SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.

FORM 10-Q/A

Quarterly Report Pursuant to Section 13 or 15 (d) of the Securities and
Exchange Act of 1934

For the quarterly period ended June 26, 2004.

Commission file number 1-13843

 

DUANE READE INC.

(Exact name of registrant as specified in its charter)

DELAWARE			04-3164702
(State or other jurisdiction of incorporation or organization)			(IRS Employer ID Number)
	DRI I Inc.*	Delaware	04-3166107
	Duane Reade*	New York	11-2731721
	Duane Reade International, Inc*	Delaware	22-3672347
	Duane Reade Realty, Inc*	Delaware	13-4074383

 

*                    Guarantors with respect to the Company’s 2.1478% Senior Convertible Notes due 2022

440 Ninth Avenue New York, New York	10001
(Address of principal executive offices)	(Zip Code)
(212) 273-5700
(Registrant’s telephone number, including area code)

 

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in the Exchange Act Rule 12b-2):  Yes x No o

The number of shares of the Common Stock outstanding as of August 4, 2004:  24,538,799

This Form 10-Q/A amends the Company’s quarterly report on Form 10-Q for the quarterly period ended June 26, 2004, as filed on August 5, 2004, to include adjustments to its previously filed consolidated financial statements related to (i) lease accounting under the provisions of FASB Technical Bulletin No. 85-3 (FTB 85-3), (ii) certain inventory resale activity under the provisions of Emerging Issues Task Force release 99-19 (EITF 99-19) and (iii) the classification of outstanding borrowings under the revolving loan facility as current liabilities, rather than as long-term debt as previously reported, because cash receipts controlled by the lenders are used to reduce outstanding debt, and the Company does not meet the criteria of Statement of Financial Accounting Standards No. 6 “Classification of Short Term Obligations Expected to be Refinanced” (FAS 6), to reclassify the debt as long-term, as well as to reflect certain previously unrecorded and immaterial audit adjustments related to the periods affected. This Form 10-Q/A further amends the Company’s quarterly report on Form 10-Q for the fiscal quarter ended June 26, 2004 to include adjustments to its previously filed consolidated statement of cash flows for the first six months of 2004 and 2003 to reflect the reporting of revolving loan borrowings and repayments separately on a gross basis as required under Statement of Financial Accounting Standard No. 95 “Statement of Cash Flows” (FAS 95). It also amends the previously filed Form 10-Q to include in Part 1, Item 4, “Controls and Procedures,” the revised conclusion of the principal executive officer and principal financial officer regarding the effectiveness of the Company’s disclosure controls and procedures as of June 26, 2004. No attempt has been made in this Form 10-Q/A to modify or update other disclosures as presented in the Form 10-Q except to conform to changes as required by applicable law. For further information about the restatements, see “Item 2.—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Restatements.”

INDEX

PART I—FINANCIAL INFORMATION		5
	ITEM 1.—FINANCIAL STATEMENTS	5
	Consolidated Statements of Operations (Unaudited)— For the 13 and 26 Weeks Ended June 26, 2004 and June 28, 2003 (restated)	5
	Consolidated Balance Sheets As of June 26, 2004 (Unaudited) and December 27, 2003 (restated)	6
	Consolidated Statements of Cash Flows (Unaudited)— For the 26 Weeks Ended June 26, 2004 and June 28, 2003 (restated)	7
	Notes to Consolidated Financial Statements (Unaudited)	8
	ITEM 2.—MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	22
	ITEM 3.—MARKET RISK	35
	ITEM 4.—CONTROLS AND PROCEDURES	35
PART II—OTHER INFORMATION		37
SIGNATURES		45

 

This and other of our public filings or public statements contain forward-looking statements within the meaning of Section 27A of the Securities Act, Section 21E of the Securities Exchange Act of 1934 and the Private Securities Litigation Reform Act of 1995, that involve a number of risks and uncertainties. These statements relate to future events or our future financial performance with respect to our financial condition, results of operations, business plans and strategies, operating efficiencies or synergies, competitive positions, growth opportunities for existing products such as private label merchandise, plans

2

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and objectives of management, capital expenditures, growth and maturation of our stores and other matters. These statements involve known and unknown risks, uncertainties and other factors that may cause our or our industry’s actual results, levels of activity, performance or achievements to be materially different from those expressed or implied by any forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “could,” “would,” “should,” “expect,” “plan,” “anticipate,” “intend,” “believe,” “estimate,” “predict,” “potential,” “pro forma,” “seek,” or “continue” or the negative of those terms or other comparable terminology. These statements are only predictions and such expectations may prove to be incorrect. Some of the things that could cause our actual results to differ substantially from our expectations are:

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

·       the ability to open and operate new stores on a profitable basis and to increase sales in existing stores;

·       the continued efforts of health maintenance organizations, managed care organizations, pharmacy benefit management companies and other third party payers to reduce prescription reimbursement rates;

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

·       our significant indebtedness;

·       the strength of the economy in general and the economic conditions in the New York greater metropolitan area, in particular, including changes in consumer purchasing power and/or spending patterns;

·       changes in the cost of goods and services;

·       trends in the healthcare industry, including continued conversion of various prescription drugs to over-the-counter medications and the increasing market share on the part of internet-based and mail-order-based providers;

·       labor disturbances, including any resulting from the suspension or termination of our collective bargaining agreements;

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

·       liability and other claims asserted against us including the items discussed under Part II, Item 1—Legal Proceedings;

·       changes in our operating strategy or development plans;

·       our ability to attract, hire and retain qualified personnel, including our ability to attract qualified pharmacists;

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

·       the outcome of the legal proceedings that have been instituted against us and others following announcement of our merger agreement with Duane Reade Acquisition Corp. and Duane Reade Shareholders, LLC;

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

·       changes in our acquisition and capital expenditure plans;

·       our ability to continue to secure suitable new store locations under acceptable lease terms;

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

·       our ability to limit fraud and shrink;

·       demographic changes; and

·       other risks and uncertainties detailed from time to time in our filings with the Securities and Exchange Commission (the “SEC”).

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

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

4

PART I—FINANCIAL INFORMATION

ITEM 1.     FINANCIAL STATEMENTS

Duane Reade Inc.
Consolidated Statements of Operations (Unaudited)
(In thousands, except per share amounts)

		Restated
		For the 13 Weeks Ended						For the 26 Weeks Ended
		June 26,			June 28,			June 26,			June 28,
		2004			2003			2004			2003
Net sales		$	402,111		$	368,894		$	785,421		$	724,888
Cost of sales		322,726			291,602			629,533			577,016
Gross profit		79,385			77,292			155,888			147,872
Selling, general & administrative expenses		59,924			57,598			118,567			111,472
Labor contingency expense		1,100			—			2,200			—
Transaction expense		1,516			—			2,619			—
Depreciation and amortization		9,239			8,154			18,305			15,712
Store pre-opening expenses		209			229			365			644
		71,988			65,981			142,056			127,828
Operating income		7,397			11,311			13,832			20,044
Interest expense, net		3,257			3,549			6,694			7,066
Debt extinguishment		—			—			—			105
Income before income taxes		4,140			7,762			7,138			12,873
Income tax provision		1,605			3,716			2,850			5,666
Net income		$	2,535		$	4,046		$	4,288		$	7,207
Per common share—basic
Net income		$	0.10		$	0.17		$	0.18		$	0.30
Weighted average common shares outstanding		24,482			24,038			24,446			24,038
Per common share—diluted
Net income		$	0.10		$	0.17		$	0.17		$	0.30
Weighted average common shares outstanding		24,687			24,351			24,646			24,345

 

The accompanying notes are an integral part of these financial statements.

5

Duane Reade Inc.
Consolidated Balance Sheets
(In thousands, except share and per share data)

		Restated
		June 26,					December 27,
		2004					2003
		(Unaudited)
ASSETS
Current Assets
Cash			$	1,328				$	1,252
Receivables, net			53,993					53,430
Inventories, net			259,451					258,139
Deferred income taxes			9,606					10,811
Prepaid expenses and other current assets			16,233					20,263
TOTAL CURRENT ASSETS			340,611					343,895
Property and equipment, net			193,174					189,469
Goodwill, net			161,625					161,318
Deferred income taxes			12,285					13,854
Other assets			98,384					88,836
TOTAL ASSETS			$	806,079				$	797,372
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Accounts payable			$	77,041				$	85,528
Accrued interest			1,544					1,633
Other accrued expenses			29,839					30,086
Current portion of debt			77,307					70,353
Current portion of capital lease obligations			441					422
TOTAL CURRENT LIABILITIES			186,172					188,022
Long-term debt			201,032					201,032
Capital lease obligations, less current portion			878					1,103
Other non-current liabilities			85,321					79,954
TOTAL LIABILITIES			473,403					470,111
Commitments and Contingencies (Note 11)
Stockholders’ equity
Preferred stock, $0.01 par; authorized 5,000,000 shares; issued and outstanding: none			—					—
Series A preferred stock, $0.01 par; authorized 75,000 shares; issued and outstanding: none			—					—
Common stock, $0.01 par; authorized 75,000,000 shares; issued and outstanding; 24,538,799 and 24,403,550 shares, respectively			245					244
Additional paid-in capital			333,043					331,917
Retained deficit			(612		)			(4,900		)
TOTAL STOCKHOLDERS’ EQUITY			332,676					327,261
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY			$	806,079				$	797,372

 

The accompanying notes are an integral part of these financial statements.

6

Duane Reade Inc.
Consolidated Statements of Cash Flows (Unaudited)
(In thousands)

		Restated
		For the 26 Weeks Ended
		June 26,			June 28,
		2004			2003
Cash flows provided by operating activities:
Net income		$	4,288		$	7,207
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		19,260			16,728
Deferred income taxes		2,774			2,848
Debt extinguishment
Non-cash rent expense		3,827			4,759
Changes in operating assets and liabilities (net of the effect of acquisitions):
Receivables		(563		)	(227		)
Inventories		(333		)	(11,438		)
Accounts payable		(8,486		)	2,325
Prepaid and accrued expenses		3,058			(3,110		)
Other assets and liabilities, net		(3,786		)	(5,112		)
NET CASH PROVIDED BY OPERATING ACTIVITIES		20,039			13,980
Cash flows used in investing activities:
Capital expenditures		(16,182		)	(25,795		)
Lease acquisition, customer file and other costs		(11,517		)	(9,903		)
NET CASH USED IN INVESTING ACTIVITIES		(27,699		)	(35,698		)
Cash flows from financing activities:
Repayment of term notes		—			(1,981		)
Retirement of senior subordinated notes		—			(1,621		)
Borrowings from revolving credit facility		798,122			171,500
Repayments of revolving credit facility		(791,168		)	(148,500		)
Proceeds from exercise of stock options		1,126			—
Deferred financing costs		(138		)	(350		)
Repayments of capital lease obligations		(206		)	(271		)
NET CASH PROVIDED BY FINANCING ACTIVITIES		7,736			18,777
Net increase (decrease) in cash		76			(2,941		)
Cash at beginning of period		1,252			4,183
Cash at end of period		$	1,328		$	1,242

 

The accompanying notes are an integral part of these financial statements.

7

Notes to Unaudited Consolidated Interim Financial Statements
(dollars in thousands, except per share data)

1. Basis of Presentation

The Unaudited Consolidated Interim Financial Statements included herein reflect all adjustments which, in the opinion of management, are necessary to present fairly the results of operations, financial position and cash flows of Duane Reade Inc. (the “Company”), and have been prepared, in all material respects, in accordance with the same accounting principles followed in the preparation of the Company’s Annual Consolidated Financial Statements for the year ended December 27, 2003. These Unaudited Consolidated Interim Financial Statements should be read in conjunction with the Company’s Consolidated Financial Statements included in its Annual Report on Form 10-K/A for the year ended December 27, 2003. The Unaudited Consolidated Interim Financial Statements include the accounts of the Company and its subsidiaries. All significant intercompany transactions and balances have been eliminated. Earnings per share amounts are calculated based on the weighted average number of shares outstanding during the period and may not add due to rounding. The results for the interim periods presented are not necessarily indicative of the results expected for the full year.

The Company has no assets or operations other than its investment in its subsidiaries, each of which is a guarantor. Accordingly, the Unaudited Consolidated Interim Financial Statements present the consolidated assets and operations of the subsidiary guarantors. The guarantees of the subsidiary guarantors, which relate to the Company’s obligations under its registered debt and credit agreement, are full and unconditional, joint and several.

2. Restatements

The Company has restated its consolidated financial statements to conform certain accounting practices to the following accounting requirements:

1.     Lease accounting under FASB Technical Bulletin No. 85-3 (FTB 85-3)

2.     Gross versus net sales and cost of sales accounting under Emerging Issues Task Force Release 99-19 (EITF 99-19)

3.     Balance sheet classification of outstanding loan borrowings under the revolving loan facility because cash receipts controlled by the lenders are used to reduce outstanding debt, and the Company does not meet the criteria under FASB No. 6 “Classification of Short-Term Obligations Expected to be Refinanced” (FAS 6) to reclassify the debt as long-term

4.     Reporting of revolving loan facility borrowings and repayments under FASB No. 95 “Statement of Cash Flows” (FAS 95)

5.     Restatements to include certain previously unrecorded and immaterial audit adjustments related to the periods affected.

In connection with these restatements, the Company obtained from the administrative agent under the amended asset-based revolving loan facility, an acknowledgement confirming that these restatements do not constitute an event of technical default, as defined in the document governing the amended asset-based revolving loan facility.

Based upon a review of the Company’s lease accounting methods the Company determined that its previous policy of commencing rent expense when a store opens (and not at the commencement of the lease) was inconsistent with FTB 85-3. For construction purposes, the Company often takes possession of leased properties prior to opening. In accordance with FTB 85-3, the Company will record rent expense

8

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commencing on the date of possession. The Company is restating its previously issued financial statements to reflect certain resales of retail inventory on a gross revenue and cost of sales basis in accordance with EITF 99-19, rather than on a net basis as previously reported. The Company is restating its previously reported balance sheets for June 26, 2004 and December 27, 2003 to reflect the classification of outstanding borrowings under the revolving loan facility as current liabilities rather than as long-term debt, as previously reported. The change is being made because cash receipts controlled by the lenders are used to reduce outstanding debt, and the Company does not meet the criteria of FAS 6 to reclassify the debt as long-term. This is not an indication that this credit facility is expected to be retired within the next year. This facility expires in July 2008 and the Company intends to continue to access it for its working capital needs throughout the remaining term. The Company has also restated its consolidated statement of cash flows for the first six months of 2004 and 2003 to reflect the reporting of revolving loan facility borrowings and repayments separately on a gross basis as required under FAS 95. The effect of these restatements on the consolidated financial statements for the thirteen weeks and twenty-six weeks ended June 26, 2004 and June 28, 2003 is shown below. The Company has identified the source of the restatements from lease accounting (FTB 85-3), gross sales and cost of sales (EITF 99-19) and other previously unrecorded and immaterial adjustments (Other).

Duane Reade Inc.
Consolidated Profit & Loss Restatement
(in thousands)

				For the 13 Weeks Ended						For the 26 Weeks Ended
				June 26, 2004			June 28, 2003			June 26, 2004			June 28, 2003
Sales		as reported		$	365,206		$	355,146		$	714,756		$	688,768
		adjustment—EITF 99-19		36,905			13,748			70,665			36,120
		as restated		$	402,111		$	368,894		$	785,421		$	724,888
Cost of Sales		as reported		$	285,018		$	278,171		$	558,803		$	541,604
		adjustment—EITF 99-19		36,905			13,748			70,665			36,120
		adjustment—FTB 85-3		452			167			760			806
		adjustment—Other		351			(484		)	(695		)	(1,514		)
		as restated		$	322,726		$	291,602		$	629,533		$	577,016
Gross Profit		as reported		$	80,188		$	76,975		$	155,953		$	147,164
		adjustment—FTB 85-3		(452		)	(167		)	(760		)	(806		)
		adjustment—Other		(351		)	484			695			1,514
		as restated		$	79,385		$	77,292		$	155,888		$	147,872
Selling, general and administrative expenses		as reported		$	59,924		$	57,260		$	118,567		$	110,834
		adjustment—Other		—			338			—			638
		as restated		$	59,924		$	57,598		$	118,567		$	111,472
Earnings before tax		as reported		$	4,943		$	7,783		$	7,203		$	12,803
		adjustment		(803		)	(21		)	(65		)	70
		as restated		$	4,140		$	7,762		$	7,138		$	12,873
Income tax provision		as reported		$	1,976		$	3,725		$	2,880		$	5,633
		adjustment		(371		)	(9		)	(30		)	33
		as restated		$	1,605		$	3,716		$	2,850		$	5,666
Net income		as reported		$	2,967		$	4,058		$	4,323		$	7,170
		adjustment		(432		)	(12		)	(35		)	37
		as restated		$	2,535		$	4,046		$	4,288		$	7,207
Net income per common share—basic		as reported		$	0.12		$	0.17		$	0.18		$	0.30
		adjustment		(0.02		)	—			—			—
		as restated		$	0.10		$	0.17		$	0.18		$	0.30
Net income per common share—diluted		as reported		$	0.12		$	0.17		$	0.18		$	0.29
		adjustment		(0.02		)	—			(0.01		)	0.01
		as restated		$	0.10		$	0.17		$	0.17		$	0.30

 

9

Duane Reade Inc.
Consolidated Balance Sheet Restatement
(in thousands)

				As at June 26, 2004												As at December 27, 2003
Caption affected by restatement				As Reported				Adjustment				As Restated				As Reported				Adjustment				As Restated
Receivables					$ 55,063				$ (1,070	)			$ 53,993				$ 53,689				$    (259	)			$ 53,430
Inventory					260,307				(856	)			259,451				259,765				(1,626	)			258,139
Current portion of deferred income taxes					7,265				2,341				9,606				8,150				2,661				10,811
Prepaid & other current assets					16,233				—				16,233				19,504				759				20,263
Total current assets					340,196				415				340,611				342,360				1,535				343,895
Deferred income taxes					3,623				8,662				12,285				5,543				8,311				13,854
Total assets					$ 797,002				$   9,077				$ 806,079				$ 787,526				$   9,846				$ 797,372
Accounts payable					$ 77,041				$         —				$ 77,041				$ 85,258				$      270				$ 85,528
Accrued expenses					28,343				1,496				29,839				27,489				2,597				30,086
Current portion of debt					—				77,307				77,307				—				70,353				70,353
Total current liabilities					107,369				78,803				186,172				114,802				73,220				188,022
Long-term debt					278,339				(77,307	)			201,032				271,385				(70,353	)			201,032
Other noncurrent liabilities					67,645				17,676				85,321				62,915				17,039				79,954
Total liabilities					$ 454,231				$ 19,172				$ 473,403				$ 450,205				$ 19,906				$ 470,111
Retained earnings					$   9,483				$ (10,095	)			$     (612	)			$   5,160				$ (10,060	)			$ (4,900	)
Total stockholders’ equity					$ 342,771				$ (10,095	)			$ 332,676				$ 337,321				$ (10,060	)			$ 327,261
Total liabilities and stockholders’ equity					$ 797,002				$   9,077				$ 806,079				$ 787,526				$   9,846				$ 797,372

 

The adjustments to other noncurrent liabilities and noncurrent deferred income taxes relate to lease accounting under FTB 85-3. The adjustments to debt relate to the classification of the revolving loan balance as a current liability as discussed above. All other balance sheet adjustments relate to other previously unrecorded and immaterial adjustments.

10

Duane Reade Inc.
Consolidated Cash Flow Restatement
(in thousands)

 

				For the 26 Weeks Ended
				6/26/04			6/28/03
Net income		as reported		$	4,323		$	7,170
		adjustment		(35		)	37
		as restated		$	4,288		$	7,207
Deferred income taxes		as reported		$	2,805		$	2,817
		adjustment		(31		)	31
		as restated		$	2,774		$	2,848
Non-cash rent expense and other		as reported		$	3,067		$	4,455
		adjustment		760			304
		as restated		$	3,827		$	4,759
Receivables		as reported		$	(1,374	)	$	(227	)
		adjustment		811			—
		as restated		$	(563	)	$	(227	)
Inventories		as reported		$	437		$	(10,954	)
		adjustment		(770		)	(484		)
		as restated		$	(333	)	$	(11,438	)
Accounts payable		as reported		$	(8,217	)	$	2,189
		adjustment		(269		)	136
		as restated		$	(8,486	)	$	2,325
Prepaid and accrued expenses		as reported		$	3,400		$	(3,229	)
		adjustment		(342		)	119
		as restated		$	3,058		$	(3,110	)
Other assets and liabilities, net		as reported		$	(3,663	)	$	(4,968	)
		adjustment		(123		)	(144		)
		as restated		$	(3,786	)	$	(5,112	)
Net borrowings (repayments) on revolving credit facility		as reported		$	6,954		$	23,000
		adjustment		(6,954		)	(23,000		)
		as restated		$	—		$	—
Borrowings from revolving credit facility		as reported		$	—		$	—
		adjustment		798,122			171,500
		as restated		$	798,122		$	171,500
Repayments of revolving credit facility		as reported		$	—		$	—
		adjustment		(791,168		)	(148,500		)
		as restated		$	(791,168	)	$	(148,500	)

 

11

3. Subsequent Event—Acquisition by Oak Hill Capital Partners, L.P.

On July 30, 2004, the Company was acquired through a merger transaction with Duane Reade Acquisition Corp. (“Duane Reade Acquisition”), a wholly owned subsidiary of Duane Reade Holdings, Inc. and an affiliate of Oak Hill Capital Partners, L.P. (“Oak Hill”), a private equity firm (the “Acquisition”). The Acquisition was accomplished through the merger of Duane Reade Acquisition into Duane Reade Inc., with Duane Reade Inc. being the surviving entity. The transaction was unanimously approved by the independent members of Duane Reade’s board of directors, who resigned from the board on July 30, 2004 in anticipation of the completion of the Acquisition. Under the terms of the merger agreement, which was approved by the Company’s stockholders at a special meeting on July 26, 2004, the Company’s stockholders (other than those who exercise and perfect their appraisal rights) will receive $16.50 per share in cash, without interest. The aggregate value of the merger transaction is approximately $744 million, including transaction expenses and the repayment of indebtedness. The equity financing necessary for the merger was provided by Oak Hill and an affiliate equity fund, Oak Hill Capital Management Partners, L.P. as well as several co-investors selected by Oak Hill to participate in the transaction. The debt financing necessary for the merger was provided by a syndicate of banking institutions led by Banc of America Securities LLC. Mr. Anthony J. Cuti, the Company’s Chairman, President and CEO, the Company’s Senior Vice Presidents and certain other members of management have equity interests in the acquiring entity and have continued in the same management positions after the Acquisition. The new board of directors is comprised of certain executives of Oak Hill and Mr. Cuti. At the special meeting of the Company’s stockholders on July 26, 2004, a total of 15,436,702 shares, representing 62.9 % of the total outstanding shares of common stock as of the June 3, 2004 record date, were voted in favor of the adoption of the merger agreement. As a result of the stockholders’ approval of the merger agreement and the satisfaction of all other conditions to the merger, the merger and related financings were consummated on July 30, 2004.

4. National Labor Relations Board Recommendation

The Company is a party to a National Labor Relations Board (“NLRB”) administrative proceeding regarding a dispute with the Allied Trade Council (“ATC”) over whether a negotiating impasse was reached between the Company and the union in August of 2001. The ATC represents employees in 139 of the Company’s stores pursuant to a collective bargaining agreement that expired on August 31, 2001. The employees have been working pursuant to the terms of the Company’s December 6, 2001 implemented contract with the ATC, which expires on August 31, 2004. The Company believes an impasse did occur and as a result, the Company had the right to implement its latest contract proposal at that time which included wage increases, health and welfare benefits, vacation and sick benefits and a 401(k) retirement program. The Company discontinued making additional payments into the various funds associated with the union as it was providing many of these benefits on a direct basis and because its past contributions to these funds had caused these funds to be in a position of excessive overfunding. In addition, the Company had concerns that its past payments into these funds were not being managed in a way to ensure they were being properly utilized for the benefit of the Company’s employees. On February 18, 2004, an Administrative Law Judge (“ALJ”) who had reviewed various matters related to this proceeding issued a decision and related recommendation, which concluded that the parties were not at impasse. The remedies recommended by the ALJ included, among other things, a requirement for the Company to make its employees whole by reimbursing them for expenses ensuing from the failure to make contributions to the union funds and to make such funds whole, plus interest. If this recommendation is adopted by the full NLRB and enforced by the circuit court of appeals, it could result in the Company being required to contribute amounts that have yet to be determined into the union’s pension benefit, health and welfare and vacation funds. Any potential required contributions resulting from a final judicial determination of this matter would potentially be subject to offset by the amounts that the Company had funded since it implemented its final contract proposal for these same benefits that were paid for its ATC employees.

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Because this is just the first phase of a long and complicated administrative process likely to be followed by a full judicial review of all of the facts and circumstances, the final outcome cannot be reliably determined at this time. The ALJ’s recommendation is not a binding order and has no force and effect of law. Rather, it is a recommendation to the full NLRB in Washington D.C., which will conduct a complete review at some point in the future and decide to uphold, reject or modify the recommendation. The full NLRB decision is also subject to judicial review by the circuit court of appeals and a compliance hearing before any financial remedy can be determined. While there can be no definitive assurance, the Company has been advised by its outside labor counsel that it has numerous meritorious defenses and arguments in response to the ALJ’s recommendation.

In light of the foregoing, while it is the Company’s belief that the final financial outcome of this litigation cannot be determined at this time, under the provisions of Statement of Financial Accounting Standard (“FAS”) No. 5 which addresses contingencies, the Company recorded a pre-tax charge of $12.6 million for the year ended December 27, 2003 and additional pre-tax charges of $1.1 million in each of the quarters ended March 27, 2004 and June 26, 2004. These charges represent the current best estimate of the loss that would result upon application of the ALJ’s recommendation. The Company notes that such charges were based upon the facts available to it at the time. In the Company’s opinion, such charges could be subject to significant modification in the future, upon review by the full NLRB, the Federal Circuit Court of Appeals, completion of a compliance hearing and any appeals relating to the outcome of that hearing. These charges reflect the amount of contributions that the Company did not make into the union benefit funds for the period from the August 31, 2001 expiration of the contract through June 26, 2004, reduced by a portion of the benefits the Company paid directly to or for the benefit of these employees over the same period. It also includes an interest cost for these net contributions from the date they would have been paid until June 26, 2004. While this represents the Company’s current best estimate of the ALJ’s recommendation, the Company believes that the actual range of loss in this matter could be from $0, if the ALJ’s recommendation is not followed, to approximately $29 million, if the ALJ’s recommendation is upheld and there is no offset for any benefits paid over this period.

Until such time as further legal developments warrant a change in the application of this accounting standard, or until this matter is resolved, the Company will record additional non-cash pre-tax charges, including interest, which are calculated on the same basis as the charge recorded in the 2003 financial statements. The Company currently estimates that the pre-tax charge in 2004 will approximate $4.4 million.

5. Inventory and Cost of Sales

At June 26, 2004, inventories, consisting solely of finished goods, would have been greater by $0.9 million if they had been valued on a lower of first-in, first-out (“FIFO”) cost or market basis instead of a last-in, first-out (“LIFO”) basis. Cost of sales includes all store occupancy-related costs and expenses, consisting of lease and sublease-related income and expenses, other recurring real estate-related income and expenses primarily from sales and terminations of leases related to store closings and relocations, sales of market-related data, store utility costs, warehouse expenses and distribution costs. The Company reflects promotional allowances from vendors as a reduction of cost of sales or advertising expense, depending on the nature of the allowance, when such advertising or promotions have been completed and the related allowances have been earned. Other real estate-related income amounted to $1.3 million and $2.1 million in the quarter and six months ended June 26, 2004, respectively, as compared to $0.2 million and $1.4 million in the quarter and six months ended June 28, 2003, respectively. There was no income realized from the sale of market-related data in the second quarter or first six months of either 2004 or 2003.

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6. Recently Issued Accounting Pronouncements

In December 2002, FAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure” was issued. This statement provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. The Company has not adopted such voluntary change to the fair value based method. In addition, this statement amends the disclosure requirements of FAS No. 123 to require prominent disclosures about the method of accounting for stock-based compensation and the effect of the method used on reported results. As required, the Company adopted the disclosure-only provisions of FAS No. 148 effective in 2002.

The Company previously adopted FAS No. 123, “Accounting for Stock-Based Compensation” and, as permitted under FAS No. 123, has elected the disclosure-only provisions. The Company accounts for its stock-based compensation plans under the recognition and measurement principles of APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. There is no stock-based employee compensation cost reflected in net income, as all options granted under those plans had an exercise price equal to or greater than the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of FAS No. 123 to stock-based employee compensation (dollars in thousands):

		For the 13 Weeks Ended										For the 26 Weeks Ended
		June 26,    2004					June 28,    2003					June 26,    2004					June 28,    2003
Net income, as reported (restated)			$	2,535				$	4,046				$	4,288				$	7,207
Adjust: Total stock-based employee compensation (expense)/income determined under fair value based method for all awards, net of related tax effects			(1,136		)			(378		)			(2,272		)			9,018
Pro forma net income (restated)			$	1,399				$	3,668				$	2,016				$	16,225
Income per common share:
Basic—as reported (restated)			$	0.10				$	0.17				$	0.18				$	0.30
Basic—pro forma (restated)			$	0.06				$	0.15				$	0.08				$	0.67
Diluted—as reported (restated)			$	0.10				$	0.17				$	0.17				$	0.30
Diluted—pro forma (restated)			$	0.06				$	0.15				$	0.08				$	0.67
Basic shares			24,482					24,038					24,446					24,038
Diluted shares			24,687					24,351					24,686					24,345

 

As described in previous SEC filings issued during 2003, the Company cancelled 1,337,449 outstanding stock options during the first quarter of 2003 in connection with the Stock Option Exchange Offer. The pro forma income shown in the table above for the six months ending June 28, 2003 includes the reversal of pro forma expenses previously disclosed totaling $9.7 million, related to the granting of these original options. On October 1, 2003, the Company issued 1,320,947 options at an exercise price of $16.55 per share to replace those options exchanged in connection with the Stock Option Exchange Offer. As a result, beginning in the fourth quarter of 2003, the Company has been incurring pro forma compensation expense which reflects the fair value of the replacement stock options granted.

The pro forma compensation income (expense) for stock options has been estimated using the Black-Scholes option pricing model with the following assumptions for each of the periods shown: dividend yield of 0%, expected volatility of 50%, risk free interest rate of 6.6% and an expected term of 8 years. These pro forma disclosures may not be representative of the effects on reported net income for future periods since options vest over several years and options granted prior to 1995 are not considered.

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On July 30, 2004, as a result of the Acquisition, all stock options, whether or not then vested, with an exercise price of $16.50 or more per share were cancelled without any payment therefore, and the remaining “in the money” options (excluding certain management options that were forfeited in connection with the Acquisition), whether or not then vested, with exercise prices of less than $16.50 per share were converted into the right to receive the excess of $16.50 per share over the exercise price of each of the options.

7. Acquisitions

During the second quarter and first six months of fiscal 2004 and fiscal 2003, the Company acquired pharmacy customer files, which were merged into existing stores, and the operations, including certain lease-related assets, of a number of pharmacy establishments, which were operated as new stores. The table below provides details of this acquisition activity for each of the periods presented (dollars in millions).

		For the 13 Weeks Ended										For the 26 Weeks Ended
		June 26,   2004					June 28,   2003					June 26,   2004					June 28,   2003
Customer prescription files			1					2					5					6
Pharmacy establishments			1					—					1					2
Total acquisitions			2					2					6					8
Cash consideration			$	0.9				$	0.4				$	7.4				$	6.0
Total acquisition cost			$	0.9				$	0.4				$	7.4				$	6.0
Purchase price allocation:
Identifiable intangibles			$	0.8				$	0.4				$	6.4				$	3.9
Goodwill			—					—					0.3					0.9
Inventory			0.2					0.1					1.0					1.0
Property and equipment			—					—					—					0.5
Other assets and liabilities, net			(0.1		)			(0.1		)			(0.3		)			(0.3		)
Total			$	0.9				$	0.4				$	7.4				$	6.0

 

The acquired operations have been included in the consolidated statement of operations from the date of acquisition and did not have a material effect on sales, results of operations or earnings per share of the Company for the periods presented.

8. Debt

Debt is composed of the following (in thousands):

				Restated					Restated
Description of Instrument				June 26, 2004					Dec. 27, 2003
Asset-Based Revolving Loan Facility					$	77,307				$	70,353
Total Current Debt					$	77,307				$	70,353
2.1478% Senior Convertible Notes due 2022					$	201,032				$	201,032
Total Non-current Debt					$	201,032				$	201,032
Total Debt					$	278,339				$	271,385

 

2.1478% Senior Convertible Notes due April 16, 2022

On April 16, 2002, the Company completed an offering of $381.5 million aggregate principal amount of Senior Convertible Notes maturing on April 16, 2022 (the “Convertible Notes”). The Convertible Notes were issued at a price of $572.76 per note (57.276% of the principal amount at maturity) and pay cash

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interest at the rate of 2.1478% per year on the principal amount at maturity, payable semi-annually in arrears on April 16 and October 16 of each year beginning on October 16, 2002, until April 16, 2007. After that date, interest will accrue on the notes as amortization of the original issue discount representing a yield to maturity of 3.75% per year, computed on a semi-annual bond equivalent basis. In December 2002, the Company repurchased a total of $30.5 million principal value of the Convertible Notes at an average purchase price of $486.99 per $1,000 note, resulting in the remaining net outstanding balance of $201.0 million.

As more fully detailed in the Registration Statement on Form S-3 filed with the SEC on June 21, 2002, holders of the Convertible Notes may convert each $1,000 in principal amount of their Convertible Notes into 14.1265 shares of the Company’s common stock, subject to adjustment, only if (1) the sale price of the Company’s common stock reaches the “conversion trigger price,” as defined in the indenture governing the Convertible Notes, of $44.60 per share, (2) the trading price of the notes falls below 103% of the “average conversion value,” as defined in the indenture governing the Convertible Notes, (3) the notes are called for redemption, or (4) specified corporate transactions, including a consolidation, merger, or a transfer of all or substantially all of the Company’s assets have occurred. Upon conversion, the Company has the right to deliver, in lieu of its common stock, cash or a combination of cash and common stock in an amount as described in the indenture. These notes are not considered to be potential common shares, and are not included in the calculation of diluted earnings per share, as the Company intends to settle any conversions in cash.

Holders of the Convertible Notes may require the Company to purchase all or a portion of their notes on April 16, 2007 at a price of $572.76 per note plus accrued cash interest, if any; on April 16, 2012 at a price of $689.68 per note plus accrued cash interest, if any; and on April 16, 2017 at a price of $830.47 per note plus accrued cash interest, if any. The Company may choose to pay the purchase price of such notes in cash or common stock or a combination of cash and common stock. In addition, each holder may require the Company to purchase for cash all or a portion of such holder’s notes at a price equal to the sum of the issue price plus accrued original issue discount and accrued cash interest, if any, to the date of purchase if the Company experiences a change of control.

The Acquisition is deemed to be a “change of control” under the indenture governing the Convertible Notes. Within 15 days after the completion of the Acquisition, the Company is required to notify the holders of the Convertible Notes of their option to require the Company to purchase the notes. The Company expects substantially all holders will exercise these repurchase rights, and the Company intends to finance the repurchase of these notes from the funds raised to finance the Acquisition.

In connection with the consummation of the Acquisition, the Company, Duane Reade Shareholders, LLC, the indirect parent of Duane Reade Acquisition Corp. and each of the subsidiaries of the Company that are guarantors of the Convertible Notes entered into a supplemental indenture. Pursuant to the supplemental indenture, as a result of the merger of Duane Reade Acquisition Corp. with and into the Company, the Convertible Notes may only be converted into the right to receive from the Company $16.50 (in cash and without interest) per share of the Company’s common stock issuable to a holder of Convertible Notes in connection with such conversion.

Revolving Credit Facility

On July 21, 2003, the Company completed the refinancing of the Fourth Amended and Restated Credit Agreement entered into by the Company on July 10, 2001 (the “Senior Credit Agreement”). The new credit facility (the “Credit Agreement”) is an asset-based revolving loan which uses a pre-determined percentage of the current value of the Company’s inventory, customer prescription files and selected accounts receivable to calculate the availability of funds eligible to be borrowed up to an aggregate principal amount of $200 million. The obligations of the Company under the Credit Agreement are

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collateralized by substantially all of the assets of the Company. In addition, the Credit Agreement has been guaranteed by each of the Company’s corporate subsidiaries, and such guarantees are collateralized by substantially all assets of such guarantors. The Credit Agreement matures on July 20, 2008.

The Credit Agreement contains a single fixed charge coverage requirement which only becomes applicable when borrowings exceed 90 percent of the borrowing base, as defined in the Credit Agreement. Borrowings under the Credit Agreement have not exceeded 90 percent of the borrowing base and, as a result, the fixed charge covenant did not become applicable during the period. There are no credit ratings related triggers in the Credit Agreement or in the indenture related to the Convertible Notes.

At June 26, 2004, there was $77.3 million outstanding under the revolving credit facility, and approximately $119.8 million of remaining availability, net of $2.9 million reserved for standby letters of credit. Obligations under this facility have been classified as current liabilities because cash receipts controlled by the lenders are used to reduce outstanding debt, and the Company does not meet the criteria of FAS 6 to reclassify the debt as long-term. The Company intends to continue to utilize this facility for its working capital needs though the date of its maturity in July 2008. Borrowings under the Credit Agreement are principally LIBOR-based. The margin on these borrowings is fixed at 1.75% for the first year, and is subject to a sliding scale adjustment thereafter, based on remaining levels of availability.

On July 22, 2004, in connection with the anticipated consummation of the Acquisition, the Credit Agreement was amended (the “Amended Credit Agreement”) to increase the Company’s borrowing capacity to an aggregate principal amount of $250 million, subject to an adjusted borrowing base calculation based upon specified advance rates against the value of the Company’s inventory, customer prescription files and selected accounts receivable. The Amended Credit Agreement includes a $50 million sub-limit for the issuance of letters of credit. Obligations under this revolving loan facility are secured by a first priority security interest in inventory, receivables, pharmacy prescription files and certain other current assets. The Company and Duane Reade, a New York general partnership which is the Company’s principal operating company and of which the Company is a general partner (“Duane Reade GP”), are co-obligors under the amended facility. The amended facility is guaranteed by Duane Reade Holdings and each of Duane Reade Inc.’s domestic subsidiaries other than Duane Reade GP. Revolving loans under the Amended Credit Agreement will, at the Company’s option, bear interest at either (i) a rate equal to LIBOR (the London Interbank Offered Rate) plus a margin of from 1.50% to 2.00%, to be determined based on levels of borrowing availability reset each fiscal quarter or (ii) a rate equal to the prime rate of Fleet Retail Group Inc. plus a margin of from 0.00% to 0.50%, to be determined based on levels of borrowing availability reset each fiscal quarter. Borrowings under the amended facility continue to be primarily LIBOR-based.

Senior Term Loan Facility

On July 30, 2004, in connection with the Acquisition, the Company entered into a Senior Term Loan Facility (the “Senior Term Loan”) in the principal amount of $155 million. This loan will mature on July 30, 2010. While there are no scheduled principal payments over its term, the Company will be required to prepay the senior term loan together with accrued interest thereon, with (a) all net cash proceeds (i) from sales of property and assets by Duane Reade Holdings and its subsidiaries (excluding sales of inventory in the normal course of business and certain other exceptions described in the Senior Term Loan), (ii) of extraordinary receipts as defined in the Senior Term Loan and (iii) from the issuance or incurrence of additional debt of Duane Reade Holdings or any of its subsidiaries other than certain identified indebtedness permitted under the Senior Term Loan, (b) 50.0% of all net cash proceeds from the issuance of additional equity of Duane Reade Holdings or any of its subsidiaries (excluding equity issued to Oak Hill or its affiliates) and (c) 50.0% of excess cash flow of Duane Reade Holdings and its subsidiaries. Loans under the Senior Term Loan facility will, at the Company’s option, bear interest at a rate per annum of (i) the reserve-adjusted LIBOR plus an applicable margin of 3.25%; or (ii) 2.25%, plus

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the higher of (a) the prime rate of Bank of America, N.A. and (b) the Federal Funds rate plus 0.50%. Duane Reade GP became a co-obligor under the Senior Term Loan upon the closing of the Acquisition. All obligations under the Senior Term Loan will be guaranteed by Duane Reade Holdings and each of the Company’s existing and future direct and indirect subsidiaries, other than Duane Reade GP and certain foreign subsidiaries. The Senior Term Loan is secured by a first priority security interest in substantially all of the Company’s assets other than those assets in which the lenders under the Amended Credit Agreement have a first priority interest. The Senior Term loan is also secured by a second priority security interest in all collateral pledged on a first priority basis to lenders under the Amended Credit Agreement. The Senior Term Loan also contains affirmative and negative covenants customary for a senior term loan facility, including, among other things, restrictions on indebtedness, liens, mergers and consolidations, sales of assets, loans, acquisitions, joint ventures, restricted payments, transactions with affiliates, dividends and other payment restrictions affecting subsidiaries and sale leaseback transactions. The Senior Term Loan also requires Duane Reade Holdings and its subsidiaries to maintain a maximum leverage ratio and a minimum interest coverage ratio. There are no credit related triggers in the Senior Term Loan Facility or in the senior subordinated notes described below.

$195 Million 93¤4% Senior Subordinated Notes Due 2011

On July 30, 2004, upon completion of the Acquisition, the Company entered into an Indenture Agreement for $195 million of 93¤4% Senior Subordinated Notes due 2011 (the “Senior Notes”). These notes mature on August 1, 2011 and bear interest at 9.75% per annum payable in semi-annual installments on February 1 and August 1, commencing February 1, 2005. These notes are unsecured obligations and subordinated in right of payment to all of the Company’s existing and future unsubordinated indebtedness, including borrowings under the Amended Credit Agreement and the Senior Term Loan. The notes rank equally with the Company’s senior subordinated indebtedness and senior to the Company’s subordinated indebtedness. These notes are guaranteed on an unsecured senior subordinated basis by all of the Company’s existing direct and indirect domestic subsidiaries other than Duane Reade GP, which is a co-obligor under the Senior Notes. The Company may redeem the notes, in whole or in part, at any time on or after August 1, 2008, at a redemption price of 104.875% declining to par on August 1, 2010, plus accrued and unpaid interest. In addition the Company can redeem up to 35% of the Senior Notes before August 1, 2007 with the net cash proceeds from certain equity offerings. Upon the occurrence of specified change of control events, the Company will be required to make an offer to repurchase all of the Senior Notes at 101% of the outstanding principal amount of the notes plus accrued and unpaid interest to the date of repurchase. The indenture governing the Senior Notes contains certain affirmative and negative covenants that limit the Company’s ability to incur additional indebtedness, pay dividends, make repayments on indebtedness that is subordinated to the Senior Notes and to make certain other restricted payments, incur certain liens, use proceeds from sales of assets, enter into business combination transactions (including mergers, consolidations and asset sales), enter into transactions with affiliates and permit restrictions on the payment of dividends by the Company’s subsidiaries. Under a registration rights agreement entered into as part of the offering of the Senior Notes, the Company is required to (i) file a registration statement within 120 days after the completion of the Acquisition, (ii) use its reasonable best efforts to cause the registration statement to become effective within 180 days after the completion of the Acquisition, and (iii) use its reasonable and best efforts to complete the exchange offer within 210 days after the Acquisition is completed.

9. Net Income per Common Share

Net income per common share is based on the weighted average shares outstanding during each period in accordance with the provisions of FAS No. 128 “Earnings per Share.” Basic earnings per share are computed based on the weighted average number of common shares outstanding during the period. Diluted earnings per share gives effect to all dilutive potential common shares outstanding during the

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period. Dilutive potential common shares include shares issuable upon exercise of the Company’s “in-the-money” stock options. Of the options to purchase 2,078,590 and 1,221,197 shares of common stock outstanding at June 26, 2004 and June 28, 2003, respectively, options to purchase 1,475,932 shares at June 26, 2004 and 195,970 shares at June 28, 2003 were not included in the computation of diluted earnings per share because the exercise prices of such options were greater than the average market price of the common shares and therefore the impact of these shares would be anti-dilutive. Dilutive potential common shares do not include any potential shares that could be issued relative to the Company’s 2.1478% Convertible Notes (see Note 7 to these Unaudited Consolidated Interim Financial Statements for a description of the relevant conversion terms of the Convertible Notes).

The following table sets forth the computation of net income per common share for the periods presented (in thousands, except per share amounts):

		For the 13 Weeks Ended										For the 26 Weeks Ended
		June 26,    2004					June 28,    2003					June 26,    2004					June 28,    2003
Net income (restated)			$	2,535				$	4,046				$	4,288				$	7,207
Weighted average common shares outstanding—basic			24,482					24,038					24,446					24,038
Potential dilutive shares			205					313					240					307
Weighted average common shares outstanding—diluted			24,687					24,351					24,686					24,345
Per common share—basic
Net income (restated)			$	0.10				$	0.17				$	0.18				$	0.30
Per common share—diluted
Net income (restated)			$	0.10				$	0.17				$	0.17				$	0.30

 

10. Income Taxes

Income taxes are recorded based on the estimated combined statutory tax rates expected to be applicable for the full fiscal year less applicable employment related tax credits. The effective tax rate is lower than the combined statutory rates, primarily reflecting the impact of these income tax credits. The effective tax rate of 39.9% recorded in the first six months of 2004 gives effect to the New York State tax legislation passed in May 2003 with retroactive application to January 1, 2003. This legislation effectively eliminated certain royalty fee and related interest expense deductions. The employment tax credits represent the economic benefits earned by the Company for its participation in various federal and state hiring incentive programs. These benefits are based on the number of qualifying employees hired and retained by the Company for a specified time period. Employees qualify for these hiring programs primarily as a result of their enrollment in various economic assistance programs.

11. Commitments and Contingencies

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

During 2002, the Company initiated a legal action against its former property insurance carrier in Federal Court in the Southern District of New York, in an attempt to recover what the Company believes to be a fair and reasonable settlement for the business interruption portion of its claim originating from the September 11, 2001 World Trade Center terrorist attack, during which the Company’s single highest

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volume and most profitable store was completely destroyed. The claim is pending before the United States District Court for the Southern District of New York. In September 2003, a trial on certain issues was held regarding some of the matters at issue in the litigation, including whether the Company would have obtained a renewal of its lease at the World Trade Center. The Company has received a favorable ruling on this and other legal issues in the case and now the matter has moved into an appraisal process. The appraisal process involves two appraisers and an umpire (to resolve differences between the two appraisers) who will determine the amount of insured loss the Company has sustained. The insurance carrier has appealed a number of the rulings by the trial court. In light of both the early state of the appraisal process and the inherent uncertainty in litigation relating to the appeal, the amount of additional insurance proceeds, if any, the Company may collect under the terms of its insurance contract with the defendant cannot be reasonably predicted or determined at this time, and therefore, the Company has not accrued any additional income related to this potential settlement. In fiscal 2002, the Company received an advance of approximately $9.4 million toward its business interruption claim that was recognized as a separate component of income in the Company’s consolidated statement of income. In the event of an unfavorable outcome to the Company, this amount would not be required to be returned to the insurance company.

The Company, Anthony J. Cuti, its Chairman, President and Chief Executive Officer, John K. Henry, its Senior Vice President and Chief Financial Officer, and Gary Charboneau, its Senior Vice President of Sales and Marketing, have been named as defendants in connection with the consolidation of several class action complaints alleging violations of the federal securities laws that were filed from August 2002 through October 2002. The action, which is in the United States District Court for the Southern District of New York, is on behalf of shareholders who purchased Duane Reade Inc.’s common stock between April 1, 2002 and July 24, 2002, inclusive. The complaint, which seeks an unspecified amount of damages, alleges that the defendants violated the federal securities laws by issuing materially false and misleading statements during the class period. On December 1, 2003, the district judge granted the Company’s motion to dismiss the plaintiff’s action, with prejudice. The plaintiffs have filed an appeal. The Company continues to believe that the plaintiffs’ actions are completely baseless and wholly without merit, and intends to continue to vigorously defend itself.

The Company is a defendant in a class action suit in the Federal Court for the Southern District of New York regarding alleged violations of the Fair Labor Standards Act as to a group of individuals who provided delivery services on a contract basis to the Company. In December 2002, the judge in the action issued a partial summary judgment in favor of a subclass of the plaintiffs and against the Company. In December 2003, the Company settled the issue of the amount of its liability to the plaintiffs without any admission of wrongdoing and in an amount consistent with the Company’s previously established reserves. The amount of attorney’s fees owed to the plaintiffs’ attorneys remains an open issue in the case, and the Company plans to vigorously defend claims by these attorneys for fees. It is not anticipated that the amount of attorneys’ fees that would be required to be paid in this matter would be material to the business and operations of the Company.

The Company is a party to related lawsuits, Irving Kroop, et al. v. Duane Reade, NY, NY et al., 00 Civ. 9841, et al., instituted by the trustees of several union benefit funds wherein the funds claim that the Company did not make certain required contributions to these funds from January 2000 through August 2001. The plaintiffs have recently filed a motion seeking summary judgment of $2.29 million of claims for alleged underfunding, including related penalties and interest. In addition, at various times, the plaintiffs have stated that they believe the Company may owe additional amounts. However, any additional amounts that the plaintiffs may claim are not known at this time. The Company has filed a motion opposing these claims. The Company believes that it has made sufficient contributions to these funds and that it has meritorious defenses to the claims being made by these funds. Accordingly, the Company intends to vigorously defend itself in these matters. At this time, it is not possible to determine the ultimate outcome of this case or the actual amount of liability the Company may face, if any.

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