-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, IyHUWXRb3MC/QumxhmVgHQyd8NByRKCAVXtJcqXxYWBQdfzeqvvmvb9i0Tt1golL /sjvkB1HflJqUjkHgKbPBA== 0000950128-98-000826.txt : 19980527 0000950128-98-000826.hdr.sgml : 19980527 ACCESSION NUMBER: 0000950128-98-000826 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 8 CONFORMED PERIOD OF REPORT: 19980228 FILED AS OF DATE: 19980526 SROS: NONE FILER: COMPANY DATA: COMPANY CONFORMED NAME: DRUG EMPORIUM INC CENTRAL INDEX KEY: 0000832922 STANDARD INDUSTRIAL CLASSIFICATION: RETAIL-DRUG STORES AND PROPRIETARY STORES [5912] IRS NUMBER: 311064888 STATE OF INCORPORATION: DE FISCAL YEAR END: 0228 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 000-16998 FILM NUMBER: 98631702 BUSINESS ADDRESS: STREET 1: 155 HIDDEN RAVINES DR CITY: POWELL STATE: OH ZIP: 43065 BUSINESS PHONE: 6145487080 MAIL ADDRESS: STREET 1: 155 HIDDEN RAVINES DR CITY: POWELL STATE: OH ZIP: 43065 FORMER COMPANY: FORMER CONFORMED NAME: NEW DE INC DATE OF NAME CHANGE: 19940518 10-K 1 DRUG EMPORIUM, INC. ANNUAL REPORT FORM 10-K 1 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K (MARK ONE) [x] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended February 28, 1998 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ____________ to ____________ Commission File Number 0-16998 DRUG EMPORIUM, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 31-1064888 (STATE OF INCORPORATION) (IRS EMPLOYER IDENTIFICATION NO.) ---------- 155 HIDDEN RAVINES DRIVE POWELL, OHIO 43065 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE) ---------- SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: COMMON STOCK, $0.10 PAR VALUE (TITLE OF CLASS) 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 so 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. [ ] At May 19, 1998 there were 13,179,785 shares of Drug Emporium common stock outstanding. The aggregate market value of shares of common stock held by non-affiliates of the Registrant as of May 19, 1998 was approximately $52,719,140 based on a closing price of $4.00 per share on Nasdaq National Market on such date. DOCUMENTS INCORPORATED BY REFERENCE Part II, Items 6., 7. and 8., and Part IV, Item 14. incorporate by reference portions of the Drug Emporium, Inc. Annual Report to Stockholders for the year ended February 28, 1998. Part III, Items 10., 11., 12., and 13. incorporate by reference portions of the Drug Emporium, Inc. Proxy Statement for the 1998 Annual Meeting of Stockholders. With the exception of the information specifically incorporated by reference, the Drug Emporium, Inc. Annual Report to Stockholders for the year ended February 28, 1998 is not deemed filed as part of this report. 1 2 ITEM 1. BUSINESS INTRODUCTION In 1977, the first Drug Emporium store was opened in Columbus, Ohio. As of February 28, 1998, the Company operates 135 company-owned stores, known as Drug Emporium, F&M Super Drug Stores and "big D". In addition to the Company-owned stores, as of February 28, 1998, there are 84 franchise stores. The accompanying financial statements include only amounts related to company-owned stores. All the stores specialize in discount-priced merchandise, including health and beauty aids, cosmetics and greeting cards. All stores with the exception of the remaining "big D" store operate full service pharmacies. The last "big D" discount store closed in April of 1998. The Company's common stock trades on the Nasdaq National Market under the symbol DEMP. As of February 28, 1998, there were 13,179,785 shares outstanding. Drug Emporium's 7-3/4% convertible subordinated debentures, due October 1, 2014, are traded on the Nasdaq National Market under the symbol DEMPG. STORE OPERATIONS Company stores range in size from 19,000 to 38,000 square feet, with a typical store having approximately 27,000 square feet, including retail selling space and storage space in the rear of each store. Retail selling space on average accounts for 80% of each store's total square footage. Each store has a manager, one or two assistant managers, a head pharmacist, and approximately 8 to 12 additional full-time employees and approximately 24 part-time employees. The stores are grouped into six operational regions, each overseen by a regional director or regional vice president. The regional director or vice president's responsibilities include visiting stores and assuring that Company standards for buying, merchandising, customer service, store appearance and store procedures are maintained. The Company's stores are located primarily in shopping centers on major commercial thoroughfares. The capital expenditure required to fixture and equip a store averages $350,000. Pre-opening expenses, including salaries and promotional expenses, average $75,000 per store, and each store requires approximately $1,200,000 in initial inventory. The typical trade area for a Drug Emporium store exceeds 200,000 people within a defined area, usually five miles. The customer profile is 80 percent middle-to-upper income women between the ages of 21 and 65 who shop on a two-and-a-half week cycle. Drug Emporium stores accommodate an average of 6,000 shoppers per week and provide an environment for shoppers seeking a pleasant and social shopping experience. Drug Emporium fills a unique tenant category in a shopping center's merchandising mix and Drug Emporium stores are well received by both hard and soft goods national retailers. Most stores are open seven days a week for a total of 84 hours per week. In addition, the Company operates a total of twenty-one 24-hour stores. Each store has a similar layout, generally with the pharmacy located in the rear of the store. Company stores accept payment in cash, check or credit card and from third-party providers. The table set forth below lists the 219 Company-owned and franchise Drug Emporium stores by market as of February 28, 1998:
WHOLLY-OWNED: ------------- Philadelphia, PA.......................................................28 Columbus, Cincinnati and Dayton, OH....................................23 Los Angeles, San Francisco and San Diego CA............................21 Atlanta and Augusta, GA,...............................................19 Detroit, MI............................................................16 Baltimore, MD and Washington, DC....................................... 9 Milwaukee, WI.......................................................... 6 Louisville, KY......................................................... 4 Minneapolis, MN........................................................ 4 St. Louis, MO.......................................................... 4 Oklahoma City, OK...................................................... 1 --- 135 ===
2 3 INDEPENDENT FRANCHISES: ----------------------- Seattle, Tacoma, WA....................................................20 Dallas, Ft. Worth, TX..................................................15 Lafayette, Shreveport, LA, and Amarillo, Abilene, Denton, Longview, Lubbock, Tyler and Waco TX, Little Rock, AR, and Wichita KS......................................11 Phoenix, Tucson, AZ.................................................... 9 San Antonio, Austin, Houston, TX....................................... 6 Charlotte, Raleigh, Durham, Concord, NC................................ 6 Barboursville, Charleston, WV.......................................... 4 Independence and Kansas City, MO and Overland Park KS.................. 3 Virginia Beach, Norfolk, VA............................................ 3 Greensboro, Winston-Salem, NC.......................................... 2 Victoria, Brownsville, TX.............................................. 2 Morris Plains, NJ...................................................... 1 Omaha, NE.............................................................. 1 Union City, NJ......................................................... 1 ---- 84 == When selecting store location, the Company considers various geographic and demographic factors, including population around the site, income level within that area, proximity to major shopping centers, traffic count, accessibility of site, proximity of competitors and available parking spaces. Market research may be utilized through an outside market research firm which identifies, among other things, trade area, trade area potential, demographic factors, competitors and competitors' sales/strengths/weaknesses, and projects three-year anticipated sales volumes. Company and, to a limited extent, franchisee pharmacy matters are supervised by the Director of Pharmacy who directs compliance with state and federal pharmacy regulations and training. The Company has implemented a computerized pharmacy system across its network of Company stores. Most franchisees have installed similar systems. The system simplifies the maintenance of patient profiles, label preparation, and inventory management. FRANCHISE OPERATIONS Drug Emporium continues to have a strong franchise-store network consisting of 84 franchise stores. Drug Emporium maintains a Franchise Advisory Board designed to provide a forum to investigate and discuss issues and concerns of the Company and its franchisees. Under its franchise system, the Company permits franchisees to operate Drug Emporium stores in a specific geographic area based on ADIs (areas of dominant influence of television signals). Prospective franchisees generally must make a minimum equity investment of $1,000,000 per store and establish an acceptable line of credit in the amount of $500,000 per store. The Company advises franchisees in site selection, store layout, and establishing purchasing and advertising policies. The Company selects its franchisees carefully and works closely with them to increase the likelihood of success for each franchisee. Prospective franchisees sign confidentiality agreements in addition to a non-compete clause contained within the executed franchise agreement. Upon execution of a franchise agreement, the franchisee must pay a nonrefundable $25,000 fee for the first store and a $10,000 commitment fee for each additional store designated for that market. The balance of the $25,000 store fee ($15,000) is payable upon the opening of each subsequent designated store in the market. The current franchise agreement provides for franchise royalties at a minimum rate of $6,000 per store for the second year and $25,000 per year per store for stores open three years or more against the following percentage royalties: 1% on gross sales from $3.5 million to $6 million, 2% from $6 million to $8 million, 3% from $8 million to $10 million, and 1.25% on gross sales over $10 million. In addition, each franchisee must pay .1% of gross sales to the Company to offset the cost of developing advertising. Each franchisee must also spend at least 1% of gross sales for advertising. The current franchise agreement permits the Company to require that .6% of the 1% advertising expenditure be contributed to a national advertising program if such program is established by the Company. The Company may either open its own stores or allow other franchisees to open stores in a franchisee's territory outside a defined area for each existing store if the franchisee fails to comply with the development schedule agreed upon by the Company and the franchisee. 3 4 Four franchise stores closed during Fiscal 1998. ACQUISITION OF FRANCHISEES The Company, from time to time, has acquired or sought to acquire certain of its franchise operations. The Company's decision to pursue the acquisition of a franchisee is based on the Company's evaluation of the growth opportunities in a particular market, the impact the acquisition would have on earnings per share and the quality of the franchisee's existing management. Since 1983, the Company has acquired franchisees located in Los Angeles, Washington, D.C., Atlanta, Cincinnati, Milwaukee, Minneapolis, St. Louis, Charleston, S.C., Indianapolis, Orlando, Louisville, Oklahoma City and Baton Rouge. The Company plans to evaluate future opportunities to acquire appropriate franchisees from time to time and may use cash or securities to pay for such acquisitions. MERCHANDISING AND MARKETING The Company's merchandising goal is to provide customers with the widest available selection of health and beauty aids, cosmetics, prescription drugs and general merchandise at everyday low prices. The Company estimates that approximately 64% of a typical store's sales mix is health and beauty aids and general merchandise, 29% pharmacy items and 7% cosmetics. The Company is continuing to aggressively oversee strategies designed to lower the total cost of acquiring merchandise in order to continue to be competitive with other national and regional chain discounters. The Company is continuing to invest in and upgrade its electronic in-store scanning and backdoor receiving systems. During Fiscal 1998, the Company's primary pharmacy supplier and general merchandise distributor, McKesson Drug, accounted for over 35% of the Company's purchases. No other single vendor accounted for more than 10% of the Company's purchases. While the Company purchases from over 7,000 vendors, a majority of its business is conducted with approximately 500 vendors. The Company believes it is a significant customer for most of these 500 vendors. The Company advertises through the use of television, radio, newspaper and direct mail. Most advertising in Fiscal 1998 was print-based, utilizing newspaper tabloids running approximately twice per month. Point of sale advertising is also used. The Company's strategy of clustering stores within ADI markets is an important factor in maximizing the effectiveness of its advertising expenditures. The Company works with an advertising agency that coordinates advertising for the entire chain. CUSTOMER SERVICE The Company believes that its commitment to customer service is an important ingredient of its success. The Company encourages its managers and other employees to be responsible to customers. The stores are designed to make products easily accessible. Store employees are trained to be friendly and helpful to customers. COMPETITION The sale of deep discount health and beauty aids, cosmetics and prescription drugs is highly competitive. The Company believes that the principal bases of competition in this market are price, product variety, service, site location and customer recognition. The Company also believes that there exist only a few similar companies, most of which are regional chains. The Company's stores compete not only with those similar companies but with numerous conventional drug stores with national or regional images, and also with supermarkets, mass merchants and category-specific discount stores. Many of the Company's supermarket, mass merchant and conventional drug store competitors have more outlets and substantially greater financial resources than the Company or have more convenient locations than Company stores. The Company believes that its prices are competitive and that it offers greater product variety and better service than its competitors. The Company also believes that the smaller size of its stores compared to the major discount competitors provides a better shopping experience and allows a better selection of sites in tight real estate markets that exist in some major cities. The Company's ability to expand successfully into new markets is especially sensitive to the competitive factors in those markets. 4 5 EMPLOYEES AND TRAINING At February 28, 1998, the Company had a total of approximately 4,900 employees, both full-time and part-time, of which 179 were corporate staff personnel. None of the employees are covered by a collective bargaining agreement. The Company considers its relations with its employees to be good. Drug Emporium believes that the training of store employees is one of the most important elements of its business. The Company conducts training classes at its headquarters, and senior management works closely with regional and district managers in this regard. REGULATION The Company is also subject to the Fair Labor Standards Act, which governs such matters as minimum wages, overtime and other working conditions. A portion of the Company's personnel are paid at rates related to the federal minimum wage, and accordingly, further increases in the minimum wage increase the Company's labor costs. The prescription drug business is subject to the federal Food, Drug and Cosmetic Act, Drug Abuse Prevention and Control Act and Fair Packaging and Labeling Act relating to the content and labeling of drug products, comparable state statutes and state regulation regarding recordkeeping and licensing matters. These regulatory functions contain civil and criminal penalties for violations. The sale of franchises by the Company is subject to regulation by the Federal Trade Commission and various states in which it currently does business or in which the Company may do business in the future. Such regulations generally require the prior registration or an exemption from registration for the sale of franchises and delivery to prospective franchisees of a franchise disclosure document. No assurances can be given that any future changes in the existing laws or the promulgation of new laws will not adversely affect the Company. SERVICE MARKS The Company has obtained federal registrations of the servicemark "Drug Emporium" and "Savings So Big You Need A Shopping Cart" for retail drug store services, "Drug Emporium" for technical aid and assistance in the establishment and operation of retail drug stores and "Drug Emporium", plus design, for retail drug store services. The marks EMPORIUM GOLD, EMPORIUM SELECT, DRUG EMPORIUM PRESCRIPTION PLUS and DRUG EMPORIUM EXPRESS are pending marks. DRUG EMPORIUM and Design have also been registered in Australia and the United Kingdom. The mark "Drug Emporium" has been registered in the states of Alabama, Arizona, California, Colorado, Florida, Indiana, Kansas, Kentucky, Maryland, Minnesota, Missouri, Nebraska, Nevada, New Jersey, New York, North Carolina, Ohio, South Carolina, Tennessee, Texas, Washington, West Virginia and Wisconsin, as well as in Mexico. The mark "Savings So Big You Need A Shopping Cart" has been filed and is pending in Canada and Mexico. The mark "Drug Emporium," plus design, and the shopping cart design have been filed in Mexico, Japan and France, and the shopping cart design is registered in Canada. The Company believes that these marks are of material importance to its business. Federal registration of a mark does not create new substantive rights to use the mark or to assert rights based on ownership, but it does provide additional remedies for the protection of the mark. EXECUTIVE OFFICERS OF THE COMPANY
Served as Name: Age: Position: Officer Since: ----- ---- --------- -------------- David L. Kriegel 52 Chairman of the Board, Chief Executive 1992 Officer, President and Director A. Joel Arnold 62 Senior Vice President 1995 Thomas H. Ziemke 55 Senior Vice president 1998 Jane H. Lagusch 52 Vice President, Secretary 1990 Michael P. Leach 28 Chief Financial Officer 1998 (1) Officers serve until their successors are chosen and are qualified subject to earlier
5 6 removal by the board of directors, and subject to rights, if any, under employment contracts. DAVID L. KRIEGEL Since December 1992, Mr. Kriegel has been the Chairman and Chief Executive Officer of the Company and since June of 1994 has been Chairman, Chief Executive Officer and President of the Company. Mr. Kriegel is Chairman and Chief Executive Officer of Kriegel Holding Company, Inc., a privately-owned corporation dealing with real estate and distribution. Until January 1993, Mr. Kriegel was Vice President of Cardinal Health, a division of Cardinal Distribution, Inc., a publicly-owned company. A. JOEL ARNOLD Mr. Arnold was appointed to the office of Senior Vice President on June 15, 1995. He formerly held the position of Director of Merchandising and Operations in which he served for two years. A registered pharmacist, Mr. Arnold has 38 years' experience in the retail drug industry. THOMAS H. ZIEMKE In March of 1998, Mr. Ziemke was appointed to the position of Senior Vice President with responsibility for marketing and purchasing. Mr. Ziemke has been associated with Drug Emporium since 1984 when he became the operator of the Los Angeles based Drug Emporium franchise. He became Vice President of Western Operations when the Company purchased the franchise in 1987 and served in that capacity until his promotion to Senior Vice President. JANE H. LAGUSCH Mrs. Lagusch has been associated with the Company in various capacities since 1980 and has been an officer of the Company since 1986. She was appointed to her current position, Vice President and Secretary of the Company, in 1993. Mrs. Lagusch has responsibility for corporate administrative functions. MICHAEL P. LEACH Since March 1998, Mr. Leach has served as Chief Financial Officer. Mr. Leach was previously Controller of the Company for approximately two years and is a Certified Public Accountant. Previous to joining Drug Emporium, Mr. Leach was employed by Ernst & Young LLP, the external auditors of the Company. ITEM 2. PROPERTIES Most of the Company's stores are occupied pursuant to long-term leases that vary as to rental provisions, expiration dates, renewal options, rental amounts and payment provisions. The Company does not deem any individual store's lease to be significant in relation to its overall operations. For information as to the amount of the Company's rental obligations for retail store leases, see Note 4 of Notes to Consolidated Financial Statements. The Company owns a 33,000 square foot executive office building and the surrounding land for use as its principal office in Powell, Ohio. The Company also owns a portion of the building and land at one of its Detroit area store locations. ITEM 3. LEGAL PROCEEDINGS Nortex Drug Distributors, Inc. v. Drug Emporium, Inc., Case No. C2-93-767, filed August 6, 1993 in the United States District Court, Southern District of Ohio, Eastern Division, was dismissed subsequent to February 28, 1998, as a result of the parties reaching a confidential settlement agreement. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. 6 7 ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's common stock is traded on the Nasdaq National Market under the symbol DEMP. The following table sets forth, for the quarterly periods shown, the high and low sale price per share as reported on the Nasdaq National Market:
Fiscal Quarter Ended High Low - ------------------------------------------------------------------------ June 1, 1996 $4.313 $3.250 August 31, 1996 $4.563 $3.688 November 30, 1996 $4.625 $3.875 March 1, 1997 $5.750 $4.125 May 31, 1997 $5.500 $4.125 August 30, 1997 $5.313 $4.000 November 29, 1997 $4.750 $3.750 February 28, 1998 $5.375 $3.875
The Company paid no dividends in Fiscal 1998 or 1997. The Company's bank credit agreement prohibits payment of dividends, stock repurchases and acquisition of the Company's convertible subordinated debt. At April 28, 1998, the Company had approximately 4,300 beneficial owners of its common stock. ITEM 6. SELECTED FINANCIAL DATA The information required by this Item 6 is incorporated by reference from page 4 of the Drug Emporium, Inc. Annual Report to Stockholders for the year ended February 28, 1998. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required by this Item 7 is incorporated by reference from pages 5 through 7 of the Drug Emporium, Inc. Annual Report to Stockholders for the year ended February 28, 1998. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this Item 8 is incorporated by reference from pages 8 through 15 of the Drug Emporium, Inc. Annual Report to Stockholders for the year ended February 28, 1998. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Certain of the information required by this Item 10 is set forth under Item 1. "Executive Officers of the Company." * 7 8 ITEM 11. EXECUTIVE COMPENSATION * ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT * ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS * * Reference is made to information under the captions "Election of Directors," "Executive Compensation," "Security Ownership of Certain Beneficial Owners and Management," and "Compensation Committee Interlocks and Insider Participation," in the Company's Proxy Statement for the Annual Meeting of Stockholders to be held June 24, 1998. The Company mailed its definitive proxy statement to stockholders on or about May 20, 1998. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a)(1) Financial Statements The following Consolidated Financial Statements of Drug Emporium, Inc. are incorporated by reference in Item 8 from the pages set forth below of the Drug Emporium, Inc. Annual Report to Stockholders for the year ended February 28, 1998. Page Nos. of Annual Report ------------- Consolidated Balance Sheets as of February 28, 1998 and March 1, 1997 8 Consolidated Statements of Operations for each of the Three Fiscal Years in the Period Ended February 28, 1998 9 Consolidated Statements of Shareholders' Equity for each of the Three Fiscal Years in the Period Ended February 28, 1998 9 Consolidated Statements of Cash Flows for each of the Three Fiscal Years in the Period Ended February 28, 1998 10 Notes to Consolidated Financial Statements 11-15 Report of Independent Auditors 16 (2) Financial Statement Schedules Schedules for which provision is made in Regulation S-X are not required under the instructions contained therein, are inapplicable, or the information is included in the Notes to the Consolidated Financial Statements. (3) Exhibits List (3) Articles of Incorporation and By-Laws 3.3 Restated Certificate of Incorporation (Incorporated by reference to Exhibit 3.3 to the Company's S-1 Registration Statement No. 33-21755) 8 9 (10) Material Contracts 10.1 Drug Emporium, Inc. 1983 Incentive Stock Option Plan (incorporated by reference to Exhibit 10.2 to the Company's S-1 Registration Statement Registration No. 33- 21755) ** 10.2 Drug Emporium, Inc. 1984 Incentive Stock Option Plan (incorporated by reference to Exhibit 10.3 to the Company's S-1 Registration Statement Registration No. 33- 21755) ** 10.3 Drug Emporium, Inc. 1987 Incentive Stock Option Plan (incorporated by reference to Exhibit 10.4 to the Company's S-1 Registration Statement Registration No. 33- 21755) ** 10.4 Drug Emporium, Inc. 1990 Incentive Stock Option Plan (incorporated by reference to Exhibit 10.41 to the Company's Annual Report on Form 10-K for the fiscal year ended February 28, 1990) ** 10.5 Drug Emporium, Inc. 1987 Non-Qualified Stock Option Plan (incorporated by reference to Exhibit 10.5 to the Company's S-1 Registration Statement Registration No. 33- 21755) ** 10.7 Form of License and Franchise Agreement (incorporated by reference to Exhibit 10.7 to the Company's S-1 Registration Statement Registration No. 33-21755) 10.8 Form of Option Agreement (incorporated by reference to Exhibit 10.8 to the Company's S-1 Registration Statement Registration No. 33-21755) 10.10 Third Amended and Restated Revolving Credit and Term Loan Agreement dated as of November 13, 1995, between Drug Emporium, Inc. and Bank One, Columbus, NA (incorporated by reference to Exhibit 10.1 of the Company's Form 10-Q for the period ended November 25, 1995) 10.11 Employment contract dated March 11, 1993 between David L. Kriegel and Drug Emporium, Inc. (incorporated by reference to the Company's Annual Report on Form 10-K for the fiscal year ended February 27, 1993) ** 10.12 Drug Emporium, Inc. 1993 Incentive Stock Option Plan (incorporated by reference to Exhibit 10.12 to the Company's Annual Report on Form 10-K for the fiscal year ended February 27, 1993) ** 10.13 Drug Emporium, Inc. 1993 Non-Qualified Stock Option Plan (incorporated by reference to Exhibit 10.13 to the Company's Annual Report on Form 10-K for the fiscal year ended February 27, 1993) ** 10.14 Amendments No. 1, 2 and 3 to Third Amended and Restated Revolving Credit and Term Loan Agreement dated as of November 13, 1995, (between Drug Emporium, Inc. and Bank One, Columbus, NA) and $5,000,000 Term Note dated April 18, 1997 (incorporated by reference to the Company's Annual Report on Form 10-K for the fiscal year ended March 1, 1997) *10.15 Amendment dated December 2, 1997 to Employment Agreement made March 11, 1993, by and between Drug Emporium, Inc. and David L. Kriegel ** *10.16 Form of Employment Security Agreements between Drug 9 10 Emporium, Inc. and each of A. Joel Arnold, Jane H. Lagusch and Timothy S. McCord, dated December 2, 1997 ** *10.17 Form of Severance Compensation Agreement between Drug Emporium, Inc. and each of Michael P. Leach and Lee Pfrogner, dated November 17, 1997 ** *10.18 Consulting Agreement dated December 2, 1997, between David L. Kriegel and Drug Emporium, Inc. ** (11) STATEMENT RE COMPUTATION OF PER SHARE EARNINGS 11.1 Computation of Per Share Earnings is readily computable from information disclosed in the financial statements and therefore is not included as a separate exhibit. *(13) ANNUAL REPORT TO SECURITY HOLDERS, FORM 10-Q OR QUARTERLY REPORT TO SECURITY HOLDERS 13.1 Annual Report to Stockholders for Fiscal Year Ended February 28, 1998 (limited to those portions incorporated herein). *(21) SUBSIDIARIES OF REGISTRANT 21.1 The Company has the following wholly-owned subsidiaries: State of Name Incorporation --------------------------------------------------- Big D Atlantic, Inc. Delaware D.E. Michigan Management Co. Delaware Drug Emporium of Michigan, Inc. Delaware Drug Emporium of Maryland, Inc. Delaware Emporium Venture, Inc. Ohio Houston Venture, Inc. Ohio RJR Drug Distributors Inc. Delaware *(23) Consent of Experts 23.1 Consent of Ernst & Young LLP *(27) Financial Data Schedule 27.1 Financial Data Schedule of the Company *Included with this Annual Report on Form 10-K **Compensatory plans, contracts or agreements (b) Reports on Form 8-K A report on Form 8-K was filed on March 5, 1998, reporting five management changes, including the appointment of Michael P. Leach to the position of Chief Financial Officer, and Thomas H. Ziemke to the position of Senior Vice President, as set forth in a press release dated March 4, 1998. 10 11 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. DRUG EMPORIUM, INC. (Registrant) Date: May 19, 1998 By: /s/ David L. Kriegel --------------------- David L. Kriegel President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated: Date: May 19, 1998 /s/ Michael P. Leach /s/ David L. Kriegel - ---------------------------------- ------------------------------------- Michael P. Leach David L. Kriegel Chief Financial Officer Chief Executive Officer and Director /s/ Robert S. Meeder, Sr. ------------------------------------- Robert S. Meeder, Sr. Director /s/ William L. Sweet, Jr. ------------------------------------- William L. Sweet, Jr. Director /s/ V. J. Wiechart, Sr. ------------------------------------- V. J. Wiechart, Sr. Director 12 EX-10.15 2 EXHIBIT 10.15 1 Exhibit 10.15 AMENDMENT TO EMPLOYMENT AGREEMENT THIS AMENDMENT amends the Employment Agreement made the 11th day of March, 1993 by and between DRUG EMPORIUM, INC., a Delaware Corporation having its principal executive offices at 155 Hidden Ravines Drive, Powell, Ohio 43065 (the "Company"), and DAVID L. KRIEGEL, an individual residing at 3410 London Drive, Lima, Ohio ("Kriegel"), and is entered into this 2nd day of December, 1997. This Amendment replaces the amendment signed on September 25, 1996. WHEREAS Kriegel is employed as Chairman and Chief Executive Officer of Company, and has served in that capacity since December 1, 1992; and WHEREAS the Company is approached from time to time by outside individuals and others who have an interest in acquiring all or a portion of the Company's stock, some of whom have a background indicating the capability of operating the Company, and some of whom do not; and WHEREAS the Company desires to evaluate such individuals, companies and potential offers in the best interests of its shareholders, without the distraction of the effect of a change in control on its Chief Executive Officer; and WHEREAS the Company also wants to assure managerial continuity and stability during any takeover attempt. NOW, THEREFORE, in consideration of the foregoing and of the agreements and covenants herein contained, Company and Kriegel agree that the Employment Agreement between them dated March 11, 1993, be amended as follows: 1. The Company agrees that if: a. There is a change in control of the Company as defined herein; and b. Kriegel leaves the employment of the Company for any reason, other than discharge for cause as defined in the Employment Agreement between Kriegel and Company, within one year after such change in control; then (1) Kriegel shall receive, in a lump sum, a cash payment in the amount of the total of the salary and bonus received by Kriegel from the Company in the last three full fiscal years prior to the date of the change in control; (2) Kriegel shall continue to receive all employment benefits, including medical benefits, health insurance and other, to which he may be entitled as a member of senior management of the Company for a period of 36 months after the date of termination; 1 2 (3) Kriegel shall receive an additional retirement benefit, over and above that to which he would normally be entitled under the Company's retirement plans, equal to the actuarial equivalent of the additional amount Kriegel would have earned under such retirement plans or programs had he accumulated three additional continuous years of service. Such amount shall be paid to Kriegel in a cash lump sum payment at his normal retirement age, or, at Kriegel's option, at his early retirement age as provided for in such retirement plan. Notwithstanding the provisions of subparagraphs (1), (2) and (3) above, the aggregate present value of the payments in the nature of compensation Kriegel shall receive hereunder shall not exceed an amount determined by multiplying three (3) times the aggregate present value of Kriegel's base amount calculated in accordance with Internal Revenue Code Section 280G by ninety-nine percent (99%). 2. The amounts paid to Kriegel hereunder shall be considered severance pay in consideration of the past services he has rendered to the Company and in consideration of his continued service from the date hereof to his entitlement to those payments. Kriegel shall have no duty to mitigate his damages by seeking other employment. Should Kriegel actually receive payments from any other employment, the payments called for hereunder shall not be reduced or offset by any such payments. 3. The Company will reimburse Kriegel for all legal fees and expenses incurred in good faith by Kriegel as a result of any dispute with any party (including, but not limited to, the Company and/or an affiliate of the Company) regarding the payment of any benefit provided for in Kriegel's Employment Agreement as amended (including, but not limited to, all fees and expenses incurred in disputing any termination or in seeking in good faith to obtain or enforce any benefit or right provided by Kriegel's Employment Agreement as amended or in connection with any tax audit or proceeding to the extent attributable to the application of Section 4999 of the Code plus in each case interest on any delayed payment at the applicable federal rate provided for in Section 7872(f)(2)(A) of the Code. Such payments will be made within five business days after delivery of Kriegel's written requests for payment accompanied by any evidence of fees and expenses incurred as the Company may reasonably require. 4. As used herein, the term "change in control" shall mean either: a. The ownership (whether direct or indirect) of shares in excess of 50% of the outstanding shares of common stock of the Company by a person or group of persons not directors of the Company as of the date of this agreement; or 2 3 b. The occurrence of both of the following: (1) The ownership (whether direct or indirect) of shares in excess of 20% of the outstanding shares of common stock of the Company by a person or group of persons not directors of the Company as of the date of this Amendment; and (2) Any change in the composition of the Board of Directors of the Company resulting in a majority of the directors of the Company, as of the date of this Amendment, no longer constituting a majority; provided, however, that in making such determination, directors who were elected by, and on the recommendation of, such present majority shall be treated as present directors. 5. The arrangements called for by this Amendment are not intended to have any effect on Kriegel's participation in any other benefits available to executive personnel or to preclude other compensation or additional benefits as may be authorized by the Company or its board from time to time. 6. This Amendment shall be binding and shall inure to the benefit of the respective successors, assigns, legal representatives and heirs to the parties hereto. 7. This Amendment shall terminate if, prior to any change in control as defined herein, Kriegel shall voluntarily resign, retire, become permanently and totally disabled, or voluntarily take another position requiring a substantial portion of his time. This Amendment shall also terminate if Kriegel's employment as Chairman and Chief Executive Officer of the Company shall have been terminated for any reason by the board of directors of the Company for any reason prior to a change in control as defined herein. DRUG EMPORIUM, INC. By order of the Board of Directors By: -------------------------------- -------------------------------- David L. Kriegel Its: Compensation Committee Chairman 3 EX-10.16 3 EXHIBIT 10.16 1 Exhibit 10.16 EMPLOYMENT SECURITY AGREEMENT This Employment Security Agreement is made as of the _____ day of ________________________, 1998, by and between DRUG EMPORIUM, INC., a Delaware Corporation having its principal executive offices at 155 Hidden Ravines Drive, Powell, Ohio 43065 (the "Company"), and _______________________________________, an individual employed by the Company (the "Executive"). This Agreement replaces the Employment Security Agreement with the above named Executive dated September 25, 1997. WHEREAS, Executive is employed by the Company in a key executive capacity and possesses intimate knowledge of the business and affairs of the Company and is a valuable asset to the operations of the Company; and WHEREAS, the Company is approached from time to time by outside individuals and others who have an interest in acquiring all or a portion of the Company's stock, some of whom have a background indicating the capability of operating the Company, and some of whom do not; and WHEREAS, the Company desires to evaluate such individuals, companies and potential offers in the best interests of its shareholders, without the distraction of the effect of change in control on Executives; and WHEREAS, the Company also wants to assure managerial continuity and stability during any takeover attempt. NOW, THEREFORE, in consideration of the foregoing, and of the agreements and covenants herein contained, Company and Executive agree as follows: 1. This Agreement shall be effective and binding immediately upon its execution, but it shall not become operative unless and until a "change in control" of the Company, as defined hereinbelow, shall occur. The date of such change in control is referred to herein as the "operative date" of this Agreement. 2. As used herein, the term "change in control" shall mean either: a. The ownership (whether direct or indirect) of shares in excess of 50% of the outstanding shares of common stock of the Company by a person or group of persons not directors of the Company as of the date of this agreement; or b. The occurrence of both of the following: (1) The ownership (whether direct or indirect) of shares in excess of 20% of the outstanding shares of common stock of the Company by 2 a person or group of persons not directors of the Company as of the date of this Agreement; and (2) Any change in the composition of the Board of Directors of the Company resulting in a majority of the directors of the Company as of the date of this Agreement no longer constituting a majority; provided, however, that in making such determination, directors who were elected by, and on the recommendation of, such present majority shall be treated as present directors. 3. The term of this Agreement shall commence with the operative date and shall continue for a term of two calendar years thereafter. During the term of this Agreement, the Company agrees to continue the Executive in the employ of the Company, and the Executive agrees to remain in the employ of the Company, in the Executive's then-present capacity with no diminution of responsibility, and to exercise such authority and perform such duties as are commensurate with the authority exercised and duties performed by the Executive during the six months immediately prior to the operative date of this Agreement. Such services shall be performed in the same metropolitan area where the Executive was employed immediately prior to the operative date, or at such other location as the Company may reasonably require or to which Company and Executive may agree. 4. During the term of this Agreement, Executive shall be compensated at a base salary, bonus, stock option and employee benefit level commensurate with the salary, bonus, stock option and benefits to which the Executive was entitled in the twelve months prior to the operative date, or such greater amount provided by the Company for Executives of comparable duties. 5. The employment of Executive under this Agreement may be terminated, and the Executive not be entitled to the benefits set forth herein, only upon the occurrence of one or more of the following events: a. Termination by the Company for cause, as defined below; or b. Voluntary resignation by the Executive, as defined below. 6. "Cause" shall mean: (i) the willful and continued failure by the Executive to substantially perform the Executive's duties with the Company, or a subsidiary of the Company, as such duties may reasonably be defined from time to time by the Board (or a duly authorized committee thereof), or to abide by the reasonable written policies of the Company or of the Executive's primary employer (Other than any such failure resulting from the Executive's incapacity due to physical or mental illness) after a written demand for substantial performance is delivered to the Executive 2 3 by the Board, which demand specifically identifies the manner in which the Board believes that the Executive has not substantially performed the Executive's duties or has not abided by any reasonable written policies, (ii) the continued and willful engaging by the Executive in conduct which is demonstrably and materially injurious to the Company or its subsidiaries, or (iii) the Executive's conviction of, or pleading of no contest to, a felony. For the purposes of clauses (i) and (ii) of this definition, no act, or failure to act, on the Executive's part shall be deemed "willful" unless done, or omitted to be done, by the Executive in bad faith and without reasonable belief that the Executive's act, or failure to act, was in the best interest of the Company or its subsidiaries. Any act, or failure to act, based upon authority given pursuant to a resolution duly adopted by the Board or upon the instructions of the Board (or committee thereof), the Company's chief executive officer or other duly authorized senior officer of the Company (as appropriate) or based upon the advice of counsel for the Company shall be conclusively presumed to be done, or omitted to be done, by the Executive in good faith and in the best interests of the Company and its subsidiaries. The cessation of employment of the Executive shall not be deemed to be for Cause unless and until there shall have been delivered to the Executive a copy of a resolution duly adopted by the affirmative vote of not less than three quarters (3/4) of the entire membership of the Board at a meeting of the Board called and held for such purpose (after reasonable notice of any such meeting is provided to the Executive and the Executive is given an opportunity, together with counsel, to be heard before the Board) finding that, in the good faith opinion of the Board, the Executive has acted in a manner described in clause (i) or (ii) above and specifying the particulars thereof in detail. No termination for cause under the preceding paragraph shall be deemed to have occurred without prior service of a written notice of termination to the Executive specifying the factual basis for the allegation of cause, and the failure of the Executive to cure such basis within 30 days after the notice. 7. The Executive's resignation shall not be "voluntary" and shall not be a reason for termination of the Agreement in the event that: a. Without the express written consent of the Executive, the Executive reasonably determines that he is assigned any duties inconsistent with his position, duties, responsibility and status with the Company at the operative date, or his authority, position or title in effect immediately prior to the operative date is materially changed; b. The base salary and bonus opportunity benefits or perquisites of the Executive in effect at the operative date of this Agreement are materially reduced; 3 4 c. The Company fails to continue in effect any benefit or compensation plan providing the Executive with substantially similar benefits to those which the Executive enjoyed as of the operative date; d. In the event that relocation of more than 25 miles or excessive travel demands in comparison to those in effect as of the operative date are made upon the Executive; or e. The Executive terminates his employment for any reason during the 30 day period immediately following the one year anniversary of the change of control. 8. In the event of a breach of this Agreement by the Company or the termination of the Executive's employment during the term of this Agreement (including without limitation due to the death or permanent disability of the Executive) other than for cause as defined above, then: a. Executive shall receive, in a lump sum, a cash payment in the amount of the total of the salary and bonus received by Executive from the Company in the last two full fiscal years prior to the operative date; b. Executive shall continue to receive all employment benefits, including medical benefits, health insurance and other, to which he may be entitled as a member of senior management of the Company for a period of 24 months after the termination date; and c. Executive shall receive an additional benefit, over and above that to which he would normally be entitled under the Company's retirement plans, equal to the actuarial equivalent of the additional amount Executive would have earned under such retirement plans or programs had he accumulated two additional continuous years of service. Such amount shall be paid to Executive in a cash lump sum payment at his normal retirement age, or, at Executive's option, at his early retirement age as provided for in such retirement net plan. The Company will reimburse the Executive for all legal fees and expenses incurred in good faith by the Executive as a result of any dispute with any party (including, but not limited to, the Company and/or any affiliate of the Company) regarding the payment of any benefit provided for in this Agreement (including, but not limited to, all fees and expenses incurred in disputing any termination or in seeking in good faith to obtain or enforce any benefit or right provided by this Agreement), or in each case interest on any delayed payment at the applicable federal rate provided for in Section 7872(f)(2)(A) of the Code. Such payments will be made within five business days after delivery of the Executive's written requests for payment accompanied by any evidence of fees and expenses incurred as the Company may reasonably require. 4 5 9. The amounts paid to Executive hereunder shall be considered severance pay in consideration of the past services Executive has rendered to the Company, and in consideration of continued service from the date hereof to Executive's entitlement to those payments. Executive shall have no duty to mitigate damages by seeking other employment. Should Executive actually receive payments from any other employment, the payments called for hereunder shall not be reduced or offset by any such payments. 10. In the event Executive's employment is terminated after the operative date: a. For twenty-four (24) months after the termination of Executive's employment hereunder, Executive shall not, unless acting with the prior written consent of Company: (1) Directly or indirectly, for himself, or on behalf of or in conjunction with any entity, solicit or endeavor to recruit or hire, as an employee, consultant, agent or representative, any person who was an employee of the Company within six months of the date that the Executive first solicited or endeavored to recruit or hire such person. (2) Discourage or otherwise attempt to prevent any person from doing business with the Company. b. In the event that the provisions of this Section should ever be deemed to exceed the time limitations permitted by applicable law, then such provisions shall be deemed reformed to the maximum time limitations permitted by applicable law. c. Executive specifically acknowledges and agrees that the remedy at law for any breach of the provision of this section will be inadequate and that the Company, in addition to any other relief available to it, shall be entitled to temporary and permanent injunctive relief without the necessity of providing actual damage. The provision of this Section 10 shall remain applicable to Executive until a final decision of a court of competent jurisdiction is entered finding that Executive was discharged by the Company in violation of Section 5 hereof. 11. The Company shall require any successor (whether direct or indirect, by purchase, merger, consolidation, reorganization or otherwise) to all or substantially all of the business and/or assets of the Company, by agreement in form and substance satisfactory to the Executive, expressly to assume and agree to perform this Agreement in the same manner and to the same extent the Company would be required to perform if no such succession had taken place. This Agreement shall be binding upon and inure to the benefit of the Company and any successor to 5 6 the Company, including without limitation any persons acquiring directly or indirectly all or substantially all of the business and/or assets of the Company whether by purchase, merger, consolidation, reorganization or otherwise (and such successor shall thereafter be deemed the "Company" for the purposes of this Agreement), but shall not otherwise be assignable, transferable or delegable by the Company. The failure of the Company to obtain such an assignment shall be a breach of this Agreement, in which event the date of succession or transfer shall be deemed to be the date of the breach. 12. This Agreement and all rights of the Executive shall inure to the benefit of and be enforceable by the Executive's personal or legal representatives, estates, executors, administrators, heirs and beneficiaries. All amounts payable to the Executive shall be paid, in the event of the Executive's death, to the Executive's estate, heirs and representatives. This Agreement shall inure to the benefit of, be binding upon and be enforceable by, any successor, surviving or resulting corporation or other entity to which all or substantially all of the Company's business and assets shall be transferred. This Agreement shall not be terminated by the voluntary or involuntary dissolution of the Company. 13. Executive's right to receive payments hereunder shall not be assignable, transferable or delegable, whether by pledge, creation of a security interest or otherwise, other than by a transfer by his will or by the laws of descent and distribution and, in the event of any attempted assignment or transfer contrary to this Section, the Company shall have no liability to pay any amount so attempted to be assigned, transferred or delegated. 14. This Agreement and the rights and obligations hereunder shall be governed by and construed in accordance with the laws of the State of Ohio, without giving effect to the principles of conflict of laws of such State. Any dispute arising out of this Agreement shall be determined by arbitration in Columbus, Ohio under the rules of the American Arbitration Association then in effect and judgment upon any award pursuant to such arbitration may be enforced in any court having jurisdiction thereof. 15. MISCELLANEOUS a. ENFORCEMENT: The provisions of this Agreement shall be regarded as divisible, and if any of said provisions or any part hereof are declared invalid or unenforceable by a court of competent jurisdiction, the validity and enforceability of the remainder of such provisions or parts hereof and the applicability thereof shall not be affected thereby. b. WITHHOLDING: The Company shall be entitled to withhold from amounts to be paid to the Executive hereunder any federal, state or local withholding or other taxes or charges which it is from time to time required to withhold. 6 7 c. EXPENSES AND INTEREST: If, after a change in control of the Company any claim or legal or arbitration proceeding shall be made or brought to recover damages for breach hereof, the Executive shall recover from the Company prejudgment interest on any money judgment or arbitration award obtained by the Executive, calculated at the rate of interest announced by Bank One Columbus, Ohio from time to time at its prime rate, calculated from the date that payments to him should have been made under this Agreement. d. PAYMENT OBLIGATIONS ABSOLUTE: The Company's obligation during and after the term of this Agreement to pay the Executive the compensation and to make the arrangements provided herein shall be absolute and unconditional and shall not be affected by any circumstances, including, without limitation, any set off, counterclaim, recoupment, defense or other right which the Company may have against him or anyone else. All amounts payable by the Company hereunder shall be paid without notice or demand. Each and every payment made hereunder by the Company will not seek to recover all or any part of such payment from the Executive or from whosoever may be entitled thereto, for any reason whatsoever. e. WAIVER AND ENTIRE AGREEMENT: No provisions of this Agreement may be modified, waived or discharged unless such waiver, modification or discharge is agreed to in writing signed by the Executive and the Company. No waiver by either party hereto at any time of any breach by the other party hereto or compliance with any condition or provision of this Agreement to be performed by such other party shall be deemed a waiver of similar or dissimilar provisions or conditions at the same or at any prior or subsequent time. NO agreements or representations, oral or otherwise, expressed or implied with respect to the subject matter hereof have been made by either party which are not set forth expressly in this Agreement. f. NOTICES: For all purposes of this Agreement, all communications including without limitation notices, consents, requests or approvals, provided for herein shall be in writing and shall be deemed to have been duly given when delivered or five business days after having been mailed by United States registered or certified mail, return receipt requested, postage prepaid, addressed to the Company (to the attention of the Secretary of the Company) at its principal executive office and to the Executive at his principal residence, or to such other address as any party may have furnished to the other in writing and in accordance herewith, except that notices of change of address shall be effective only upon receipt. g. SEVERABILITY: The invalidity or unenforceability of any particular provision of this Agreement shall not affect the other provisions hereof, and this 7 8 Agreement shall be construed in all respects as if such invalid or unenforceable provisions were omitted. IN WITNESS WHEREOF, the parties have caused this Agreement to be duly executed and delivered as of the date first written above. DRUG EMPORIUM, INC. By order of the Board of Directors By:___________________________________ Its: _________________________________ EXECUTIVE: __________________________ 8 EX-10.17 4 EXHIBIT 10.17 1 Exhibit 10.17 (Date) *** *** *** RE: Severance Compensation Dear : The Board of Directors (the "Board") of Drug Emporium, Inc. (the "Company") believes that the Company's employees are valuable asset and acknowledges that the security of the Company's employees is important to the Board and the Company. Therefore, if you are involuntarily terminated (other than a termination of employment due to your death or disability), after the date of this letter and prior to the second anniversary thereof, by the Company without Cause (as defined below) following the occurrence of a Change in Control (as defined below), you will be entitled to receive the following payments and benefits: 1. A lump sum payment equal to two times your regular per annum base salary compensation; 2. Continuation of your medical coverage (at no increased cost to you) for twelve months; and 3. Outplacement services (at no cost to you) at a firm selected by the Company for the period beginning on your termination date and ending on the earlier of (a) the 3 month anniversary of your termination date, and (b) the date on which you accept a new employment position. For purposes of this letter, "Cause" means (1) your failure in a material and substantial way to perform your assigned duties, (2) you materially breach any of your obligations to the Company, as set forth herein or otherwise, or (3) you commit a material act of malfeasance, disloyalty, dishonesty or breach of trust against the Company. For purposes of this letter, "Change in Control" means: * The acquisition (whether direct or indirect) of shares representing in excess of 50% of the outstanding shares of common stock of the Company by a person or group of persons not directors of the Company as of the date of this letter; or 1 2 * The occurrence of both of the following: The acquisition (whether direct or indirect) of shares representing in excess of 20% of the outstanding shares of common stock of the Company by a person or group of persons not directors of the Company as of the date of this letter; and Any change in the composition of the Board resulting in a majority of the directors of the Company as of the date of this letter no longer constituting a majority; provided, however, that in making such determination, directors who were elected by, and on the recommendation of, such present majority will be treated as present directors. The Company will reimburse you for all legal fees and expenses incurred in good faith by you as a result of any dispute with any party (including, but not limited to, the Company and/or any affiliate of the Company) regarding the payment of any benefit provided for in this letter. These payments will be made within five business days after delivery of your written requests for payment accompanied by any evidence of fees and expenses incurred as the Company reasonably may require. The amounts paid to you hereunder will be considered severance pay in consideration of the past services you have rendered to the Company, and in consideration of your continued service from the date hereof until your entitlement to those payments. You will have no duty to mitigate damages by seeking other employment. Should you actually receive payments from other employment, the payments called for under this letter will not be reduced or offset by any such payments. You agree to hold in a fiduciary capacity for the benefit of the Company all secret or confidential information, knowledge or data relating to the Company or any of its affiliated companies, and their respective businesses, which has been or may be obtained by you during your employment by the Company or any of its affiliated companies and which is not public knowledge (other than by direct or indirect acts by you in violation of this letter). After termination of your employment with the Company, you agree to not, without the prior written consent of the Company or as may otherwise be required by law or legal process, communicate or divulge any such information, knowledge or data to anyone other than the Company and those designated by it. The Company will require any successor to all or substantially all of the business and/or assets of the Company to assume and agree to perform the obligations set forth in this letter in the same manner and to the same extent the Company would be required to perform if no such succession had occurred. This letter and all your rights hereunder will inure to the benefit of and be enforceable by your personal or legal representatives, estate, executor(s), administrator(s), 2 3 heirs or beneficiaries. All amounts payable to you will be paid, in the event of your death, to your estate, heirs and representatives. This letter will inure to the benefit of, by binding upon and be enforceable by, any successor, surviving or resulting corporation or other entity to which all or substantially all of the Company's business and assets are transferred. Your right to receive payments hereunder will not be assignable, transferable or delegable to you, whether by pledge, creation of a security interest or otherwise other than by a testamentary transfer or by the laws of descent and distribution and, in the event of any attempted assignment or transfer to the contrary, the Company will have no liability to pay any amount so attempted to be assigned, transferred or delegated. This letter and the rights and obligations hereunder will be governed by and construed in accordance with the laws of the State of Ohio, without giving effect to the principles of conflict of the laws of Ohio. Any dispute arising out of the this letter will be determined by arbitration in Columbus, Ohio under the rules of the American Arbitration Association then in effect and judgement upon any award pursuant to such arbitration may be entered and enforced in any court having jurisdiction thereof. The Company is entitled to withhold from amounts to be paid to you thereunder any federal, state and local withholding or other taxes or charges which it is form time to time required to withhold. ************** If the Above meets with your approval, kindly sign both copies of this letter in the space provided below. Please return the one original to the Company and keep the other for your records. Sincerely, DRUG EMPORIUM, INC. By:_______________________________ David L. Kriegel Chairman & Chief Executive Officer Agreed to and acknowledged: ___________________________________ (Name) 3 EX-10.18 5 EXHIBIT 10.18 1 Exhibit 10.18 CONSULTING AGREEMENT THIS CONSULTING AGREEMENT ("Agreement"), dated December 2, 1997 is made by and between David L. Kriegel ("Consultant") and Drug Emporium, Inc. ("Company"). Recitals -------- 1. The Company desires to continue to benefit from the Consultant's business acumen and expertise by retaining the Consultant as a consultant after his termination of employment as chief executive officer and Chairman of the Board of the Company due to a change in control as defined in the amendment to Consultant's Employment Agreement dated December 2, 1997. 2 . The Consultant, in accordance with the terms and provisions set forth below, desires to be retained as a business consultant to the Company and to consult with the Company's chief executive officer and certain other senior officers of the Company regarding the retail deep-discount drugstore industry and other relevant business matters. Agreement --------- NOW THEREFORE, in consideration of the mutual covenants and the premises set forth herein, the Company and the Consultant hereby agree as follows: 1. Term ---- The consulting term, ("Term"), shall commence upon the termination of the Consultant's employment due to a change in control as defined in the first amendment to the Consultant's Employment Agreement with the Company, ("Commencement Date"), and shall end on the first year anniversary of the Commencement Date. The consulting Term may be extended or renewed only pursuant to the mutual written agreement of the Consultant and the Company. 2. Consulting Commitment --------------------- 2.1 During each month of the consulting Term, the Consultant (subject to allowances for illness and reasonable vacation) shall hold himself available, upon reasonable notice and during normal business hours, for 20 hours of business discussions or consultations with the chief executive officer of the Company or with other senior officers or directors of the Company as designated by the chief executive officer with the advice and consent of the Consultant. In connection with any consulting services rendered, the Consultant shall report solely and directly to the chief executive officer. 2.2. During the Term all business discussions and consultations shall occur either (a) by 1 2 telephonic conference call, or (b) in person at the Company's corporate offices (or at such other locations, as may be mutually agreed upon from time to time by the Consultant and the chief executive officer). Except as provided in the immediately preceding sentence, the Consultant shall not be required, without his consent, to travel to any specified geographic location or to provide any consulting service from any location other than the Consultant's primary personal residence. 2.3 During the consulting Term, the Consultant's arrangement with the Company under this Agreement shall be an exclusive consulting arrangement and during such period the Consultant shall not, directly or indirectly, provide consulting services, or offer to provide consulting services, for a fee or any other remuneration or benefit to any individual or entity engaged in any business which competes, directly or indirectly, with the business of the Company or any of its subsidiaries. 3. Consulting Fees --------------- During the Term, the Consultant shall receive a consulting fee equal to $150,000 per annum to be evaluated annually commencing in December 1998, payable by the Company on bi-weekly basis. 4. Expense Reimbursement --------------------- During and in respect of the Term, the Consultant shall, upon presentation to the Company of reasonable documentation, be entitled to prompt and frill reimbursement for all reasonable business expenses, including, without limitation, travel and commutations, hotel, restaurant and communication costs incurred by or charged to the Consultant in or with respect to the performance of consulting services under this Agreement and directed by the chief executive officer. 5. Termination ----------- 5.1 The consulting Term may be terminated, effective upon thirty (30) days prior written notice given by the Consultant or the Company, at any time for any reason including, without limitation, prior to the Commencement Date. If the Consultant should die during the consulting Term, the consulting Term shall automatically be terminated. Any termination under this Section 5 shall not be deemed to constitute a breach of this Agreement. 5.2 If the Agreement is terminated voluntarily by the Consultant during the Term (other than for Good Reason as defined below or due to his death or disability as defined below), the Consultant must provide thirty (30) days notice after which the Company will not be obligated to pay the aggregate amount of the remaining consulting fees that would have been paid to the Consultant under this Agreement had the Term continued for the term specified in Section 1 of this Agreement. For purposes of this Agreement, "Good Reason" shall mean the repeated failure by the Company, after notice from the Consultant, to pay the Consultant's consulting 2 3 fees. For purposes of this Agreement, "disability" shall have the meaning provided in the Company's disability insurance plan. 5.3 If the Agreement is terminated by the Company for any reason, by the Consultant for Good Reason or due to the Consultant's death or his becoming disabled, the Consultant shall be entitled to receive, within thirty (30) days after the effective date of such termination, a lump sum payment equal to (a) any remaining consulting fees earned by the consultant through the effective date of such termination, but not yet paid by the Company, and (b) the aggregate amount of the remaining consulting fees that would have been paid to the Consultant under this Agreement had the Term continued for the term specified in Section 1 of this Agreement. 5.4 If the consultant dies during the Term, the Consultant's estate shall be entitled to receive, within thirty (30) days after the Consultant's death, a lump sum payment in cash equal to the sum of (a) any consulting fees earned by the Consultant through the date of death, but not yet paid by the Company, and (b) the aggregate amount of the remaining consulting fees that would, but for his death, have been paid to the Consultant under this Agreement through the end of the Term. If the Consultant dies prior to the Commencement Date, the Consultant's estate shall not be entitled to receive any amounts hereunder. 5.5 Except as set forth in this Section 6, the Consultant shall not be entitled to Any other compensation or benefits under this Agreement upon or as a result of the termination of the Agreement. 6. Legal Fees ---------- In the event that a claim by the Consultant (or his estate) for consulting fees under this Agreement is disputed by the Company, the Consultant (or his estate) shall be promptly reimbursed by the Company for all legal fees incurred by or charged to the Consultant (or his estate) in prosecuting such claim, provided that the Consultant (or his estate) is successful as to the disputed claim by reason of litigation, arbitration or settlement. 7. Miscellaneous ------------- 7.1 The parties hereto agree that the Consultant shall be an independent contractor of the Company and shall not, among other things, be subject to the supervision of any employee or director of the Company. The Company and the Consultant agree that the Company shall not withhold any amounts from the Consultant's bi-weekly consulting fee., without the prior express written consent of the Consultant. 7.2 The Company shall, to the fullest extent permitted by law, indemnify the Consultant from, and hold him harmless against, any and all liabilities, costs and expenses (including, without limitation, fees and expenses of legal counsel and/or other experts) incurred by reason of any claim, suit or action brought against the Consultant as a direct or indirect result of any act, omission, or failure to act, by or on behalf of the Consultant while providing 3 4 the services contemplated by this Agreement for the Company or for any affiliate thereof, except for any act or omission which constitutes willful gross misconduct by the Consultant. The obligation of the Company under this Section 7.2 shall be in addition to and not in derogation of any other indemnification by the Company which the Consultant may be entitled to under other arrangements with the Company. 7.3 The Company shall require any successor to all or substantially all of the business and/or assets of the Company, whether direct or indirect, to assume and perform this Agreement. 7.4 No amendment, modification or waiver of any provision of this Agreement shall be valid, binding or enforceable, unless it is in writing and signed by the party against whom it is to be charged. 7.5 This Agreement constitutes a Consulting Agreement between the Consultant and the Company regarding the subject matter here of and supersedes any/all previous consulting agreements, promises, proposals, representations, understanding and negotiations, whether written or oral, between the Consultant and the Company regarding such subject matters. 7.6 All notices and other communications under this Agreement shall be in writing and shall be delivered by hand or by certified mail (return receipt requested), postage prepaid, properly addressed to the respective addresses set forth below, or to such other address which the sending party has previously received written notice of. Notice shall be deemed given upon delivery to the addressee. 7.7 In the event that any disputes of any kind arise under or with respect to this Agreement, the parties hereto agree to submit any such dispute to binding arbitration in the State of Ohio in accordance with the rules of the American Arbitration Association then in effect. 7.8 The validity, interpretation and performance of this Agreement shall be governed by the laws of the State of Ohio. IN WITNESS WHEREOF, the Consultant and the Company have executed this Agreement as of the day and year first above written. For: DRUG EMPORIUM, INC. Consultant: By order of the Board of Directors __________________________________ ______________________________ Its David L. Kriegel Address: Address: 155 Hidden Ravines Drive 3410 London Drive Powell, Ohio 43065 Lima, Ohio 45805 4 EX-13 6 EXHIBIT 13 1 Exhibit 13 FINANCIAL HIGHLIGHTS
February 28, 1998 March 1, 1997 (Dollars in thousands, except per share data) (52 weeks) (52 weeks) ===================================================================================== FOR THE YEAR ENDED: - ------------------------------------------------------------------------------------- Net sales $ 836,405 $ 855,016 - ------------------------------------------------------------------------------------- Operating income before special charges* $ 8,705 $ 12,915 - ------------------------------------------------------------------------------------- Net income $ 1,691 $ 1,152 - ------------------------------------------------------------------------------------- Average sales per store (52-week weighted average) $ 6,105 $ 6,151 - ------------------------------------------------------------------------------------- AT YEAR END: - ------------------------------------------------------------------------------------- Inventories at current cost $ 189,043 $ 208,991 - ------------------------------------------------------------------------------------- LIFO reserve (21,751) (21,042) - ------------------------------------------------------------------------------------- Inventories $ 167,292 $ 187,949 - ------------------------------------------------------------------------------------- Working capital $ 79,113 $ 76,302 - ------------------------------------------------------------------------------------- Shareholders' equity $ 51,390 $ 49,567 - ------------------------------------------------------------------------------------- Current ratio 1.73 1.59 - ------------------------------------------------------------------------------------- Long-term debt to equity 1.09 1.20 - ------------------------------------------------------------------------------------- Shares outstanding (in thousands) 13,180 13,153 - ------------------------------------------------------------------------------------- STORES OPEN: - ------------------------------------------------------------------------------------- Company-owned 135 138 - ------------------------------------------------------------------------------------- Franchised 84 91 - ------------------------------------------------------------------------------------- Total 219 229 - ------------------------------------------------------------------------------------- PER SHARE (BASIC AND DILUTED): - ------------------------------------------------------------------------------------- Earnings $ 0.13 $ 0.09 - ------------------------------------------------------------------------------------- Shareholders' equity $ 3.90 $ 3.77 =====================================================================================
* Special charges (credits) of $(2,092,000) and $2,800,000 were recorded in fiscal years 1998 and 1997, respectively. 2 SELECTED CONSOLIDATED FINANCIAL DATA The following table sets forth selected financial data and other operating information of the Company. The selected financial data is derived from the consolidated financial statements of the Company. The financial data should be read in conjunction with the consolidated financial statements and related notes contained elsewhere in this report and Management's Discussion and Analysis of Financial Condition and Results of Operations. STATEMENT OF OPERATIONS DATA
Year Ended - ---------------------------------------------------------------------------------------------------------------------------------- February 28, March 1, March 2, February 25, February 26, 1998 1997 1996 1995 1994 (in thousands, except per share data) (52 weeks) (52 weeks) (53 weeks) (52 weeks) (52 weeks) ================================================================================================================================== Net sales $ 836,405 $ 855,016 $ 738,772 $ 729,503 $ 749,040 - ---------------------------------------------------------------------------------------------------------------------------------- Gross margin 178,289 185,475 160,146 153,696 155,473 - ---------------------------------------------------------------------------------------------------------------------------------- Selling, administrative and occupancy expenses 169,584 172,560 146,774 143,337 146,920 - ---------------------------------------------------------------------------------------------------------------------------------- Operating income before special charges 8,705 12,915 13,372 10,359 8,553 - ---------------------------------------------------------------------------------------------------------------------------------- Special charges (credits) (2,092) 2,800 3,000 11,850 -- - ---------------------------------------------------------------------------------------------------------------------------------- Interest, net 7,653 7,882 6,468 6,697 6,183 - ---------------------------------------------------------------------------------------------------------------------------------- Income (loss) before income taxes 3,144 2,233 3,904 (8,188) 2,370 - ---------------------------------------------------------------------------------------------------------------------------------- Provision (benefit) for income taxes 1,453 1,081 1,562 (2,797) 1,089 - ---------------------------------------------------------------------------------------------------------------------------------- Net income (loss) $ 1,691 $ 1,152 $ 2,342 $ (5,391) $ 1,281 ================================================================================================================================== PER SHARE DATA: Earnings (loss) (1) $ 0.13 $ 0.09 $ 0.18 $ (0.41) $ 0.10 - ---------------------------------------------------------------------------------------------------------------------------------- Cash dividends -- -- -- -- -- - ---------------------------------------------------------------------------------------------------------------------------------- Shareholders' equity $ 3.90 $ 3.77 $ 3.68 $ 3.50 $ 3.91 - ---------------------------------------------------------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEET DATA: Working capital $ 79,113 $ 76,302 $ 80,195 $ 83,664 $ 82,176 - ---------------------------------------------------------------------------------------------------------------------------------- Total assets $ 219,784 $ 243,319 $ 243,898 $ 176,444 $ 198,085 - ---------------------------------------------------------------------------------------------------------------------------------- Non-current liabilities $ 60,330 $ 63,523 $ 67,391 $ 67,738 $ 68,761 - ---------------------------------------------------------------------------------------------------------------------------------- Total shareholders' equity $ 51,390 $ 49,567 $ 48,545 $ 46,149 $ 51,484 ==================================================================================================================================
(1) Represents basic and diluted per share amounts as defined by Statement of Financial Accounting Standards No. 128, "Earnings Per Share" (FAS No. 128). Earnings (loss) per share amounts prior to 1998 have been restated as required to comply with FAS No. 128. For further discussion, see the notes to the consolidated financial statements. 4 3 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS The following table sets forth selected items from the Company's Consolidated Statements of Operations expressed as a percentage of net sales for the years indicated.
Year Ended - ---------------------------------------------------------------------- February 28, March 1, March 2, 1998 1997 1996 (52 weeks) (52 weeks) (53 weeks) - ---------------------------------------------------------------------- Net sales (in thousands) $836,405 $855,016 $738,772 - ---------------------------------------------------------------------- Gross margin 21.3% 21.7% 21.7% - ---------------------------------------------------------------------- Selling, administrative and occupancy expense 20.3% 20.2% 19.9% - ---------------------------------------------------------------------- Operating income 1.0% 1.5% 1.8% - ----------------------------------------------------------------------
SALES Total sales for Fiscal 1998 decreased two percent from Fiscal 1997 and comparable-store sales decreased by approximately one-half of one percent. Overall sales decreased due to a lower store count and the comparable-store sales decrease. Average sales per store for Fiscal 1998 (based on a weighted average number of stores) were down approximately one percent over Fiscal 1997 due primarily to the comparable-store sales decreases. Sales for Fiscal 1997 increased 16 percent over Fiscal 1996 and comparable-store sales increased two percent in Fiscal 1997. The Fiscal 1997 overall sales increase was achieved due to the impact of sales at acquired stores and comparable-store sales increases, partially offset by the impact of having 52 weeks in Fiscal 1997 versus 53 weeks in Fiscal 1996. Average sales per store for Fiscal 1997 (based on a weighted average number of stores) were up three percent over Fiscal 1996 as a result of the closing of underperforming stores, the acquisition of higher volume stores and comparable-store sales increases. In Fiscal 1996, the additional one week of sales contributed $14.9 million to net sales. Pharmacy sales as a percentage of total sales were 29 percent, 27 percent, and 25 percent of sales in Fiscal 1998, 1997, and 1996, respectively. Management expects that pharmacy sales will continue to increase slightly as a percentage of total sales in the coming year. The following table lists stores opened or acquired and stores closed for the years indicated:
Year Ended - ----------------------------------------------------------------- February 28, March 1, March 2, 1998 1997 1996 (52 weeks) (52 weeks) (53 weeks) - ----------------------------------------------------------------- Number of stores at beginning of year 138 136 113 - ----------------------------------------------------------------- Stores opened or acquired 1 9 34 - ----------------------------------------------------------------- Stores closed (4) (7) (11) - ----------------------------------------------------------------- Total stores at end of year 135 138 136 - -----------------------------------------------------------------
GROSS MARGIN Fiscal 1998 gross margins were lower than the previous fiscal year due to increased inventory shrinkage and lower pharmacy margins, partially offset by the benefits of improved category management on non-pharmacy margins. Fiscal 1998 revenue recognized from vendor contract payments has impacted margins at levels similar to those seen in the previously reported two fiscal years. For Fiscal 1999, management expects continued pressure on the pharmacy margins due to the impact of pricing changes initiated by managed care networks. It is also anticipated that income recognized from vendor contract payments will decrease during Fiscal 1999 relative to the previous fiscal periods although the Company believes that its category management efforts and lower inventory shrinkage will eclipse the impact of this decrease. If the Company is successful in its category management efforts, overall gross margins are anticipated to recover and show a slight improvement over the levels seen in Fiscal 1997. SELLING, ADMINISTRATIVE AND OCCUPANCY Net advertising costs were slightly lower in dollars and as a percentage of sales, compared to the prior fiscal year; however, gross advertising costs were approximately .5% of sales higher than the prior year. Despite a planned increase in the print advertising for Fiscal 1999, the Company anticipates lower net advertising costs in Fiscal 1999 of .1% of sales through a more focused approach to the costs associated with distributing and producing its advertising. Payroll costs were lower in dollars and as a percentage of sales by .2% over the prior year as a result of an ongoing initiative to reduce administrative costs. This trend is expected to continue in Fiscal 1999, although at a slightly slower pace. In Fiscal 1998, occupancy costs were constant in dollars and higher as a percentage of sales by .1% relative to Fiscal 1997. Fiscal 1999 occupancy costs are expected to remain fixed as a percentage of sales. Other operating expenses were higher in Fiscal 1998 over Fiscal 1997 in dollars and as a percentage of sales due to decreased sales leverage and higher pharmacy costs. In Fiscal 1999, the Company anticipates reductions in operating costs of .1% over Fiscal 1998 due to lower POS equipment rental expense. Franchise fees, which are included as a reduction to operating costs, were $4,794,000, $4,840,000 and $4,669,000 in Fiscal 1998, 1997 and 1996, respectively. The Company has entered into an agreement with Western Drug Distributors, Inc., its franchise store operator in the Seattle and Portland area, to terminate Western's franchise agreement. The termination agreement is contingent upon the successful completion of due diligence and subsequent purchase of Western by Longs Drug Stores of Walnut Creek, California. The Company's agreement with Western provides for a one-time lump sum payment to Drug Emporium, Inc. based on the discounted present value of the future cash flows of franchise fees anticipated over the life of the franchise agreement. This transaction, if completed, is expected to result in significant reductions to franchise fee revenue and interest costs on an ongoing basis as well as a large one-time income impact at the date of the closing, which is estimated to be early in the Company's second quarter of Fiscal 1999. Selling, administrative and occupancy expenses increased in Fiscal 1997 compared to Fiscal 1996 in total dollars and as a percentage of net sales. The increase in Fiscal 1997 over Fiscal 1996 is a result of transitional costs associated with the acquired stores and increased litigation costs. 5 4 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) SPECIAL CHARGES (CREDITS) The impact of special charges (credits) on net income and descriptions of the components of the charges are shown below:
Year Ended - ------------------------------------------------------------------------------ February 28, March 1, March 2, 1998 1997 1996 (in thousands, except per share data) (52 weeks) (52 weeks) (53 weeks) ============================================================================== RECONCILIATION OF NET INCOME TO NET INCOME BEFORE SPECIAL CHARGES (CREDITS): Net income $1,691 $1,152 $2,342 - ------------------------------------------------------------------------------ Special charges (credits), net of income taxes (1,255) 1,680 1,800 - ------------------------------------------------------------------------------ Net income before special charges (credits) $ 436 $2,832 $4,142 - ------------------------------------------------------------------------------ Earnings per share before special charges (credits) (basic and diluted) $ 0.03 $ 0.22 $ 0.31 - ------------------------------------------------------------------------------
Store Closure Expense Store closing reserves are established based on management's expectation of the costs which will be incurred over the remaining lease terms of the closed locations, net of expected sublease income. During Fiscal 1996, a pretax charge of $3,000,000 was taken to cover rent and related charges for several closed store locations. In Fiscal 1997, the Company recorded costs associated with stores closed during Fiscal 1997 and earlier of $1,300,000, which was recorded as a part of special charges. In Fiscal 1998, additional store closing charges were offset by the receipt of $1,600,000 related to a favorable lease buyout. Management's goal is to sublease or through other means remove all significant closed-store obligations. Since March 1994, the Company has closed 46 stores, of which non-subleased obligations continue at February 28, 1998 on four stores. Management continues to seek ways to relieve obligations on these stores. Impairment of Long-Lived Assets In Fiscal 1997, the Company adopted SFAS No. 121, "Accounting for the Impairment of Long Lived Assets and for Long-Lived Assets to Be Disposed Of". Accordingly, the Company evaluated the ongoing value of its long-lived assets. Based on this evaluation, the Company determined that leasehold improvements and lease assets for certain stores were impaired and recorded as a part of special charges the transitional amortization charge of $1,500,000 in Fiscal 1997. A $300,000 charge was recorded in Fiscal 1998 and is shown as occupancy expense in the consolidated statement of operations. Settlement of Litigation and Recovery of Legal Costs Subsequent to the end of Fiscal 1998, the Company reached a confidential settlement agreement with one of its franchisees to resolve a longstanding lawsuit. The impact of the settlement and associated legal costs is reflected in the Fiscal 1998 results, net of a third-party recovery. The Company also recorded a recovery of related prior period legal costs as a special credit in Fiscal 1998. Interest, Net Interest, net decreased slightly in Fiscal 1998 over the previous period due primarily to lower borrowings related to the $19,948,000 in inventory reductions which took place during Fiscal 1998. Because these reductions followed unusually high first quarter Fiscal 1998 borrowings and took place over the course of Fiscal 1998, the full impact of the inventory reductions on interest expense will not be seen until Fiscal 1999. Interest, net increased during Fiscal 1997 compared to Fiscal 1996 due to increased borrowing related to store acquisitions. Acquisitions On May 29, 1996, the Company completed a purchase of certain assets of six stores in the Philadelphia market. The acquisition was accounted for as a purchase. Late in the third quarter of Fiscal 1996, the Company acquired 26 stores from F&M Distributors, Inc. ("F&M") in two separate transactions. The acquired stores were located in Milwaukee, Baltimore and Detroit, with Detroit representing a new market for the Company. Three of the stores were subsequently closed or merged with existing Drug Emporium operations, and none of the closed stores carried any future lease obligations to the Company. Six additional stores were also purchased in three separate transactions in Fiscal 1996. The consolidated statements of operations reflect the results of operations of the acquired stores from the dates acquired. INVENTORY VALUATION The Company uses the LIFO method of accounting for its inventories. Under this method, the cost of merchandise sold reported in the financial statements approximates current costs. The Company uses an estimated percentage rate of inflation determined at the beginning of the fiscal year in computing its LIFO charges throughout the fiscal year. This LIFO charge is adjusted at each year end based upon the actual weighted average percentage rate of inflation during the fiscal year.
Year Ended - ---------------------------------------------------------------- February 28, March 1, March 2, 1998 1997 1996 ================================================================ LIFO provision (benefit) (in thousands) $709 $(112) $1,573 - ---------------------------------------------------------------- Inflation (deflation) rate .4% (-.1)% 1.1% - ----------------------------------------------------------------
Inventory turnover approximated 3 turns for each of the years presented. During Fiscal 1998, the Company began to realize the benefits of its new inventory management system in the form of lower inventory levels, with FIFO inventory dropping in total by $19,948,000, or $114,000 per store. Management anticipates continued reductions in per-store inventory levels in the coming fiscal year due to its ongoing inventory management efforts related to its improved procurement and distribution processes. LIQUIDITY AND CAPITAL RESOURCES As of February 28, 1998, the Company's credit facility consisted of a term loan of $9,000,000 and a revolving credit loan availability of up to $55,000,000. The revolver expires on May 31, 2000, while the term debt is paid in quarterly installments of $750,000. 6 5 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) During Fiscal 1998, the Company decreased borrowings under the revolving credit facility by $19,400,000, as set forth in the consolidated statements of cash flows, which was due primarily to the Company's successful inventory reduction program. As noted above, the Company anticipates further reductions in its per store inventory levels, and thus its borrowing needs, due to its ongoing efforts to better manage its procurement and distribution processes. The Company's borrowing rate can fluctuate between the bank's prime rate and a LIBO-based rate, depending on the ability of the Company to meet certain financial covenants. The Agreement requires a commitment fee on the revolver of .25% on the unused available credit and has no compensating balance requirements. Borrowings made pursuant to the Agreement are secured by substantially all assets of the company. The Agreement prohibits the payment of dividends, stock repurchases and acquisition of the Company's convertible subordinated debentures. Cash paid for interest on the revolving credit line and long-term debt approximated interest expense in Fiscal 1998. Cash paid for interest on the revolving credit line and long-term debt exceeded interest expense by approximately $1,000,000 in Fiscal 1997 and was lower than interest expense by approximately $1,000,000 in Fiscal 1996. The Company believes that internally generated funds and borrowings available under its Agreement are sufficient to finance the Company's current operations. DEFERRED TAX ASSET The Company's deferred tax asset at February 28, 1998 is primarily comprised of net operating loss and AMT credit carryforwards of $5,772,000. Management expects to generate taxable income through operations of at least this amount during the next few years. However, the Company has the ability to generate taxable income through tax planning strategies, if necessary, to utilize the net operating loss carryforward. CLOSURE OF "BIG D" STORES The Company is in the process of closing the remaining "Big D" store. Costs to close the "Big D" stores and Fiscal 1998 "Big D" pretax losses from operations, together totaling approximately $1,200,000, are recorded in the Fiscal 1998 results. IMPACT OF YEAR 2000 Some of the Company's older computer programs were written using two digits rather than four to define the applicable year. As a result, those computer programs have time-sensitive software that does not correctly recognize the year 2000. This could cause a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions, send purchase orders, or engage in similar normal business activities. The Company has completed an assessment of this issue and is in the process of modifying and replacing portions of its software so that its computer systems will function properly with respect to dates in the year 2000 and thereafter. The total Year 2000 project cost is not expected to exceed $500,000, which includes $350,000 for the purchase of new hardware and software that will be capitalized and $150,000 that will be expensed as incurred. The Company expects to incur most of its Year 2000 costs during Fiscal 1999. Most portions of the project are estimated to be completed not later than February 27, 1999, which is prior to any anticipated impact on its operating systems. The Company believes that with modifications to existing software and conversions to new software, the Year 2000 issue will not pose significant operational problems for its computer systems. However, if such modifications and conversions are not made, or are not completed timely, the Year 2000 issue could have a material impact on the operations of the Company. The Company has initiated formal communications with all of its significant suppliers to determine the extent to which the Company's interface systems are vulnerable to those third parties' failure to remediate their own Year 2000 Issues. There is no guarantee that the systems of other companies on which the Company's systems rely will be timely converted and would not have an adverse effect on the Company's systems. The costs of the project and the date on which the Company believes it will complete the Year 2000 modifications are based on management's best estimates, which were derived utilizing numerous assumptions of future events, including the continued availability of certain resources and other factors. However, there can be no guarantee that these estimates will be achieved and actual results could differ materially from those anticipated. Specific factors that might cause such material differences include, but are not limited to, the availability and cost of personnel trained in this area, the ability to locate and correct all relevant computer codes, and similar uncertainties. FORWARD-LOOKING STATEMENTS Statements in this Management's Discussion and Analysis of Financial Condition and Results of Operations, as well as in certain other parts of this report that look forward in time, which includes everything other than historical information, are forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include statements concerning plans, objectives, goals, strategies, future events or performance, and underlying assumptions and other statements which are other than statements of historical facts. From time to time, the Company may publish or otherwise make available forward-looking statements of this nature. All such forward-looking statements are based on the current expectations of management and are subject to, and are qualified by, risks and uncertainties that could cause actual results to differ materially from those expressed or implied by those statements. These risks and uncertainties include, but are not limited to the high level of competition as to price and selection from a variety of sources, the recent pressure on pharmacy margins from managed care networks, the Company's ability to economically eliminate underperforming stores and general economic conditions. 7 6 CONSOLIDATED BALANCE SHEETS
(in thousands) - ------------------------------------------------------------------------------------------------ ASSETS FEBRUARY 28, 1998 March 1, 1997 ================================================================================================= CURRENT ASSETS: Cash and cash equivalents $ 783 $ 779 - ------------------------------------------------------------------------------------------------ Accounts receivable 17,410 14,525 - ------------------------------------------------------------------------------------------------ Inventories 167,292 187,949 - ------------------------------------------------------------------------------------------------ Income taxes and other current assets 1,692 3,278 - ------------------------------------------------------------------------------------------------ TOTAL CURRENT ASSETS 187,177 206,531 - ------------------------------------------------------------------------------------------------ Property and equipment, net 26,777 30,412 - ------------------------------------------------------------------------------------------------ Goodwill 4,215 4,763 - ------------------------------------------------------------------------------------------------ Other assets 1,615 1,613 - ------------------------------------------------------------------------------------------------ TOTAL ASSETS $219,784 $243,319 =================================================================================================
(dollars in thousands) - ------------------------------------------------------------------------------------------------ LIABILITIES AND SHAREHOLDERS' EQUITY FEBRUARY 28, 1998 March 1, 1997 ================================================================================================= CURRENT LIABILITIES: Revolving credit line $ 22,200 $ 41,600 - ------------------------------------------------------------------------------------------------ Accounts payable 64,025 64,571 - ------------------------------------------------------------------------------------------------ Accrued liabilities 14,785 15,142 - ------------------------------------------------------------------------------------------------ Deferred income 3,679 4,966 - ------------------------------------------------------------------------------------------------ Current maturities of long-term debt 3,375 3,950 - ------------------------------------------------------------------------------------------------ TOTAL CURRENT LIABILITIES 108,064 130,229 - ------------------------------------------------------------------------------------------------ Deferred rent 4,164 4,192 - ------------------------------------------------------------------------------------------------ Convertible subordinated debt 49,421 49,421 - ------------------------------------------------------------------------------------------------ Long-term debt, other 6,745 9,910 - ------------------------------------------------------------------------------------------------ TOTAL LONG-TERM DEBT 56,166 59,331 - ------------------------------------------------------------------------------------------------ SHAREHOLDERS' EQUITY: Preferred stock, authorized 2,000,000 shares, none issued -- -- - ------------------------------------------------------------------------------------------------ Common stock, stated value $.10 per share, authorized 28,000,000; issued and outstanding 13,180,000 in 1998; 13,153,000 in 1997 1,318 1,315 - ------------------------------------------------------------------------------------------------ Additional paid-in capital 32,123 31,994 - ------------------------------------------------------------------------------------------------ Retained earnings 17,949 16,258 - ------------------------------------------------------------------------------------------------ TOTAL SHAREHOLDERS' EQUITY 51,390 49,567 - ------------------------------------------------------------------------------------------------ TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $219,784 $243,319 =================================================================================================
See accompanying notes. 8 7 CONSOLIDATED STATEMENTS OF OPERATIONS
Year Ended - -------------------------------------------------------------------------------------------------- FEBRUARY 28, 1998 March 1, 1997 March 2, 1996 (in thousands, except per share amounts) (52 WEEKS) (52 weeks) (53 weeks) ================================================================================================== Net sales $ 836,405 $ 855,016 $ 738,772 - -------------------------------------------------------------------------------------------------- Cost of sales 658,116 669,541 578,626 - -------------------------------------------------------------------------------------------------- Gross margin 178,289 185,475 160,146 - -------------------------------------------------------------------------------------------------- Selling, administrative and occupancy expenses 169,584 172,560 146,774 - -------------------------------------------------------------------------------------------------- Special charges (credits) (2,092) 2,800 3,000 - -------------------------------------------------------------------------------------------------- Interest expense, net 7,653 7,882 6,468 - -------------------------------------------------------------------------------------------------- Income before provision for income taxes 3,144 2,233 3,904 - -------------------------------------------------------------------------------------------------- Provision for income taxes 1,453 1,081 1,562 - -------------------------------------------------------------------------------------------------- Net income $ 1,691 $ 1,152 $ 2,342 - -------------------------------------------------------------------------------------------------- Earnings per share (basic and diluted) $ 0.13 $ 0.09 $ 0.18 - -------------------------------------------------------------------------------------------------- WEIGHTED AVERAGE NUMBER OF COMMON SHARES USED IN COMPUTING EARNINGS PER SHARE: Basic 13,180 13,169 13,182 - -------------------------------------------------------------------------------------------------- Diluted 13,197 13,182 13,190 ==================================================================================================
See accompanying notes. CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
- ------------------------------------------------------------------------------------------------------------------------------ Common Common Additional Total Stock Stock Paid-In Retained Shareholders' (in thousands) Shares Amount Capital Earnings Equity ============================================================================================================================== Balance at February 25, 1995 13,171 $1,317 $32,068 $12,764 $46,149 - ------------------------------------------------------------------------------------------------------------------------------ Exercise of stock options 13 1 53 -- 54 - ------------------------------------------------------------------------------------------------------------------------------ Net income -- -- -- 2,342 2,342 - ------------------------------------------------------------------------------------------------------------------------------ Balance at March 2, 1996 13,184 $1,318 $32,121 $15,106 $48,545 - ------------------------------------------------------------------------------------------------------------------------------ Retirement of treasury shares (31) (3) (127) -- (130) - ------------------------------------------------------------------------------------------------------------------------------ Net income -- -- -- 1,152 1,152 - ------------------------------------------------------------------------------------------------------------------------------ Balance at March 1, 1997 13,153 $1,315 $31,994 $16,258 $49,567 - ------------------------------------------------------------------------------------------------------------------------------ Exercise of stock options 27 3 129 -- 132 - ------------------------------------------------------------------------------------------------------------------------------ Net income -- -- -- 1,691 1,691 - ------------------------------------------------------------------------------------------------------------------------------ BALANCE AT FEBRUARY 28, 1998 13,180 $1,318 $31,123 $17,949 $51,390 ==============================================================================================================================
See accompanying notes. 9 8 CONSOLIDATED STATEMENTS OF CASH FLOWS
Year Ended - -------------------------------------------------------------------------------------------------------------- FEBRUARY 28, 1998 March 1, 1997 March 2, 1996 (in thousands) (52 WEEKS) (52 weeks) (53 weeks) ============================================================================================================== OPERATING ACTIVITIES Net income $ 1,691 $ 1,152 $ 2,342 - -------------------------------------------------------------------------------------------------------------- ADJUSTMENTS TO RECONCILE TO CASH PROVIDED BY OPERATIONS: Depreciation and amortization 7,345 8,788(1) 6,934 - -------------------------------------------------------------------------------------------------------------- Deferred income taxes 610 500 1,000 - -------------------------------------------------------------------------------------------------------------- LIFO provision (benefit) 709 (112) 1,573 - -------------------------------------------------------------------------------------------------------------- CASH PROVIDED BY (USED FOR) CURRENT ASSETS AND LIABILITIES: Accounts payable and accrued liabilities (2,725) (18,626) 34,128 - -------------------------------------------------------------------------------------------------------------- Accounts receivable (2,885) (1,507) (2,494) - -------------------------------------------------------------------------------------------------------------- Inventories at current cost 19,948 7,921 (23,064) - -------------------------------------------------------------------------------------------------------------- Other 1,268 2,439 3,446 - -------------------------------------------------------------------------------------------------------------- NET CASH PROVIDED BY OPERATING ACTIVITIES 25,961 555 23,865 - -------------------------------------------------------------------------------------------------------------- INVESTING ACTIVITIES Purchase of property and equipment, net (2,949) (5,809) (2,773) - -------------------------------------------------------------------------------------------------------------- Payment for purchase of retail stores, net of cash acquired -- (10,093) (40,644) - -------------------------------------------------------------------------------------------------------------- NET CASH USED FOR INVESTING ACTIVITIES (2,949) (15,902) (43,417) - -------------------------------------------------------------------------------------------------------------- FINANCING ACTIVITIES Net borrowings (repayments) under revolving credit line (19,400) 20,100 21,500 - -------------------------------------------------------------------------------------------------------------- Proceeds from term debt -- -- 15,000 - -------------------------------------------------------------------------------------------------------------- Net repayments on term debt and other (3,608) (4,741) (17,903) - -------------------------------------------------------------------------------------------------------------- NET CASH PROVIDED BY (USED FOR) FINANCING ACTIVITIES (23,008) 15,359 18,597 - -------------------------------------------------------------------------------------------------------------- INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 4 12 (955) - -------------------------------------------------------------------------------------------------------------- CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 779 767 1,722 - -------------------------------------------------------------------------------------------------------------- CASH AND CASH EQUIVALENTS, END OF YEAR $ 783 $ 779 $ 767 ==============================================================================================================
See accompanying notes. (1) Includes $1,500,000 related to the Company's adoption of FAS 121. 10 9 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Consolidation The consolidated financial statements include the accounts of Drug Emporium, Inc. and subsidiaries (the Company). All significant intercompany accounts and transactions have been eliminated in consolidation. Nature of Operations The Company is primarily in the business of operating and franchising retail stores specializing in the sale of health and beauty care products, over-the-counter medication, prescription drugs, greeting cards, cosmetics and highly-consumable products primarily in an everyday-low-price format. During Fiscal 1998, the stores operated under the names of Drug Emporium, F&M Super Drug Stores, I got it at Gary's and "Big D." As of year-end, approximately seventy percent of the Company-owned stores were located in the states of California, Georgia, Michigan, New Jersey, Ohio and Pennsylvania. Fiscal Year The fiscal year of the Company is the 52-53 week period ending on the Saturday closest to February 28 (29). The quarter and fiscal year ends for 1998 and 1997 were as follows:
Fiscal year 1998 Fiscal year 1997 - ----------------------------------------------------------------------- First quarter May 31, 1997 June 1, 1996 - ----------------------------------------------------------------------- Second quarter August 30, 1997 August 31, 1996 - ----------------------------------------------------------------------- Third quarter November 29, 1997 November 30, 1996 - ----------------------------------------------------------------------- Year end February 28, 1998 March 1, 1997 - -----------------------------------------------------------------------
Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Cash and Cash Equivalents For purposes of reporting cash flows, cash and cash equivalents includes cash on hand and deposits at financial institutions with maturities of less than three months. Accounts Receivable The Company uses the allowance method of accounting for uncollectible accounts. Accounts receivable are stated net of allowances for uncollectible accounts of $1,155,000 and $1,921,000 as of February 28, 1998 and March 1, 1997, respectively. The decrease from Fiscal 1997 to Fiscal 1998 relates to the write-off of approximately $700,000 of a specifically reserved franchise receivable. Inventories Inventories are stated at the lower of cost or market. Cost is determined by use of the last-in, first-out (LIFO) method. If current cost had been used, inventories would have been approximately $21,751,000 and $21,042,000 higher than reported at February 28, 1998 and March 1, 1997, respectively. Cost of sales is primarily computed on an estimated basis and adjusted based on physical inventory counts which are generally taken at all locations twice annually. Property and Equipment Property and equipment are stated at cost. Depreciation is provided on a straight-line basis over the estimated useful lives of owned assets. Leasehold improvements are amortized over the estimated useful life of the asset or the term of the lease, whichever is shorter. Pre-Opening Expenses Expenditures related to the opening of new stores, other than expenditures for capital assets, are charged against earnings when incurred. Goodwill Goodwill is amortized over 15 years using the straight-line method. The Company amortized $548,000, $548,000, and $597,000 of goodwill during Fiscal 1998, 1997 and 1996, respectively. Accumulated amortization was $4,321,000 at February 28, 1998 and $3,773,000 at March 1, 1997. The Company reviews its goodwill for impairment annually, based upon expectations of nondiscounted cash flows and operating income. As of February 28, 1998, management believes that none of its goodwill is materially impaired. Debt Issuance Costs Debt issuance costs incurred in connection with the convertible subordinated debt are amortized using a straight-line method over the term of the debt. Amortization expense related to the issuance costs is reported as interest expense and approximated $55,000 in 1998, $55,000 in 1997, and $57,000 in 1996. The amount of accumulated amortization, at February 28, 1998 and March 1, 1997, was $464,000 and $409,000, respectively. Advertising Costs The Company expenses production costs of radio and television advertising in the year incurred. Gross advertising costs, before vendor reimbursements, as a percentage of net sales, were: 1998 - 2.6%; 1997 - 2.1%; and 1996 - 2.3%. Earnings Per Share In 1997, the Financial Accounting Standards Board issued Statement No. 128, "Earnings per Share." Statement 128 replaced the calculation of primary and fully diluted earnings per share with 11 10 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) basic and diluted earnings per share. Unlike primary earnings per share, basic earnings per share excludes any dilutive effects of options, warrants and convertible securities. Diluted earnings per share is very similar to the previously reported fully diluted earnings per share. All earnings per share amounts for all periods have been presented, and where appropriate, restated to conform to the Statement 128 requirements. Franchise Arrangements Arrangements with franchisees who operate throughout the United States generally provide for initial fees, new store opening fees and continuing payments to the Company based upon a percentage of sales. The fees, when earned, and related costs are recorded net and included in the Company's selling, administrative and occupancy expenses. Franchise fees were $4,794,000, $4,840,000 and $4,669,000 in Fiscal 1998, 1997 and 1996, respectively. Vendor Contract Income Recognition From time to time the Company enters into contracts with various suppliers for the purchase of merchandise for sale. These contracts may provide for contractual payments from vendors in exchange for product conversion, product placement, coverage of operational costs, purchase commitments, or similar inducements. The Company records vendor contract payments as a reduction to cost of sales over the life of the contract in the case of payments made with recourse, or upon receipt in the case of non-recourse payments. Store Closure Expense The store closing reserve has been established based on management's expectation of the costs which will be incurred over the remaining lease terms of the closed locations, net of expected sublease income. In Fiscal 1996, a pretax charge of $3,000,000 was taken to cover rent and related charges at several properties which have taken longer than expected to sublease. In Fiscal 1997, the Company incurred costs associated with stores closed during Fiscal 1997 and earlier of $1,300,000, which was recorded as a part of special charges. In Fiscal 1998, additional store closing charges were offset by the receipt of $1,600,000 related to a favorable lease buyout. Impairment of Long-Lived Assets In Fiscal 1997, the Company adopted SFAS No. 121, "Accounting for the Impairment of Long Lived Assets and for Long-Lived Assets to Be Disposed Of". Accordingly, the Company evaluated the ongoing value of its long-lived assets. Based on this evaluation, the Company determined that leasehold improvements and lease assets for certain stores were impaired and recorded a transitional amortization charge of $1,500,000 to recognize the impairment. The Fiscal 1997 transitional impairment charge was recorded as a part of special charges. A charge of $300,000 related to SFAS No. 121 was recorded as occupancy expense in the consolidated statement of operations in Fiscal 1998. Reclassifications Certain amounts in prior years' financial statements have been reclassified to conform to the Fiscal 1998 presentation. NOTE 2 - REVOLVING CREDIT LINE As of February 28, 1998, the Company's credit facility consisted of the term loan of $9,000,000 (see Note 3) and a revolving credit loan availability of up to $55,000,000 of which $22,200,000 was utilized at February 28, 1998. The revolver expires on May 31, 2000, while the term debt is paid in quarterly installments of $750,000. The Company's borrowing rate can fluctuate between the bank's prime rate and a LIBO-based rate, depending on the ability of the Company to meet certain financial covenants. The Agreement requires a commitment fee on the revolver of .25% on the unused available credit and has no compensating balance requirements. Borrowings made pursuant to the Agreement are secured by substantially all of the assets of the Company. The Agreement prohibits the payment of dividends, stock repurchases, and acquisition of the Company's convertible subordinated debentures. NOTE 3 - LONG-TERM DEBT
- ---------------------------------------------------------------------- (in thousands) February 28, 1998 March 1, 1997 ====================================================================== Convertible subordinated debentures $49,421 $49,421 - ---------------------------------------------------------------------- Term debt 9,000 12,000 - ---------------------------------------------------------------------- Other 1,120 1,860 - ---------------------------------------------------------------------- 59,541 63,281 - ---------------------------------------------------------------------- Less current maturities (3,375) (3,950) - ---------------------------------------------------------------------- $56,166 $59,331 - ----------------------------------------------------------------------
The Company has $49,421,000 of 7.75% convertible subordinated debentures outstanding. These debentures are unsecured obligations of the Company and may be converted into common stock of the Company at any time prior to maturity, unless previously redeemed. The conversion rate is 65.1466 shares per $1,000 principal amount of debentures (or approximately $15.35 per share), subject to certain adjustments under the terms of these debentures. These debentures are redeemable at the option of the Company at 101.4% of par plus accrued interest. This redemption rate declines by .7% annually to par on October 1, 1999. The debentures are subject to a sinking fund, commencing October 1, 2000, calculated to retire at least 70% of the debentures prior to the final maturity date of October 1, 2014. The Company has reserved 3,387,624 shares of common stock for issuance upon conversion of the debentures. During Fiscal 1998, the convertible debentures traded in a range of 78.5% to 91.75% of par, with a year-end price of 89% of par. The term debt is part of the Agreement discussed in Note 2 and is payable in quarterly installments, with annual amounts of 12 11 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) $3,000,000 due in Fiscal 1999, 2000 and 2001. The Company has other notes bearing interest at rates ranging from 8.18% to 9.00%. Principal amounts related to the notes due for fiscal years 1999 through 2003 are $375,000, $238,000, $258,000, $234,000 and $9,000, respectively. NOTE 4 - OPERATING LEASES The Company leases retail stores and certain equipment under non-cancelable operating leases which expire at various dates. Certain of the store leases require contingent rentals based upon sales in excess of specified amounts and generally require the Company to pay utilities, common area maintenance, insurance and taxes, and certain leases are renewable with escalation clauses. Rent expense (excluding rent expense for closed stores from the date closed) was $33,732,000, $32,854,000, and $28,354,000 during Fiscal 1998, 1997 and 1996, respectively. At February 28, 1998, future minimum operating lease payments during the next five years and thereafter are: 1999 - $29,315,000; 2000 - $26,538,000; 2001 - - $22,820,000; 2002 - $18,418,000; 2003 - $15,123,000; and $38,334,000 thereafter. At February 28, 1998, the future minimum lease payments for closed stores total approximately $8,275,000 for which the Company estimates it will receive approximately $6,970,000 of sublease income (for which there are subleases in force aggregating $4,516,000 at February 28, 1998). This estimate is contingent on the ability of the Company to sublease remaining closed-store leases within approximately one year. NOTE 5 - PROPERTY AND EQUIPMENT Property and equipment is summarized as follows:
- ------------------------------------------------------------------ (in thousands) February 28, 1998 March 1, 1997 ================================================================== Land and building $ 3,331 $ 3,475 - ------------------------------------------------------------------ Furniture and fixtures 40,188 38,941 - ------------------------------------------------------------------ Acquired leases and leasehold improvements 26,449 26,502 - ------------------------------------------------------------------ 69,968 68,918 - ------------------------------------------------------------------ Less allowances for depreciation and amortization (43,191) (38,506) - ------------------------------------------------------------------ $26,777 $30,412 ==================================================================
NOTE 6 - INCOME TAXES Deferred income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The tax amounts recorded in the consolidated balance sheets consisted of the following:
- -------------------------------------------------------------------- TAX AFFECTED AMOUNTS - -------------------------------------------------------------------- (in thousands) February 28, 1998 March 1, 1997 ==================================================================== DEFERRED TAX ASSETS (LIABILITIES): Loss and AMT credit carryforwards $ 5,772 $ 4,911 - -------------------------------------------------------------------- Store closing reserve 554 1,114 - -------------------------------------------------------------------- Allowance for receivables 439 730 - -------------------------------------------------------------------- Property and equipment 1,133 1,053 - -------------------------------------------------------------------- Other, net 1,748 2,062 - -------------------------------------------------------------------- 9,646 9,870 - -------------------------------------------------------------------- Inventory valuation (4,739) (3,923) - -------------------------------------------------------------------- Deferred income (3,974) (4,121) - -------------------------------------------------------------------- Other (663) (946) - -------------------------------------------------------------------- (9,376) (8,990) - -------------------------------------------------------------------- Net deferred tax asset 270 880 - -------------------------------------------------------------------- Current tax balance 181 2,160 - -------------------------------------------------------------------- $ 451 $ 3,040 ====================================================================
There were no significant deferred tax valuation allowances as of February 28, 1998 and March 1, 1997. Significant components of the provision for income taxes are as follows:
- ------------------------------------------------------------- (in thousands) 1998 1997 1996 ============================================================= CURRENT: Federal $ 579 $ 339 $ 298 - ------------------------------------------------------------- State and local 264 242 264 - ------------------------------------------------------------- Total current 843 581 562 - ------------------------------------------------------------- Deferred 610 500 1,000 - ------------------------------------------------------------- $1,453 $1,081 $1,562 =============================================================
The reconciliation of income tax computed at the U.S. federal statutory tax rates to income tax expense is:
- ----------------------------------------------------------------------- (in thousands) 1998 1997 1996 ======================================================================= Tax at statutory rate $ 1,069 $ 759 $ 1,327 - ----------------------------------------------------------------------- State income tax, net 174 160 174 - ----------------------------------------------------------------------- Goodwill 186 186 203 - ----------------------------------------------------------------------- Other, net 24 (24) (142) - ----------------------------------------------------------------------- $ 1,453 $ 1,081 $ 1,562 =======================================================================
The Company received refunds, net of income taxes paid, of $1,889,000 during Fiscal 1996 and $550,000 during Fiscal 1998, and made an income tax payment of $1,050,000 in Fiscal 1997. At February 28, 1998, the Company has net operating loss carryforwards of $9,316,882 for income tax purposes that expire in years 2010, 2012 and 2013, and $2,604,431 of alternative minimum tax credit carryforward which has no expiration date. 13 12 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 7 - SHAREHOLDERS' EQUITY The Company has authorized 2,000,000 shares of $1.00 par value preferred stock. The terms of the preferred stock are subject to determination by the Company's Board of Directors. The Company has a shareholder rights plan which provides for the distribution of a right to purchase one-hundredth of a share of preferred stock to each holder of common stock. The rights become exercisable upon the occurrence of certain triggering events, as defined in the plan. The Company has reserved 33,900 shares of Series A Preferred Stock in connection with the rights to be distributed under the plan with respect to the reserved shares of common stock. The plan expires on July 1, 1998, unless extended by the Company. NOTE 8 - STOCK OPTION PLANS The Company has adopted stock option plans for key employees. Under such plans, the Board of Directors may grant options for shares of common stock at a price not less than 100% of the fair market value of the shares on the date of grant. If an employee owns stock possessing more than 10% of the total combined voting power of the Company, the option price must be 110% of the fair market value on the date of grant. The options vest based on the term of the optionee's continuous employment at 10% to 30% per year. Service prior to date of grant is considered under certain plans. In Fiscal 1997, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 123, "Accounting for Stock-Based Compensation." In accordance with the provisions of SFAS No. 123, the Company applies Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" and related interpretations in accounting for its employee stock options and, accordingly does not recognize compensation costs when the exercise price of its employee stock options is equal to or greater than the fair market value of the stock at the grant date. If the Company had elected to recognize compensation cost based on the fair value of the options granted at grant date as prescribed by SFAS No. 123, net income would have been impacted by $55,000 and $59,000 in Fiscal 1998 and 1997, respectively. The financial effects of applying SFAS No. 123 for providing proforma disclosures are not likely to be representative of the effects on reported net income and earnings per share for future years. The estimated fair value of the options is amortized into expense over the options' vesting periods. The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions for Fiscal 1998, 1997 and 1996: Risk-free interest rate of 6.5%; no dividend yield; volatility factor of the expected market price of the Company's common stock of 0.44; and a weighted-average expected life of each option of four or five years. A summary of the Company's stock option activity during 1998, 1997, and 1996 and related information follows:
- --------------------------------------------------------------------------------------------- SHARES UNDER OPTION - --------------------------------------------------------------------------------------------- (in thousands, except per share amounts) 1998 1997 1996 ============================================================================================= Outstanding, beginning of year 916 881 931 - --------------------------------------------------------------------------------------------- Granted (at $4.16 to $4.97 per share) -- 118 5 - --------------------------------------------------------------------------------------------- Cancelled (93) (83) (42) - --------------------------------------------------------------------------------------------- Exercised (at $4.00 to $5.00 per share) (27) -- (13) - --------------------------------------------------------------------------------------------- Outstanding, end of year (at prices ranging from $4.13 to $8.81 per share) 796 916 881 - --------------------------------------------------------------------------------------------- Exercisable, end of year (at prices ranging from $4.13 to $8.81 per share) 655 761 302 =============================================================================================
The weighted average per share price for options outstanding was $5.02 and $4.98 at the end of Fiscal 1998 and 1997, respectively. At the end of fiscal years 1998, 1997 and 1996, there were 187,000, 143,000 and 217,000 shares, respectively, reserved for future grants. NOTE 9 - ACQUISITIONS On May 29, 1996, the Company completed a purchase of certain assets of six stores in the Philadelphia market at a total purchase price of $10.1 million. The acquisition was accounted for as a purchase. The consolidated statements of operations reflect the results of operations of the stores since the date acquired. The acquired stores contributed approximately $38,150,000 in sales during Fiscal 1997. During Fiscal 1996, the Company acquired 32 stores in five separate transactions for a total purchase price of $42 million. These acquisitions were accounted for as purchases. The consolidated statements of operations reflect the results of operations of the acquired enterprises since the dates acquired. The acquired stores contributed approximately $80 million in sales during Fiscal 1996. NOTE 10 - DEFINED CONTRIBUTION PLAN The Company provides a defined contribution 401(k) plan to substantially all employees. Participants may make voluntary contributions to the plan of up to 15% of their compensation. Approximately $154,000, $65,000, and $50,000 was charged to expense for this plan in fiscal years 1998, 1997 and 1996, respectively. NOTE 11 - SETTLEMENT OF LITIGATION Subsequent to the end of Fiscal 1998, the Company reached a confidential settlement agreement with one of its franchisees to resolve a longstanding lawsuit. The impact of the settlement and associated legal costs is reflected in the Fiscal 1998 results, net of a third-party recovery. The Company recorded a recovery of related prior period legal costs as a special credit in Fiscal 1998. 14 13 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 12 - EARNINGS PER SHARE The following table sets forth the computation of basic and diluted earnings per share:
- ------------------------------------------------------------------------------------------ (in thousands, except per share amounts) 1998 1997 1996 ========================================================================================== NUMERATOR: Net income and numerator for basic earnings per share - income available to common stockholders $ 1,691 $ 1,152 $ 2,342 - ------------------------------------------------------------------------------------------ Effect of dilutive securities: 7.75% convertible debentures (1) -- -- -- - ------------------------------------------------------------------------------------------ Numerator for diluted earnings per share - income available to common stockholders after assumed conversions $ 1,691 $ 1,152 $ 2,342 - ------------------------------------------------------------------------------------------ DENOMINATOR: Denominator for basic earnings per share - weighted-average shares 13,180 13,169 13,182 - ------------------------------------------------------------------------------------------ Effect of dilutive securities: Employee stock options (2) 17 13 8 - ------------------------------------------------------------------------------------------ 7.75% convertible debentures (1) -- -- -- - ------------------------------------------------------------------------------------------ Dilutive potential common shares -- -- -- - ------------------------------------------------------------------------------------------ Denominator for diluted earnings per share - adjusted weighted-average shares and assumed conversions 13,197 13,182 13,190 - ------------------------------------------------------------------------------------------ Basic earnings per share $ 0.13 $ 0.09 $ 0.18 - ------------------------------------------------------------------------------------------ Diluted earnings per share $ 0.13 $ 0.09 $ 0.18 ==========================================================================================
(1) The effect of the 7.75% convertible debentures is antidilutive and thus excluded in the calculation of diluted earnings per share. (2) Additional options to purchase shares of common stock were outstanding during each period but were not included in the computation of diluted earnings per share because the exercise price of the options was greater than the average market price of the common shares and, therefore, the effect would be antidilutive. NOTE 13 - SUBSEQUENT EVENT The Company has entered into an agreement with Western Drug Distributors, Inc., its franchise store operator in the Seattle and Portland area, to terminate Western's franchise agreement. The termination agreement is contingent upon the successful completion of due diligence and subsequent purchase of Western by Longs Drug Stores of Walnut Creek, California. The Company's agreement with Western provides for a one-time lump sum payment to Drug Emporium, Inc. based on the discounted present value of the future cash flows of franchise fees anticipated over the life of the franchise agreement. This transaction, if completed, is expected to result in significant reductions to franchise fee revenue and interest costs on an ongoing basis as well as a large one-time income impact at the date of the closing, which is estimated to be early in the Company's second quarter of Fiscal 1999. NOTE 14 - QUARTERLY FINANCIAL DATA (UNAUDITED)
- ------------------------------------------------------------------------------------------------------------------------------ (in thousands, except per share amounts) - ------------------------------------------------------------------------------------------------------------------------------ Stock Prices Net Gross Net Earnings Per Common ------------ Dividends Paid Sales Profit Income Share (Basic and Diluted) High Low Per Common Share ============================================================================================================================== 1998: First quarter $209,214 $ 44,622 $ 528 $ .04 $ 5.50 $ 4.13 -- - ------------------------------------------------------------------------------------------------------------------------------ Second quarter 204,235 43,549 274 .02 5.31 4.00 -- - ------------------------------------------------------------------------------------------------------------------------------ Third quarter 199,571 42,344 283 .02 4.75 3.75 -- - ------------------------------------------------------------------------------------------------------------------------------ Fourth quarter 223,385 47,774 606 .05 5.38 3.88 -- - ------------------------------------------------------------------------------------------------------------------------------ $836,405 $178,289 $ 1,691 $ .13 -- ============================================================================================================================== 1997: First quarter $206,743 $ 43,528 $ 501 $ .04 $ 4.31 $ 3.25 -- - ------------------------------------------------------------------------------------------------------------------------------ Second quarter 212,573 45,922 250 .02 4.56 3.69 -- - ------------------------------------------------------------------------------------------------------------------------------ Third quarter 206,219 45,187 271 .02 4.63 3.88 -- - ------------------------------------------------------------------------------------------------------------------------------ Fourth quarter 229,481 50,838 130 .01 5.75 4.13 -- - ------------------------------------------------------------------------------------------------------------------------------ $855,016 $185,475 $ 1,152 $ .09 -- ==============================================================================================================================
15 14 REPORT OF INDEPENDENT AUDITORS BOARD OF DIRECTORS DRUG EMPORIUM, INC. We have audited the accompanying consolidated balance sheets of Drug Emporium, Inc. and subsidiaries as of February 28, 1998 and March 1, 1997, and the related consolidated statements of operations, shareholders' equity and cash flows for each of the three years in the period ended February 28, 1998. 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 generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Drug Emporium, Inc. and subsidiaries at February 28, 1998 and March 1, 1997, and the consolidated results of their operations and their cash flows for each of the three years in the period ended February 28, 1998, in conformity with generally accepted accounting principles. /s/ Ernst & Young LLP Columbus, Ohio April 15, 1998 16 EX-23.1 7 EXHIBIT 23.1 1 EXHIBIT 23.1 CONSENT OF INDEPENDENT AUDITORS We consent to the incorporation by reference in the Registration Statements (Forms S-8, Numbers 33-25768 and 33-69638) of Drug Emporium, Inc. and subsidiaries of our report dated April 15, 1998, with respect to the consolidated financial statements of Drug Emporium, Inc. and subsidiaries, incorporated by reference in this Annual Report (Form 10-K) for the year ended February 28, 1998. ERNST & YOUNG LLP Columbus, Ohio May 19, 1998 11 EX-27 8 EXHIBIT 27
5 1,000 12-MOS FEB-28-1998 MAR-02-1997 FEB-28-1998 783 0 17,410 0 167,292 187,177 69,968 43,191 219,784 108,064 56,166 0 0 1,318 50,072 219,784 836,405 836,405 658,116 169,584 (2,092) 0 7,653 3,144 1,453 1,691 0 0 0 1,691 .13 .13
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