**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C.**

 

**FORM 10-Q**

 

**QuarterlyReport Pursuant to Section 13 or 15 (d) of the Securities and Exchange Actof 1934**

 
| **For  the quarterly period ended September 27, 2003.** |   | **Commission file number 333-41239** |
|--------------------------------------------------------------|--------|--------------------------------------|

 

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**DUANE READE INC.**

(Exactname 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** |

 

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*  Guarantors with respect tothe 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) |       |
|                                           |                                                           |            |  |  |

 

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**Securities registered pursuant toSection 12(b) of the Act:**

 
| **Title of  each class**               |   | **Name of  each exchange on which registered** |
|----------------------------------------|--------|------------------------------------------------|
| Common Stock, $.01 par value per share |   | New York Stock Exchange. Inc.                  |

 

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| **Securities registered pursuant to  Section 12 (g) of the Act:** |
|------------------------------------------------------------------------|
| None.                                                                  |

 

Indicate by check mark whether the registrant: (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.  Yes  ý  No  o

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in the Exchange Act Rule 12b-2): Yes  ýNo  o

 

The number ofshares of the Common Stock outstanding as of November 6, 2003: **24,037,742**

 

 

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INDEX

 
| PART I – FINANCIAL  INFORMATION |                                                                                                                                   |   |   |
|--------------------------------------|----------------------------------------------------------------------------------------------------------------------------------------|--------|--------|
|                                 |                                                                                                                                   |   |   |   |
|                                 | ITEM 1. – FINANCIAL  STATEMENTS                                                                                                   |   |
|                                 |                                                                                                                                   |   |   |   |
|                                 | Consolidated  Statements of Operations (Unaudited) -For  the 13 and 39 Weeks Ended September 27, 2003 and September 28, 2002 |   |
|                                 |                                                                                                                                   |   |   |   |
|                                 | Consolidated Balance SheetsAs of September 27,  2003 (Unaudited) and December 28, 2002                                       |   |
|                                 |                                                                                                                                   |   |   |   |
|                                 | Consolidated  Statements of Cash Flows (Unaudited) -For  the 39 Weeks Ended September 27, 2003 and September 28, 2002        |   |
|                                 |                                                                                                                                   |   |   |   |
|                                 | Notes to  Consolidated Financial Statements (Unaudited)                                                                                |   |
|                                 |                                                                                                                                   |   |   |   |
|                                 | ITEM  2. – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION  AND RESULTS OF OPERATIONS                             |   |
|                                 |                                                                                                                                   |   |   |   |
|                                 | ITEM 3. – MARKET RISK                                                                                                             |   |
|                                 |                                                                                                                                   |   |   |   |
|                                 | ITEM 4. – CONTROLS AND PROCEDURES                                                                                                 |   |
|                                 |                                                                                                                                   |   |   |   |
| PART II – OTHER INFORMATION     |                                                                                                                                   |   |   |
|                                 |                                                                                                                                   |   |   |   |
| SIGNATURES                           |                                                                                                                                   |   |   |
|                                      |                                                                                                                                        |        |        |  |  |

 

Forward-looking statements in our public filings orother public statements are subject to known and unknown risks, uncertaintiesand other factors which may cause our actual results, performance orachievements to be materially different from any future results, performance orachievements expressed or implied by such forward-looking statements. These forward-lookingstatements were based on various factors and were derived utilizing numerousassumptions and other important factors that could cause actual results todiffer materially from those in the forward-looking statements. Forward-lookingstatements include the information concerning our future financial performance,business strategy, projected plans and objectives. Statements preceded by,followed by or that otherwise include the words “believes”, “expects”,“anticipates”, “intends”, “projects”, “estimates”, “plans”, “may increase”,“may fluctuate” and similar expressions or future or conditional verbs such as“will”, “should”, “would”, “may”, “might” and “could” are generallyforward-looking in nature and not historical facts. You should understand thatthe following important factors and assumptions could affect our future resultsand could cause actual results to differ materially from those expressed insuch forward-looking statements:

 

•                  thecompetitive environment in the drugstore industry in general and in themetropolitan New York area;

 

•                  thecontinued efforts of health maintenance organizations, managed careorganizations, pharmacy benefit management companies and other third partypayers to reduce prescription reimbursement rates;

 

•                  thecontinued efforts of Federal, State and municipal government agencies to reduceMedicaid reimbursement rates, modify Medicare benefits and/or reduceprescription drug costs;

 

2

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•                  thestrength of the economy in general and the economic conditions in themetropolitan New York area, in particular, including changes in consumerpurchasing power and/or spending patterns;

 

•                  changesin cost of goods and services;

 

•                  trendsin the healthcare industry, including continued conversion of variousprescription drugs to over-the-counter medications;

 

•                  changesin federal and state laws and regulations, including the potential impact ofchanges in regulations surrounding the importation of pharmaceuticals fromforeign countries;

 

•                  liabilityand other claims asserted against us;

 

•                  changesin our operating strategy or development plans;

 

•                  ourability to attract, hire and retain qualified personnel, including our abilityto attract qualified pharmacists;

 

•                  oursignificant indebtedness;

 

•                  interestrate fluctuations and changes in capital market conditions or other eventsaffecting our ability to obtain necessary financing on favorable terms to fundthe anticipated growth of our business;

 

•                  labordisturbances, including any resulting from the suspension or termination of ourcollective bargaining agreements;

 

•                  thecontinued impact of, or new occurrences of, terrorist attacks in the New YorkCity metropolitan area;

 

•                  changesin our acquisition and capital expenditure plans;

 

•                  ourability to continue to secure suitable new store locations under acceptablelease terms;

 

•                  ourability to successfully implement and manage new computer systems andtechnologies;

 

•                  demographicchanges; and

 

•                  otherrisks and uncertainties detailed from time to time in our filings with theSecurities and Exchange Commission.

 

Other factors and assumptions not identified abovewere also involved in the derivation of these forward-looking statements, andthe failure of such other assumptions to be realized as well as other factorsmay also cause actual results to differ materially from those projected. Mostof these factors are difficult to predict accurately and are generally beyondour control.

 

You should consider theareas of risk described above in connection with any forward-looking statementsthat may be made by us generally. Except for our ongoing obligations todisclose material information under the federal securities laws, we undertakeno obligation to release publicly any revisions to any forward-lookingstatements, to report events or to report the occurrence of unanticipatedevents unless required by law. For any forward-looking statements contained inany document, we claim the protection of the safe harbor for forward-lookingstatements contained in the Private Securities Litigation Reform Act of 1995.

 

 

3

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**PART I - FINANCIAL INFORMATION**

**ITEM 1.  FINANCIAL STATEMENTS**

 

**Duane Reade Inc.**

Consolidated Statements ofOperations (Unaudited)

(Inthousands, except per share amounts)

 
|                                                                         |   | **For the 13  Weeks Ended**  |    | **For the 39  Weeks Ended**  |   |
|------------------------------------------------------------------------------|--------|------------------------------|---------|------------------------------|--------|
|                                                                         |   | **September 27,  2003** |    | **September 28,  2002** |   | **September 27,  2003** |   | **September 28,  2002** |   |
|                                                                         |   |                         |    |                         |   |   |   |   |   |
| Net sales                                                                    |   | $                            | 338,630 |                         | $      | 312,818 |   | $ | 1,027,398 |   | $ | 943,376 |   |
| Cost of sales                                                                |   | 266,520                      |    | 240,047                      |   | 808,124 |   | 732,669 |   |
|                                                                         |   |                         |    |                         |   |   |   |   |   |
| Gross profit                                                                 |   | 72,110                       |    | 72,771                       |   | 219,274 |   | 210,707 |   |
|                                                                         |   |                         |    |                         |   |   |   |   |   |
| Selling, general & administrative expenses                               |   | 56,296                       |    | 48,921                       |   | 167,130 |   | 145,078 |   |
| Insurance recovery                                                           |   | —                       |    | —                       |   | — |   | (9,378 | ) |
| Depreciation and amortization                                                |   | 8,162                        |    | 6,874                        |   | 23,874 |   | 20,377 |   |
| Store pre-opening expenses                                                   |   | 154                          |    | 265                          |   | 798 |   | 1,610 |   |
|                                                                         |   | 64,612                       |    | 56,060                       |   | 191,802 |   | 157,687 |   |
|                                                                         |   |                         |    |                         |   |   |   |   |   |
| Operating income                                                             |   | 7,498                        |    | 16,711                       |   | 27,472 |   | 53,020 |   |
|                                                                         |   |                         |    |                         |   |   |   |   |   |
| Interest expense, net                                                        |   | 3,386                        |    | 3,706                        |   | 10,452 |   | 14,375 |   |
| Debt extinguishment                                                          |   | 707                          |    | 325                          |   | 812 |   | 13,432 |   |
|                                                                         |   |                         |    |                         |   |   |   |   |   |
| Income before income taxes and cumulative effect of  accounting  change |   | 3,405                        |    | 12,680                       |   | 16,208 |   | 25,213 |   |
| Income taxes                                                                 |   | 1,499                        |    | 4,896                        |   | 7,132 |   | 9,837 |   |
| Income before cumulative effect of accounting change                         |   | 1,906                        |    | 7,784                        |   | 9,076 |   | 15,376 |   |
| Cumulative effect of accounting change,  net of  income taxes           |   | —                       |    | —                       |   | — |   | (9,262 | ) |
| Net income                                                                   |   | $                            | 1,906   |                         | $      | 7,784 |   | $ | 9,076 |   | $ | 6,114 |   |
|                                                                         |   |                         |    |                         |   |   |   |   |   |
| Per Common Share – Basic                                                |   |                         |    |                         |   |   |   |   |   |
|                                                                         |   |                         |    |                         |   |   |   |   |   |
| Income before cumulative effect of accounting  change                        |   | $                            | 0.08    |                         | $      | 0.32 |   | $ | 0.38 |   | $ | 0.65 |   |
| Cumulative effect of accounting change,  net of  income taxes           |   | —                       |    | —                       |   | — |   | (0.39 | ) |
| Net income                                                                   |   | $                            | 0.08    |                         | $      | 0.32 |   | $ | 0.38 |   | $ | 0.26 |   |
|                                                                         |   |                         |    |                         |   |   |   |   |   |
| Weighted Average Common Shares Outstanding                                   |   | 24,038                       |    | 23,948                       |   | 24,038 |   | 23,816 |   |
|                                                                         |   |                         |    |                         |   |   |   |   |   |
| Per Common Share – Diluted                                              |   |                         |    |                         |   |   |   |   |   |
|                                                                         |   |                         |    |                         |   |   |   |   |   |
| Income before cumulative effect of accounting  change                        |   | $                            | 0.08    |                         | $      | 0.32 |   | $ | 0.37 |   | $ | 0.63 |   |
| Cumulative effect of accounting change,  net of  income taxes           |   | —                       |    | —                       |   | — |   | (0.38 | ) |
| Net income                                                                   |   | $                            | 0.08    |                         | $      | 0.32 |   | $ | 0.37 |   | $ | 0.25 |   |
|                                                                         |   |                         |    |                         |   |   |   |   |   |
| Weighted Average Common Shares Outstanding                                   |   | 24,415                       |    | 24,424                       |   | 24,355 |   | 24,574 |   |

 

Theaccompanying notes are an integral part of these financial statements.

 

4

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**Duane ReadeInc.**

Consolidated Balance Sheets

(In thousands, except share and per share data)

 
|                                                                                              |   | **September 27,****  2003** |    | **December 28,****  2002** |   |
|---------------------------------------------------------------------------------------------------|--------|---------------------------------------|---------|--------------------------------------|--------|
|                                                                                              |   | **(Unaudited)**                       |    |                                 |   |
| ASSETS                                                                                            |   |                                  |    |                                 |   |
| Current Assets                                                                                    |   |                                  |    |                                 |   |
| Cash                                                                                              |   | $                                     | 1,303   |                                 | $      | 4,183 |   |
| Receivables                                                                                       |   | 63,125                                |    | 62,008                               |   |
| Inventories                                                                                       |   | 244,224                               |    | 220,338                              |   |
| Deferred income taxes                                                                             |   | 3,514                                 |    | 5,416                                |   |
| Prepaid expenses and other current assets                                                         |   | 20,621                                |    | 16,006                               |   |
| TOTAL CURRENT ASSETS                                                                              |   | 332,787                               |    | 307,951                              |   |
|                                                                                              |   |                                  |    |                                 |   |
| Property and equipment, net                                                                       |   | 188,668                               |    | 169,507                              |   |
| Goodwill, net of accumulated amortization of $35,323                                              |   | 161,318                               |    | 160,403                              |   |
| Deferred income taxes                                                                             |   | 2,685                                 |    | 6,489                                |   |
| Other assets                                                                                      |   | 89,581                                |    | 85,173                               |   |
| TOTAL ASSETS                                                                                      |   | $                                     | 775,039 |                                 | $      | 729,523 |   |
|                                                                                              |   |                                  |    |                                 |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                         |   |                                  |    |                                 |   |
| Current liabilities                                                                               |   |                                  |    |                                 |   |
| Accounts payable                                                                                  |   | $                                     | 69,833  |                                 | $      | 57,776 |   |
| Accrued interest                                                                                  |   | 3,597                                 |    | 2,192                                |   |
| Other accrued expenses                                                                            |   | 28,024                                |    | 27,453                               |   |
| Current portion of long-term debt                                                                 |   | —                                |    | 3,962                                |   |
| Current portion of capital lease obligations                                                      |   | 412                                   |    | 472                                  |   |
| TOTAL CURRENT LIABILITIES                                                                         |   | 101,866                               |    | 91,855                               |   |
|                                                                                              |   |                                  |    |                                 |   |
| Long-term debt, less current portion                                                              |   | 283,448                               |    | 263,782                              |   |
| Capital lease obligations, less current portion                                                   |   | 1,212                                 |    | 1,525                                |   |
| Other non-current liabilities                                                                     |   | 49,570                                |    | 42,493                               |   |
| TOTAL LIABILITIES                                                                                 |   | 436,096                               |    | 399,655                              |   |
|                                                                                              |   |                                  |    |                                 |   |
| Commitments and Contingencies (Note 12)                                                           |   |                                  |    |                                 |   |
|                                                                                              |   |                                  |    |                                 |   |
| 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: 24,037,742 shares |   | 240                                   |    | 240                                  |   |
| Paid-in capital                                                                                   |   | 329,542                               |    | 329,542                              |   |
| Retained earnings                                                                                 |   | 9,161                                 |    | 86                                   |   |
| TOTAL STOCKHOLDERS’ EQUITY                                                                   |   | 338,943                               |    | 329,868                              |   |
|                                                                                              |   |                                  |    |                                 |   |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                   |   | $                                     | 775,039 |                                 | $      | 729,523 |   |

 

Theaccompanying notes are an integral part of these financial statements.

 

5

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**Duane ReadeInc.**

ConsolidatedStatements of Cash Flows (Unaudited)

(In thousands)

 
|                                                                               |   | **For the 39 Weeks Ended**   |   |
|------------------------------------------------------------------------------------|--------|------------------------------|--------|
|                                                                               |   | **September 27,  2003** |   | **September 28,  2002** |   |
| Cash flows provided by operating activities:                                       |   |                         |   |   |   |
| Net income                                                                         |   | $                            | 9,076  |   | $ | 6,114 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities: |   |                         |   |   |   |
| Depreciation and amortization                                                      |   | 25,333                       |   | 21,740 |   |
| Deferred income taxes                                                              |   | 5,706                        |   | 15,754 |   |
| Cumulative effect of accounting change, net of tax                                 |   | —                       |   | 9,262 |   |
| Other                                                                              |   | 7,110                        |   | 4,694 |   |
| Changes in operating assets and liabilities (net of  the effect of acquisitions):  |   |                         |   |   |   |
| Receivables                                                                        |   | (1,117                       | )      | 538 |   |
| Inventories                                                                        |   | (22,767                      | )      | (16,558 | ) |
| Accounts payable                                                                   |   | 12,057                       |   | (14,581 | ) |
| Prepaid and accrued expenses                                                       |   | (259                         | )      | 299 |   |
| Other assets and liabilities, net                                                  |   | (5,375                       | )      | (7,597 | ) |
| NET CASH PROVIDED BY OPERATING ACTIVITIES                                          |   | 29,764                       |   | 19,665 |   |
|                                                                               |   |                         |   |   |   |
| Cash flows used in investing activities:                                           |   |                         |   |   |   |
| Capital expenditures                                                               |   | (34,523                      | )      | (36,400 | ) |
| Lease acquisition, customer file and other costs                                   |   | (11,261                      | )      | (8,159 | ) |
| NET CASH USED IN INVESTING ACTIVITIES                                              |   | (45,784                      | )      | (44,559 | ) |
|                                                                               |   |                         |   |   |   |
| Cash flows from financing activities:                                              |   |                         |   |   |   |
| Proceeds from convertible note offering                                            |   | —                       |   | 218,501 |   |
| Repayment of term loans                                                            |   | (65,091                      | )      | (90,217 | ) |
| Net borrowing (repayment) of revolving credit facility                             |   | 82,416                       |   | (10,000 | ) |
| Retirement of senior subordinated notes                                            |   | (1,621                       | )      | (78,379 | ) |
| Proceeds from exercise of stock options                                            |   | —                       |   | 1,157 |   |
| Deferred financing costs                                                           |   | (2,191                       | )      | (8,000 | ) |
| Repayments of capital lease obligations                                            |   | (373                         | )      | (1,017 | ) |
| NET CASH PROVIDED BY FINANCING ACTIVITIES                                          |   | 13,140                       |   | 32,045 |   |
|                                                                               |   |                         |   |   |   |
| Net (decrease) increase in cash                                                    |   | (2,880                       | )      | 7,151 |   |
| Cash at beginning of period                                                        |   | 4,183                        |   | 4,972 |   |
| Cash at end of period                                                              |   | $                            | 1,303  |   | $ | 12,123 |   |

 

Theaccompanying notes are an integral part of these financial statements.

 

6

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**Notesto Consolidated Financial Statements**

**(Unaudited, dollars in thousands, except per share data)**

 

**1. Basis of Presentation**

 

The UnauditedConsolidated Financial Statements included herein reflect all adjustments(consisting of normal recurring items) which, in the opinion of management, arenecessary to present fairly the results of operations, financial position andcash flows of Duane Reade Inc. (the “Company”), and have been prepared, in allmaterial respects, in accordance with the same accounting principles followedin the preparation of the Company’s annual financial statements for the yearended December 28, 2002. These financial statements should be read inconjunction with the Company’s financial statements included in its AnnualReport on Form 10-K for the year ended December 28, 2002. The UnauditedConsolidated Financial Statements include the accounts of the Company and itssubsidiaries.  All significantintercompany transactions and balances have been eliminated. Cost of salesincludes all store occupancy related costs and expenses, consisting of leaseand sublease related income and expenses, other recurring real estate relatedincome and expenses primarily from sales and terminations of leases related tostore closings and relocations, sales of market related data, store utilitycosts and warehouse expenses and distribution costs. The Company reflects promotionalallowances from vendors as a reduction of cost of sales or advertising expense,depending on the nature of the allowance, when such advertising or promotionshave been completed and the related allowances have been earned. Otherrecurring real estate related income and income from sales of market relateddata amounted to $0.1 million and $1.4 million, for the three and nine monthsended September 27, 2003, respectively, as compared to $3.7 million and$4.8 million, for the three and nine months ended September 28, 2002,respectively. Earnings per share amounts are calculated based on the weightedaverage number of shares outstanding during the period and may not add due torounding. The results for the interim periods presented are not necessarily indicativeof the results expected for the full year.

 

The Company has no assetsor operations other than its investment in its subsidiary guarantors.Accordingly, the Unaudited Consolidated Financial Statements present thecombined assets and operations of the subsidiary guarantors. The guarantees ofthe subsidiary guarantors, which relate to the Company’s obligations under itsrecently enacted Credit Agreement (more clearly described in Note 5), are fulland unconditional, joint and several.

 

**2. World Trade Center Disaster and Related BusinessInterruption and Property Losses**

 

On September 11,2001, a terrorist attack on the World Trade Center complex in downtownManhattan resulted in the total destruction of that landmark and significantdisruption of commerce throughout the entire city, within which most of theCompany’s stores are located. The attack resulted in the complete loss of twostores. During the fourth quarter of 2001, the Company received insurancereimbursement for a portion of the property losses associated with thisdisaster. In fiscal 2002, the remaining September 11th related propertylosses were reimbursed and the Company recorded approximately $9.4 milliontoward its business interruption claim that was recognized as a separate itemof income in the second quarter of fiscal 2002. This business interruptionrecovery represented a partial payment of the Company’s losses and the Companyis currently in litigation with the insurance carrier to recover the balance ofits business interruption claim. Additional insurance recoveries for thebusiness interruption portion of the Company’s insurance claim, which, if any,could be material, will be recognized when collection of such recoveries isassured.  Litigation expenses associatedwith this insurance recovery are being expensed as incurred.

 

**3. Accounting Change**

 

Asof December 30, 2001, the Company adopted a change in accounting method toconvert from the retail dollar first-in, first-out (“FIFO”) method to aspecific cost based last-in, first-out (“LIFO”) method. Adoption of thespecific cost LIFO method more accurately values inventory by eliminating theaveraging inherent in the retail method. In addition, the specific cost LIFOmethod reflects the impact of inflation in the Company’s gross margin. Theeffect of changing from the retail FIFO method to the specific cost LIFO methodwas a reduction in inventory of $16.0 million, resulting in a cumulative effectof an accounting change as of December 30, 2001 of approximately $9.3million, net of an income tax benefit of $6.7 million ($0.39 per basic commonshare and $0.38 per diluted common share, respectively).

 

7

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**4. Inventory**

 

AtSeptember 27, 2003, inventories would have been greater by $0.4 million ifthey had been valued on a lower of FIFO cost or market basis.

 

**5. Debt**

 

Long-term debt iscomposed of the following (in thousands):

 
| **Description of Instrument**              |   | **Balance at  Sept. 27, 2003** |        | **Balance at  Dec. 28, 2002** |   |
|--------------------------------------------|--------|--------------------------------|-------------|-------------------------------|--------|
|                                       |   |                           |        |                          |   |
| 2.1478%  Senior Convertible Notes due 2022 |   | $                              | 201,032     |                          | $      | 201,032 |   |
| Revolving  credit facility                 |   | 82,416                         |        | —                        |   |
| Term  loan facility                        |   | —                         |        | 65,091                        |   |
| 9.25%  Senior Subordinated Notes           |   | —                         |        | 1,621                         |   |
|                                       |   | 283,448                        |        | 267,744                       |   |
| Less  – Current portion               |   | —                         |        | 3,962                         |   |
|                                       |   | **$**                          | **283,448** |                          | **$**  | **263,782** |   |

 

**2.1478% Senior Convertible Notes dueApril 16, 2022:* ***OnApril 16, 2002, the Company completed an offering of $381.5 millionaggregate principal amount of Senior Convertible Notes maturing onApril 16, 2022 (the “Convertible Notes”). The Convertible Notes wereissued at a price of $572.76 per note (57.276% of the principal amount atmaturity) and pay cash interest at the rate of 2.1478% per year on theprincipal amount at maturity, payable semi-annually in arrears on April 16and October 16 of each year beginning on October 16, 2002, untilApril 16, 2007. After that date, interest will accrue on the notes asamortization of the original issue discount representing a yield to maturity of3.75% per year, computed on a semi-annual bond equivalent basis. In December2002, the Company repurchased a total of $30.5 million principal value of theConvertible 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 inthe Registration Statement on Form S-3 filed with the Securities and ExchangeCommission on June 21, 2002, holders of the Convertible Notes may converteach $1,000 in principal amount of their convertible notes into 14.1265 sharesof the Company’s common stock, subject to adjustment, only if (1) the saleprice of the Company’s common stock reaches the “conversion trigger price,” asdefined, of $44.60 per share, (2) the trading price of the notes falls below103% of the “average conversion value,” as defined, (3) the notes are calledfor redemption, or (4) specified corporate transactions, including aconsolidation, merger, or a transfer of all or substantially all of theCompany’s assets have occurred. Upon conversion, the Company has the right todeliver, in lieu of its common stock, cash or a combination of cash and commonstock in an amount as described in the indenture. These notes are notconsidered to be potential common shares, and are not included in thecalculation of diluted earnings per share, as the Company intends to settle anyconversions in cash.

 

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

 

The Company may redeemfor cash all or a portion of the convertible notes at any time afterApril 16, 2007, at a price equal to the sum of the issue price plusaccrued original issue discount and accrued cash interest, if any, to theredemption date.

 

8

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**Revolving credit facility: **On July 21, 2003, the Company completed therefinancing of the Senior Credit Agreement. The new credit facility (the “CreditAgreement”) is an asset-based revolving loan which uses a pre-determinedpercentage of the current value of the Company’s inventory and selectedaccounts receivable to calculate the availability of funds eligible to beborrowed up to an aggregate principal amount of $200 million. The obligationsof the Company under the Credit Agreement are secured by substantially all ofthe assets of the Company. In addition, the Credit Agreement has beenguaranteed by each of the Company’s corporate subsidiaries, and such guaranteesare secured by substantially all assets of such guarantors.  The Credit Agreement matures onJuly 20, 2008.

 

Under the new facility,approximately $184 million was initially available, of which approximately$103.5 million was borrowed and used to repay in full the outstanding balancesof Term A, Term B and revolver borrowings ($101.6 million) under the SeniorCredit Agreement, as well as accumulated interest to the repayment date andcertain expenses associated with the new financing ($1.9 million).  Upon closing and repayment of alloutstanding borrowings and related costs, the Company had approximately $80million of additional availability under this new Credit Agreement, and theSenior Credit Agreement has been terminated. At September 27, 2003, therewas $82.4 million outstanding under the revolving credit facility, andapproximately $114.4 million of remaining availability, net of $2.0 millionreserved for standby letters of credit.

 

**6. Debt Extinguishment**

 

As previouslydetailed in Note 5, during the third quarter of 2003, the Company refinancedits Senior Credit Agreement with an asset-based revolving loan agreement. Inconnection with the refinancing and termination of the Senior Credit Agreement,the Company recorded a $0.7 million debt extinguishment charge, representingthe accelerated amortization of the remaining deferred financing costsassociated with the term loan and revolving borrowings that were fully repaidas a result of the refinancing. During the first quarter of 2003, the Companyretired the remaining $1.6 million principal amount of the outstanding 9.25%Senior Subordinated Notes due 2008 (the “Senior Notes”). In connection withthis retirement, the Company recorded a $0.1 million debt extinguishmentcharge, representing the premium paid to the holders of the Senior Notes andthe accelerated amortization of deferred financing costs associated with theSenior Notes retired. The total cash outlay required for this retirement,including principal ($1.6 million), early termination premiums ($0.1 million)and accrued interest earned from August 15, 2002 to the payment date ($0.1million), amounted to approximately $1.8 million.

 

In the third quarter of2002, the Company recorded debt extinguishment charges of $0.3 million, reflectingthe accelerated amortization of deferred financing costs related to SeniorCredit Agreement loans repaid with proceeds from the 2002 convertible noteoffering. In the second quarter of 2002, the Company recorded debtextinguishment charges of $13.1 million, reflecting (a) $2.1 million ofaccelerated amortization of deferred financing costs related to Senior CreditAgreement loans repaid and Senior Notes retired with proceeds from the 2002convertible note offering, (b) $7.1 million for payment of consent premiums andexpenses related to the Senior Note tender offer and (c) $3.9 million relatedto the termination of an interest rate swap agreement. In accordance with theprovisions of FAS 145, which became effective January 1, 2003, these debtextinguishment costs, which were shown previously as extraordinary items totaling $7.9 million, net of a 41.0%income tax provision, were reclassified and are now included as a component ofincome before income taxes and cumulative effect of accounting change. Reportednet income was unaffected, and the Company’s results of operations, financialposition and cash flows were not impacted by this reclassification.

 

9

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**7. Stock Option Exchange Offer**

 

On February 27, 2003,the Company offered each eligible employee the opportunity to exchange all ofhis or her currently outstanding options to purchase shares of the Company’scommon stock granted under the 1992 Stock Option Plan or the 1997 EquityParticipation Plan with an exercise price equal to or in excess of $16 pershare (other than certain options granted on May 7, 1999 pursuant to theCompany’s Deferred Compensation Stock Grant Program). At the close of the offeron March 27, 2003, the Company accepted for exchange and cancellationoptions to purchase an aggregate of 1,337,449 shares of common stock.  On October 1, 2003, the Company granted1,320,947 options to replace those previously exchanged. Each new option issuedas a result of the exchange has an exercise price of $16.55 per share,reflecting the average closing price of the Company’s common stock as reportedon the New York Stock Exchange for the five-day trading period endingimmediately prior to the October 1 grant date. Each new option has a ten yearterm and vests in three equal annual installments, beginning on the firstanniversary of the date of grant, except under certain change of controlevents, in which case the new options immediately become fully vested. Thedifference between the number of options originally exchanged and the number ofoptions issued on October 1, 2003, represents options held by individualswho resigned or were terminated prior to the grant date and whose options werenot reissued. This grant of stock options is considered non-compensatory, asthe closing price of the Company’s common stock on the grant date, $16.30 pershare, was less than the exercise price of the options granted.

 

**8. Acquisitions**

 

During the third quarterand first nine months of fiscal 2003 and fiscal 2002, the Company acquiredpharmacy customer files (which were merged into existing stores) and theoperations, including certain lease-related assets, of a number of pharmacyestablishments (which were operated as new stores).  The table below provides details of this acquisition activity foreach of the periods presented (dollars in millions).

 
|                         |   | **For the 13 Weeks Ended** |   | **For the 39 Weeks Ended** |   |
|------------------------------|--------|----------------------------|--------|----------------------------|--------|
|                         |   | **Sept 27,  2003**         |   | **Sept 28,  2002**         |   | **Sept 27,  2003** |   | **Sept 28,  2002** |   |
|                         |   |                       |   |                       |   |   |   |   |   |
| Customer  prescription files |   | 1                          |   | 3                          |   | 7 |   | 9 |   |
| Pharmacy  establishments     |   | —                     |   | —                     |   | 2 |   | 7 |   |
| Total  acquisitions          |   | 1                          |   | 3                          |   | 9 |   | 16 |   |
|                         |   |                       |   |                       |   |   |   |   |   |
| Cash  consideration          |   | $                          | 0.1    |                       | $      | 1.8 |   | $ | 6.2 |   | $ | 4.8 |   |
| Common  stock consideration  |   | —                     |   | —                     |   | — |   | 14.3 |   |
| Total  acquisition cost      |   | $                          | 0.1    |                       | $      | 1.8 |   | $ | 6.2 |   | $ | 19.1 |   |
|                         |   |                       |   |                       |   |   |   |   |   |
| Purchase  price allocation:  |   |                       |   |                       |   |   |   |   |   |
| Identifiable  intangibles    |   | $                          | — |                       | $      | 0.8 |   | $ | 3.9 |   | $ | 13.3 |   |
| Goodwill                     |   | —                     |   | 0.1                        |   | 0.9 |   | 1.8 |   |
| Inventory                    |   | 0.1                        |   | 0.2                        |   | 1.1 |   | 1.9 |   |
| Property  and equipment      |   | —                     |   | 0.8                        |   | 0.5 |   | 2.5 |   |
| Accruals  and liabilities    |   | —                     |   | (0.1                       | )      | (0.2 | ) | (0.4 | ) |
| Total                        |   | $                          | 0.1    |                       | $      | 1.8 |   | $ | 6.2 |   | $ | 19.1 |   |

 

The operations of theacquired pharmacies have been included in the consolidated statement ofoperations from the date of acquisition and did not have a material effect onthe sales, results of operations or earnings per share of the Company for theperiods presented.

 

10

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**9. Net Income per Common Share**

 

Net income per commonshare is based on the weighted average shares outstanding during each period inaccordance with the provisions of Financial Accounting Standards Board (“FASB”)Statement No. 128 “Earnings Per Share.” Basic earnings per share iscomputed based on the weighted average number of common shares outstandingduring the period. Diluted earnings per share gives effect to all dilutivepotential common shares outstanding during the period. Dilutive potentialcommon shares include shares issuable upon exercise of the Company’s“in-the-money” stock options. Of the options to purchase 1,298,697 and2,673,015 shares of common stock outstanding at September 27, 2003 andSeptember 28, 2002, respectively, options to purchase 155,870 shares atSeptember 27, 2003 and 1,510,588 shares at September 28, 2002 werenot included in the computation of diluted earnings per share because theexercise prices of such options were greater than the average market price ofthe common shares and therefore the impact of these shares would beanti-dilutive.  Dilutive potentialcommon shares do not include any potential shares that could be issued relativeto the Company’s 2.1478% Convertible Notes (see Note 5 for a description of therelevant conversion terms of the Convertible Notes).  The significant reduction in the number of “out-of-the-money”stock options at September 27, 2003 as compared to September 28, 2002reflects the cancellation of options tendered for exchange in connection withthe Stock Option Exchange Offer more fully described in Note 7.

 

The followingtable sets forth the computation of income per common share for the periodspresented (in thousands, except per share amounts):

 
|                                                               |   | **For the 13  Weeks Ended** |   | **For the 39  Weeks Ended** |   |
|--------------------------------------------------------------------|--------|-----------------------------|--------|-----------------------------|--------|
|                                                               |   | **Sept  27,  2003**    |   | **Sept 28,  2002**          |   | **Sept 27,  2003** |   | **Sept 28,  2002** |   |
|                                                               |   |                        |   |                        |   |   |   |   |   |
| Income before cumulative effect of accounting change               |   | $                           | 1,906  |                        | $      | 7,784 |   | $ | 9,076 |   | $ | 15,376 |   |
| Cumulative effect of accounting change,  net of  income taxes |   | —                      |   | —                      |   | — |   | (9,262 | ) |
| Net  income                                                        |   | $                           | 1,906  |                        | $      | 7,784 |   | $ | 9,076 |   | $ | 6,114 |   |
|                                                               |   |                        |   |                        |   |   |   |   |   |
| Weighted  average common shares outstanding – basic           |   | 24,038                      |   | 23,948                      |   | 24,038 |   | 23,816 |   |
| Potential  dilutive shares                                         |   | 377                         |   | 476                         |   | 317 |   | 758 |   |
| Weighted  average common shares outstanding – diluted         |   | 24,415                      |   | 24,424                      |   | 24,355 |   | 24,574 |   |
|                                                               |   |                        |   |                        |   |   |   |   |   |
| Per  common share – basic                                     |   |                        |   |                        |   |   |   |   |   |
|                                                               |   |                        |   |                        |   |   |   |   |   |
| Income before cumulative effect of accounting change               |   | $                           | 0.08   |                        | $      | 0.32 |   | $ | 0.38 |   | $ | 0.65 |   |
| Cumulative effect of accounting change,  net of  income taxes |   | —                      |   | —                      |   | — |   | (0.39 | ) |
| Net income                                                         |   | $                           | 0.08   |                        | $      | 0.32 |   | $ | 0.38 |   | $ | 0.26 |   |
|                                                               |   |                        |   |                        |   |   |   |   |   |
| Per  common share – diluted                                   |   |                        |   |                        |   |   |   |   |   |
|                                                               |   |                        |   |                        |   |   |   |   |   |
| Income before cumulative effect of accounting change               |   | $                           | 0.08   |                        | $      | 0.32 |   | $ | 0.37 |   | $ | 0.63 |   |
| Cumulative effect of accounting change,  net of  income taxes |   | —                      |   | —                      |   | — |   | (0.38 | ) |
| Net income                                                         |   | $                           | 0.08   |                        | $      | 0.32 |   | $ | 0.37 |   | $ | 0.25 |   |

 

**10. Income Taxes**

 

Income taxes are recordedbased on the estimated combined statutory tax rates expected to be applicablefor the full fiscal year less applicable tax credits. The effective tax rate islower than the combined statutory rates, primarily reflecting the impact ofthese tax credits. The effective income tax rate of 44% recorded in 2003 giveseffect to the New York State tax legislation passed in May 2003, withretroactive application to January 1, 2003. This legislation effectivelyeliminated certain royalty fee and related interest deductions.

 

11

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**11. Recently Issued Accounting Pronouncements**

 

During the first quarterof 2003, the Company adopted Statement of Financial Accounting Standards (“FAS”)No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASBStatement No. 13, and Technical Corrections.” Under FAS No. 145, gains andlosses related to the extinguishment of debt should no longer be segregated onthe income statement as extraordinary items. Instead, such gains and lossesshould be included as a component of income from continuing operations. Theprovisions of FAS No. 145 are effective for fiscal years beginning afterMay 15, 2002. Upon adoption, the Company reclassified from extraordinarycharges to “Debt extinguishment,” for the fiscal years ended December 28,2002 and December 29, 2001, pre-tax debt extinguishment costs of $11.4million and $2.6 million, respectively. The income tax provisions for the 2002and 2001 fiscal years applicable to income before income taxes and cumulativeeffect of accounting change were adjusted commensurately. Reported net incomeremained unaffected by the reclassification, and thus, this adoption did nothave an impact on the Company’s results of operations, financial position orcash flows.

 

During the first quarterof 2003, the Company adopted FAS No. 146, “Accounting for Costs Associated withExit or Disposal Activities.” This statement nullifies Emerging Issues TaskForce (EITF) Issue No. 94-3, “Liability Recognition for Certain EmployeeTermination Benefits and Other Costs to Exit an Activity (including CertainCosts Incurred in a Restructuring).” FAS No. 146 requires that a liability forcosts associated with an exit or disposal activity be recognized when theliability is incurred. The provisions of FAS No. 146 are effective for exit ordisposal activities initiated after December 31, 2002. The adoption of FASNo. 146 did not have an impact on the Company’s results of operations, financialposition or cash flows.

 

In September 2002,the Emerging Issues Task Force released Issue No. 02-16, “Accounting by aReseller for Cash Consideration Received from a Vendor”. The pronouncementaddresses two issues. The first issue requires that vendor allowances becategorized as a reduction in cost of sales unless they are a reimbursement ofcosts incurred to sell the vendor’s products, in which case, the cashconsideration should be characterized as a reduction of that cost. Cashconsideration received in excess of the fair value of the benefit receivedshould be characterized as a reduction of cost of sales. Transition provisionsfor this portion of the pronouncement apply to all agreements entered into ormodified after December 31, 2002. As a result of the application of thisportion of the pronouncement, the Company changed its accounting policy tolimit vendor allowances treated as a reduction of advertising costs to onlythose allowances paid by vendors to fund the costs of running specific radioadvertising promotions. All other promotional advertising allowances will betreated as a reduction in cost of sales. The application of this new accountingpolicy did not have a material impact on the Company’s consolidated results ofoperations, financial position or cash flows for the periods reported, and isnot expected to have a material impact on the Company’s consolidated results ofoperations, financial position or cash flows in the future. The second issuerequires that rebates or refunds payable only if the customer completes aspecified cumulative level of purchases should be recognized as a reduction ofcost of sales based on a systematic and rational allocation over the periodduring which such purchases are sold. This provision is required to be appliedto all new arrangements initiated after November 21, 2002 and isconsistent with the Company’s past practice.

 

In November 2002,the Financial Accounting Standards Board issued FASB Interpretation (FIN) No.45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees,Including Indirect Guarantees of Indebtedness of Others.” FIN No. 45 clarifiesthe requirements of FAS No. 5, “Accounting for Contingencies,” relating to aguarantor’s accounting for, and disclosure of, the issuance of certain types ofguarantees. FIN No. 45 elaborates on the existing disclosure requirements formost guarantees, including loan guarantees such as standby letters of credit.It also clarifies that at the time a company issues a guarantee, the company mustrecognize an initial liability for the fair value, or market value, of theobligations it assumes under the guarantee and must disclose that informationin its interim and annual financial statements. The provisions related torecognizing a liability at inception of the guarantee for the fair value of theguarantor’s obligations does not apply to product warranties or to guaranteesaccounted for as derivatives. The recognition provisions of FIN No. 45 areeffective for certain guarantees issued after January 1, 2003. Theadoption of this interpretation did not have a material impact on the Company’sresults of operations, financial position or cash flows.

 

12

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In December 2002,FAS No. 148, “Accounting for Stock-Based Compensation – Transition andDisclosure” was issued. This statement provides alternative methods oftransition for a voluntary change to the fair value based method of accountingfor stock-based employee compensation. The Company has not adopted suchvoluntary change to the fair value based method. In addition, this statementamends the disclosure requirements of FAS No. 123 to require prominentdisclosures about the method of accounting for stock-based compensation and theeffect of the method used on reported results. As required, the Company adoptedthe disclosure-only provisions of FAS No. 148 effective in 2002.

 

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

 
|                                                                                                                                                    |   | **For the 13 Weeks Ended** |   | **For the 39 Weeks Ended** |   |
|---------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------|--------|----------------------------|--------|
|                                                                                                                                                    |   | **Sept 27,  2003**         |   | **Sept 28,  2002**         |   | **Sept 27,  2003** |   | **Sept 28,  2002** |   |
|                                                                                                                                                    |   |                       |   |                       |   |   |   |   |   |
| Net  income, as reported                                                                                                                                |   | $                          | 1,906  |                       | $      | 7,784 |   | $ | 9,076 |   | $ | 6,114 |   |
|                                                                                                                                                    |   |                       |   |                       |   |   |   |   |   |
| Adjust:  Total stock-based employee compensation (expense)/income determined under  fair value based method for all awards, net of related tax effects. |   | (378                       | )      | (967                       | )      | 8,640 |   | (2,900 | ) |
|                                                                                                                                                    |   |                       |   |                       |   |   |   |   |   |
| Pro  forma net income                                                                                                                                   |   | $                          | 1,528  |                       | $      | 6,817 |   | $ | 17,716 |   | $ | 3,214 |   |
|                                                                                                                                                    |   |                       |   |                       |   |   |   |   |   |
| Income  per common share:                                                                                                                               |   |                       |   |                       |   |   |   |   |   |
| Basic  - as reported                                                                                                                                    |   | $                          | 0.08   |                       | $      | 0.32 |   | $ | 0.38 |   | $ | 0.26 |   |
| Basic  - pro forma                                                                                                                                      |   | $                          | 0.06   |                       | $      | 0.28 |   | $ | 0.74 |   | $ | 0.13 |   |
|                                                                                                                                                    |   |                       |   |                       |   |   |   |   |   |
| Diluted  - as reported                                                                                                                                  |   | $                          | 0.08   |                       | $      | 0.32 |   | $ | 0.37 |   | $ | 0.25 |   |
| Diluted  - pro forma                                                                                                                                    |   | $                          | 0.06   |                       | $      | 0.28 |   | $ | 0.73 |   | $ | 0.13 |   |

 

As described in moredetail in Note 7, the Company cancelled 1,337,449 outstanding stock optionsduring the first quarter of 2003 in connection with the Stock Option ExchangeOffer. The pro forma income shown in the table above for the nine months endingSeptember 27, 2003 includes the reversal of pro forma expenses previouslydisclosed totaling $9.7 million, related to the granting of these originaloptions.  On October 1, 2003, theCompany issued 1,320,947 options at an exercise price of $16.55 per share toreplace those options exchanged in connection with the Stock Option ExchangeOffer. As a result, in the fourth quarter of 2003 and prospectively, theCompany expects to incur pro forma compensation expense which will reflect thefair value of the replacement stock options granted.

 

The pro formacompensation income (expense) for stock options has been estimated using theBlack-Scholes option pricing model with the following assumptions for each ofthe periods shown: dividend yield of 0%, expected volatility of 50%, risk freeinterest rate of 6.6% and an expected term of 8 years. These pro formadisclosures may not be representative of the effects on reported net income forfuture periods since options vest over several years and options granted priorto 1995 are not considered.

 

13

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In January 2003, theFinancial Accounting Standards Board issued FIN No. 46, “Consolidation ofVariable Interest Entities.” FIN No. 46 requires a variable interest entity tobe consolidated by a company if that company is subject to a majority of therisk of loss from the variable interest entity’s activities or entitled toreceive a majority of the entity’s residual returns or both. As initiallyissued, the consolidation requirements of FIN No. 46 applied immediately tovariable interest entities created after January 31, 2003 and, for olderentities, in the first fiscal year or interim period beginning afterJune 15, 2003. In addition, certain of the disclosure requirements appliedin all financial statements issued after January 31, 2003, regardless ofwhen the variable interest entity was established. The FASB, at theirOctober 8, 2003 meeting, deferred the latest date by which all publicentities must apply FIN 46 to the first reporting period ending afterDecember 15, 2003, with early adoption encouraged. The Company hadpreviously adopted the provisions of FIN 46, but this adoption did not have amaterial impact on its results of operations, financial position or cash flows.

 

**12. Commitments and Contingencies**

 

During 2002, the Companyinitiated a legal action against its former property insurance carrier inFederal Court in the Southern District of New York, in an attempt to recoverwhat the Company believes to be a fair and reasonable settlement for thebusiness interruption portion of its claim originating from theSeptember 11, 2001 World Trade Center terrorist attack, during which theCompany’s single highest volume and most profitable store was completelydestroyed. In September 2003, a trial on certain issues was held regardingsome of the matters at issue in the litigation, including whether the Companywould have obtained a renewal of its lease at the World Trade Center.  The Company has received a favorable rulingon this and other legal issues in the case and now expects the litigation tomove into an appraisal process.  Itremains uncertain whether the Company will obtain a favorable resolution of thecase.

 

The Company, Anthony J.Cuti, its Chairman, President and Chief Executive Officer, John K. Henry, itsChief Financial Officer, and Gary Charboneau, its Senior Vice President ofSales and Marketing, have been named as defendants in connection with theconsolidation of several class action complaints alleging violations of thefederal securities laws that were filed from August 2002 throughOctober 2002. The action, which is in the United States District Court forthe Southern District of New York, is on behalf of shareholders who purchasedDuane Reade Inc.’s common stock between April 1, 2002 and July 24,2002, inclusive. The complaint alleges that the defendants violated the federalsecurities laws by issuing materially false and misleading statements duringthe class period.  The Company believesthat these actions are completely baseless and wholly without merit. TheCompany will continue to vigorously defend these actions.

 

TheCompany is a defendant in a class action suit in the Federal Court for theSouthern District of New York regarding alleged violations of the Fair LaborStandards Act as to a group of individuals who provided delivery services on acontract basis to the Company. In December 2002, the judge in the actionissued a partial summary judgment in favor of a subclass of the plaintiffs andagainst the Company. The Company, while admitting no liability, hasreached an agreement with the plaintiffs that has been approved by the court toprovide for a settlement for the plaintiff in this action in order to avoid theincurrence of further legal costs and distraction to management. The Company has established reserves that itbelieves are appropriate in its judgment and in accordance with applicableaccounting rules.

 

TheCompany is party to other legal actions arising in the ordinary course ofbusiness.  Based on informationpresently available, the Company believes that it has adequate legal defensesor insurance coverage for these actions and that the ultimate outcome of theseactions will not have a material adverse effect on the Company’s results ofoperations, financial position or cash flows.

 

A recent New York State TaxAppeals Tribunal ruling in a matter involving another company may have anadverse impact upon the Company’s New York State Franchise Tax filings fromyears 1999 through 2002. This matter relates to the required combination ofaffiliated subsidiaries in recognizing royalty fee and related income forintangible property. The ruling of the Tribunal is subject to further legalappeal and interpretation in light of the Company’s own specific facts andcircumstances. The outcome of this matter, and the resulting amount ofadditional income tax expense, if any, cannot be determined by the Company atthis time.

 

14

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**ITEM2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND**

** RESULTS OF OPERATIONS**

 

**Results of Operations**

 

Thefollowing sets forth the results of operations as a percentage of sales for theperiods indicated.

 
|                                                                   |   | **For the 13 Weeks Ended** |   | **For the 39 Weeks Ended** |   |
|------------------------------------------------------------------------|--------|----------------------------|--------|----------------------------|--------|
|                                                                   |   | **Sept 27, 2003**          |   | **Sept 28, 2002**          |   | **Sept 27, 2003** |   | **Sept 28, 2002** |   |
| Net  sales                                                             |   | 100.0                      | %      | 100.0                      | %      | 100.0 | % | 100.0 | % |
| Cost  of sales                                                         |   | 78.7                       |   | 76.7                       |   | 78.7 |   | 77.7 |   |
| Gross  profit                                                          |   | 21.3                       |   | 23.3                       |   | 21.3 |   | 22.3 |   |
| Selling,  general and administrative expenses                          |   | 16.6                       |   | 15.6                       |   | 16.3 |   | 15.4 |   |
| Insurance  recovery                                                    |   | —                     |   | —                     |   | — |   | (1.0 | ) |
| Depreciation  & amortization                                       |   | 2.4                        |   | 2.2                        |   | 2.3 |   | 2.1 |   |
| Store  pre-opening expense                                             |   | 0.1                        |   | 0.1                        |   | 0.1 |   | 0.2 |   |
| Operating  income                                                      |   | 2.2                        |   | 5.4                        |   | 2.6 |   | 5.6 |   |
| Interest  expense, net                                                 |   | 1.0                        |   | 1.2                        |   | 1.0 |   | 1.5 |   |
| Debt  extinguishment                                                   |   | 0.2                        |   | 0.1                        |   | 0.1 |   | 1.4 |   |
| Income  before income taxes and cumulative effect of accounting change |   | 1.0                        |   | 4.1                        |   | 1.5 |   | 2.7 |   |
| Income  taxes                                                          |   | 0.4                        |   | 1.6                        |   | 0.7 |   | 1.0 |   |
| Income  before cumulative effect of accounting change                  |   | 0.6                        |   | 2.5                        |   | 0.8 |   | 1.7 |   |
| Cumulative  effect of accounting change, net of income taxes           |   | —                     |   | —                     |   | — |   | (1.0 | ) |
| Net  income                                                            |   | 0.6                        | %      | 2.5                        | %      | 0.8 | % | 0.7 | % |

 

**Thirteen Weeks Ended September 27, 2003 versus ThirteenWeeks Ended September 28, 2002**

 

Net sales were $338.6million in the third quarter of 2003, an increase of 8.3% over net sales of$312.8 million for the third quarter of 2002. The increase represented a lowerrate of sales growth than experienced in prior years that is attributable to acontinuation of the adverse economic conditions and high rates of unemploymentthroughout the New York metro market. Sales in the current year’s third quarterwere also impacted by a power outage on August 14, 2003, which forced theclosings of all of our stores for most of a day resulting in lost sales ofapproximately $3.3 million. Pharmacy sales increased from $131.0 million in thethird quarter of 2002 to $148.7 million in the third quarter of 2003, anincrease of 13.5%, and represented 43.9% of total sales, as compared with 41.9%of total sales in the third quarter of 2002. Front-end sales increased from$181.8 million in the third quarter of 2002 to $189.9 million in the thirdquarter of 2003, an increase of 4.5%, and represented 56.1% of total sales, ascompared to 58.1% of total sales in the third quarter of 2002.  For the third quarter of 2003, third-partyreimbursed pharmacy sales represented 91.4% of total pharmacy sales, ascompared to 90.0% in the third quarter of 2002. The increase in total salesover last year was attributable to the full quarterly impact of four new storesopened during the third quarter of 2002 and sales from 18 net new stores openedsince September 2002, combined with a comparable store sales increase of3.0%, including an 8.6% increase in pharmacy same-store sales partially offsetby a 1.1% decline in front-end same-store sales. During the third quarter of2003, we opened three new stores, as compared to four new stores opened and onestore closed during the third quarter of 2002. At September 27, 2003, weoperated 239 stores, as compared to 221 stores at September 28, 2002.

 

15

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Cost of sales as apercentage of net sales increased to 78.7% for the third quarter of 2003 from76.7% for the third quarter of 2002, resulting in a decrease in gross profitmargin to 21.3% for the third quarter of 2003 from 23.3% for the third quarterof 2002.  This decrease was attributableto higher store occupancy costs resulting in part from a January 1, 2003New York City real estate tax increase, reduced real estate related income andthe reduced rate of sales growth. The lower gross margins were also the resultof an increased proportion of lower margin pharmacy and third party reimbursedpharmacy sales, reductions in New York State Medicaid prescriptionreimbursement rates and lower realized margins on generic prescriptions. Costof sales includes a $0.2 million LIFO provision in the current year, comparedto $0.5 million in the comparable period last year.

 

Selling, general andadministrative expenses were $56.3 million, or 16.6% of net sales, and $48.9million, or 15.6% of net sales, in the third quarters of 2003 and 2002,respectively.  The increase in theseexpenses as a percentage of sales is attributable to lower than historicalrates of sales growth, litigation related expenses primarily associated withour efforts to recover our business interruption loss insurance claim,increased costs of insurance premiums, and store level labor costs to install anew store shelf labeling system.

 

Depreciation andamortization of intangibles in the third quarters of 2003 and 2002 were $8.2million and $6.9 million, respectively. This increase resulted primarily from increases in the amortization ofidentifiable intangibles resulting from pharmacy acquisitions completed sincethe third quarter of 2002, combined with incremental depreciation expensesrelated to capital expenditures in 2002 and 2003.

 

We incurred storepre-opening expenses of $0.2 million during the third quarter of 2003 relatedto the opening of three new stores. During the comparable period last year, we incurred pre-opening expensesof $0.3 million related to the opening of four new stores.

 

Net interest expensedeclined 8.6% to $3.4 million from $3.7 million in the prior year**,**primarily due to reduced interest rates resulting from the senior debtrefinancing completed in July of this year.

 

In the third quarter of2003, we recorded debt extinguishment charges of $0.7 million, as compared to$0.3 million in the third quarter of 2002.

 

In the third quarter of2003, we recorded an income tax provision of $1.5 million, reflecting anestimated annual effective tax rate of 44.0%, inclusive of the anticipatedbenefits of tax credits. In the comparable period last year, the income taxprovision of $4.9 million reflected an estimated effective tax rate of 38.6%,inclusive of the anticipated benefits of tax credits. The effective income taxrate of 44% recorded in 2003 gives effect to the New York State tax legislationpassed in May 2003, with retroactive application to January 1, 2003.This legislation effectively eliminated certain royalty fee and relatedinterest deductions.

 

**Thirty-Nine Weeks Ended September 27, 2003 versusThirty-Nine Weeks Ended September 28, 2002**

 

Net sales were $1.0billion in the first nine months of 2003, an increase of 8.9% over net sales of$943.4 million for the first nine months of 2002. The increase represented alower rate of sales growth than experienced in prior years that is attributableto a continuation of the adverse economic conditions and high rates ofunemployment throughout the New York metro market. Pharmacy sales increasedfrom $393.5 million in the first nine months of 2002 to $447.8 million in thefirst nine months of 2003, an increase of 13.8%, and represented 43.6% of totalsales, as compared with 41.7% of total sales in the first nine months of 2002.Front-end sales increased from $549.8 million in the first nine months of 2002to $579.6 million in the first nine months of 2003, an increase of 5.4%, andrepresented 56.4% of total sales, as compared to 58.3% of total sales in thefirst nine months of 2002.  For thefirst nine months of 2003, third-party reimbursed pharmacy sales represented91.3% of total pharmacy sales, as compared to 89.7% in the first nine months of2002. The increase in total sales over last year was attributable to the fullnine month impact of 24 stores opened during the first nine months of 2002 andsales from 18 net new stores opened since September 2002, combined with acomparable store sales increase of 2.6%, including a 7.7% increase in pharmacysame-store sales partially offset by a 1.1% decline in front-end same-storesales. During the first nine months of 2003, we opened 14 new stores and closedthree stores, as compared to 24 new stores opened and three stores closedduring the first nine months of 2002.

 

16

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Cost of sales as a percentage of net sales increased to 78.7% for thefirst nine months of 2003 from 77.7% for the first nine months of 2002,resulting in a decrease in gross profit margin to 21.3% for the first ninemonths of 2003 from 22.3% for the first nine months of 2002.  This decrease was attributable to reducedlevels of higher margin front-end same-store sales reflecting the continuedimpact of the recessionary economy in the New York metropolitan area, increasedChristmas holiday clearance markdowns incurred in the first quarter of thisyear, reduced rates of sales related vendor allowances, reductions in New YorkState Medicaid reimbursement rates and higher store occupancy costs resultingin part from a January 1, 2003 New York City real estate tax increase.Cost of sales includes a $0.5 million LIFO provision in the first nine monthsof the current year, compared to $1.3 million in the comparable period lastyear.

 

Selling, general and administrative expenses were $167.1 million, or16.3% of net sales, and $145.1 million, or 15.4% of net sales, in the firstnine months of 2003 and 2002, respectively. The increase in these expenses as a percentage of sales is attributableto the lower rate of sales growth from historical levels, increased costsassociated with the significant number of one-hour photo departments operatedthroughout the first nine months of 2003 versus 2002, increased litigationrelated expenses and higher costs of insurance premiums.

 

During the first nine months of 2002, we received a partial payment of$9.9 million toward our business interruption insurance claim originating fromthe September 11th World Trade Center disaster. After deductingcertain claims-related expenses, we recorded a net benefit of $9.4 million inpre-tax income. We are currently engaged in litigation to recover the balanceof the outstanding claim. Additional insurance recoveries related to thebusiness interruption claim, which, if any, could be material, will berecognized when such collection is assured.

 

Depreciation and amortization of intangibles in the first nine monthsof 2003 and 2002 were $23.9 million and $20.4 million, respectively.  This increase resulted primarily fromincreases in the amortization of identifiable intangibles resulting frompharmacy acquisitions completed since the third quarter of 2002, combined withincremental depreciation expenses related to capital expenditures in 2002 and2003.

 

We incurred store pre-opening expenses of $0.8 million during the firstnine months of 2003 related to the opening of 14 new stores.  During the comparable period last year, weincurred pre-opening expenses of $1.6 million related to the opening of 24 newstores.

 

Net interest expense decreased 27.3% to $10.5 million in the first ninemonths of 2003 from $14.4 million in the first nine months of 2002.  This decline was primarily attributable tothe second quarter 2002 completion of the convertible note offering, theproceeds of which were used to retire higher cost senior subordinated notes andterm loan debt, combined with the declines in interest rates which reduceinterest costs on floating-rate debt.

 

In the first nine months of 2003, we recorded debt extinguishmentcharges of $0.8 million, as compared to $13.4 million in the first nine monthsof 2002. The large debt extinguishment costs incurred in 2002 resulted from theretirement of our Senior Notes and term loans with the proceeds of ourConvertible Note offering.

 

In the first nine months of 2003, we recorded anincome tax provision of $7.1 million, reflecting an estimated annual effectivetax rate of 44.0%, inclusive of the anticipated benefits of tax credits. In thecomparable period last year, the income tax provision of $9.8 million reflectedan estimated effective tax rate of 39.0%, inclusive of the anticipated benefitsof tax credits. The increase in the effective tax rate was primarily the resultof increased taxes attributable to New York State tax legislation passed inMay 2003 with retroactive application to January 1, 2003. Thislegislation effectively eliminated certain royalty fee and related interestdeductions.

 

During the first nine months of 2002, as a result ofthe change in accounting method of inventory valuation from retail dollar FIFOto specific cost LIFO, we recorded a one-time, non-cash charge of $9.3 million,net of an income tax benefit of $6.7 million.

 

17

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**Liquidityand Capital Resources**

 

Working capital was $230.9 million as of September 27, 2003 and$216.1 million as of December 28, 2002. The increase was primarily due toan increase in inventory related to the opening of 11 net additional stores andthe elimination of the current portion of our long-term debt resulting from theJuly 2003 refinancing of our previous credit agreement through a newasset-based revolving loan agreement.

 

For the first nine months of 2003, net cash providedby operating activities was $29.8 million, as compared to $19.7 million in thefirst nine months of 2002.

 

Net cash used ininvesting activities was $45.8 million during the first nine months of 2003,compared to $44.6 million during the first nine months of 2002.  In the first nine months of 2003, capitalexpenditures, the majority of which related to new store openings and theremodeling of existing locations, amounted to $34.5 million, while leaseacquisition, pharmacy customer file and other costs accounted for $11.3 millionof cash used in investing activities. In the first nine months of 2002, we spent $36.4 million on capitalexpenditures and $8.2 million on lease acquisition, pharmacy customer file andother costs.

 

Net cash provided by financing activities was $13.1million for the first nine months of 2003, compared to $32.0 million for thefirst nine months of 2002. The decrease reflects the improved amount of cashprovided by operations.

 

Our capital requirements primarily result from openingand stocking new stores, remodeling and renovating existing retail locationsand from the continuing development of management information systems. Webelieve that there are significant opportunities to open additional stores, andcurrently plan to open approximately 3 to 5 additional new stores during theremainder of this year (a total of 17 to 19 for all of 2003), and 15 to 20 newstores in fiscal 2004. We expect to spend approximately $40.0 million in 2003on capital expenditures, primarily for new, renovated and replacement stores,and an additional $13.0 million for lease, pharmacy customer file and otheracquisition costs. We also require working capital to support inventory for ourexisting stores. Historically, we have been able to lease almost all of ourstore locations.

 

On July 21, 2003, we completed a refinancing ofour senior credit agreement. Refer to Note 5 to the consolidated financialstatements for additional information regarding this transaction.

 

We believe that, based on current levels of operationsand anticipated growth, cash flow from operations, together with other availablesources of funds, including revolving loan borrowings under our new CreditAgreement, will be adequate for at least the next two years to make requiredpayments of principal and interest on our indebtedness, to fund anticipatedcapital expenditures and to satisfy our working capital requirements. Ourability to meet our debt service obligations and reduce our total debt willdepend upon our future performance which, in turn, will be subject to generaleconomic, financial, business, competitive, legislative, regulatory and otherconditions, many of which are beyond our control. In addition, we cannot assureyou that our operating results, cash flow and capital resources will besufficient for repayment of our indebtedness in the future. As borrowings underthe new Credit Agreement bear interest at floating rates, our financialcondition will be affected by changes in prevailing interest rates.

 

The new Credit Agreement and the indenture relating toour senior convertible notes contain various covenants that limit or restrict,among other things, subject to certain exceptions, capital expenditures, theincurrence of indebtedness, the creation of liens, transactions withaffiliates, restricted payments, investments and acquisitions, mergers,consolidations, dissolutions, asset sales, dividends, distributions and certainother transactions and business activities. Financial performance covenants included in the new Credit Agreement arelimited to a single fixed charge coverage requirement that only becomesoperable when borrowings exceed 90 percent of the borrowing base, as defined inthe new Credit Agreement.  OnSeptember 27, 2003, we had approximately $114.4 million of borrowingcapacity, net of approximately $2.0 million reserved for standby letters of credit.Borrowings under the new Credit Agreement have not exceeded 90 percent of theborrowing base. There are no credit ratings related triggers in our new CreditAgreement or in the indenture related to our convertible notes.

 

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### **Critical Accounting Policies**

 

Our discussion of resultsof operations and financial condition relies on our consolidated financialstatements that are prepared based on certain critical accounting policies thatrequire management to make judgments and estimates that are subject to varyingdegrees of uncertainty. We believe that investors need to be aware of thesepolicies and how they impact our financial reporting to gain a more completeunderstanding of our consolidated financial statements as a whole, as well asour related discussion and analysis presented herein. While we believe thatthese accounting policies are grounded on sound measurement criteria, actualfuture events can and often do result in outcomes that can be materiallydifferent from these estimates or forecasts. The accounting policies andrelated risks described in our Annual Report on Form 10-K for the year endedDecember 28, 2002 are those that depend most heavily on these judgmentsand estimates.  As of September 27,2003, there have been no material changes to any of the Critical AccountingPolicies contained therein.

 

**Seasonality**

 

In general, sales of drugstore items such asprescription drugs, over-the-counter drugs and health and beauty care productsexhibit limited seasonality in the aggregate, but do vary by product category.Quarterly results are primarily affected by the timing of new store openingsand the sale of seasonal products, with the Christmas holiday season typicallygenerating a higher proportion of sales and earnings than other periods.

 

**RecentlyIssued Accounting Pronouncements**

 

During the first quarter of 2003, we adopted Statementof Financial Accounting Standards (“FAS”) No. 145, “Rescission of FASBStatements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and TechnicalCorrections.” Under FAS No. 145, gains and losses related to the extinguishmentof debt should no longer be segregated on the income statement as extraordinaryitems. Instead, such gains and losses should be included as a component ofincome from continuing operations. The provisions of FAS No. 145 are effectivefor fiscal years beginning after May 15, 2002. Upon adoption, wereclassified from extraordinary charges to “Debt extinguishment,” for thefiscal years ended December 28, 2002 and December 29, 2001, pre-taxamounts of $11.4 million and $2.6 million, respectively. The income taxprovisions for the 2002 and 2001 fiscal years applicable to income beforeincome taxes and cumulative effect of accounting change were adjustedcommensurately. Reported net income remained unaffected by thereclassification, and thus, this adoption did not have an impact on our resultsof operations, financial position or cash flows.

 

During the first quarter of 2003, we adopted FAS No. 146, “Accountingfor Costs Associated with Exit or Disposal Activities.” This statementnullifies Emerging Issues Task Force (EITF) Issue No. 94-3, “LiabilityRecognition for Certain Employee Termination Benefits and Other Costs to Exitan Activity (including Certain Costs Incurred in a Restructuring).” FAS No. 146requires that a liability for costs associated with an exit or disposalactivity be recognized when the liability is incurred. The provisions of FASNo. 146 are effective for exit or disposal activities initiated afterDecember 31, 2002. The adoption of FAS No. 146 did not have an impact onour results of operations, financial position or cash flows.

 

In September 2002, the Emerging Issues Task Force released IssueNo. 02-16, “Accounting by a Reseller for Cash Consideration Received from aVendor”. The pronouncement addresses two issues. The first issue requires thatvendor allowances be categorized as a reduction in cost of sales unless theyare a reimbursement of costs incurred to sell the vendor’s products, in whichcase, the cash consideration should be characterized as a reduction of thatcost. Cash consideration received in excess of the fair value of the benefitreceived should be characterized as a reduction of cost of sales. Transitionprovisions for this portion of the pronouncement apply to all agreementsentered into or modified after December 31, 2002. As a result of theapplication of this portion of the pronouncement, we changed our accountingpolicy to limit vendor allowances treated as a reduction of advertising coststo only those allowances paid by vendors to fund the costs of running specificradio advertising promotions. All other promotional advertising allowances willbe treated as a reduction in cost of sales. The application of this newaccounting policy did not have a material impact on our consolidated results ofoperations, financial position or cash flows for the periods reported, and isnot expected to have a material impact on our consolidated results ofoperations, financial position or cash flows in the future. The second issuerequires that rebates or refunds payable only if the customer completes aspecified cumulative level of purchases should be recognized as a reduction ofcost of sales based on a systematic and rational allocation over the periodduring which such purchases are sold. This provision is required to be appliedto all new arrangements initiated after November 21, 2002 and isconsistent with our past practice.

 

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In November 2002, the Financial Accounting Standards Board issuedFASB Interpretation (FIN) No. 45, “Guarantor’s Accounting and DisclosureRequirements for Guarantees, Including Indirect Guarantees of Indebtedness ofOthers.” FIN No. 45 clarifies the requirements of FAS No. 5, “Accounting forContingencies,” relating to a guarantor’s accounting for and disclosure of, theissuance of certain types of guarantees. FIN No. 45 elaborates on the existingdisclosure requirements for most guarantees, including loan guarantees such asstandby letters of credit. It also clarifies that at the time a company issuesa guarantee, the company must recognize an initial liability for the fairvalue, or market value, of the obligations it assumes under the guarantee andmust disclose that information in its interim and annual financial statements.The provisions related to recognizing a liability at inception of the guaranteefor the fair value of the guarantor’s obligations does not apply to productwarranties or to guarantees accounted for as derivatives. The recognitionprovisions of FIN No. 45 are effective for certain guarantees issued afterJanuary 1, 2003. The adoption of this interpretation did not have amaterial impact on our results of operations, financial position or cash flows.

 

In December 2002, FAS No. 148, “Accounting for Stock-BasedCompensation – Transition and Disclosure” was issued. This statement providesalternative methods of transition for a voluntary change to the fair valuebased method of accounting for stock-based employee compensation. We have notadopted such voluntary change to the fair value based method. In addition, thisstatement amends the disclosure requirements of FAS No. 123 to requireprominent disclosures about the method of accounting for stock-basedcompensation and the effect of the method used on reported results. Asrequired, we adopted the disclosure-only provisions of FAS No. 148 effective in2002.

 

In January 2003, the Financial Accounting Standards Board issuedFIN No. 46, “Consolidation of Variable Interest Entities.” FIN No. 46 requiresa variable interest entity to be consolidated by a company if that company issubject to a majority of the risk of loss from the variable interest entity’sactivities or entitled to receive a majority of the entity’s residual returnsor both. As initially issued, the consolidation requirements of FIN No. 46applied immediately to variable interest entities created afterJanuary 31, 2003 and, for older entities, in the first fiscal year or interimperiod beginning after June 15, 2003. In addition, certain of thedisclosure requirements applied in all financial statements issued afterJanuary 31, 2003, regardless of when the variable interest entity wasestablished. The FASB, at their October 8, 2003 meeting, deferred thelatest date by which all public entities must apply FIN 46 to the firstreporting period ending after December 15, 2003, with early adoptionencouraged.  We have previously adoptedthe provisions of FIN 46, but this adoption did not have a material impact onour results of operations, financial position or cash flows.

 

**ITEM 3****. MARKETRISK**

 

Our financial results are subject to risk frominterest rate fluctuations on that portion of our debt which carries variableinterest rates. At September 27, 2003, we had approximately $82.4 millionof variable rate debt outstanding under our new Credit Agreement, and theweighted average combined interest rate in effect on these borrowings was2.91%. A 0.50% change in interest rates applied to the $82.4 million balance offloating rate debt would affect pre-tax annual results of operations byapproximately $0.4 million. We also have $201.0 million of senior convertiblenotes outstanding at September 27, 2003, which bear interest payable semi-annuallyat a fixed rate of 3.75%, and are therefore not subject to risk from interestrate fluctuations.

 

The principal objective of our investment managementactivities is to maintain acceptable levels of interest rate and liquidity riskto facilitate our funding needs. As part of our risk management, we may usederivative financial products such as interest rate hedges and interest rateswaps in the future. The Company has not been a party to any such derivativefinancial instruments in 2003.

 

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**ITEM 4****. CONTROLSAND PROCEDURES**

 

(a)          Evaluation of DisclosureControls and Procedures.  Our ChiefExecutive Officer and Chief Financial Officer have evaluated the effectivenessof our disclosure controls and procedures (as such term is defined in Rules13a-15 and 15d-15 under the Securities Exchange Act of 1934, as amended (the“Exchange Act”)) as of the end of the period covered by this quarterly report(the “Evaluation Date”). Based on such evaluation, such officers have concludedthat, as of the Evaluation Date, our disclosure controls and procedures areeffective in alerting them on a timely basis to material information relatingto our Company (including our consolidated subsidiaries) required to beincluded in our reports filed or submitted under the Exchange Act.

 

(b)         Changes in InternalControls over Financial Reporting. During the most recent fiscal quarter, there have not been anysignificant changes in our internal controls over financial reporting or in otherfactors that have materially affected, or are reasonably likely to materiallyaffect, our internal controls over financial reporting.

 

**PART II**

 

**OTHER INFORMATION**

 

**ITEM1.  Legal Proceedings**

 

During 2002, we initiated a legal action against our former propertyinsurance carrier in Federal Court in the Southern District of New York, in anattempt to recover what we believe to be a fair and reasonable settlement forthe business interruption portion of our claim originating from theSeptember 11, 2001 World Trade Center terrorist attack, during which oursingle highest volume and most profitable store was completely destroyed. InSeptember 2003, a trial on certain issues was held regarding some of thematters at issue in the litigation, including whether the Company would haveobtained a renewal of its lease at the World Trade Center.  We have received a favorable ruling on thisand other legal issues in the case and now expect the litigation to move intoan appraisal process.  It remainsuncertain whether we will obtain a favorable resolution of the case.

 

Duane Reade Inc., Anthony J. Cuti, our Chairman, President and ChiefExecutive Officer, John K. Henry, our Chief Financial Officer, and GaryCharboneau, our Senior Vice President of Sales and Marketing, have been namedas defendants in connection with the consolidation of several class actioncomplaints alleging violations of the federal securities laws that were filedfrom August 2002 through October 2002. The action, which is in theUnited States District Court for the Southern District of New York, is onbehalf of shareholders who purchased our common stock between April 1,2002 and July 24, 2002, inclusive. The complaint alleges that thedefendants violated the federal securities laws by issuing materially false andmisleading statements during the class period. We believe that these actions are completely baseless and wholly withoutmerit. We will continue to vigorously defend these actions.

 

Weare a defendant in a class action suit in the Federal Court for the SouthernDistrict of New York regarding alleged violations of the Fair Labor StandardsAct as to a group of individuals who provided delivery services on a contractbasis to us. In December 2002, the judge in the action issued a partial summaryjudgment in favor of a subclass of the plaintiffs and against us. Whileadmitting no liability, we have reached an agreement with the plaintiffs thathas been approved by the court to provide for a settlement for the plaintiff inthis action in order to avoid the incurrence of further legal costs anddistraction to management. We haveestablished reserves that we believe are appropriate in our judgment and inaccordance with applicable accounting rules.

 

Weare party to other legal actions arising in the ordinary course ofbusiness.  Based on informationpresently available to us, we believe that we have adequate legal defenses orinsurance coverage for these actions and that the ultimate outcome of theseactions will not have a material adverse effect on our results of operations,financial position or cash flows.

 

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**ITEM2.  Changes in Securities and Use ofProceeds**

 

Not applicable

 

**ITEM 3.  Defaults Upon Senior Securities**

 

Not applicable

 

**ITEM4.  Submission of Matters to a Vote ofSecurity Holders**

 

Not applicable

**ITEM5.  Other Information**

 

The Company inadvertentlyomitted the following information regarding Mr. Kevin Roberg from its Proxy for2002:  Mr. Roberg is a member of theBoards of Directors of Accredo Health, Inc. and OmniCell Technologies.

 

**ITEM 6.  Exhibits, Financial Statement Schedules and Reports on Form 8-K**

 

(a)                                  Thefollowing documents are filed as a part of this report:

(i)                                     FinancialStatements

 

(ii)                                  Exhibits:

 
| **Exhibit No.** |   | **Description**                                                                                                                                                                                                                                                                                                                             |
|-----------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|            |   |                                                                                                                                                                                                                                                                                                                                        |
| 3.1(i)          |   | Amended and Restated  Certificate of Incorporation of the Company (incorporated by reference to  Exhibit 3.1(i) to the Company’s Registration Statement No. 333-41239 (the  “Common Stock S-1”)).                                                                                                                            |
| 3.1(ii)         |   | Certificate of  Amendment of Amended and Restated Certificate of Incorporation (incorporated  by reference to Exhibit 3.1 to Amendment No. 1 to the Company’s Registration  Statement on Form S-3 dated July 22, 2001).                                                                                                           |
| 3.1(iii)        |   | Amended and Restated  Bylaws of the Company (incorporated by reference to Exhibit 3.1(ii) to the  Common Stock S-1).                                                                                                                                                                                                                        |
| 3.2(i)          |   | Certificate of  Incorporation of DRI I Inc. (incorporated by reference to Exhibit 3.2(i) to  the S-1 Registration Statement No. 333-43313 with respect to the Company’s 91/4  Senior Subordinated Notes due 2008 (the “Notes S-1”)).                                                                                         |
| 3.2(ii)         |   | By-laws of DRI I Inc.  (incorporated by reference to Exhibit 3.2(ii) of the Notes S-1).                                                                                                                                                                                                                                                     |
| 3.3             |   | Third Amended and  Restated Partnership Agreement of Duane Reade dated July 16, 2003,  (incorporated by reference to the Company’s Quarterly Report on Form 10-Q for  the period ended June 28, 2003).                                                                                                                            |
| 3.4(i)          |   | Certificate of  Incorporation of Duane Reade International, Inc. (incorporated by reference  to Exhibit 3.4(i) to the Company’s Annual Report on Form 10 – K for the year  ended December 25, 1999 (the “1999 10-K”)).                                                                                             |
| 3.4(ii)         |   | By-laws of Duane Reade  International, Inc. (incorporated by reference to Exhibit 3.4(ii) to the 1999  10-K).                                                                                                                                                                                                                               |
| 3.5(i)          |   | Certificate of  Incorporation of Duane Reade Realty, Inc. (incorporated by reference to  Exhibit 3.5(i) to the 1999 10-K).                                                                                                                                                                                                                  |
| 3.5(ii)         |   | By-laws of Duane Reade  Realty, Inc. (incorporated by reference to Exhibit 3.5(ii) to the 1999 10-K).                                                                                                                                                                                                                                       |
| 4.1             |   | Indenture, dated as of April 16, 2002, between  Duane Reade Inc., as issuer, the guarantors named therein and State Street Bank  and Trust Company, as trustee (incorporated by reference to Exhibit 4.2 to  the Company’s Registration Statement on Form S-3 dated June 21, 2002  (the “Convertible Notes S-3”)). |
| 4.2             |   | Form of Senior Convertible Notes due 2022  (incorporated by reference to Exhibit 4.2 to the Convertible Notes S-3).                                                                                                                                                                                                                         |
| 10.1            |   | Duane Reade Inc. 1997  Equity Participation Plan, as amended (incorporated by reference to  Exhibit 10.1 to the Common Stock S-1).                                                                                                                                                                                                     |
| 10.2            |   | Duane Reade Inc.  Holding Corp. 1992 Stock Incentive Plan (incorporated by reference to Exhibit  10.2 to the Common Stock S-1).                                                                                                                                                                                                             |
| 10.3            |   | Employment Agreement,  dated as of February 22, 1993, as amended, between the Company and Gary  Charboneau (incorporated by reference to Exhibit 10.4 to the Common Stock  S-1).                                                                                                                                                       |

 

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| 10.4   |   | Employment Agreement,  dated as of April 10, 1995, as amended, between Duane Reade and Jerry M.  Ray (incorporated by reference to Exhibit 10.5 to the Common Stock S-1).                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.5   |   | Employment Letter  Agreement, dated as of October 9, 1996, between Duane Reade and Joseph  Lacko (incorporated by reference to Exhibit 10.6 to the Common Stock S-1).                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.6   |   | Agreement, dated as of  November 22, 1996, as amended, between Duane Reade and Drug, Chemical,  Cosmetic, Plastics and Affiliated Industries Warehouse Employees Local 815  (incorporated by reference to Exhibit 10.8 to the Common Stock S-1).                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.7   |   | Agreement, dated  December 6, 2001, between Duane Reade and Allied Trades Council  (incorporated by reference to Exhibit 10.8 to the Company’s Annual Report on  Form 10-K for the year ended December 29, 2001 (the “2001 10-K”)).                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.8   |   | Promissory Note, dated  as of November 9, 1998, between the Company and Anthony J. Cuti  (incorporated by reference to Exhibit 10.16 to the Company’s 1998 Annual  Report on Form 10-K (the “1998 10-K”)).                                                                                                                                                                                                                                                                                                                                                                                                                |
| 10.9   |   | Employment Letter,  dated June 10, 1999, between the Company and John K. Henry (incorporated  by reference to Exhibit 10.18 to the 1999 10-K).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.10  |   | Agreement, dated  April 1, 2001, between Duane Reade and Local 340A New York Joint Board,  UNITE AFL-CIO (incorporated by reference to Exhibit 10.19 to the 2001 10-K).                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.11  |   | First Amendment to Stockholders and Registration  Rights Agreement, dated as of January 16, 2002, by and among Duane Reade  Inc. and the stockholders party thereto (incorporated by reference to Exhibit 4.9 to the Convertible Notes S-3).                                                                                                                                                                                                                                                                                                                                                                                             |
| 10.12  |   | Preferability Letter, dated as of May 13, 2002,  issued by PricewaterhouseCoopers LLP, with respect to the Company’s change in  accounting method of inventory valuation (incorporated by reference to the  Company’s Quarterly Report on Form 10-Q for the period ended March 30,  2002).                                                                                                                                                                                                                                                                                                                                |
| 10.13  |   | Amended and Restated Employment Agreement, dated  August 12, 2002, between the Company and Anthony J. Cuti (incorporated by  reference to the Company’s Quarterly Report on Form 10-Q for the period ended  June 29, 2002).                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.14  |   | Shareholder Rights Agreement, dated as of  September 12, 2002, between the Company and EquiServe Trust Company,  N.A., as Rights Agent (incorporated by reference to Exhibit 4.1 to the  Company’s Current Report on Form 8-K, dated September 12, 2002).                                                                                                                                                                                                                                                                                                                                                                      |
| 10.15  |   | Third Amendment to the 1997 Equity Participation  Plan, dated May 8, 2003, (incorporated by reference to the Company’s  Quarterly Report on Form 10-Q for the period ended June 28, 2003).                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.16  |   | Employment Letter, dated June 24, 2003, between  the Company and Timothy R. LaBeau, (incorporated by reference to the  Company’s Quarterly Report on Form 10-Q for the period ended June 28, 2003).                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.17  |   | Credit Agreement, dated as of July 21, 2003,  among Duane Reade, as the Borrower, Duane Reade Inc. and corporate  subsidiaries as the Facility Guarantors, Various Financial Institutions set  forth therein, as the Lenders, Fleet National Bank as the Administrative Agent  and Issuing Bank, Fleet Retail Finance Inc. as the Collateral Agent, General  Electric Capital Corporation as the Syndication Agent for the Lenders and  Congress Financial Corporation as the Documentation Agent for the Lenders,  (incorporated by reference to the Company’s Quarterly Report on Form 10-Q for  the period ended June 28, 2003). |
| 10.18  |   | Facility Guarantee, dated as of July 21, 2003,  among the Facility Guarantors, Fleet Retail Finance Inc., Fleet National Bank  and the Lenders, (incorporated by reference to the Company’s Quarterly Report  on Form 10-Q for the period ended June 28, 2003).                                                                                                                                                                                                                                                                                                                                                                     |
| 10.19  |   | Intellectual Property Security Agreement, dated as  of July 21, 2003, between Duane Reade, the Facility Guarantors and Fleet  Retail Finance Inc., as Collateral Agent, (incorporated by reference to the  Company’s Quarterly Report on Form 10-Q for the period ended June 28, 2003).                                                                                                                                                                                                                                                                                                                                             |
| 10.20  |   | Security Agreement, dated as of July 21, 2003,  among Duane Reade, the Facility Guarantors, and Fleet Retail Finance Inc., as  Collateral Agent, (incorporated by reference to the Company’s Quarterly  Report on Form 10-Q for the period ended June 28, 2003).                                                                                                                                                                                                                                                                                                                                                                    |
| 10.21  |   | Ownership Interest Pledge Agreement, dated as of  July 21, 2003, among Duane Reade Inc. and DRI I Inc., and Fleet Retail  Finance Inc., as Collateral Agent, (incorporated by reference to the  Company’s Quarterly Report on Form 10-Q for the period ended June 28, 2003).                                                                                                                                                                                                                                                                                                                                                        |
| 21.1   |   | Subsidiaries of the  Company (incorporated by reference to Exhibit 21.1 to the 1999 10-K).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 23.0   |   | Consent of Independent  Accountants (incorporated by reference to Exhibit 23.0 to the Company’s  Annual Report on Form 10-K for the year ended December 28, 2002 (the  “2002 10-K”)).                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 31.0 * |   | Sarbanes-Oxley  Section 302 Certifications of the Company’s CEO and CFO.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 32.0 * |   | Sarbanes-Oxley  Section 906 Certifications of the Company’s CEO and CFO.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |

 

----

*  filed herewith

 

23

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(b)                                 Reportson Form 8-K:

 

OnAugust 22, 2003, the Company filed a Current Report on Form 8-K whichcontained, as an exhibit, a press release providing information with respect tothe estimated impact on the Company’s financial results, resulting from thesignificant power outage which occurred on August 14 – 15, 2003.

 

OnOctober 7, 2003, the Company filed a Current Report on Form 8-K whichcontained, as an exhibit, a press release providing information with respect tothe Company’s anticipated financial results for the 13 weeks endedSeptember 27, 2003.

 

OnOctober 23, 2003, the Company filed a Current Report on Form 8-K whichcontained, as an exhibit, a press release providing information with respect tothe Company’s financial results for the 13 and 39 weeks endedSeptember 27, 2003 and its outlook for the remainder of the 2003 fiscalyear.

 

(c)                                  FinancialStatement Schedules:                           None

 

Schedules forwhich provision is made in the applicable accounting regulations of theCommission are either not required under the related instructions, areinapplicable or not material, or the information called for thereby is otherwiseincluded in the financial statements and therefore has been omitted.

 

24

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**SIGNATURES**

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.

 

 
| Dated: | November 7, 2003 |   |                  |
|--------|-----------------------|--------|-----------------------|
|   |                  |   | **DUANE  READE INC.** |
|   |                  |   | (Registrant)          |
|   |                  |   |                  |
|   |                  |   | By:                   | /s/ John K. Henry |   |
|   |                  |   |                  | Name: | John K. Henry |
|   |                  |   |                  | Title: | Senior Vice President and Chief Financial  Officer |
|        |                       |        |                       |  |  |  |

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, this report has been signed below by the followingpersons on behalf of the registrant in the capacities indicated onNovember 7, 2003.
| **SIGNATURES**      |   | **TITLES**                                         |
|---------------------|--------|----------------------------------------------------|
|                |   |                                               |
| /s/ Anthony J. Cuti |   | President and Chief Executive Officer and Director |
| Anthony J. Cuti     |   | (Principal Executive Officer)                      |
|                |   |                                               |
|                |   |                                               |
| /s/ John K. Henry   |   | Senior Vice President and Chief Financial Officer  |
| John K. Henry       |   | (Principal Accounting and Financial Officer)       |

 

25

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**SIGNATURES**

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.

 
| Dated: | November 7, 2003 |            |
|--------|-----------------------|-----------------|
|   |                  | **DRI I  Inc.** |
|   |                  |            |
|   |                  | By:             | /s/ John K. Henry |   |
|   |                  |            | Name: | John K. Henry |
|   |                  |            | Title: | Senior Vice President and Chief Financial  Officer |
|        |                       |                 |  |  |  |

 

 

Pursuant to therequirements of the Securities Exchange Act of 1934, this report has beensigned on November 7, 2003 by:

 
| **SIGNATURES**      |   | **TITLES**                                         |
|---------------------|--------|----------------------------------------------------|
|                |   |                                               |
| /s/ Anthony J. Cuti |   | President and Chief Executive Officer and Director |
| Anthony J. Cuti     |   | (Principal Executive Officer)                      |
|                |   |                                               |
|                |   |                                               |
| /s/ John K. Henry   |   | Senior Vice President and Chief Financial Officer  |
| John K. Henry       |   | (Principal Accounting and Financial Officer)       |

 

26

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**SIGNATURES**

** **

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.

 
| Dated:             November 7, 2003 |                                              |
|------------------------------------------------------------------------------------------------------|---------------------------------------------------|
|                                                                                                 |                                              |
|                                                                                                 | **DUANE  READE**                                  |
|                                                                                                 |                                              |
| By:                                                                                                  | DRI I Inc., a general partner                     | By: | DUANE READE INC., a general partner |
|                                                                                                 |                                              |
|                                                                                                 |                                              |
| By:                                                                                                  | /s/ John K. Henry                                 |   | By: | /s/ John K. Henry |   |
| Name:                                                                                                | John K. Henry                                     | Name: | John K. Henry |
| Title:                                                                                               | Senior Vice President and Chief Financial Officer | Title: | Senior Vice President and Chief Financial Officer |
|                                                                                                      |                                                   |  |  |  |  |  |  |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below on November 7, 2003 by the following persons in thecapacities indicated with respect to Duane Reade Inc. and DRI I Inc., thegeneral partners of Duane Reade, on behalf of Duane Reade (except as otherwiseindicated):

 
| **SIGNATURES**       |   | **TITLES**                                         |
|----------------------|--------|----------------------------------------------------|
|                 |   |                                               |
| /s/ Anthony J.  Cuti |   | President and Chief Executive Officer and Director |
| Anthony J. Cuti      |   | (Principal Executive Officer)                      |
|                 |   |                                               |
|                 |   |                                               |
| /s/ John K.  Henry   |   | Senior Vice President and Chief Financial Officer  |
| John K. Henry        |   | (Principal Accounting and Financial Officer)       |

 

27

----

 

**SIGNATURES**

** **

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.

 
| Dated: | November 7, 2003 |                          |
|--------|-----------------------|-------------------------------|
|   |                  |                          |
|   |                  | **DUANE  READE REALTY, Inc.** |
|   |                  |                          |
|   |                  | By:                           | /s/ John K. Henry |   |
|   |                  |                          | Name: | John K. Henry |
|   |                  |                          | Title: | Senior Vice President and Chief Financial Officer |
|        |                       |                               |  |  |  |

 

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, this report has been signed on November 7, 2003 by:
| **SIGNATURES**      |   | **TITLES**                                         |
|---------------------|--------|----------------------------------------------------|
|                |   |                                               |
| /s/ Anthony J. Cuti |   | President and Chief Executive Officer and Director |
| Anthony J. Cuti     |   | (Principal Executive Officer)                      |
|                |   |                                               |
|                |   |                                               |
| /s/ John K. Henry   |   | Senior Vice President and Chief Financial Officer  |
| John K. Henry       |   | (Principal Accounting and Financial Officer)       |

 

28

----

 

**SIGNATURES**

** **

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.

 
| Dated: | November 7, 2003 |                                 |              |
|--------|-----------------------|--------------------------------------|-------------------|
|   |                  | **DUANE  READE INTERNATIONAL, Inc.** |
|   |                  |                                 |
|   |                  | By:                                  | /s/ John K. Henry |   |
|   |                  |                                 | Name:             | John K. Henry |
|   |                  |                                 | Title:            | Senior Vice President and Chief Financial Officer |
|        |                       |                                      |                   |  |  |  |

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, this report has been signed on November 7, 2003 by:
| **SIGNATURES**      |   | **TITLES**                                         |
|---------------------|--------|----------------------------------------------------|
|                |   |                                               |
| /s/ Gary Charboneau |   | President and Chief Executive Officer and Director |
| Gary Charboneau     |   | (Principal Executive Officer)                      |
|                |   |                                               |
|                |   |                                               |
| /s/ John K. Henry   |   | Senior Vice President and Chief Financial Officer  |
| John K. Henry       |   | (Principal Accounting and Financial Officer)       |

 

29

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