rate to increase when compared to the 2004 tax rate include a reduction in federal jobs credits of approximately $1.0 million, additional net foreign income tax expense of approximately $0.8 million and a decrease in the contingent income tax reserve due to resolution of contingent liabilities that was $3.6 million less than the decrease that occurred in 2004. Factors causing the 2005 tax rate to decrease when compared to the 2004 tax rate include the recognition of state tax credits of approximately $2.3 million related to the Company’s construction of a DC in Indiana and a benefit of approximately $2.6 million related to an internal restructuring that was completed during 2005.


Deferred taxes reflect the effects of temporary differences between carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company’s deferred tax assets and liabilities are as follows:


(In thousands)

2006

 

2005

Deferred tax assets:

     

Deferred compensation expense

$

10,090 

 

$

15,166 

Accrued expenses and other

 

4,037 

  

3,916 

Accrued rent

 

10,487 

  

7,137 

Accrued insurance

 

9,899 

  

9,240 

Deferred gain on sale/leasebacks

 

2,312 

  

2,465 

Inventories

 

5,874 

  

Other

 

4,609 

  

3,712 

State tax net operating loss carryforwards, net of federal tax

 

4,004 

  

7,416 

State tax credit carryforwards, net of federal tax

 

8,604 

  

4,711 

  

59,916 

  

53,763 

Less valuation allowances

 

(5,249)

  

(2,038)

Total deferred tax assets

 

54,667 

  

51,725 

Deferred tax liabilities:

     

Property and equipment

 

(71,465)

  

(74,609)

Inventories

 

  

(32,301)

Other

 

(478)

  

(536)

Total deferred tax liabilities

 

(71,943)

  

(107,446)

Net deferred tax liabilities

$

(17,276)

 

$

(55,721)

Net deferred tax liabilities are reflected separately on the consolidated balance sheets as current and noncurrent deferred income taxes. The following table summarizes net deferred income tax liabilities from the consolidated balance sheets:

(In thousands)

2006

 

2005

Restated

(see Note 1)

Current deferred income tax assets (liabilities), net

$

24,321 

 

$

(7,267)

Noncurrent deferred income tax liabilities, net

 

(41,597)

  

(48,454)

Net deferred tax liabilities

$

(17,276)

 

$

(55,721)

State net operating loss carryforwards as of February 2, 2007, totaled approximately $94 million and will expire beginning in 2017 through 2027.  The Company also has state tax credit carryforwards of approximately $13.2 million that will expire beginning in 2007 through 2021.



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The valuation allowance, as of 2006, has been provided for certain state tax credit carryforwards that are principally associated with the Company’s distribution centers.  The increase in the valuation allowance for 2006 of $3.2 million is the result of an increase in available state tax credits during 2006 in excess of the amount that the Company believes will be utilized prior to their expiration.

The valuation allowance, as of 2005, had been provided principally for certain state tax credit carryforwards. In 2005, after an internal restructuring, all valuation allowances related to state net operating loss carryforwards were removed resulting in a reduction in the valuation allowance of approximately $1.1 million.  This decrease was offset by additions to the valuation allowance applied to certain state tax credit carryforwards of approximately $0.9 million due to the same internal restructuring.  The remaining change in the valuation allowance, an increase of approximately $0.1 million, related primarily to changes in state tax credits that were unrelated to the 2005 internal restructuring.

The change in the valuation allowance was an increase of $3.2 million in 2006 and a decrease of $0.1 million in both 2005 and 2004.  Based upon expected future income and available tax planning strategies, management believes that it is more likely than not that the results of operations will generate sufficient taxable income to realize the deferred tax assets after giving consideration to the valuation allowance.

The Company estimates its contingent income tax liabilities based on its assessment of probable income tax-related exposures and the anticipated settlement of those exposures translating into actual future liabilities. As of February 2, 2007 and February 3, 2006, the Company’s accrual for these contingent liabilities, included in Income taxes payable in the consolidated balance sheets, was approximately $15.2 million and $13.4 million, respectively, and the related accrued interest included in Accrued expenses and other in the consolidated balance sheets was approximately $10.2 million and $6.2 million respectively.


As of February 2, 2007 and February 3, 2006, the Company had additional exposure in the amount of $4.2 million and $3.8 million, respectively, related to contingent income tax liabilities that had a reasonable possibility of being recognized as a loss in a future period.  These additional amounts relate principally to income tax audits.  As the Company does not consider it probable that a loss has yet been incurred related to these items, no portion of these liabilities has been recorded.

6.

Current and long-term obligations

Current and long-term obligations consist of the following:

(In thousands)

February 2, 2007

 

February 3, 2006

8 5/8% Notes due June 15, 2010, net of discount of $146 and $189 at February 2, 2007 and February 3, 2006, respectively

$

199,832 

   

$

199,789 

 

Tax increment financing due February 1, 2035

 

14,495 

    

14,495 

 

Capital lease obligations (see Note 8)

 

18,407 

    

22,028 

 

Financing obligations (see Note 8)

 

37,304 

    

42,435 

 
  

270,038 

    

278,747 

 

Less: current portion

 

(8,080)

    

(8,785)

 

Long-term portion

$

261,958 

   

$

269,962 

 



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In June 2006, the Company amended its revolving credit facility to increase the maximum commitment to $400 million and to extend the expiration date to June 2011. The amended credit facility contains provisions that would allow the maximum commitment to be increased to up to $500 million upon mutual agreement of the Company and its lenders. The amended credit facility is unsecured. The Company has two interest rate options: base rate (which is usually equal to prime rate) or LIBOR. The Company pays interest on funds borrowed under the LIBOR option at rates that are subject to change based upon the ratio of the Company’s debt to EBITDA (as defined in the amended credit facility). Under the amended credit facility, the facility fees can range from 10 to 20 basis points; the all-in drawn margin under the LIBOR option can range from LIBOR plus 55 to 125 basis points; and the all-in drawn margin under the base rate option can range from the base rate plus 10 to 20 basis points.

The amended credit facility contains financial covenants, which include limits on certain debt to cash flow ratios, a fixed charge coverage test, and minimum allowable consolidated net worth ($1.45 billion at February 2, 2007). In December 2006, the Company amended the revolving credit facility to lower the fixed charge coverage test for future periods through fiscal 2008 to take into account the impact that the initiatives discussed in Note 2 related to merchandising and real estate strategies may have on the ratio in those periods. As of February 2, 2007, the Company was in compliance with all of these covenants. During 2006 and 2005, the Company had peak borrowings of $253.4 million and $100.3 million, respectively, under the amended credit facility. As of February 2, 2007, the Company had no outstanding borrowings or letters of credit outstanding under the amended credit facility.

In 2000, the Company issued $200 million principal amount of 8 5/8% Notes due June 2010 (the “Notes”). The Notes require semi-annual interest payments in June and December of each year through June 15, 2010, at which time the entire balance becomes due and payable.  The Notes contain certain restrictive covenants.  At February 2, 2007, the Company was in compliance with all such covenants.

In July 2005, as an inducement for the Company to select Marion, Indiana as the site for construction of a new DC, the Economic Development Board of Marion approved a tax increment financing in the amount of $14.5 million. The principal amounts on this financing are due to be repaid during fiscal years 2015 to 2035. Pursuant to this financing, proceeds from the issuance of certain revenue bonds were loaned to the Company in connection with the construction of this DC.   The variable interest rate on this loan is based on the weekly remarketing of the bonds, which are supported by a bank letter of credit, and ranged from 4.60% to 5.43% in 2006 and from 3.52% to 4.60% in 2005.

At February 2, 2007 and February 3, 2006, the Company had commercial letter of credit facilities totaling $200.0 million and $195.0 million, respectively, of which $116.1 million and $85.1 million, respectively, were outstanding for the funding of imported merchandise purchases. This merchandise is subject to lien until it is paid for by the Company.



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7.

Earnings per share

The amounts reflected below are in thousands except per share data.

 

2006

 

Net

Income

 

Weighted Average

Shares

Per Share

Amount

Basic earnings per share

$

137,943

  

312,556

 

$

0.44

 

Effect of dilutive stock options, restricted stock and restricted stock units

    

954

    

Diluted earnings per share

$

137,943

  

313,510

 

$

0.44

 


 

2005

 

Net

Income

 

Weighted Average

Shares

Per Share

Amount

Basic earnings per share

$

350,155

  

321,835

 

$

1.09

 

Effect of dilutive stock options, restricted stock and restricted stock units

    

2,298

    

Diluted earnings per share

$

350,155

  

324,133

 

$

1.08

 


 

2004

 

Net

Income

 

Weighted Average

Shares

Per Share

Amount

Basic earnings per share

$

344,190

  

329,376

 

$

1.04

 

Effect of dilutive stock options, restricted stock and restricted stock units

    

2,692

    

Diluted earnings per share

$

344,190

  

332,068

 

$

1.04

 


Basic earnings per share was computed by dividing net income by the weighted average number of shares of common stock outstanding during the year.  Diluted earnings per share was determined based on the dilutive effect of stock options using the treasury stock method.

Options to purchase shares of common stock that were outstanding at the end of the respective fiscal year, but were not included in the computation of diluted earnings per share because the options’ exercise prices were greater than the average market price of the common shares, were 15.0 million, 7.9 million and 7.3 million in 2006, 2005 and 2004, respectively.

8.

Commitments and contingencies

As of February 2, 2007, the Company was committed under capital and operating lease agreements and financing obligations for most of its retail stores, three of its DCs, and certain of its furniture, fixtures and equipment.  The majority of the Company’s stores are subject to short-term leases (usually with initial or primary terms of three to five years) with multiple renewal options when available.  The Company also has stores subject to build-to-suit arrangements with landlords, which typically carry a primary lease term of between 7 and 10 years with multiple renewal options. Approximately half of the stores have provisions for contingent rentals based upon a percentage of defined sales volume.  Certain leases contain restrictive covenants.  As of February 2, 2007, the Company is not aware of any material violations of such covenants.



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In January 1999 and April 1997, the Company sold its DCs located in Ardmore, Oklahoma and South Boston, Virginia, respectively, for 100% cash consideration.  Concurrent with the sale transactions, the Company leased the properties back for periods of 23 and 25 years, respectively.  The transactions were recorded as financing obligations rather than sales as a result of, among other things, the lessor’s ability to put the properties back to the Company under certain circumstances.  The property and equipment, along with the related lease obligations, associated with these transactions were recorded in the consolidated balance sheets.

In May 2003, the Company purchased two secured promissory notes (the “DC Notes”) from Principal Life Insurance Company totaling $49.6 million. The DC Notes represented debt issued by the third party entity (“TPE”) from which the Company leased the South Boston DC. The DC Notes were being accounted for as “held to maturity” debt securities in accordance with the provisions of SFAS 115, “Accounting for Certain Investments in Debt and Equity Securities.” However, by acquiring the DC Notes, the Company holds the debt instruments pertaining to its lease financing obligation and, because a legal right of offset exists, reflected the acquired DC Notes as a reduction of its outstanding financing obligations in its consolidated balance sheet as of February 3, 2006 in accordance with the provisions of FASB Interpretation 39, “Offsetting of Amounts Related to Certain Contracts – An Interpretation of APB Opinion 10 and FASB Statement 105.”

In June 2006, the Company acquired the TPE, which owned legal title to the South Boston DC assets and had issued the related debt in connection with the original financing transaction described above. There was no material gain or loss recognized as a result of this transaction. Based on the Company’s ownership of the TPE at February 2, 2007, the financing obligation and DC notes are eliminated in the Company’s consolidated financial statements.

Future minimum payments as of February 2, 2007 for capital leases, financing obligations and operating leases are as follows:

(In thousands)

Capital

Leases

 

Financing Obligations

 

Operating

Leases

2007

7,658 

 

 4,435 

 

304,567 

 

2008

 

5,440 

  

 4,381 

  

254,087 

 

2009

 

2,082 

  

 3,785 

  

206,369 

 

2010

 

599 

  

 3,785 

  

169,454 

 

2011

 

599 

  

 3,785 

  

139,841 

 

Thereafter

 

7,036 

  

50,188 

  

415,263 

 
     

 

    

Total minimum payments

 

23,414 

  

 70,359 

 

1,489,581 

 

Less: imputed interest

 

(5,007)

  

(33,055)

    

Present value of net minimum lease payments

 

18,407 

  

 37,304 

    

Less: current portion, net

 

(6,667)

  

(1,413)

    

Long-term portion

11,740 

 

35,891 

    


Capital leases were discounted at an effective interest rate of approximately 6.7% at February 2, 2007.  The gross amount of property and equipment recorded under capital leases and financing obligations at February 2, 2007 and February 3, 2006, was $85.1 million and $150.2 million, respectively.  Accumulated depreciation on property and equipment under capital leases



71



and financing obligations at February 2, 2007 and February 3, 2006, was $41.0 million and $70.5 million, respectively.  

Rent expense under all operating leases is as follows:

(In thousands)

2006

 

2005

 

2004

Minimum rentals (a)

$

327,911 

  

$

295,061 

  

$

253,364 

 

Contingent rentals

 

16,029 

   

17,245 

   

15,417 

 
 

$

343,940 

  

$

312,306 

  

$

268,781 

 
            

(a) Excludes contract termination costs of $5.7 million recorded in association with the closing of 128 stores in the fourth quarter of 2006


Legal proceedings

On March 14, 2002, a complaint was filed in the United States District Court for the Northern District of Alabama (Edith Brown, on behalf of herself and others similarly situated v. Dolgencorp, Inc., and Dollar General Corporation, CV02-C-0673-W (“Brown”)). Brown was a collective action against the Company on behalf of current and former salaried store managers claiming that these individuals were entitled to overtime pay and should not have been classified as exempt employees under the Fair Labor Standards Act (“FLSA”). Plaintiffs sought to recover overtime pay, liquidated damages, declaratory relief and attorneys’ fees.


On January 12, 2004, the court certified an opt-in class of plaintiffs consisting of all persons employed by the Company as store managers at any time since March 14, 1999, who regularly worked more than 50 hours per week and either: (1) customarily supervised less than two employees at one time; (2) lacked authority to hire or discharge employees without supervisor approval; or (3) sometimes worked in non-managerial positions at stores other than the one he or she managed. The Company’s request to appeal the certification decision on a discretionary basis to the 11th U.S. Circuit Court of Appeals was denied.


Notice was sent to prospective class members and the deadline for individuals to opt in to the lawsuit was May 31, 2004. Approximately 5,000 individuals opted in. Following the close of discovery in April 2005, the Company filed several motions, including a motion to decertify the class as a collective action. On March 31, 2006, the court denied the Company’s motion to decertify, but granted, either in whole or in part, certain other motions, thereby reducing the number of class members to approximately 2,500. Trial of this matter began on July 31, 2006. During the trial, on August 4, 2006, the court decertified the class. The Company reached a settlement agreement with the twelve named plaintiffs in the case for an amount that was not material to the Company’s financial statements, and the matter was dismissed as settled on August 9, 2006.


On October 10, 2005, the Company was served with an additional lawsuit, Moldoon, et al. v. Dolgencorp, Inc., et al. (Western District of Louisiana, Lake Charles Division, CV05-0852, filed May 19, 2005), filed as a putative collective action in which five current or former store managers claim to have been improperly classified as exempt executive employees under the FLSA. Plaintiffs seek injunctive relief, back wages, liquidated damages and attorneys’ fees. On



72



April 26, 2006, this action was conditionally transferred to the Northern District of Alabama and consolidated with the Brown case. The Company opposed the transfer and consolidation of this matter, and on August 11, 2006, the conditional transfer order was vacated.  


On August 7, 2006, a lawsuit entitled Cynthia Richter, et al. v. Dolgencorp, Inc., et al. was filed in the United States District Court for the Northern District of Alabama (Case No. 7:06-cv-01537-LSC) in which the plaintiff alleges that she and other current and former Dollar General store managers were improperly classified as exempt executive employees under the FLSA and seeks to recover overtime pay, liquidated damages, and attorneys’ fees and costs. On August 15, 2006, the Richter plaintiff filed a motion in which she asked the court to certify a nationwide class of current and former store managers. The Company has opposed the plaintiff’s motion. On March 23, 2007, the Court conditionally certified a nationwide class of individuals who worked for Dollar General as Store Managers since August 7, 2003. The Court further ordered the parties to jointly file a proposed Notice to the class and a plan to facilitate the transmission of that Notice within 10 days. The number of persons to whom Notice will be sent has not been determined.  Following the close of the discovery period in this case, the Company will have an opportunity to seek decertification of the class, and the Company expects to file such a motion.


The Company believes that its store managers are and have been properly classified as exempt employees under the FLSA and that the actions described above are not appropriate for collective action treatment. The Company intends to vigorously defend these actions. However, at this time, it is not possible to predict whether the courts will permit these actions to proceed collectively, and no assurances can be given that the Company will be successful in its defense on the merits or otherwise. If the Company is not successful in its efforts to defend these actions, the resolution or resolutions could have a material adverse effect on the Company’s financial statements as a whole.


On May 18, 2006, the Company was served with a lawsuit entitled Tammy Brickey, Becky Norman, Rose Rochow, Sandra Cogswell and Melinda Sappington v. Dolgencorp, Inc. and Dollar General Corporation (Western District of New York, Case 6:06-cv-06084-DGL, originally filed on February 9, 2006 and amended on May 12, 2006 (“Brickey”)). The Brickey plaintiffs seek to proceed collectively under the FLSA and as a class under New York, Ohio, Maryland and North Carolina wage and hour statutes on behalf of, among others, individuals employed by the Company as assistant store managers who claim to be owed wages (including overtime wages) under those statutes. At this time, it is not possible to predict whether the court will permit this action to proceed collectively or as a class. However, the Company believes that this action is not appropriate for either collective or class treatment, and believes that its wage and hour policies and practices comply with both federal and state law. The Company plans to vigorously defend this action; however, no assurances can be given that the Company will be successful in its defense on the merits or otherwise, and, if it is not, the resolution of this action could have a material adverse effect on the Company’s financial statements as a whole.


On March 7, 2006, a complaint was filed in the United States District Court for the Northern District of Alabama (Janet Calvert v. Dolgencorp, Inc., Case No. 2:06-cv-00465-VEH (“Calvert”)), in which the plaintiff, a former store manager, alleged that she was paid less than


73



male store managers because of her sex, in violation of the Equal Pay Act (“EPA”) and Title VII of the Civil Rights Act of 1964, as amended (“Title VII”). On March 9, 2006, the Calvert complaint was amended to include seven additional plaintiffs, who also allege to have been paid less than males because of their sex, and to add allegations of sex discrimination in promotional opportunities and undefined terms and conditions of employment. In addition to allegations of intentional sex discrimination, the amended Calvert complaint also alleges that the Company’s employment policies and practices have a disparate impact on females. The amended Calvert complaint seeks to proceed collectively under the EPA and as a class under Title VII, and requests back wages, injunctive and declaratory relief, liquidated damages and attorney’s fees and costs.


At this time, it is not possible to predict whether the court will permit Calvert to proceed collectively or as a class. However, the Company believes that the case is not appropriate for class or collective treatment and believes that its policies and practices comply with the EPA and Title VII. The Company intends to vigorously defend the action; however, no assurances can be given that the Company will be successful in its defense on the merits or otherwise. If the Company is not successful in defending the Calvert action, its resolution could have a material adverse effect on the Company’s financial statements as a whole.


On April 28, 2006, the Company was served with an additional lawsuit, Linda Beeman, on behalf of herself and all others similarly situated, v. Dolgencorp, Inc. d/b/a Dollar General, 06-CV-0250 (“Beeman”), filed on February 28, 2006 in the United States District Court for the Northern District of New York, in which the plaintiff, a former store manager, raised claims substantially similar to those raised in the Calvert matter. The Beeman plaintiff sought to proceed collectively under the EPA and as a class under Title VII, and requested back wages, injunctive and declaratory relief, liquidated damages and attorney’s fees and costs. On November 6, 2006, the parties reached an agreement to settle plaintiff’s claims for an amount that was not material to the Company’s financial statements, and that matter is now concluded.


On September 8, 2005, the Company received a request for information from the Environmental Protection Agency ("EPA") with respect to Krazy String, a product that was offered for sale in the Company’s stores.  The EPA asserted that Krazy String contained an aerosol composed of an ozone depleting substance in violation of the Clean Air Act.  On July 12, 2006, the Company agreed to an Administrative Compliance Order requiring the destruction of the Krazy String remaining in inventory.  On December 21, 2006, the EPA advised the Company that they were considering imposing a penalty in connection with Krazy String, but they did not indicate an estimated amount.  On February 5, 2007, the EPA proposed a penalty of approximately $800,000 which the Company believes is in excess of the amount that is appropriate pursuant to applicable EPA policies.  The Company intends to vigorously defend the action; however, no assurances can be given that the Company will be successful in its defense on the merits or otherwise.


Subsequent to the announcement of the Agreement and Plan of Merger among the Company, Buck Holdings LP and Buck Acquisition Corp (each of Buck Holdings LP and Buck Acquisition Corp is an affiliate of Kohlberg Kravis Roberts & Co., L.P. (“KKR”)), as more fully described in Note 14, the Company and its directors were named in seven putative class actions



74



alleging claims for breach of fiduciary duty arising out of the proposed sale of the Company to KKR.  The cases are captioned City of Miami General Employees’ & Sanitation Employees’ Retirement Trust and Louisiana Sheriffs’ Pension and Relief Fund v. David A. Perdue, et al (the “City of Miami Complaint”), Lee S. Grubman v. Dollar General Corporation, et al (the “Grubman Complaint”), William Hochman, IRA v. Dollar General Corporation, et al (the “Hochman Complaint”), Helene Hutt v. Dollar General Corporation, et al (the “Hutt Complaint”), Shalom Rechnieder v. David L. Beré, et al (the “Rechnieder Complaint”), Catherine Rubbery v. Dollar General Corporation, et al (the “Rubbery Complaint”), and David B. Shaev, IRA v. David A. Perdue, et al, Case No. 07-559 (the “Shaev Complaint”).   The City of Miami Complaint, the Grubman Complaint, the Hochman Complaint, the Hutt Complaint, the Rubbery Complaint, and the Shaev Complaint were each brought in the Chancery Court for Davidson County, Tennessee, and the Rechnieder Complaint was brought in the Circuit Court of Davidson County, Tennessee.  Each of the complaints allege, among other things, that the $22 per share price of the proposed transaction is inadequate and that the process leading to the transaction was unfair.  The plaintiffs seek, among other things, an injunction enjoining completion of the transaction and, in certain cases, compensatory damages.

The Company believes that each of the foregoing lawsuits is without merit and intends to defend these actions vigorously.  

In addition to the matters described above, the Company is involved in other legal actions and claims arising in the ordinary course of business. The Company believes, based upon information currently available, that such other litigation and claims, both individually and in the aggregate, will be resolved without a material effect on the Company’s financial statements as a whole. However, litigation involves an element of uncertainty. Future developments could cause these actions or claims to have a material adverse effect on the Company’s financial statements as a whole.


9.

Benefit plans

The Dollar General Corporation 401(k) Savings and Retirement Plan became effective on January 1, 1998.  The 401(k) plan is a safe harbor defined contribution plan and is subject to the Employee Retirement and Income Security Act (“ERISA”).

Participants are permitted to contribute between 1% and 25% of their pre-tax annual eligible compensation   as defined in the 401(k) plan document, subject to certain limitations under the Internal Revenue Code.  Employees who are over age 50 are permitted to contribute additional amounts on a pre-tax basis under the catch-up provision of the 401(k) plan subject to Internal Revenue Code limitations. The Company currently matches employee contributions, including catch-up contributions, at a rate of 100% of employee contributions, up to 5% of annual eligible salary, after an employee has been employed for one year and has completed a minimum of 1,000 hours of service.

A participant’s right to claim a distribution of his or her account balance is dependent on ERISA guidelines and Internal Revenue Service regulations. All active employees are fully vested in all contributions to the 401(k) plan. During 2006, 2005 and 2004, the Company



75



expensed approximately $6.4 million, $5.8 million, and $4.9 million, respectively, for matching contributions.

The Company also has a nonqualified supplemental retirement plan and compensation deferral plan (called the Dollar General Corporation CDP/SERP Plan) for a select group of management and highly compensated employees.  The supplemental retirement plan is a noncontributory defined contribution plan with annual Company contributions ranging from 2% to 12% of base pay plus bonus depending upon age plus years of service and job grade.  Under the compensation deferral plan, participants may defer up to 65% of base pay and up to 100% of bonus pay. An employee may be designated for participation in one or both of the plans, according to the eligibility requirements of the plans. The Company matches base pay deferrals at a rate of 100% of base pay deferral, up to 5% of annual salary, with annual salary offset by the amount of match-eligible salary in the 401(k) plan. All participants are 100% vested in their compensation deferral plan accounts.  Supplemental retirement plan accounts vest at the earlier of the participant’s attainment of age 50, the participant’s being credited with 10 or more “years of service”, upon termination of employment due to death or “total and permanent disability”, or upon a “change in control,” all as defined in the plan.  The Company incurred compensation expense for these plans of approximately $0.8 million in 2006 and $0.6 million in both 2005 and 2004.

The supplemental retirement plan and compensation deferral plan assets are invested at the option of the participant in either an account that mirrors the performance of a fund or funds selected by the Compensation Committee of the Company’s Board of Directors or its delegate (the “Mutual Funds Option”), or in an account which mirrors the performance of the Company’s common stock (the “Common Stock Option”).  Investments in the Common Stock Option cannot be subsequently diversified and investments in the Mutual Funds Option cannot be subsequently transferred into the Common Stock Option.  

A participant’s compensation deferral plan and supplemental retirement plan account balances will be paid in accordance with the participant’s election by (a) lump sum, (b) monthly installments over a 5, 10 or 15 year period or (c) a combination of lump sum and installments.  The vested amount will be payable at the time designated by the plan upon the participant’s termination of employment or retirement, except that participants may elect to receive an in-service distribution or an “unforeseeable emergency hardship” distribution of vested amounts credited to the compensation deferral account. Account balances deemed to be invested in the Mutual Funds Option are payable in cash and account balances deemed to be invested in the Common Stock Option are payable in shares of Dollar General common stock and cash in lieu of fractional shares.  

Asset balances in the Mutual Funds Option are stated at fair market value, which is based on quoted market prices. The current portion of these balances are included in Prepaid expenses and other current assets and the long term portion is included in Other assets, net in the consolidated balance sheets.  In accordance with EITF 97-14 “Accounting for Deferred Compensation Arrangements Where Amounts Earned Are Held in a Rabbi Trust and Invested,” the Company’s stock is recorded at historical cost and included in Other shareholders’ equity.  The deferred compensation liability related to the Company stock for active plan participants is included in shareholders’ equity and subsequent changes to the fair value of the obligation are



76



not recognized, in accordance with the provisions of EITF 97-14. The deferred compensation liability related to the Mutual Funds Option is recorded at the fair value of the investments held in the trust. The current portion of these balances is included in Accrued expenses and other and the long term portion is included in Other liabilities in the consolidated balance sheets.

The Company sponsors a supplemental executive retirement plan for the Chief Executive Officer (called the Supplemental Executive Retirement Plan for David A. Perdue) and accounts for the plan in accordance with SFAS 158. The plan has an unfunded liability balance of $2.9 million as of February 2, 2007, included in Other liabilities in the consolidated balance sheet as of February 2, 2007. This balance includes a $0.6 million transition adjustment ($0.4 million net of tax) for net actuarial losses recorded in 2006 as prescribed by SFAS 158, with the net of tax offset to Accumulated other comprehensive income. The Company has not included additional disclosures due to the plan’s immateriality to the consolidated financial statements as a whole. Effective January 25, 2006, the Board approved the restatement of the plan to clarify certain provisions, comply with pending federal legislation and establish a grantor trust to hold certain assets in connection with the plan.  The grantor trust provides for assets to be placed in the trust upon an actual or potential change in control (as defined in the grantor trust).  The assets of the grantor trust are subject to the claims of the Company’s creditors.

Non-employee directors may defer all or a part of any fees normally paid by the Company to a voluntary nonqualified compensation deferral plan.  The compensation eligible for deferral includes the annual retainer, meeting and other fees, as well as any per diem compensation for special assignments, earned by a director for his or her service to the Company’s Board of Directors or one of its committees.  The deferred compensation is credited to a liability account, which is then invested at the option of the director, in deemed investments which mirror either the Mutual Funds Option or the Common Stock Option and the deferred compensation will be paid in accordance with the director’s election in a lump sum or in monthly installments over a 5, 10 or 15 year period, or a combination of both, at the time designated by the plan upon a director’s resignation or termination from the Board. However, a director may request to receive an “unforeseeable emergency hardship” in-service distribution of amounts credited to his account in accordance with the terms of the directors’ deferral plan.  All deferred compensation will be immediately due and payable upon a “change in control” (as defined in the directors’ deferral plan) of the Company. Account balances deemed to be invested in the Mutual Funds Option are payable in cash and account balances deemed to be invested in the Common Stock Option are payable in shares of Dollar General common stock and cash in lieu of fractional shares.

10.

Share-based payments

The Company has a shareholder-approved stock incentive plan under which stock options, nonvested shares in the form of restricted stock and restricted stock units (which represent the right to receive one share of common stock for each unit upon vesting), and other equity-based awards may be granted to certain officers, directors and key employees. The plan authorizes the issuance of up to 29.375 million shares of the Company’s common stock, up to 4 million of which may be issued in the form of restricted stock or restricted stock units. As of February 2, 2007, there were approximately 6.4 million shares available for future grant, approximately 3.0 million of which may be issued as restricted stock or restricted stock units.



77



The Company believes that stock-based awards assist in retaining employees and better align the interests of its employees with those of its shareholders.


Stock options granted under the plan are non-qualified stock options issued at an exercise price equal to the market price of the Company’s common stock on the grant date, vest ratably over a four-year period (subject to earlier vesting in certain circumstances such as a change in control), and expire no more than 10 years following the grant date. The number of options granted is generally based on individual job grade levels, which are determined based upon competitive market data. Dividends are not paid or accrued on stock options.


Unvested options generally are forfeited upon the cessation of employment with the Company. In the event employment terminates for a reason other than cause, death, disability or retirement, any outstanding vested options issued under the plan generally may be exercised for a period of three months. In the event employment terminates due to death, disability or retirement, the option recipient (or the recipient’s legal representative or beneficiary) generally may exercise any outstanding vested options issued under the plan for a period of three years. Notwithstanding the foregoing, no option may be exercised beyond its initial 10-year expiration date.


Restricted stock awards and restricted stock unit awards granted under the plan generally vest ratably over three years (subject to earlier vesting in certain circumstances such as a change in control). Unvested restricted stock and restricted stock unit awards generally are forfeited upon the cessation of a grantee’s employment with the Company. Recipients of restricted stock are entitled to receive cash dividends and to vote their respective shares, but are generally prohibited from selling or transferring restricted shares prior to vesting. Recipients of restricted stock units are entitled to accrue dividend equivalents on the units but are not entitled to vote, sell or transfer the units or the shares underlying the units prior to both vesting and payout. Dividends or dividend equivalents, as the case may be, are paid or accrued on the grants of restricted stock and restricted stock units at the same rate that dividends are paid to shareholders generally. Dividend equivalents on restricted stock units vest at the same time that the underlying shares vest.


The plan provides for the automatic annual grant of 4,600 restricted stock units to each non-employee director that vest one year after the grant date (subject to earlier vesting upon retirement, change in control or other circumstances set forth in the plan) and generally may not be paid until the individual has ceased to be a member of the Company’s Board of Directors.


In the past, the Company had various stock and incentive plans under which stock options were granted. Stock options that were granted under prior plans and were outstanding on February 2, 2007 continue in accordance with the terms of the respective plans.


On February 3, 2006, the vesting of all outstanding options granted prior to August 2, 2005, other than options previously granted to the Company’s CEO and options granted in 2005 to the officers of the Company at the level of Executive Vice President or above, accelerated pursuant to a January 24, 2006 action of the Compensation Committee of the Company’s Board of Directors. In addition, pursuant to that Compensation Committee action, the vesting of all



78



outstanding options granted on or after August 2, 2005 but prior to January 24, 2006, other than options granted during that time period to the officers of the Company at the level of Executive Vice President or above, accelerated effective as of the date that is six months after the applicable grant date. Certain options granted on January 24, 2006 to certain newly hired officers below the level of Executive Vice President were granted with a six-month vesting period. The decision to accelerate the vesting of these stock options resulted in compensation expense of $0.9 million, before income taxes, recognized during the fourth quarter of 2005, and was made primarily to reduce non-cash compensation expense to be recorded in future periods under the provisions of SFAS 123(R). The future expense eliminated as a result of the decision to accelerate the vesting of these options was approximately $28 million, or $17 million net of income taxes, over the four-year period during which the stock options would have vested, subject to the impact of additional adjustments related to certain stock option forfeitures. The Company also believed this decision benefited employees.


Effective February 4, 2006, the Company adopted SFAS 123(R) and began recognizing compensation expense for stock options based on the fair value of the awards on the grant date. The Company adopted SFAS 123(R) under the modified-prospective-transition method and, therefore, results from prior periods have not been restated. The following table illustrates the effect on net income and earnings per share as if the Company had applied the fair value recognition provisions of SFAS 123 to options granted under the Company’s stock plans for the years ended February 3, 2006 and January 28, 2005. For purposes of this pro forma disclosure, the value of the options is estimated using the Black-Scholes-Merton option pricing model for all option grants.


(In thousands except per share data)

Year Ended

February 3, 2006

 

Year Ended

January 28, 2005

Net income – as reported

$

350,155 

 

$

 344,190 

Deduct: Total pro forma stock-based employee compensation expense determined

under fair value based method for all awards, net of related tax effects per SFAS 123

 

 32,621 

  

 10,724 

Net income – pro forma

$

 317,534 

 

$

 333,466 

      

Earnings per share – as reported

     

Basic

$

 1.09 

 

$

 1.04 

Diluted

$

 1.08 

 

$

 1.04 

Earnings per share – pro forma

     

Basic

$

 0.99 

 

$

 1.01 

Diluted

$

 0.98 

 

$

 1.00 


 

 Under SFAS 123(R), forfeitures are estimated at the time of valuation and reduce expense ratably over the vesting period. Under SFAS 123, the Company elected to account for forfeitures when awards were actually forfeited, at which time all previous pro forma expense (which, after-tax, approximated $5.5 million and $8.5 million in the years ended February 3, 2006 and January 28, 2005, respectively) was reversed to reduce pro forma expense for those years.


For the year ended February 2, 2007, the adoption of the fair value method of SFAS 123(R) resulted in additional share-based compensation expense (a component of SG&A expenses) and a corresponding reduction in net income before income taxes in the amount of



79



$3.6 million, a reduction in net income of $2.2 million, and a reduction in basic and diluted earnings per share of approximately $0.01.

 

SFAS 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required prior to the adoption of SFAS 123(R). For the year ended February 2, 2007, the $2.5 million excess tax benefit classified as a financing cash inflow would have been classified as an operating cash inflow if the Company had not adopted SFAS 123(R). The impact of the adoption of SFAS 123(R) on future results will depend on, among other things, levels of share-based payments granted in the future, actual forfeiture rates and the timing of option exercises.


The fair value of each option grant is separately estimated by applying the Black-Scholes-Merton option pricing valuation model. The weighted average for key assumptions used in determining the fair value of options granted in the years ended February 2, 2007, February 3, 2006 and January 28, 2005, and a summary of the methodology applied to develop each assumption, are as follows:


 

February 2, 2007

February 3, 2006

January 28, 2005

Expected dividend yield

0.82 

%

0.85 

%

0.85 

%

Expected stock price volatility

28.8 

%

27.1 

%

35.5 

%

Weighted average risk-free interest rate

4.7 

%

4.2 

%

3.5 

%

Expected term of options (years)

5.7 

 

5.0 

 

5.0 

 


Expected dividend yield - This is an estimate of the expected dividend yield on the Company’s stock. This estimate is based on historical dividend payment trends. An increase in the dividend yield will decrease compensation expense.


Expected stock price volatility - This is a measure of the amount by which the price of the Company’s common stock has fluctuated or is expected to fluctuate. The Company uses actual historical changes in the market price of the Company’s common stock and implied volatility based upon traded options, weighted equally, to calculate the volatility assumption, as it is the Company’s belief that this methodology provides the best indicator of future volatility. For historical volatility, the Company calculates daily market price changes from the date of grant over a past period representative of the expected life of the options to determine volatility, excluding the period from April 30, 2001 to January 31, 2002 due to a restatement of the Company’s financial statements for fiscal years 2001 and prior and the Company’s inability, during a substantial portion of this period, to file annual and quarterly reports required by the Securities Exchange Act of 1934. The Company believes that the restatement and related inability to file periodic Exchange Act reports is an event specific to the Company that resulted in higher than normal share price volatility during this period and is not expected to recur during the estimated term of current option grants. An increase in the expected volatility will increase compensation expense.

 

Weighted average risk-free interest rate - This is the U.S. Treasury rate for the week of the grant having a term approximating the expected life of the option. An increase in the risk-free interest rate will increase compensation expense.



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Expected term of options - This is the period of time over which the options granted are expected to remain outstanding. Because the terms of the Company’s stock option grants prior to August 2002 were significantly different than grants issued on and after that date and the Company does not currently intend to grant stock options similar to those granted prior to August 2002 in future periods, the Company believes that the historical and post-vesting employee behavior patterns for grants prior to August 2002 are of little or no value in determining future expectations and, therefore, has generally excluded these pre-August 2002 grants from its analysis of expected term. The Company has estimated expected term using a computation based on an assumption that outstanding options will be exercised approximately halfway through their contractual term, taking into consideration such factors as grant date, expiration date, weighted-average time-to-vest, actual exercises and post-vesting cancellations. Options granted have a maximum term of 10 years. An increase in the expected term will increase compensation expense.


The Company issues new shares when options are exercised. A summary of stock option activity during the year ended February 2, 2007 is as follows:

 

Options
Issued

 

Weighted Average
Exercise Price

Balance, February 3, 2006

 

 20,258,324 

   

$

18.19 

 

Granted

 

 2,648,600 

    

17.41 

 

Exercised

 

 (1,573,354)

    

12.65 

 

Canceled

 

 (1,934,689)

    

19.68 

 

Balance, February 2, 2007

 

 19,398,881 

   

$

18.38 

 


During the years ended February 2, 2007, February 3, 2006 and January 28, 2005, the weighted average grant date fair value of options granted was $5.86, $6.33 and $6.36, respectively; 617,234, 8,281,184 and 1,037,126 options vested, net of forfeitures, respectively; with a total fair value of approximately $2.5 million, $56.5 million and $4.2 million, respectively; and the total intrinsic value of stock options exercised was $6.8 million, $16.7 million and $24.0 million, respectively.


At February 2, 2007, the aggregate intrinsic value of all outstanding options was $14.6 million with a weighted average remaining contractual term of 5.2 years, of which 16,923,305 of the outstanding options are currently exercisable with an aggregate intrinsic value of $14.1 million, a weighted average exercise price of $18.50 and a weighted average remaining contractual term of 4.7 years. At February 2, 2007, the total unrecognized compensation cost related to non-vested stock options was $11.6 million with an expected weighted average expense recognition period of 3.1 years.


All stock options granted in the years ended February 2, 2007 and February 3, 2006 under the terms of the Company’s stock incentive plan were non-qualified stock options issued at a price equal to the fair market value of the Company’s common stock on the date of grant, were originally scheduled to vest ratably over a four-year period, and expire 10 years following the date of grant.




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A summary of activity related to nonvested restricted stock and restricted stock unit awards during the year ended February 2, 2007 is as follows:


 


Nonvested

Shares

 

Weighted Average
Grant Date

Fair Value

Balance, February 3, 2006

 

 363,687 

   

$

19.66 

 

Granted

 

 571,603 

    

15.20 

 

Vested

 

 (149,066)

    

18.01 

 

Canceled

 

 (37,593)

    

18.76 

 

Balance, February 2, 2007

 

 748,631 

   

$

16.63 

 


The purchase price was set at zero for all nonvested restricted stock and restricted stock unit awards granted in the year ended February 2, 2007. The Company records compensation expense on a straight-line basis over the restriction period based on the market price of the underlying stock on the date of grant. The nonvested restricted stock and restricted stock unit awards granted under the plan to employees during the year ended February 2, 2007 are scheduled to vest and become payable ratably over a three-year period from the respective grant dates, except for a restricted stock unit grant made to the Company’s Chairman and Chief Executive Officer in the third quarter of fiscal 2006 which is scheduled to vest ratably over a three-year period from the grant date but which is not payable until after he ceases to be employed by the Company. The nonvested restricted stock unit awards granted under the plan to non-employee directors during the year ended February 2, 2007 are scheduled to vest over a one-year period from the respective grant dates, but become payable only after the recipient ceases to serve as a Board member (or upon a change-in-control as discussed above).


The Company accounts for nonvested restricted stock and restricted stock unit awards in accordance with the provisions of SFAS 123(R). Under the provisions of SFAS 123(R), unearned compensation is not recorded within shareholders’ equity, and accordingly, during the year ended February 2, 2007, the Company reversed its unearned compensation balance as of February 3, 2006 of approximately $5.2 million, with an offset to common stock and additional paid-in capital. The Company recognized compensation expense relating to its nonvested restricted stock and restricted stock unit awards of approximately $4.0 million, $2.4 million and $1.8 million in 2006, 2005 and 2004, respectively. At February 2, 2007, the total compensation cost related to nonvested restricted stock and restricted stock unit awards not yet recognized was approximately $9.1 million.

 

There have been no modifications to any of the Company’s outstanding share-based payment awards during the year ended February 2, 2007. The Company recognized total compensation expense relating to share-based awards of approximately $7.6 million, $3.3 million and $1.8 million in 2006, 2005 and 2004, respectively.


11.

Capital stock

The Company has a Shareholder Rights Plan (the “Plan”), filed with the Securities and Exchange Commission, under which Series B Junior Participating Preferred Stock Purchase Rights (the “Rights”) were issued for each outstanding share of common stock.  The Rights were attached to all common stock outstanding as of March 10, 2000. On May 8, 2000, we effected a



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five for four stock split at which time, pursuant to the adjustment provisions contained in the Rights Agreement, each outstanding share of the Company’s common stock evidenced the right to receive eight-tenths of a right.  Such Rights will be attached to all additional shares of common stock issued prior to the Plan’s expiration on February 28, 2010, or such earlier termination, if applicable.  The Rights entitle the holders to purchase from the Company one one-hundredth of a share (a “Unit”) of Series B Junior Participating Preferred Stock (the “Preferred Stock”), no par value, at a purchase price of $100 per Unit, subject to adjustment.  Initially, the Rights will attach to all certificates representing shares of outstanding common stock, and no separate Rights Certificates will be distributed.  The Rights will become exercisable upon the occurrence of a triggering event as defined in the Plan. The triggering events generally include any unsolicited attempt to acquire more than 15 percent of the Company's outstanding common stock. The practical operation of the Plan, if triggered, allows a holder of rights: (a) to acquire $200 of the Company's common stock in exchange for the $100 purchase price in the event of an acquisition of the Company in which the Company is the surviving entity; and (b) in the event of an acquisition of the Company in which the Company is not the surviving entity, to acquire $200 of the surviving entity's securities in exchange for the $100 purchase price.

On November 29, 2006, the Board of Directors authorized the Company to repurchase up to $500 million of its outstanding common stock.  On September 30, 2005 and November 30, 2004, the Board of Directors authorized the Company to repurchase up to 10 million shares of its outstanding common stock on each date. These authorizations allow or allowed, as applicable, for purchases in the open market or in privately negotiated transactions from time to time, subject to market conditions. The objective of the Company’s share repurchase initiative is to enhance shareholder value by purchasing shares at a price that produces a return on investment that is greater than the Company's cost of capital. Additionally, share repurchases generally are undertaken only if such purchases result in an accretive impact on the Company's fully diluted earnings per share calculation.  The 2006 authorization expires December 31, 2008 and as of February 2, 2007 no purchases had been made pursuant to this authorization. The 2005 and 2004 authorizations were completed prior to their expiration dates. During 2006, the Company purchased approximately 4.5 million shares pursuant to the 2005 authorization at a total cost of $79.9 million. During 2005, the Company purchased approximately 5.5 million shares pursuant to the 2005 authorization at a total cost of $104.7 million and approximately 9.5 million shares pursuant to the 2004 authorization at a total cost of $192.9 million. During 2004, the Company purchased approximately 0.5 million shares pursuant to the 2004 authorization at a total cost of $10.9 million and approximately 10.5 million shares pursuant to a 2003 authorization at a total cost of $198.4 million.


12.

Insurance settlement


During 2006 and 2005, the Company received proceeds of $13.0 million and $8.0 million, respectively, representing insurance recoveries for destroyed and damaged assets, costs incurred and business interruption coverage related to Hurricane Katrina, which is reflected in results of operations for these years as a reduction of SG&A expenses. The claim was settled in 2006. The business interruption portion of the proceeds was approximately $5.8 million and was received in 2006. Insurance recoveries related to fixed assets losses are included in cash flows



83



from investing activities and recoveries related to inventory losses and business interruption are included in cash flows from operating activities.


13.

Segment reporting


The Company manages its business on the basis of one reportable segment.  See Note 1 for a brief description of the Company’s business.  As of February 2, 2007, all of the Company’s operations were located within the United States with the exception of an immaterial Hong Kong subsidiary formed to assist in the process of importing certain merchandise that began operations in early 2004.  The following data is presented in accordance with SFAS 131, “Disclosures about Segments of an Enterprise and Related Information.”

(In thousands)

2006

 

2005

 

2004

Classes of similar products:

           

Highly consumable

$

6,022,014

  

$

5,606,466

  

$

4,825,051

 

Seasonal

 

1,509,999

   

1,348,769

   

1,263,991

 

Home products

 

914,357

   

907,826

   

879,476

 

Basic clothing

 

723,452

   

719,176

   

692,409

 

Net sales

$

9,169,822

  

$

8,582,237

  

$

7,660,927

 


14.

Subsequent event

On March 11, 2007, the Company entered into an Agreement and Plan of Merger (the “Merger Agreement”) with Buck Holdings LP, a Delaware limited partnership (“Parent”) and Buck Acquisition Corp., a Tennessee corporation and wholly owned subsidiary of Parent (“Merger Sub”).

Pursuant to the Merger Agreement, Merger Sub will be merged with and into the Company (the “Merger”), with the Company surviving the Merger as a wholly owned subsidiary of Parent. Merger Sub and Parent are affiliates of Kohlberg Kravis Roberts & Co., L.P. Pursuant to the Merger Agreement, at the effective time of the Merger, each outstanding share of common stock of the Company, other than any shares held by any wholly owned subsidiary of the Company and any shares owned by Parent or Merger Sub or held by the Company, will be cancelled and converted into the right to receive $22.00 in cash, without interest (the “Merger Consideration”). In addition, immediately prior to the effective time of the Merger, all shares of Company restricted stock and restricted stock units will, unless otherwise agreed by the holder and Parent, vest and be converted into the right to receive the Merger Consideration. All options to acquire shares of Company common stock will vest immediately prior to the effective time of the Merger and holders of such options will, unless otherwise agreed by the holder and Parent, be entitled to receive an amount in cash equal to the excess, if any, of the Merger Consideration over the exercise price per share of Company common stock subject to the option.

The Board of Directors of the Company unanimously approved the Merger Agreement and amended the Company’s Shareholder Rights Plan to exempt the Merger from that Plan’s operation.

Consummation of the Merger is not subject to a financing condition but is subject to customary closing conditions, including approval of the Merger Agreement by the Company’s



84



shareholders, regulatory approval and other customary closing conditions. The Merger Agreement places specified restrictions on certain of the Company’s business activities, including but not limited to: acquisitions or dispositions of assets, capital expenditures, modifications of debt, leasing activities, compensatory changes, dividend increases, investments and share repurchases. The accompanying consolidated financial statements do not include any financial reporting impacts related to potential consummation of the Merger, including but not limited to potential change in basis of accounting, and acceleration of vesting of restricted stock, stock units or options.

Subsequent to the announcement of the Merger Agreement, the Company and its directors were named in seven putative class actions alleging claims for breach of fiduciary duty arising out of the proposed sale of the Company to KKR, all as described more fully under “Legal Proceedings” in Note 8 above.

15.

Quarterly financial data (unaudited)

The following is selected unaudited quarterly financial data for the fiscal years ended February 2, 2007 and February 3, 2006.  With the exception of the fourth quarter of 2005, which was a 14-week accounting period, each quarter listed below was a 13-week accounting period. The sum of the four quarters for any given year may not equal annual totals due to rounding. Amounts are in thousands except per share data.  

Quarter

First

 

Second

 

Third

 

Fourth

2006:

               

Net sales

$

2,151,387

  

$

2,251,053

  

$

2,213,396 

  

$

2,553,986

 

Gross profit

 

584,274

   

611,534

   

526,447 

   

645,950

 

Operating profit

 

81,285

   

80,577

   

3,339 

   

83,075

 

Net income (loss)

 

47,670

   

45,468

   

(5,285)

   

50,090

 

Basic earnings (loss) per share

 

0.15

   

0.15

   

(0.02)

   

0.16

 

Diluted earnings (loss) per share

 

0.15

   

0.15

   

(0.02)

   

0.16

 
                

2005:

               

Net sales

$

1,977,829

  

$

2,066,016

  

$

2,057,888 

  

$

2,480,504

 

Gross profit

 

563,349

   

591,530

   

579,016 

   

730,929

 

Operating profit

 

106,921

   

121,070

   

101,612 

   

232,264

 

Net income

 

64,900

   

75,558

   

64,425 

   

145,272

 

Basic earnings per share

 

0.20

   

0.23

   

0.20 

   

0.46

 

Diluted earnings per share

 

0.20

   

0.23

   

0.20 

   

0.46

 


As discussed in Note 12, during the first and third quarters of 2006, the Company received proceeds, net of taxes, of $3.2 million ($0.01 per diluted share), and $5.0 million, ($0.02 per diluted share) respectively, representing insurance recoveries for destroyed and damaged assets, costs incurred and business interruption coverage related to Hurricane Katrina, which is reflected in results of operations for these periods as a reduction of SG&A expenses.

As discussed in Note 2, in the third quarter of 2006, the Company completed a strategic review of its real estate portfolio and traditional inventory packaway strategy. The review resulted in plans to close approximately 400 underperforming stores and to eliminate nearly all



85



packaway merchandise by the close of fiscal 2007. As a result, in the third quarter of 2006, the Company recorded SG&A charges and a lower of cost or market inventory impairment, which reduced the Company’s net income and related per share amounts. Also, the fourth quarter 2006 change in merchandising strategy resulted in substantially higher markdowns on inventory in the fourth quarter of 2006 ($179.9 million at cost) and the Company’s ending inventory being valued lower than under historical practices as ending inventory on-hand as of February 2, 2007 reflects the immediate impact of the markdowns at the time such markdowns were taken rather than at the time such inventory is sold. The impact of this reduction to inventory value approximated $30.7 million in the fourth quarter of 2006.

In 2005, the Company expanded the number of departments it utilizes for its gross profit calculation from 10 to 23. The estimated impact of this change was a reduction of the Company’s net income and related per share amounts above of $2.1 million ($0.01 per diluted share), $2.2 million ($0.01 per diluted share) and $6.8 million ($0.02 per diluted share) in the first, second and third quarters of 2005, respectively, and a $7.7 million ($0.02 per diluted share) increase in the Company’s fourth quarter 2005 net income and related per share amounts.

16.

Guarantor subsidiaries

All of the Company’s subsidiaries except for its not-for-profit subsidiary for which the assets and revenues are not material (the “Guarantors”) have fully and unconditionally guaranteed on a joint and several basis the Company’s obligations under certain outstanding debt obligations.  Each of the Guarantors is a direct or indirect wholly owned subsidiary of the Company.

The following consolidating schedules present condensed financial information on a combined basis. Dollar amounts are in thousands.



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As of February 2, 2007

 

DOLLAR GENERAL CORPORATION

 

GUARANTOR SUBSIDIARIES

 

ELIMINATIONS

 

CONSOLIDATED

TOTAL

                

BALANCE SHEET:

               

ASSETS

               

Current assets:

               

Cash and cash equivalents

$

114,310 

  

$

74,978 

  

$

  

$

189,288 

 

Short-term investments

 

   

29,950 

   

   

29,950 

 

Merchandise inventories

 

   

1,432,336 

   

   

1,432,336 

 

Income tax receivable

 

4,896 

   

4,937 

   

   

9,833 

 

Deferred income taxes

 

5,099 

   

19,222 

   

   

24,321 

 

Prepaid expenses and other current assets

 

139,913 

   

1,086,890 

   

(1,169,783)

   

57,020 

 

Total current assets

 

264,218 

   

2,648,313 

   

(1,169,783)

   

1,742,748 

 
                

Property and equipment, at cost

 

213,781 

   

2,217,030 

   

   

2,430,811 

 

Less accumulated depreciation
and amortization

 

115,201 

   

1,078,736 

   

   

1,193,937 

 

Net property and equipment

 

98,580 

   

1,138,294 

   

   

1,236,874 

 
                

Other assets, net

 

2,686,697 

   

43,622 

   

(2,669,427)

   

60,892 

 
                

Total assets

$

3,049,495 

  

$

3,830,229 

  

$

(3,839,210)

  

$

3,040,514 

 
                

LIABILITIES AND SHAREHOLDERS’ EQUITY

               

Current liabilities:

               

Current portion of long-term
obligations

$

  

$

8,080 

  

$

  

$

8,080 

 

Accounts payable

 

1,076,028 

   

647,153 

   

(1,167,907)

   

555,274 

 

Accrued expenses and other

 

13,327 

   

242,107 

   

(1,876)

   

253,558 

 

Income taxes payable

 

   

15,959 

   

   

15,959 

 

Total current liabilities

 

1,089,355 

   

913,299 

   

(1,169,783)

   

832,871 

 

Long-term obligations

 

199,842 

   

1,584,526 

   

(1,522,410)

   

261,958 

 

Deferred income taxes

 

(793)

   

42,390 

   

   

41,597 

 

Other liabilities

 

15,344 

   

142,997 

   

   

158,341 

 
                

Shareholders’ equity:

               

Preferred stock

 

   

   

   

 

Common stock

 

156,218 

   

23,853 

   

(23,853)

   

156,218 

 

Additional paid-in capital

 

486,145 

   

673,611 

   

(673,611)

   

486,145 

 

Retained earnings

 

1,103,951 

   

449,553 

   

(449,553)

   

1,103,951 

 

Accumulated other comprehensive loss

 

(987)

   

   

   

(987)

 

Other shareholders’ equity

 

420 

   

   

   

420 

 

Total shareholders’ equity

 

1,745,747 

   

1,147,017 

   

(1,147,017)

   

1,745,747 

 
                

Total liabilities and shareholders’ equity

$

3,049,495 

  

$

3,830,229 

  

$

(3,839,210)

  

$

3,040,514 

 




87






 

As of February 3, 2006 Restated (see Note 1)

 

DOLLAR GENERAL CORPORATION

 

GUARANTOR SUBSIDIARIES

 

ELIMINATIONS

 

CONSOLIDATED

TOTAL

                

BALANCE SHEET:

               

ASSETS

               

Current assets:

               

Cash and cash equivalents

$

110,410 

  

$

90,199 

  

$

  

$

200,609 

 

Short-term investments

 

   

8,850 

   

   

8,850 

 

Merchandise inventories

 

   

1,474,414 

   

   

1,474,414 

 

Deferred income taxes

 

7,100 

   

   

(7,100)

   

 

Prepaid expenses and other current assets

 

78,361 

   

789,811 

   

(816,833)

   

51,339 

 

Total current assets

 

195,871 

   

2,363,274 

   

(823,933)

   

1,735,212 

 
                

Property and equipment, at cost

 

199,396 

   

2,022,144 

   

   

2,221,540 

 

Less accumulated depreciation
and amortization

 

94,701 

   

934,667 

   

   

1,029,368 

 

Net property and equipment

 

104,695 

   

1,087,477 

   

   

1,192,172 

 
                

Other assets, net

 

2,389,994 

   

36,665 

   

(2,373,768)

   

52,891 

 
                

Total assets

$

2,690,560 

  

$

3,487,416 

  

$

(3,197,701)

  

$

2,980,275 

 
                

LIABILITIES AND SHAREHOLDERS’ EQUITY

               

Current liabilities:

               

Current portion of long-term
obligations

$

(800)

  

$

9,585 

  

$

  

$

8,785 

 

Accounts payable

 

789,497 

   

536,097 

   

(817,208)

   

508,386 

 

Accrued expenses and other

 

13,149 

   

228,830 

   

375 

   

242,354 

 

Income taxes payable

 

89 

   

43,617 

   

   

43,706 

 

Deferred income taxes

 

   

14,367 

   

(7,100)

   

7,267 

 

Total current liabilities

 

801,935 

   

832,496 

   

(823,933)

   

810,498 

 

Long-term obligations

 

153,756 

   

1,429,116 

   

(1,312,910)

   

269,962 

 

Deferred income taxes

 

1,750 

   

46,704 

   

   

48,454 

 

Other liabilities

 

12,324 

   

118,242 

   

   

130,566 

 
                

Shareholders’ equity:

               

Preferred stock

 

   

   

   

 

Common stock

 

157,840 

   

23,853 

   

(23,853)

   

157,840 

 

Additional paid-in capital

 

462,383 

   

673,612 

   

(673,612)

   

462,383 

 

Retained earnings

 

1,106,165 

   

363,393 

   

(363,393)

   

1,106,165 

 

Accumulated other comprehensive loss

 

(794)

   

   

   

(794)

 

Other shareholders’ equity

 

(4,799)

   

   

   

(4,799)

 

Total shareholders’ equity

 

1,720,795 

   

1,060,858 

   

(1,060,858)

   

1,720,795 

 
                

Total liabilities and shareholders’ equity

$

2,690,560 

  

$

3,487,416 

  

$

(3,197,701)

  

$

2,980,275 

 




88






 

For the year ended February 2, 2007

 

DOLLAR GENERAL CORPORATION

 

GUARANTOR SUBSIDIARIES

 

ELIMINATIONS

 

CONSOLIDATED

TOTAL

                

STATEMENTS OF INCOME:

               

Net sales

$

165,463 

  

$

9,169,822 

  

$

(165,463)

  

$

9,169,822 

 

Cost of goods sold

 

   

6,801,617 

   

   

6,801,617 

 

Gross profit

 

165,463 

   

2,368,205 

   

(165,463)

   

2,368,205 

 

Selling, general and administrative

 

149,272 

   

2,136,120 

   

(165,463)

   

2,119,929 

 

Operating profit

 

16,191 

   

232,085 

   

   

248,276 

 

Interest income

 

(92,598)

   

(2,907)

   

88,503 

   

(7,002)

 

Interest expense

 

26,826 

   

96,592 

   

(88,503)

   

34,915 

 

Income before income taxes

 

81,963 

   

138,400 

   

   

220,363 

 

Income taxes

 

30,180 

   

52,240 

   

   

82,420 

 

Equity in subsidiaries’ earnings, net of taxes

 

86,160 

   

   

(86,160)

   

 

Net income

$

137,943 

  

$

86,160 

  

$

(86,160)

  

$

137,943 

 


 

For the year ended February 3, 2006

 

DOLLAR GENERAL CORPORATION

 

GUARANTOR SUBSIDIARIES

 

ELIMINATIONS

 

CONSOLIDATED

TOTAL

                

STATEMENTS OF INCOME:

               

Net sales

$

162,805 

  

$

8,582,237 

  

$

(162,805)

  

$

8,582,237 

 

Cost of goods sold

 

   

6,117,413 

   

   

6,117,413 

 

Gross profit

 

162,805 

   

2,464,824 

   

(162,805)

   

2,464,824 

 

Selling, general and administrative

 

139,879 

   

1,925,883 

   

(162,805)

   

1,902,957 

 

Operating profit

 

22,926 

   

538,941 

   

   

561,867 

 

Interest income

 

(31,677)

   

(509)

   

23,185 

   

(9,001)

 

Interest expense

 

20,208 

   

29,203 

   

(23,185)

   

26,226 

 

Income before income taxes

 

34,395 

   

510,247 

   

   

544,642 

 

Income taxes

 

12,852 

   

181,635 

   

   

194,487 

 

Equity in subsidiaries’ earnings, net of taxes

 

328,612 

   

   

(328,612)

   

 

Net income

$

350,155 

  

$

328,612 

  

$

(328,612)

  

$

350,155 

 


 

For the year ended January 28, 2005

 

DOLLAR GENERAL CORPORATION

 

GUARANTOR SUBSIDIARIES

 

ELIMINATIONS

 

CONSOLIDATED

TOTAL

                

STATEMENTS OF INCOME:

               

Net sales

$

171,369 

  

$

7,660,927 

  

$

(171,369)

  

$

7,660,927 

 

Cost of goods sold

 

   

5,397,735 

   

   

5,397,735 

 

Gross profit

 

171,369 

   

2,263,192 

   

(171,369)

   

2,263,192 

 

Selling, general and administrative

 

138,111 

   

1,739,474 

   

(171,369)

   

1,706,216 

 

Operating profit

 

33,258 

   

523,718 

   

   

556,976 

 

Interest income

 

(6,182)

   

(393)

   

   

(6,575)

 

Interest expense

 

21,435 

   

7,359 

   

   

28,794 

 

Income before income taxes

 

18,005 

   

516,752 

   

   

534,757 

 

Income taxes

 

7,667 

   

182,900 

   

   

190,567 

 

Equity in subsidiaries’ earnings, net of taxes

 

333,852 

   

   

(333,852)

   

 

Net income

$

344,190 

  

$

333,852 

  

$

(333,852)

  

$

344,190 

 



89






 

For the year ended February 2, 2007

 

DOLLAR GENERAL CORPORATION

 

GUARANTOR SUBSIDIARIES

 

ELIMINATIONS

 

CONSOLIDATED

TOTAL

STATEMENTS OF CASH FLOWS:

               

Cash flows from operating activities:

               

Net income

$

137,943 

  

$

86,160 

  

$

(86,160)

  

$

137,943 

 

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

               

Depreciation and amortization

 

21,436 

   

179,172 

   

   

200,608 

 

Deferred income taxes

 

(315)

   

(37,903)

   

   

(38,218)

 

Noncash share-based compensation

 

7,578 

   

   

   

7,578 

 

Tax benefit from stock option exercises

 

(2,513)

   

   

   

(2,513)

 

Noncash inventory adjustments and asset impairments

 

   

78,115 

   

   

78,115 

 

Equity in subsidiaries’ earnings, net

 

(86,160)

   

   

86,160 

   

 

Change in operating assets and liabilities:

               

Merchandise inventories

 

   

(28,057)

   

   

(28,057)

 

Prepaid expenses and other current assets

 

(1,042)

   

(4,369)

   

   

(5,411)

 

Accounts payable

 

(4,247)

   

57,791 

   

   

53,544 

 

Accrued expenses and other

 

(225)

   

38,578 

   

   

38,353 

 

Income taxes

 

(2,570)

   

(32,595)

   

   

(35,165)

 

Other

 

430 

   

(1,850)

   

   

(1,420)

 

Net cash provided by operating activities

 

70,315 

   

335,042 

   

   

405,357 

 
                

Cash flows from investing activities:

               

Purchases of property and equipment

 

(13,270)

   

(248,245)

   

   

(261,515)

 

Purchases of short-term investments

 

(38,700)

   

(10,975)

   

   

(49,675)

 

Sales of short-term investments

 

38,700 

   

12,825 

   

   

51,525 

 

Purchases of long-term investments

 

   

(25,756)

   

   

(25,756)

 

Insurance proceeds related to property and equipment

 

   

1,807 

   

   

1,807 

 

Proceeds from sale of property and equipment

 

143 

   

1,507 

   

   

1,650 

 

Net cash used in investing activities

 

(13,127)

   

(268,837)

   

   

(281,964)

 
                

Cash flows from financing activities:

               

Borrowings under revolving credit facility

 

2,012,700 

   

   

   

2,012,700 

 

Repayments of borrowings under revolving credit facility

 

(2,012,700)

   

   

   

(2,012,700)

 

Repayments of long-term obligations

 

97 

   

(14,215)

   

   

(14,118)

 

Payment of cash dividends

 

(62,472)

   

   

   

(62,472)

 

Proceeds from exercise of stock options

 

19,894 

   

   

   

19,894 

 

Repurchases of common stock

 

(79,947)

   

   

   

(79,947)

 

Tax benefit of stock options

 

2,513 

   

   

   

2,513 

 

Changes in intercompany note balances, net

 

66,588 

   

(66,588)

   

   

 

Other financing activities

 

39 

   

(623)

   

   

(584)

 

Net cash used in financing activities

 

(53,288)

   

(81,426)

   

   

(134,714)

 
                

Net increase (decrease) in cash and cash equivalents

 

3,900 

   

(15,221)

   

   

(11,321)

 

Cash and cash equivalents, beginning of year

 

110,410 

   

90,199 

   

   

200,609 

 

Cash and cash equivalents, end of year

$

114,310 

  

$

74,978 

  

$

  

$

189,288 

 



90






 

For the year ended February 3, 2006

 

DOLLAR GENERAL CORPORATION

 

GUARANTOR SUBSIDIARIES

 

ELIMINATIONS

 

CONSOLIDATED

TOTAL

STATEMENTS OF CASH FLOWS:

               

Cash flows from operating activities:

               

Net income

$

350,155 

  

$

328,612 

  

$

(328,612)

  

$

350,155 

 

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

               

Depreciation and amortization

 

20,046 

   

166,778 

   

   

186,824 

 

Deferred income taxes

 

(750)

   

8,994 

   

   

8,244 

 

Noncash share-based compensation

 

3,332 

   

-

   

-

   

3,332 

 

Tax benefit from stock option exercises

 

6,457 

   

   

   

6,457 

 

Equity in subsidiaries’ earnings, net

 


(328,612)

   

   

328,612 

   

 

Change in operating assets and liabilities:

               

Merchandise inventories

 

   

(97,877)

   

   

(97,877)

 

Prepaid expenses and other current assets

 

(4,546)

   

(6,084)

   

   

(10,630)

 

Accounts payable

 

(26,052)

   

113,282 

   

   

87,230 

 

Accrued expenses and other

 

(12,210)

   

52,586 

   

   

40,376 

 

Income taxes

 

13 

   

(26,030)

   

   

(26,017)

 

Other

 

2,919 

   

4,472 

   

   

7,391 

 

Net cash provided by operating activities

 

10,752 

   

544,733 

   

   

555,485 

 
                

Cash flows from investing activities:

               

Purchases of property and equipment

 

(18,089)

   

(266,023)

   

   

(284,112)

 

Purchases of short-term investments

 

(123,925)

   

(8,850)

   

   

(132,775)

 

Sales of short-term investments

 

166,350 

   

500 

   

   

166,850 

 

Purchases of long-term investments

 

   

(16,995)

   

   

(16,995)

 

Insurance proceeds related to property and equipment

 

   

1,210 

   

   

1,210 

 

Proceeds from sale of property and equipment

 

100 

   

1,319 

   

   

1,419 

 

Net cash provided by (used in) investing activities

 

24,436 

   

(288,839)

   

   

(264,403)

 
                

Cash flows from financing activities: