**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C.**

 

**FORM 10-Q**

 

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

 

**For thequarterly period ended September 28, 2002.**

 

**Commissionfile number 333-41239**

 

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**DUANE READEINC.**

(Exact name of registrant as specified in its charter)

 

| **DELAWARE**                                                                                                                                                                     |   |         |   | **04-3164702**           |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------|--------|--------------------------|
| (State or other jurisdiction of incorporation or organization)                                                                                                                   |   |         |   | (IRS Employer ID Number) |
|                                                                                                                                                                             |   |         |   |                     |
| **DRI  I Inc.***                                                                                                                                                            |   | **Delaware** |   | **04-3166107**           |
| **Duane Reade***                                                                                                                                                                 |   | **New York** |   | **11-2731721**           |
| **Duane Reade International, Inc***                                                                                                                                              |   | **Delaware** |   | **22-3672347**           |
| **Duane Reade Realty, Inc ***                                                                                                                                                    |   | **Delaware** |   | **13-4074383**           |
|                                                                                                                                                                             |   |         |   |                     |
|                                                                                                                                                                                  |
| *    Guarantors with respect to the Company’s  2.1478% Senior Convertible Notes due 2022 and the Company’s 91⁄4% Senior  Subordinated Notes due 2008 |
|                                                                                                                                                                             |   |         |   |                     |
| **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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Securitiesregistered pursuant to Section 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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Securitiesregistered pursuant to Section 12 (g) of the Act:

**None.**

 

Indicate by check mark whether the registrant: (1) hasfiled all reports 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 ýNo o

 

The number of shares ofthe Common Stock outstanding as of November 8, 2002:  **23,947,742**

 

 

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INDEX

 
| PART  I  -  |
|------------------|
|             |   |
|             | ITEM 1. - FINANCIAL  STATEMENTS |
|             |   |
|             |   | Consolidated  Statements of Operations (Unaudited) -  For the 13 and 39 Weeks Ended September 28, 2002 and September 29, 2001 |
|             |   |   |
|             |   | Consolidated Balance Sheets  As of September 28, 2002 (Unaudited) and December 29, 2001 |
|             |   |   |
|             |   | Consolidated  Statements of Cash Flows (Unaudited) -  For the 39 Weeks Ended September 28, 2002 and September 29, 2001 |
|             |   |   |
|             |   | Notes to  Consolidated Financial Statements (Unaudited) |
|             |   |
|             | ITEM  2. - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL  CONDITION AND RESULTS OF OPERATIONS |
|             |   |
|             | ITEM 3. - MARKET RISK |
|             |   |
|             | ITEM 4. - CONTROLS AND  PROCEDURES |
|             |
| PART  II  - | OTHER INFORMATION |
|             |
| SIGNATURES       |
|             |
| CERTIFICATIONS   |

 

2

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PART I - FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS

 

**Duane ReadeInc.**

Consolidated  Statements of Operations (Unaudited)

(In thousands, except per share amounts)

 
|                                                                            |   | **For the 13 Weeks Ended** |    | **For the 39 Weeks Ended** |   |
|---------------------------------------------------------------------------------|--------|----------------------------|---------|----------------------------|--------|
|                                                                            |   | **Sept 28,****2002**       |    | **Sept 29,****2001**       |   | **Sept 28,  2002** |   | **Sept 29,  2001** |   |
|                                                                            |   |                       |    |                       |   |   |   |   |   |
| Net sales                                                                       |   | $                          | 312,818 |                       | $      | 279,433 |   | $ | 943,376 |   | $ | 843,460 |   |
| Cost of sales                                                                   |   | 240,047                    |    | 213,614                    |   | 732,669 |   | 641,768 |   |
|                                                                            |   |                       |    |                       |   |   |   |   |   |
| Gross profit                                                                    |   | 72,771                     |    | 65,819                     |   | 210,707 |   | 201,692 |   |
|                                                                            |   |                       |    |                       |   |   |   |   |   |
| Selling, general & administrative expenses                                  |   | 48,921                     |    | 42,974                     |   | 145,078 |   | 130,870 |   |
| Insurance recovery                                                              |   | —                     |    | —                     |   | (9,378 | ) | — |   |
| Depreciation and amortization                                                   |   | 6,874                      |    | 6,685                      |   | 20,377 |   | 19,745 |   |
| Store pre-opening expenses                                                      |   | 265                        |    | 482                        |   | 1,610 |   | 1,381 |   |
|                                                                            |   | 56,060                     |    | 50,141                     |   | 157,687 |   | 151,996 |   |
|                                                                            |   |                       |    |                       |   |   |   |   |   |
| Operating income                                                                |   | 16,711                     |    | 15,678                     |   | 53,020 |   | 49,696 |   |
| Interest expense, net                                                           |   | 3,706                      |    | 5,099                      |   | 14,375 |   | 21,834 |   |
|                                                                            |   |                       |    |                       |   |   |   |   |   |
| Income before income taxes                                                      |   | 13,005                     |    | 10,579                     |   | 38,645 |   | 27,862 |   |
| Income taxes                                                                    |   | 5,029                      |    | 4,224                      |   | 15,344 |   | 11,649 |   |
| Income before extraordinary charges and  cumulative effect of accounting change |   | 7,976                      |    | 6,355                      |   | 23,301 |   | 16,213 |   |
| Extraordinary charges, net of income taxes                                      |   | 192                        |    | —                     |   | 7,925 |   | 1,491 |   |
| Cumulative effect of accounting change,  net of income taxes                    |   | —                     |    | —                     |   | 9,262 |   | — |   |
| Net income                                                                      |   | $                          | 7,784   |                       | $      | 6,355 |   | $ | 6,114 |   | $ | 14,722 |   |
|                                                                            |   |                       |    |                       |   |   |   |   |   |
| Per common share – basic                                                   |   |                       |    |                       |   |   |   |   |   |
|                                                                            |   |                       |    |                       |   |   |   |   |   |
| Income before extraordinary charges and  cumulative effect of accounting change |   | $                          | 0.33    |                       | $      | 0.28 |   | $ | 0.98 |   | $ | 0.80 |   |
| Extraordinary charges, net of income taxes                                      |   | 0.01                       |    | —                     |   | 0.33 |   | 0.07 |   |
| Cumulative effect of accounting change,  net of income taxes                    |   | —                     |    | —                     |   | 0.39 |   | — |   |
| Net income                                                                      |   | $                          | 0.32    |                       | $      | 0.28 |   | $ | 0.26 |   | $ | 0.73 |   |
|                                                                            |   |                       |    |                       |   |   |   |   |   |
| Weighted average common shares outstanding                                      |   | 23,948                     |    | 22,933                     |   | 23,816 |   | 20,254 |   |
|                                                                            |   |                       |    |                       |   |   |   |   |   |
| Per common share – diluted                                                 |   |                       |    |                       |   |   |   |   |   |
|                                                                            |   |                       |    |                       |   |   |   |   |   |
| Income before extraordinary charges and  cumulative effect of accounting change |   | $                          | 0.33    |                       | $      | 0.27 |   | $ | 0.95 |   | $ | 0.77 |   |
| Extraordinary charges, net of income taxes                                      |   | 0.01                       |    | —                     |   | 0.32 |   | 0.07 |   |
| Cumulative effect of accounting change,  net of income taxes                    |   | —                     |    | —                     |   | 0.38 |   | — |   |
| Net income                                                                      |   | $                          | 0.32    |                       | $      | 0.27 |   | $ | 0.25 |   | $ | 0.70 |   |
|                                                                            |   |                       |    |                       |   |   |   |   |   |
| Weighted average common shares outstanding                                      |   | 24,424                     |    | 23,781                     |   | 24,574 |   | 21,168 |   |

 

The accompanying notes are an integral part of these financialstatements.

 

3

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**Duane Reade Inc.**

Consolidated Balance Sheets

(Inthousands, except share amounts)

 
|                                                                                                            |   | **September 28,  2002** |    | **December 29,****2001** |   |
|-----------------------------------------------------------------------------------------------------------------|--------|-------------------------|---------|--------------------------|--------|
|                                                                                                            |   | **(Unaudited)**         |    |                     |   |
| ASSETS                                                                                                          |   |                    |    |                     |   |
| Current Assets                                                                                                  |   |                    |    |                     |   |
| Cash                                                                                                            |   | $                       | 12,123  |                     | $      | 4,972 |   |
| Receivables                                                                                                     |   | 57,147                  |    | 57,085                   |   |
| Inventories                                                                                                     |   | 223,184                 |    | 220,707                  |   |
| Deferred income taxes                                                                                           |   | 9,124                   |    | 14,295                   |   |
| Prepaid expenses and other current assets                                                                       |   | 16,356                  |    | 19,412                   |   |
| TOTAL CURRENT ASSETS                                                                                            |   | 317,934                 |    | 316,471                  |   |
|                                                                                                            |   |                    |    |                     |   |
| Property and equipment, net                                                                                     |   | 162,419                 |    | 135,835                  |   |
| Goodwill, net of accumulated amortization of $35,323                                                            |   | 160,236                 |    | 158,395                  |   |
| Deferred income taxes                                                                                           |   | —                  |    | 1,082                    |   |
| Other assets                                                                                                    |   | 86,411                  |    | 67,202                   |   |
| TOTAL ASSETS                                                                                                    |   | $                       | 727,000 |                     | $      | 678,985 |   |
|                                                                                                            |   |                    |    |                     |   |
| LIABILITIES AND STOCKHOLDERS’  EQUITY                                                                      |   |                    |    |                     |   |
| Current liabilities                                                                                             |   |                    |    |                     |   |
| Accounts payable                                                                                                |   | $                       | 54,507  |                     | $      | 69,088 |   |
| Accrued interest                                                                                                |   | 4,173                   |    | 5,599                    |   |
| Other accrued expenses                                                                                          |   | 19,290                  |    | 19,097                   |   |
| Current portion of long-term debt                                                                               |   | 3,822                   |    | 7,758                    |   |
| Current portion of capital lease obligations                                                                    |   | 530                     |    | 820                      |   |
| TOTAL CURRENT LIABILITIES                                                                                       |   | 82,322                  |    | 102,362                  |   |
|                                                                                                            |   |                    |    |                     |   |
| Long-term debt, less current portion                                                                            |   | 282,242                 |    | 238,401                  |   |
| Capital lease obligations, less current portion                                                                 |   | 1,625                   |    | 176                      |   |
| Other noncurrent liabilities                                                                                    |   | 41,540                  |    | 42,839                   |   |
| TOTAL LIABILITIES                                                                                               |   | 407,729                 |    | 383,778                  |   |
|                                                                                                            |   |                    |    |                     |   |
| 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 23,947,742 and 23,423,422 shares |   | 239                     |    | 234                      |   |
| Paid-in capital                                                                                                 |   | 328,410                 |    | 314,060                  |   |
| Accumulated other comprehensive income                                                                          |   | —                  |    | (3,596                   | )      |
| Accumulated deficit                                                                                             |   | (9,378                  | )       | (15,491                  | )      |
| TOTAL STOCKHOLDERS’ EQUITY                                                                                 |   | 319,271                 |    | 295,207                  |   |
|                                                                                                            |   |                    |    |                     |   |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                 |   | $                       | 727,000 |                     | $      | 678,985 |   |

 

Theaccompanying notes are an integral part of these financial statements.

 

4

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**Duane Reade Inc.**

ConsolidatedStatements of Cash Flows (Unaudited)

(Inthousands)

 
|                                                                                               |   | **For the 39 Weeks Ended** |   |
|----------------------------------------------------------------------------------------------------|--------|----------------------------|--------|
|                                                                                               |   | **September 28,2002**      |   | **September 29,2001** |   |
| Cash flows provided by (used in) operating activities:                                             |   |                       |   |   |   |
| Net income                                                                                         |   | $                          | 6,114  |   | $ | 14,722 |   |
| Adjustments to reconcile net   income to net cash provided by (used in) operating activities: |   |                       |   |   |   |
| Depreciation and amortization of property and equipment                                            |   | 13,880                     |   | 11,155 |   |
| Amortization of goodwill and other intangibles                                                     |   | 7,860                      |   | 9,784 |   |
| Deferred tax provision                                                                             |   | 15,754                     |   | 11,974 |   |
| Extraordinary charges, net of tax                                                                  |   | (3,067                     | )      | 1,491 |   |
| Cumulative effect of accounting change, net of tax                                                 |   | 9,262                      |   | — |   |
| Non-cash rent expense                                                                              |   | 7,761                      |   | 4,142 |   |
| Changes in operating assets and liabilities (net of the effect of  acquisitions):                  |   |                       |   |   |   |
| Receivables                                                                                        |   | 538                        |   | (11,997 | ) |
| Inventories                                                                                        |   | (16,558                    | )      | (37,192 | ) |
| Accounts payable                                                                                   |   | (14,581                    | )      | 3,660 |   |
| Prepaid and accrued expenses                                                                       |   | 299                        |   | (6,750 | ) |
| Other assets and liabilities, net                                                                  |   | (7,597                     | )      | (5,235 | ) |
| NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES                                                |   | 19,665                     |   | (4,246 | ) |
|                                                                                               |   |                       |   |   |   |
| Cash flows used in investing activities:                                                           |   |                       |   |   |   |
| Capital expenditures                                                                               |   | (36,400                    | )      | (31,883 | ) |
| Lease, customer file and other acquisition costs                                                   |   | (8,159                     | )      | (4,391 | ) |
| NET CASH USED IN INVESTING ACTIVITIES                                                              |   | (44,559                    | )      | (36,274 | ) |
|                                                                                               |   |                       |   |   |   |
| Cash flows provided by financing activities:                                                       |   |                       |   |   |   |
| Proceeds from convertible note offering                                                            |   | 218,501                    |   | — |   |
| Proceeds from equity offering                                                                      |   | —                     |   | 130,446 |   |
| Repayment of term loans                                                                            |   | (90,217                    | )      | (99,640 | ) |
| Net (repayment) borrowing of revolving credit facility                                             |   | (10,000                    | )      | 11,000 |   |
| Repayment of senior subordinated notes                                                             |   | (78,379                    | )      | — |   |
| Exercise of stock options                                                                          |   | 1,157                      |   | 2,181 |   |
| Financing costs                                                                                    |   | (8,000                     | )      | (1,889 | ) |
| Repayments of capital lease obligations                                                            |   | (1,017                     | )      | (1,462 | ) |
| NET CASH PROVIDED BY FINANCING ACTIVITIES                                                          |   | 32,045                     |   | 40,636 |   |
|                                                                                               |   |                       |   |   |   |
| Net increase in cash                                                                               |   | 7,151                      |   | 116 |   |
| Cash at beginning of period                                                                        |   | 4,972                      |   | 979 |   |
| Cash at end of period                                                                              |   | $                          | 12,123 |   | $ | 1,095 |   |

 

Theaccompanying notes are an integral part of these financial statements.

 

5

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**Notesto Consolidated Financial Statements**

 

**1. Basisof Presentation**

 

The Unaudited Consolidated Financial Statements included herein reflectall adjustments (consisting of normal recurring items) which, in the opinion ofmanagement, are necessary to present fairly the results of operations,financial position and cash flows of Duane Reade Inc. (the “Company”), and havebeen prepared, in all material respects, in accordance with the same accountingprinciples followed in the preparation of the Company’s annual financialstatements for the year ended December 29, 2001, except as disclosedherein.  These financial statementsshould be read in conjunction with the Company’s financial statements includedin its Annual Report on Form 10-K for the year ended December 29, 2001.  The Unaudited Consolidated FinancialStatements include the accounts of the Company and its subsidiaries.  All significant intercompany transactions andbalances have been eliminated. Cost of sales includes all occupancy related costsand expenses, consisting of lease and sublease related income and expenses,other recurring real estate related income and expenses primarily from salesand terminations of leases related to store closings and relocations, incomefrom sales of market related data, store utility costs and warehouse expensesand distribution costs. Other related real estate income and income from salesof market related data amounted to $3.7 million in the quarter ended September28, 2002 versus $5.4 million in the quarter ended September 29, 2001, and$4.8 million in the nine months ended September 28, 2002 as comparedto $8.9 million in the nine months ended September 29, 2001. Earningsper share amounts are calculated based on the weighted average number of sharesoutstanding during the period and may not add due to rounding. The results forthe interim periods presented are not necessarily indicative of the resultsexpected for the full year.

 

The Company has no assets or operations other than its investment inits subsidiary guarantors. Accordingly, the Unaudited Consolidated FinancialStatements present the combined assets and operations of the subsidiaryguarantors.

 

**2. WorldTrade Center Disaster and Related Business Interruption and Property Losses**

 

On September 11, 2001, as a result of the terrorist attack on the WorldTrade Center in lower Manhattan, the Company lost all of its inventory andother property and equipment in its World Trade Center location and lost aportion of its inventory and other property in several other locations. TheCompany also experienced substantial business disruption resulting from thepermanent loss of two stores and temporary closings of 20 additional storesduring the period immediately following the attack. The Company believes thatit is fully insured for its property and business interruption losses inconnection with this event, as well as the extra costs to return temporarilyclosed stores to normal operations. The Company has collected its property lossclaim and a partial payment of $9.9 million toward its business interruptionand extra expenses claim.  On September24, 2002, after additional claim settlement discussions were unsuccessful, theCompany filed suit against its insurance carrier to recover the balance of itsbusiness interruption claim related to these losses.  Additional insurance recoveries for the business interruptionportion of the Company’s insurance claim, which could be material, will berecognized when collection of such recoveries is assured.

 

**3.Accounting Change**

 

As of December 30, 2001, the Company adopted achange in accounting method to convert from the retail dollar first-in,first-out (“FIFO”) method to a specific cost based last-in, first-out (“LIFO”)method. Adoption of the specific cost LIFO method will more accurately valueinventory by eliminating the averaging inherent in the retail method. Inaddition, the specific cost LIFO method will reflect the impact of inflation inthe Company’s gross margin. The effect of changing from the retail method tothe specific cost method was a reduction in inventory of $16.0 million,resulting in a cumulative effect of an accounting change as of December 30,2001 of approximately $9.3 million, net of an income tax benefit of $6.7million ($0.39 per basic common share and $0.38 per diluted common share,respectively). The cumulative effect of changing from FIFO to LIFO on periodsprior to December 30, 2001 cannot be determined. Pro forma effects of thechange for prior periods have not been presented as cost information is notdeterminable.

 

**4.Inventory**

 

At September 28, 2002, inventories would have been greater by $1.3million if they had been valued on a lower of FIFO cost or market basis.

 

6

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**5.Convertible Notes Offering and Tender Offer**

 

On April 16, 2002, theCompany completed an offering (the “Offering”) of $381.5 million aggregateprincipal amount of Senior Convertible Notes maturing on April 16, 2022 (the“Convertible Notes”). The Convertible Notes were issued at a price of $572.76per note (57.276% of the principal amount at maturity) and pay cash interest atthe rate of 2.1478% per year on the principal amount at maturity, payablesemi-annually in arrears on April 16 and October 16 of each year beginning onOctober 16, 2002, until April 16, 2007. After that date, interest will accrueon the notes as amortization of the original issue discount representing ayield to maturity of 3.75% per year, computed on a semi-annual bond equivalentbasis. After deducting commissions and expenses related to the offering, netproceeds of $210.5 million were realized by the Company. A portion of theproceeds was used to repay an aggregate of approximately $50.1 million inprincipal amount of Term A loans and Term B loans and $41.5 million inprincipal amount of revolving loans (which revolving loans may be reborrowed)under our Senior Credit Agreement. In addition, the Company terminated aninterest rate swap agreement, which was set to expire in January 2003, at acost of approximately $3.9 million.

 

Holders of the Convertible Notes may convert each $1,000 in principalamount of their convertible notes into 14.1265 shares of the Company’s commonstock, subject to adjustment, only if (1) the sale price of the Company’scommon stock reaches, or the trading price of the notes falls below, specifiedthresholds, (2) the notes are called for redemption, or (3) specifiedcorporate transactions have occurred. Upon conversion, the Company has theright to deliver, in lieu of its common stock, cash or a combination of cashand common stock in an amount as described in the indenture.

 

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

 

The Company may redeem for cash all or a portion of the convertiblenotes at any time after April 16, 2007, at a price equal to the sum of theissue price plus accrued original issue discount and accrued cash interest, ifany, to the redemption date.

 

On June 3, 2002, the Company completed a tender offer and consentsolicitation (the “Tender Offer”) to purchase all of its $80 million ofoutstanding principal amount of 91⁄4% Senior Notes due 2008 (the “Senior Notes”).The Tender Offer was priced at $1,083.50 per each $1,000 principal amount ofSenior Notes tendered to the Company on or before the consent deadline of May20, 2002 (the “Consent Deadline”), and $1,063.50 per each $1,000 principalamount of Senior Notes tendered to the Company after the Consent Deadline butbefore the May 31, 2002 expiration date, plus accrued and unpaid interest onthe principal amount thereof through the payment date. Of the total $80 millionSenior Notes outstanding, $78.2 million were tendered on or before the ConsentDeadline and an additional $0.2 million were tendered thereafter. On June 3,2002, the Company paid a total of $87.1 million from the balance of theproceeds of the Offering in satisfying the Tender Offer. This payment wascomposed of principal value ($78.4 million), premium payments ($6.5 million)and accrued interest earned from February 16, 2002 through the payment date($2.2 million).

 

On July 10, 2002, theCompany, using the remaining proceeds from the Offering, repaid an aggregate of$36.0 million in principal amount of Term A loans and Term B loans under theSenior Credit Agreement. After giving effect to this repayment, the Company hada remaining outstanding balance of $66.8 million of Term A loans and Term Bloans in the aggregate.

 

7

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**6.Extraordinary Charges**

 

During the second quarter, the Company repaid an aggregate ofapproximately $50.1 million of Term A loans and Term B loans outstanding underthe Senior Credit Agreement and $78.4 million of the $80 million aggregateprincipal amount of outstanding Senior Notes. In connection with theserepayments, the Company recorded a $1.2 million extraordinary charge, net of anincome tax benefit of $0.9 million, representing the accelerated amortizationof deferred financing costs associated with the portion of outstanding termloans and Senior Notes retired. In addition, the Company recorded a $4.2million extraordinary charge, net of an income tax benefit of $2.9 million,representing the consent premium paid to the holders of the Senior Notestendered for retirement and certain related expenses. Finally, the Companyrecorded a $2.3 million extraordinary charge, net of an income tax benefit of$1.6 million, representing the cost to terminate the interest rate swapagreement that was tied to interest expenses on Term A loans, Term B loans andrevolving loans that were repaid with the proceeds of the Offering.

 

During the third quarter, the Company repaid an aggregate ofapproximately $36.0 million of Term A loans and Term B loans outstanding underthe Senior Credit Agreement. In connection with this repayment, the Companyrecorded an extraordinary charge of $0.2 million, net of an income tax benefitof $0.1 million, representing the accelerated amortization of that portion ofdeferred financing costs attributable to the Term A loans and Term B loans thatwere repaid.

 

**7. NetIncome per Common Share**

 

Net income per common share is based on the weighted average sharesoutstanding during each period in accordance with the provisions of FASBStatement No. 128 “Earnings Per Share.” Basic earnings per share is computed based on the weighted averagenumber of common shares outstanding during the period.  Diluted earnings per share gives effect toall dilutive potential common shares outstanding during the period.  Dilutive potential common shares includeshares issuable upon exercise of the Company’s “in-the-money” stockoptions.  Of the options to purchase2,673,015 and 2,286,143 shares of common stock outstanding at September 28,2002 and September 29, 2001, respectively, options to purchase 1,510,588 sharesat September 28, 2002 and 45,156 shares at September 29, 2001 were not includedin the computation of diluted earnings per share because the exercise prices ofsuch options were greater than the average market price of the common sharesand the impact of these shares would have been anti-dilutive.

 

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

 
|                                                                                 |   | **For the 13  Weeks Ended** |   | **For the 39  Weeks Ended** |   |
|--------------------------------------------------------------------------------------|--------|-----------------------------|--------|-----------------------------|--------|
|                                                                                 |   | **Sept 28,  2002**          |   | **Sept 29,  2001**          |   | **Sept 28,  2002** |   | **Sept 29,  2001** |   |
|                                                                                 |   |                        |   |                        |   |   |   |   |   |
| Income before extraordinary charges and  cumulative effect of accounting change      |   | $                           | 7,976  |                        | $      | 6,355 |   | $ | 23,301 |   | $ | 16,213 |   |
| Extraordinary charges, net of income taxes                                           |   | 192                         |   | —                      |   | 7,925 |   | 1,491 |   |
| Cumulative effect of accounting change,  net of income taxes                         |   | —                      |   | —                      |   | 9,262 |   | — |   |
| Net income                                                                           |   | $                           | 7,784  |                        | $      | 6,355 |   | $ | 6,114 |   | $ | 14,722 |   |
|                                                                                 |   |                        |   |                        |   |   |   |   |   |
| Weighted average  number of common shares outstanding during the period – basic |   | 23,948                      |   | 22,933                      |   | 23,816 |   | 20,254 |   |
| Potential  dilutive shares                                                           |   | 476                         |   | 848                         |   | 758 |   | 914 |   |
| Weighted average  number of shares outstanding – diluted                        |   | 24,424                      |   | 23,781                      |   | 24,574 |   | 21,168 |   |
|                                                                                 |   |                        |   |                        |   |   |   |   |   |
| Per common share  – basic                                                       |   |                        |   |                        |   |   |   |   |   |
|                                                                                 |   |                        |   |                        |   |   |   |   |   |
| Income before extraordinary charges and  cumulative effect of accounting change      |   | $                           | 0.33   |                        | $      | 0.28 |   | $ | 0.98 |   | $ | 0.80 |   |
| Extraordinary charges, net of income taxes                                           |   | 0.01                        |   | —                      |   | 0.33 |   | 0.07 |   |
| Cumulative effect of accounting change,  net of income taxes                         |   | —                      |   | —                      |   | 0.39 |   | — |   |
| Net income                                                                           |   | $                           | 0.32   |                        | $      | 0.28 |   | $ | 0.26 |   | $ | 0.73 |   |
|                                                                                 |   |                        |   |                        |   |   |   |   |   |
| Per common share  – diluted                                                     |   |                        |   |                        |   |   |   |   |   |
|                                                                                 |   |                        |   |                        |   |   |   |   |   |
| Income before extraordinary charges and  cumulative effect of accounting change      |   | $                           | 0.33   |                        | $      | 0.27 |   | $ | 0.95 |   | $ | 0.77 |   |
| Extraordinary charges, net of income taxes                                           |   | 0.01                        |   | —                      |   | 0.32 |   | 0.07 |   |
| Cumulative effect of accounting change,  net of income taxes                         |   | —                      |   | —                      |   | 0.38 |   | — |   |
| Net income                                                                           |   | $                           | 0.32   |                        | $      | 0.27 |   | $ | 0.25 |   | $ | 0.70 |   |

 

8

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**8.Income Taxes**

 

Income taxes are recorded based on the estimated combined statutory taxrates expected to be applicable for the full fiscal year less applicableemployment related tax credits. The effective tax rate is lower than thecombined statutory rates, primarily reflecting the impact of these wage-relatedincome tax credits.

 

**9.Acquisitions**

 

During the first nine months of fiscal 2002, the Company acquired thecustomer files of nine pharmacies and the operations, including certainlease-related assets, of seven pharmacy establishments.  The total cost of these acquisitions, ofwhich $14.3 million was paid for by the issuance of common stock, was$19.1 million and was allocated as follows: Identified intangibles ($13.3million), property and equipment ($2.5 million), inventory ($1.9 million),goodwill ($1.8 million) and other assets ($0.1 million), net of accruals forexpenses and liabilities assumed ($0.5 million).  For the 13 weeks ended September 28, 2002, the Company acquiredthe customer files of three pharmacies and the operation, including thelease-related asset, of one pharmacy establishment at a total cost of $1.8million.  The operations of the acquiredstores have been included in the consolidated financial statements from thedates of the acquisitions. The pro forma impact of these acquisitions was notmaterial to sales, results of operations or earnings per share of the Companyfor the thirteen or thirty-nine week periods ended September 28, 2002.

 

**10. Shareholder Rights Plan**

** **

On September 5, 2002, theCompany’s Board of Directors adopted a Shareholder Rights Plan designed to enhancethe Board’s ability to protect shareholders against, among other things,unsolicited attempts to acquire control of the Company that do not offer anadequate price to all shareholders or are otherwise not in the best interestsof the Company and its shareholders. The Plan was not adopted in response to any specific effort to acquirecontrol of the Company.  

 

Under the Plan, eachcommon shareholder of the Company at the close of business on September 30,2002 received a dividend of one right for each share held of the Common Stockof the Company.  Each right entitles theholder to purchase from the Company, in certain circumstances described below,one one-thousandth of a share of newly created Series A Preferred Stock of theCompany for an initial purchase price of $130. The rights distribution is not taxable to shareholders.

 

Initially the rights willbe represented by the Company’s Common Stock certificates and will not beexercisable.  The rights will becomeexercisable 10 days after any person has become the beneficial owner of 15% ormore of the Company’s Common Stock or has commenced a tender or exchange offerwhich, if consummated, would result in any person becoming the beneficial ownerof 15% or more of the Common Stock of the Company.

 

If any person becomes thebeneficial owner of 15% or more of the Company’s Common Stock, each right willentitle the holder, other than the acquiring person, to purchase for thepurchase price of the right Company Common Stock or common stock of the acquiringperson having a value of twice the purchase price.

 

The Company may redeemthe rights at a price of $.01 per right at any time prior to the tenth dayafter any person has become the beneficial owner of 15% or more of the CommonStock of the Company.  The rights willexpire on September 30, 2012 unless earlier exchanged or redeemed.

 

**11.Newly Issued Accounting Standards**

 

During the third quarter of 2001, the Company adopted FinancialAccounting Standards Board Pronouncements Nos. 141 (FAS 141) and 142 (FAS 142)“Business Combinations” and “Goodwill and Other Intangible Assets”,respectively, for acquisitions completed after June 30, 2001 (See Note No. 9“Acquisitions”). These adoptions did not have a material impact on theCompany’s results of operations, financial position or cash flows.  During the first quarter ended March 30,2002, the Company adopted these same standards for goodwill related toacquisitions completed prior to July 1, 2001. For the thirteen and thirty-nineweeks ended September 28, 2002, the Company’s goodwill amortization expense wasreduced by $1.1 million and $3.3 million, respectively, as a result of theadoption of these standards. Had these standards been adopted prior to the 2001fiscal year, the Company’s net income for the thirteen and thirty-nine weeksended September 29, 2001 would have been approximately $7.0 million and $16.7million, respectively. In addition, for the thirteen and thirty-nine weeksended September 29, 2001, the Company’s net income per basic share outstandingwould have been $0.31 and $0.83, respectively, and the Company’s net income perdiluted share outstanding would have been $0.30 and $0.79, respectively. AtSeptember 28, 2002, included within the “other assets” category on theCompany’s balance sheet, were intangible assets totaling $71.0 million, net ofaccumulated amortization of $51.2 million. The $71.0 million is primarilycomposed of costs related to the acquisition of store leases ($34.1 million)and pharmacy customer files ($21.5 million), deferred financing costs ($8.4million) and all other net intangible assets ($7.0 million).  Lease acquisition costs are generallyamortized over the remaining lease life, pharmacy file acquisition costs areamortized over seven years, and deferred financing costs are amortized over thelife of the financing agreement.  Basedon the net intangible asset values at September 28, 2002, the Companyanticipates that it will incur expenses related to the amortization of existingintangible assets of $3.0 million for the balance of fiscal 2002.  For the 2003 through 2006 fiscal years, theCompany expects to incur annual expenses related to the amortization ofexisting intangible assets of $11.6 million, $10.8 million, $9.7 million and$9.2 million, respectively.

 

9

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During the first quarter of 2002, the Company adopted FinancialAccounting Standards Board Pronouncement No. 144 (FAS 144), “Accounting for theImpairment or Disposal of Long-Lived Assets.” FAS 144 supercedes FAS 121,“Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assetsto be Disposed of.” The provisions of FAS 144 are effective for financialstatements issued after December 15, 2001. This adoption did not have amaterial impact on the Company’s results of operations, financial position orcash flows.

 

In April 2002, FAS No. 145, “Rescission of FASB Statements No. 4, 44,and 64, Amendment of FASB Statement No. 13, and Technical Corrections,” wasissued. Under FAS No. 145, gains and losses related to the extinguishment ofdebt 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 with early adoption encouraged.The Company is currently evaluating the impact of this statement.

 

In July 2002, FAS No. 146, “Accounting for Costs Associated with Exitor Disposal Activities,” was issued. This statement nullifies Emerging IssuesTask Force (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, with early adoptionencouraged. The Company does not believe that this statement will have amaterial impact on its results of operations, financial position or cash flows.

 

**12.Commitments and Contingencies**

 

The Company is a party to legalactions arising in the ordinary course of business.  Based on information presently available, the Company believesthat it has adequate legal defenses or insurance coverage for these actions andthat the ultimate outcome of these actions will not have a material adverseeffect on the Company’s financial position, cash flows or results ofoperations.

 

On October 1, 2002, the Company completed a new three year agreement withthe Drug, Chemical, Cosmetic, Plastics and Affiliated Industries WarehouseEmployees Local 815, an affiliate of the International Brotherhood ofTeamsters. This agreement covers most of the Company’s warehouse employees andreplaced a previous labor agreement that expired on September 30, 2002.  This new agreement will expire on September30, 2005.

 

**13.Executive Compensation**

 

On August 12,2002, Anthony J. Cuti, the Company’s Chairman, President and CEO and theCompensation Committee of the Board of Directors executed an amended andrestated employment agreement (the “Employment Agreement”) extending the termof Mr. Cuti’s employment to December 31, 2004. The EmploymentAgreement provides for a continuation of his current salary of $750,000 perannum through December 31, 2002 and an increase to $850,000 per annum forcalendar year 2003. Thereafter, the Board of Directors may increase, but notdecrease, Mr. Cuti’s base salary. In addition, on each January 1beginning with January 1, 2004, the rate of Mr. Cuti’s base salarywill be increased by the percentage increase in the Consumer Price Index ForAll Urban Consumers respecting New York, New York, as published by the Bureauof Labor Statistics for the 12-month period preceding such date. The EmploymentAgreement also provides for a continuation of annual incentive bonuses of up to200% of Mr. Cuti’s base salary if certain maximum performance targets areachieved. The Employment Agreement provides for an additional long-term cashtarget award of $975,000 if the targeted performance objectives for both 2003and 2004 are achieved. Mr. Cuti will also receive an increase in his annualsupplemental employment retirement benefit, to 50% of his maximum salary andannual incentive bonus, increased by 2% for each full or partial year after age60 that Mr. Cuti provides services to the Company as an employee or in anyother capacity in which he is actively engaged by the Company as a director orconsultant. As a result, the Company has increased the previously existingsplit dollar life insurance policy in an amount sufficient to yield theseannual retirement benefits to Mr. Cuti. Under terms more fully describedin the Employment Agreement, upon Mr. Cuti’s termination of employment forreasons other than cause, Mr. Cuti would be entitled to severance benefitsequal to five years of his maximum base salary and incentive bonus (the “SeveranceAmount”), plus an additional 60% of the Severance Amount.

 

At September 28, 2002, Mr. Cuti hadapproximately $1.2 million in notes payable to the Company, which are dueon December 19, 2002, and $2.6 million in notes payable to theCompany, which are due on November 9, 2003 (the “Cuti Notes”). Upon theoccurrence of certain change of control and employment termination events (noneof which has occurred as of the filing date) under Mr. Cuti’s previousemployment agreement and the new Employment Agreement, all principal andinterest on the Cuti Notes would be forgiven. Mr. Cuti has notified theBoard of Directors that he has waived his right to receive the benefit of anyforgiveness event related to the Cuti Notes.

 

10

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**ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION AND RESULTS OF OPERATIONS**

 

***The information contained herein includescertain forward-looking statements that involve a number of risks anduncertainties. A number of facts could cause our actual results, performance,achievements, or industry results to be materially different from any futureresults, performance or achievements expressed or implied by suchforward-looking statements. These factors include, but are not limited to, thecompetitive environment in the drugstore industry in general and in ourspecific market area; inflation; changes in costs of goods and services;economic conditions in general and in our specific market areas; demographicchanges; changes in prevailing interest rates and the availability of and termsof financing to fund the anticipated growth of our business; liability andother claims asserted against us; changes in operating strategy or developmentplans; the ability to attract and retain qualified personnel; our significantindebtedness; additional regulatory and legal requirements; labor disturbances;the continued impact of, or new occurrences of, terrorist attacks in the NewYork City metropolitan area; changes in our acquisition and capital expenditureplans; and other factors referenced herein. In addition, such forward lookingstatements are necessarily dependent upon assumptions, estimates and dates thatmay be incorrect or imprecise and involve known and unknown risks,uncertainties and other factors. Accordingly, any forward-looking statementsincluded herein do not purport to be predictions of future events orcircumstances and may not be realized. Forward-looking statements can beidentified by, among other things, the use of forward-looking terminology suchas “believes,” “expects,” “may,” “will,” “should,” “seeks,” “pro forma,”“anticipates,” “intends” or the negative of any thereof or other variationsthereon or comparable terminology, or by discussion of strategy or intentions.  Given these uncertainties, investors arecautioned not to place undue reliance on such forward-looking statements. Wedisclaim any obligations to update any such factors or to publicly announce theresults of any revisions to any of the forward-looking statements containedherein to reflect future events or developments.***

 

**Resultsof Operations**

 

The following sets forth the results of operations as a percentage ofsales for the periods indicated.

 
|                                                                            |   | **13 Weeks  Ended** |   | **39 Weeks  Ended** |   |
|---------------------------------------------------------------------------------|--------|---------------------|--------|---------------------|--------|
|                                                                            |   | **Sept 28,  2002**  |   | **Sept 29,  2001**  |   | **Sept 28, 2002** |   | **Sept 29,  2001** |   |
| Net sales                                                                       |   | 100.0               | %      | 100.0               | %      | 100.0 | % | 100.0 | % |
| Cost of sales                                                                   |   | 76.7                |   | 76.4                |   | 77.7 |   | 76.1 |   |
| Gross profit                                                                    |   | 23.3                |   | 23.6                |   | 22.3 |   | 23.9 |   |
| Selling, general and admin expenses                                             |   | 15.6                |   | 15.4                |   | 15.4 |   | 15.5 |   |
| Insurance recovery                                                              |   | —              |   | —              |   | (1.0 | ) | — |   |
| Depreciation & amortization                                                 |   | 2.2                 |   | 2.4                 |   | 2.1 |   | 2.3 |   |
| Store pre-opening expense                                                       |   | 0.1                 |   | 0.2                 |   | 0.2 |   | 0.2 |   |
| Operating income                                                                |   | 5.4                 |   | 5.6                 |   | 5.6 |   | 5.9 |   |
| Interest expense, net                                                           |   | 1.2                 |   | 1.8                 |   | 1.5 |   | 2.6 |   |
| Income before income taxes                                                      |   | 4.2                 |   | 3.8                 |   | 4.1 |   | 3.3 |   |
| Income taxes                                                                    |   | 1.6                 |   | 1.5                 |   | 1.6 |   | 1.4 |   |
| Income before extraordinary charges and cumulative effect of  accounting change |   | 2.6                 |   | 2.3                 |   | 2.5 |   | 1.9 |   |
| Extraordinary charges, net of income taxes                                      |   | 0.1                 |   | —              |   | 0.8 |   | 0.2 |   |
| Cumulative effect of accounting change, net of income taxes                     |   | —              |   | —              |   | 1.0 |   | — |   |
| Net income                                                                      |   | 2.5                 | %      | 2.3                 | %      | 0.7 | % | 1.7 | % |

 

**ThirteenWeeks Ended September 28, 2002 versus Thirteen Weeks Ended September 29, 2001**

 

Net sales were $312.8 million in the third quarter of 2002, an increaseof 11.9% over net sales of $279.4 million for the third quarter of 2001.Pharmacy sales increased from $109.9 million in the third quarter of 2001 to$131.0 million in the third quarter of 2002, an increase of 19.2%, andrepresented 41.9% of total sales, as compared with 39.3% of total sales in thethird quarter of 2001. Front-end sales increased from $169.5 million in thethird quarter of 2001 to $181.8 million in the third quarter of 2002, anincrease of 7.3%, and represented 58.1% of total sales, as compared with 60.7%of total sales in the third quarter of 2001. For the third quarter of 2002, third-party reimbursed

 

11

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pharmacy sales represented 90.0% of total pharmacy sales, as comparedto 86.9% in the third quarter of 2001. The increase in total sales over lastyear was attributable to increased comparable store sales of 6.0%, including anincrease in pharmacy same store sales of 13.2% and an increase in front-endsame store sales of 1.3%, combined with the full quarterly impact of six netnew stores opened during the third quarter of 2001 and sales from 28 net newstores opened since the third quarter of 2001. During the third quarter of2002, we opened four stores and closed one store, compared to nine storeopenings, one store closing and the loss of two stores as a result of the WorldTrade Center disaster during the third quarter of 2001.  At September 28, 2002, we operated 221stores, as compared to 193 at September 29, 2001.  While pharmacy same store sales improved 13.2%, the increase wasreduced by approximately eight percentage points due to higher genericsubstitution rates, which nevertheless improved overall pharmacyprofitability.  The increase infront-end same store sales reflects a favorable comparison with post-September11th results, partially offset by the impact of the general economic slowdownsince the September 11th World Trade Center disaster.

 

Cost of sales as a percentage of net sales increased to 76.7% for thethird quarter of 2002 from 76.4% for the third quarter of 2001, resulting in adecrease in gross profit margin to 23.3% for the third quarter of 2002 from23.6% for the third quarter of 2001. This decrease was primarily attributable to a higher percentage of lowermargin pharmacy and third party pharmacy sales in the current year. Inaddition, gross margins declined due to increased levels of inventoryshrinkage.  Cost of sales also includesa $0.5 million LIFO charge in the current year, while the previous year’s costof sales was based on a retail FIFO inventory valuation method.

 

Selling, general and administrative expenses were $48.9 million, or15.6% of net sales, and $43.0 million, or 15.4% of net sales in the thirdquarters of 2002 and 2001, respectively. The increase in these expenses as a percentage of sales is primarily dueto start-up costs related to a large number of one-hour photo departmentsopened during the current year and increased insurance, maintenance andsecurity service costs.

 

Depreciation and amortization of intangibles in the third quarters of2002 and 2001 were $6.9 million and $6.7 million, respectively.  This increase resulted primarily fromincreases in the amortization of identifiable intangibles resulting frompharmacy acquisitions completed since the third quarter of 2001, combined withincremental depreciation expenses related to capital expenditures in 2001 and2002, partially offset by the elimination of goodwill amortization expenseresulting from the adoption of FAS 142. Included in the third quarter 2001expense is $1.1 million related to the amortization of goodwill that would havebeen eliminated if FAS 142 had been adopted at the beginning of the thirdquarter of 2001.

 

We incurred store pre-opening expenses of $0.3 million during the thirdquarter of 2002 related to the opening of four stores.  During the comparable period last year, weincurred pre-opening expenses of $0.5 million related to the opening of ninestores.

 

Net interest expense decreased 27.3% to $3.7 million in the thirdquarter of 2002 from $5.1 million in the third quarter of 2001.  This decrease was primarily attributable tolower interest rates on the 2.1478% Convertible Note Offering that wascompleted in April, the proceeds of which were used to retire $78.4 million of9.25% Senior Notes and higher cost term loan and revolver borrowings.

 

Our income before income taxes in the third quarter of 2002 increased22.9% to $13.0 million from $10.6 million in the third quarter of 2001,reflecting the factors discussed above.

 

In the third quarter of 2002, we recorded an income tax provision of$5.0 million, reflecting an estimated annual effective tax rate of 40.9%,reduced by $0.3 million of employment tax credits. In the comparable periodlast year, the income tax provision of $4.2 million reflected an estimatedeffective tax rate of 43.0%, reduced by $0.3 million of employment tax credits.

 

During the third quarter of 2002, we recorded total extraordinarycharges, net of a 40.9% income tax benefit, of $0.2 million, reflecting theaccelerated amortization of deferred financing costs related to $36.0 millionof Term A and Term B loans under our Senior Credit Agreement that were repaidwith a portion of the proceeds from our offering of Senior Convertible Notes.

 

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**Thirty-NineWeeks Ended September 28, 2002 versus Thirty-Nine Weeks Ended September 29,2001**

 

Net sales were $943.4 million in the first nine months of 2002, anincrease of 11.8% over net sales of $843.5 million for the first nine months of2001. Pharmacy sales increased from $324.7 million in the first nine months of2001 to $393.5 million in the first nine months of 2002, an increase of 21.2%,and represented 41.7% of total sales, as compared with 38.5% of total sales inthe first nine months of 2001. Front-end sales increased from $518.8 million inthe first nine months of 2001 to $549.8 million in the first nine months of2002, an increase of 6.0%, and represented 58.3% of total sales, as comparedwith 61.5% of total sales in the first nine months of 2001.  For the first nine months of 2002,third-party reimbursed pharmacy sales represented 89.7% of total pharmacysales, as compared to 86.5% in the first nine months of 2001. The increase intotal sales over last year was attributable to increased comparable store salesof 5.1%, including an increase in pharmacy same store sales of 13.8%, partiallyoffset by a decrease in front-end same store sales of 0.4%, combined with thefull nine-month impact of 24 stores opened during the first nine months of 2001and sales from 28 net new stores opened since the third quarter of 2001. Duringthe first nine months of 2002, we opened 24 new stores and closed three stores,compared to 24 store openings, one store closing and the loss of two stores dueto the World Trade Center disaster during the first nine months of 2001.

 

Cost of sales as a percentage of net sales increased to 77.7% for thefirst nine months of 2002 from 76.1% for the first nine months of 2001,resulting in a decrease in gross profit margin to 22.3% for the first ninemonths of 2002 from 23.9% for the first nine months of 2001.  This decrease was primarily attributable toincreased promotional activity and lower levels of sales related vendor rebatesand allowances in the first half of 2002, combined with an increased percentageof lower margin pharmacy and third party pharmacy sales and higher physicalinventory shrink losses.  Cost of salesin the first nine months of 2002 also includes a $1.3 million LIFO charge.

 

Selling, general and administrative expenses were $145.1 million, or15.4% of net sales, and $130.9 million, or 15.5% of net sales, in the firstnine months of 2002 and 2001, respectively. The decrease in these expenses as a percentage of sales is primarilyattributable to lower payroll and related costs as a percentage of sales.

 

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.

 

Depreciation and amortization of intangibles in the first nine monthsof 2002 and 2001 were $20.4 million and $19.7 million, respectively.  This increase resulted primarily fromincreases in the amortization of identifiable intangibles resulting frompharmacy acquisitions completed since the third quarter of 2001, combined withincremental depreciation expenses related to capital expenditures in 2001 and 2002,partially offset by the elimination of goodwill amortization expense resultingfrom the adoption of FAS 142. Included in the expense for the first nine monthsof 2001 is $3.3 million related to the amortization of goodwill that would havebeen eliminated if FAS 142 had been adopted at the beginning of 2001.

 

We incurred store pre-opening expenses of $1.6 million during the firstnine months of 2002 related to the opening of 24 stores.  During the comparable period last year, weincurred pre-opening expenses of $1.4 million related to the opening of 24stores.

 

Net interest expense decreased 34.2% to $14.4 million in the first ninemonths of 2002 from $21.8 million in the first nine months of 2001.  This decrease was primarily attributable tothe second quarter 2001 repayment of $130.4 million of senior debt from theproceeds of the follow-on equity offering, combined with the second quarter2002 repayment of higher cost senior subordinated debt and term loans from theproceeds of the Convertible Note Offering.

 

Our income before income taxes in the first nine months of 2002increased 38.7% to $38.6 million, from $27.9 million in the first nine monthsof 2001, reflecting the factors discussed above.

 

In the first nine months of 2002, we recorded an income tax provisionof $15.3 million, reflecting an estimated annual effective tax rate of 40.9%,reduced by $0.5 million of employment tax credits. In the comparable periodlast year, the income tax provision of $11.6 million reflected an estimatedeffective tax rate of 43.0%, partially offset by $0.3 million of employment taxcredits.

 

13

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During the first nine months of 2002, we recorded total extraordinarycharges, net of a 40.9% income tax benefit, of $7.9 million, which werecomposed of the following: (1) $1.4 million, reflecting the acceleratedamortization of deferred financing costs related to (a) loans under our SeniorCredit Agreement that were repaid with the proceeds of our offering of SeniorConvertible Notes and (b) our 91⁄4% Senior Notes due 2008 that were purchasedpursuant to a tender offer completed in June 2002, (2) $4.2 million associatedwith the payment of consent premiums and other expenses related to the tenderoffer, and (3) $2.3 million related to the termination of the interest rateswap agreement tied to interest expenses on the loans under the Senior CreditAgreement that were retired with proceeds from the convertible notes offering.During the first nine months of 2001, we recorded total extraordinary charges,net of a 43.0% income tax benefit, of $1.5 million, reflecting the acceleratedamortization of deferred financing costs related to (a) loans under our SeniorCredit Agreement that were repaid with the proceeds of the primary shares issuedin our June 2001 equity offering, and (b) the remaining Term B loans and Term Cloans that were refinanced as a result of amending and restating our SeniorCredit Agreement.

 

During the first ninemonths of 2002, as a result of the change in accounting method of inventoryvaluation from retail dollar FIFO to specific cost LIFO, we recorded aone-time, non-cash charge of $9.3 million, net of an income tax benefit of $6.7million.

 

**Liquidity and Capital Resources**

 

On April 16, 2002, we completed an offering (the "Offering")of $381.5 million aggregate principal amount of senior convertible notesmaturing on April 16, 2022 (the "Convertible Notes"). The ConvertibleNotes were issued at a price of $572.76 per note (57.276% of the principalamount at maturity) and pay cash interest at the rate of 2.1478% per year onthe principal amount at maturity, payable semi-annually in arrears on April 16and October 16 of each year beginning on October 16, 2002, until April 16,2007. After that date, interest will accrue on the notes as amortization of theoriginal issue discount representing a yield to maturity of 3.75% per year,computed on a semi-annual bond equivalent basis. After deducting commissionsand expenses related to the offering, we realized net proceeds of $210.5million. A portion of the proceeds was used to repay an aggregate ofapproximately $86.1 million in principal amount of Term A loans and Term Bloans and $41.5 million in principal amount of revolving loans (which revolvingloans may be reborrowed) under our Senior Credit Agreement. In addition, weterminated an interest rate swap agreement, which was set to expire in January2003, at a cost of approximately $3.9 million.

 

Holders of the Convertible Notes may convert each $1,000 in principalamount of their Convertible Notes into 14.1265 shares of our common stock,subject to adjustment, only if (1) the sale price of our common stockreaches, or the trading price of the notes falls below, specified thresholds,(2) the notes are called for redemption, or (3) specified corporatetransactions have occurred. Upon conversion, we have the right to deliver, inlieu of our common stock, cash or a combination of cash and common stock in anamount as described in the indenture.

 

Holders of the Convertible Notes may require us to purchase all or aportion of their notes on April 16, 2007 at a price of $572.76 per noteplus accrued cash interest, if any; on April 16, 2012 at a price of$689.68 per note plus accrued cash interest, if any; and on April 16, 2017at a price of $830.47 per note plus accrued cash interest, if any. We maychoose to pay the purchase price of such notes in cash or common stock or acombination of cash and common stock. In addition, if we experience a change incontrol, each holder may require us 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.

 

We may redeem for cash all or a portion of the Convertible Notes at anytime after April 16, 2007, at a price equal to the sum of the issue priceplus accrued original issue discount and accrued cash interest, if any, to theredemption date.

 

On June 3, 2002, we completed a tender offer and consent solicitation(the "Tender Offer") to purchase our outstanding 91⁄4% Senior Notes due2008 (the "Senior Notes"). The Tender Offer was priced at $1,083.50per each $1,000 principal amount of Senior Notes tendered to us on or beforethe Consent Deadline of May 20, 2002 (the "Consent Deadline"), and$1,063.50 per each $1,000 principal amount of Senior Notes tendered to us afterthe Consent Deadline but before the May 31, 2002 expiration date. Of the total$80 million Senior Notes outstanding, $78.2 million were tendered on or beforethe Consent Deadline and an additional $0.2 million were tendered thereafter.On June 3, 2002, we expended a total of $87.1 million from the balance of theproceeds of the Convertible Notes Offering to pay our obligations under the TenderOffer. This payment was composed of principal value ($78.4 million), premiumpayments ($6.5 million) and accrued interest earned from February 16, 2002through the payment date ($2.2 million).

 

14

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At September 28, 2002, we had$5.5 million in Term A and $60.4 million in Term B loans outstandingunder our Senior Credit Agreement, $218.5 million of outstandingConvertible Notes and $1.6 million of outstanding Senior Notes. We had nooutstanding borrowings under our $80 million revolving credit facility(other than $0.7 million of outstanding standby Letters of Credit) and$12.1 million in cash.  We intendto retire the remaining $1.6 million of outstanding Senior Notes duringthe first quarter of 2003.  Any amountsoutstanding under revolving loans and Term A loans mature on February 15,2004, and the Term B loans mature on February 15, 2007. We expect that we willbe able to extend or replace the revolving loan and Term A loan portions of theSenior Credit Agreement prior to maturity.

 

Working capital was $235.6 million as of September 28, 2002 and $214.1million as of December 29, 2001. The increase was primarily due to additionalinvested cash of $7.0 million, a reduction in short-term borrowings resultingfrom the issuance of the convertible notes and the payment of a liability to aformer pharmacy supplier.

 

For the first nine months of 2002, net cash provided by operatingactivities was $19.7 million, as compared to net cash used in operatingactivities of $4.2 million in the first nine months of 2001. The increase wasprimarily due to a reduced level of inventory growth in 2002 compared to theprior year and collection of amounts due for our September 11 property lossinsurance claim.

 

Net cash used in investing activities was $44.6 million during thefirst nine months of 2002, compared to $36.3 million during the first ninemonths of 2001.  In the first ninemonths of 2002, capital expenditures, primarily related to new store openingsand the remodeling of existing locations, amounted to $36.4 million, whilelease, pharmacy customer file and other acquisition costs accounted for $8.2million of cash used in investing activities. In the first nine months of 2001, we spent $31.9 million on capitalexpenditures and $4.4 million on lease, pharmacy customer file and otheracquisition costs.

 

Net cash provided by financing activities was $32.0 million for thefirst nine months of 2002, compared to $40.6 million for the first nine monthsof 2001. The decrease reflects the higher levels of cash provided by operationspartially offset by increased use of cash for capital expenditures andacquisitions.

 

Our capital requirements primarily result from opening and stocking newstores, remodeling and renovating existing stores and from the continuingdevelopment of management information systems. We believe that there aresignificant opportunities to open additional stores, and currently plan to openapproximately 11 to 13 additional new stores during the remainder of this year(a total of 35 to 37 for all of 2002), and 35 to 40 new stores in fiscal 2003.We expect to spend approximately $48.0 million in 2002 on capital expenditures,primarily for new, renovated and replacement stores and an additional $10.0million to $12.0 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 our store locations.

 

We believe that, based on current levels of operations and anticipatedgrowth, cash flow from operations, together with other available sources offunds, including revolving loan borrowings with an extension, refinancing orreplacement of our Senior Credit Agreement, will be adequate for at least thenext two years to make required payments of principal and interest on ourindebtedness, to fund anticipated capital expenditures and working capitalrequirements, and to comply with the terms of our debt agreements. As ofSeptember 28, 2002, we had no borrowings under the revolving portion of ourSenior Credit Agreement and had $79.3 million of remaining availability, net of$0.7 million of outstanding standby letters of credit.  Our ability to meet our debt serviceobligations and reduce our total debt will be dependent upon our futureperformance, which, in turn, will be subject to general economic, financial,business, competitive, legislative, regulatory, and other conditions, many ofwhich are beyond our control. In addition, we cannot assure you that ouroperating results, cash flow and capital resources will be sufficient to repayour indebtedness in the future. Substantially all of our future revolving andoutstanding term loan borrowings under our Senior Credit Agreement bearinterest at floating rates. There was approximately $65.9 million of floatingrate debt outstanding on September 28, 2002. Therefore, our financial conditionwill be affected by changes in prevailing interest rates.

 

15

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The Senior Credit Agreement contains various covenants that limit orrestrict, among other things, subject to specified exceptions, our ability tomake capital expenditures, incur indebtedness, permit liens on our property,enter into transactions with affiliates, make restricted payments, investmentsor acquisitions, enter into mergers, consolidations or dissolutions, conductassets sales, pay dividends or distributions and enter into other specifiedtransactions and business activities. Financial performance covenants included in our Senior Credit Agreementinclude interest coverage, leverage ratios, minimum net worth requirements andfixed charge coverage requirements.  AtSeptember 28, 2002, we were in compliance with all financial performancecovenants. There are no credit ratings related triggers in either our SeniorCredit Agreement or the indentures related to either our Convertible Notes orour remaining Senior Notes that would impact cost of borrowing, annualamortization of principal or related debt maturities.

 

**Critical Accounting Policies**

 

Our discussion of results of operations and financial condition relieson our consolidated financial statements that are prepared based on certaincritical accounting policies that require management to make judgments andestimates that are subject to varying degrees of uncertainty. We believe thatinvestors need to be aware of these policies and how they impact our financialreporting to gain a more complete understanding of our consolidated financialstatements as a whole, as well as our related discussion and analysis presentedherein. While we believe that these accounting policies are grounded on soundmeasurement criteria, actual future events can and often do result in outcomesthat can be materially different from these estimates or forecasts. Theaccounting policies and related risks described in our Annual Report on Form10-K for the year ended December 29, 2001 are those that depend most heavily onthese judgments and estimates.  AtSeptember 28, 2002, there have been no material changes to any of the CriticalAccounting Policies contained therein.

 

**Seasonality**

 

In general, sales of drugstore items such as prescription drugs,over-the-counter drugs and health and beauty care products exhibit limitedseasonality in the aggregate, but do vary by product category. Quarterlyresults are primarily affected by the timing of new store openings and the saleof seasonal products, with the Christmas holiday season generating a higherproportion of sales and earnings than other periods.

 

**RecentlyIssued Accounting Pronouncements**

 

In April 2002, FAS No. 145, “Rescission of FASB Statements No. 4, 44,and 64, Amendment of FASB Statement No. 13, and Technical Corrections,” wasissued. Under FAS No. 145, gains and losses related to the extinguishment ofdebt 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 with early adoption encouraged.

 

In July 2002, FAS No. 146, “Accounting for Costs Associated with Exitor Disposal Activities,” was issued. This statement nullifies Emerging IssuesTask Force (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, with early adoptionencouraged.

 

**ITEM 3. MARKET RISK**

 

Our financial results are subject to risk from interest ratefluctuations on debt which carries variable interest rates. Variable rate debtoutstanding under our Senior Credit Agreement was approximately $65.9 millionat September 28, 2002. At September 28, 2002, the weighted average combined interestrate in effect on all borrowings under the Senior Credit Agreement was 4.31%. A0.50% change in interest rates applied to the $65.9 million balance of floatingrate debt existing at September 28, 2002 would affect pre-tax annual results ofoperations by approximately $0.3 million. In addition, we also have $218.5million of Senior Convertible Notes and $1.6 million of Senior SubordinatedNotes outstanding at September 28, 2002. These notes bear interest payablesemi-annually at fixed rates of 3.75% and 9.25%, respectively, and aretherefore not subject to risk from interest rate fluctuations.

 

16

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The principal objective of our investment management activities is tomaintain acceptable levels of interest rate and liquidity risk to facilitateour funding needs. As part of our risk management, we may consider usingadditional derivative financial products such as interest rate hedges andinterest rate swaps in the future.

 

**ITEM4. CONTROLS AND PROCEDURES**

 

The Company maintainsdisclosure controls and procedures that are designed to ensure that informationrequired to be disclosed in the Company's Exchange Act reports is recorded,processed, summarized and reported within the time periods specified in the SEC'srules and forms, and that such information is accumulated and communicated tothe Company's management, including its Chief Executive Officer and ChiefFinancial Officer, as appropriate, to allow timely decisions regarding requireddisclosure.  In designing and evaluating the disclosure controls andprocedures, management recognized that any controls and procedures, no matterhow well designed and operated, can provide only reasonable assurance ofachieving the desired control objectives, and management necessarily wasrequired to apply its judgment in evaluating the cost-benefit relationshipof possible controls and procedures. 

 

Within 90 days prior tothe date of this report, the Company carried out an evaluation, under thesupervision and with the participation of the Company's management, includingthe Company's Chief Executive Officer and the Company's Chief FinancialOfficer, of the effectiveness of the design and operation of the Company'sdisclosure controls and procedures.  Based on the foregoing, the Company'sChief Executive Officer and Chief Financial Officer concluded that theCompany's disclosure controls and procedures were effective.

 

There have been nosignificant changes in the Company's internal controls or in other factors thatcould significantly affect the internal controls subsequent to the date theCompany completed its evaluation.

** **

**PART II**

 

**OTHERINFORMATION**

 

**ITEM 1.  Legal Proceedings**

 

From August 14 through October2002, several class action complaints for violations of securities laws werefiled against the Company and Anthony J. Cuti, its Chairman, President and CEO.These complaints were filed in the Federal Court for the Southern District ofNew York on behalf of shareholders who acquired Duane Reade, Inc. securitiesbetween April 25, 2002 and July 24, 2002, inclusive (the “Class Period”).Recently, the plaintiffs in these actions filed a request to consolidate theseactions into one proceeding. These actions allege that the Company violatedfederal securities laws by issuing a series of materially false and misleadingstatements. The Company believes that these actions are completely baseless andwithout merit. The Company will vigorously defend these actions in court.

 

Weare a 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 financial position, cashflows or results of operations.

 

**ITEM 2.  Changes in Securities and Use of Proceeds**

 

Not applicable

 

**ITEM 3.  Defaults Upon Senior Securities**

 

Not applicable

 

**ITEM 4.  Submission of Matters to a Vote of Security Holders**

 

Not applicable

 

**ITEM 5.  OtherInformation**

 

Notapplicable

 

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

 

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

 

(i)            Financial Statements

 

(ii)           Exhibits:

 

17

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| 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  By-laws 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                    | Second Amended and  Restated Partnership Agreement of Duane Reade (incorporated by reference to  Exhibit 3.3 of the Notes S-1).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 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                    | Form of Indenture  (incorporated by reference to Exhibit 4.1 of the Notes S-1).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 4.2*                   | Second Supplemental  Indenture, dated as of May 20, 2002, between Duane Reade Inc., the Subsidiary  Guarantors, and State Street Bank, as trustee.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 4.3                    | 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”)).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 4.4                    | 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 (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 October 27, 1997, between the Company and Anthony J. Cuti  (incorporated by reference to Exhibit 10.3 to the Common Stock S-1).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.4                   | 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).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 10.5                   | 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).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.6                   | 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).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.7                   | 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).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 10.8                   | 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”)).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.9                   | Stockholders and  Registration Rights Agreement, dated as of June 18, 1997, among the Company,  DLJMB Funding II, Inc., DLJ Merchant Banking Partners II, L.P., DLJ  Diversified Partners, L.P., DLJ First ESC L.L.C., DLJ Offshore Partners, II,  C.V., DLJ EAB Partners, L.P., UK Investment Plan 1997 Partners, Bankers Trust  New York Corporation, Conac & Co., Muico & Co., Roton & Co.,  Putnam High Yield Trust, PaineWebber Managed Investment Trust on behalf of  PaineWebber High Income Fund, USL Capital Corporation, Pearlman Family  Partners, The Marion Trust, Bruce L. Weitz, BCIP Associates, BCIP Trust  Associates, L.P., Tyler Capital Fund L.P., Tyler International, L.P.—II, and  Tyler Massachusetts, L.P. (incorporated by reference to Exhibit 10.13 to the  Common Stock S-1). |
| 10.10                  | Amended and Restated  Partnership Security Agreement, dated as of September 11, 1998, among Duane  Reade Inc. and DRI I Inc. and Fleet National Bank, as Administrative Agent  (incorporated by reference to Exhibit 10.15 to the Company’s Current Report  on Form 8-K dated September 24, 1998).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 10.11                  | Amended and Restated  Borrower Security Agreement, dated as of September 11, 1998, between Duane  Reade and Fleet National Bank as Administrative Agent (incorporated by  reference to Exhibit 10.16 to the Company’s Current Report on Form 8-K dated  September 24, 1998).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.12                  | Amended and Restated  Holdings Pledge Agreement, dated as of September 11, 1998, among Duane Reade  Inc. and Fleet National Bank, as Administrative Agent (incorporated by  reference to Exhibit 10.17 to the Company’s Current Report on Form 8-K dated  September 24, 1998).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.13                  | 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 Annual Report on Form 10-K for  the year ended December 26, 1998 (the “1998 10-K”)).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.14                  | 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).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.15                  | Promissory Note, dated  as of June 7, 1999, between the Company and Anthony J. Cuti (incorporated by  reference to Exhibit 10.19 to the 1999 10-K).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.16                  | Promissory Note, dated  as of December 30, 1999, between the Company and Anthony J. Cuti  (incorporated by reference to Exhibit 10.20 to the 1999 10-K).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.17                  | Fourth Amended and  Restated Credit Agreement, dated as of July 10, 2001, among Duane Reade, as  the Borrower, Duane Reade Inc. and DRI I Inc., as the Parent Guarantors,  Various Financial Institutions set forth therein, as the Lenders, Credit  Suisse First Boston, as the Syndication Agent for the Lenders, and Credit  Lyonnais New York Branch, as the Documentation Agent for the Lenders  (incorporated by reference to Exhibit 10.29 to the Company’s Quarterly Report  on Form 10-Q for the period ended June 30, 2001).                                                                                                                                                                                                                                                                                  |
| 10.18                  | First Amendment to  Employment Agreement, dated March 13, 2000, between the Company and Anthony  J. Cuti (incorporated by reference to Exhibit 10.23 to the 1999 10-K).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 10.19                  | 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).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 10.20                  | Promissory Note, dated  as of January 10, 2001, between the Company and Anthony J. Cuti (incorporated  by reference to Exhibit 10.24 to the Company’s Annual Report on Form 10-K for  the year ended December 30, 2000 (the “2000 10-K”)).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.21                  | Second Amendment to  Employment Agreement, dated May 1, 2001, between the Company and Anthony J.  Cuti (incorporated by reference to Exhibit 10.25 to the Company’s Quarterly  Report on Form 10-Q for the period ended March 31, 2001).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| 10.22                  | Second Amendment to  Employment Agreement, as amended, dated May 21, 2001, between the Company,  Credit Suisse First Boston Ltd. And Anthony J. Cuti (incorporated by  reference to Exhibit 10.1 to Amendment No. 1 to the Company’s Registration  Statement on Form S-3 dated July 22, 2001).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.23                  | Promissory Note, dated  as of January 2, 2002, between the Company and Anthony J. Cuti (incorporated  by reference to Exhibit 10.23 to the 2001 10-K).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.24                  | 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).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| 10.25                  | 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).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.26                  | Third Amendment to  Employment Agreement, effective June 16, 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).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 10.27                  | 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).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 10.28 *                | First Amendment to the  Fourth Amended and Restated Credit Agreement, dated as of April 9, 2002,  among Duane Reade, as the Borrower, Duane Reade Inc. and DRI I Inc., as the  Parent Guarantors, Various Financial Institutions set forth therein, as the  Lenders, Credit Suisse First Boston, as the Syndication Agent for the  Lenders, and Credit Lyonnais New York Branch, as the Documentation Agent for  the Lenders.                                                                                                                                                                                                                                                                                                                                                                                                |
| 10.29 *                | Second Amendment to the  Fourth Amended and Restated Credit Agreement, dated as of September 25, 2002,  among Duane Reade, as the Borrower, Duane Reade Inc. and DRI I Inc., as the  Parent Guarantors, Various Financial Institutions set forth therein, as the  Lenders, Credit Suisse First Boston, as the Syndication Agent for the  Lenders, and Credit Lyonnais New York Branch, as the Documentation Agent for  the Lenders.                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.30                  | 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).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 21.1                   | Subsidiaries of the  Company (incorporated by reference to Exhibit 21.1 to the 1999 10-K).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
|                   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|                        |
| *  filed herewith |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |

 

18

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| (b)                                                                                                                                                                                                                                                                                                                                                          | Reports on Form 8-K:                                                                 |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                                                                                                         |
| On August 13, 2002, the  Company filed a Current Report on Form 8-K which contained, in response to  item 9, the Officer’s Certifications attesting to the completeness and  accuracy of the information contained within the Company’s Quarterly Report  on Form 10-Q for the period ended June 29, 2002, filed concurrently on August  13, 2002. |
|                                                                                                                                                                                                                                                                                                                                                         |
| On September 12, 2002,  the Company filed a Current Report on Form 8-K which contained information  related to the Company’s adoption of a Shareholder Rights Agreement effective  September 5, 2002.                                                                                                                                                   |
|                                                                                                                                                                                                                                                                                                                                                         |
| (c)                                                                                                                                                                                                                                                                                                                                                          | Financial Statement  Schedules:         None |
|                                                                                                                                                                                                                                                                                                                                                         |
| Schedules for which  provision is made in the applicable accounting regulations of the Commission  are either not required under the related instructions, are inapplicable or  not material, or the information called for thereby is otherwise included in  the financial statements and therefore has been omitted.                                       |

 

19

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**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) ofthe Securities Exchange Act of 1934, the registrant has duly caused this reportto be signed on its behalf by the undersigned, thereunto duly authorized.

 

 
| Dated: |   November 12,  2002 |   |                   |              |                                               |
|--------|---------------------------|--------|------------------------|-------------------|----------------------------------------------------|
|   |                      |   | **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 on November 12,2002.

 
| **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) |

 

20

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Pursuant to the requirements of Section 13 or 15(d) ofthe Securities Exchange Act of 1934, the registrant has duly caused this reportto be signed on its behalf by the undersigned, thereunto duly authorized.

 

 
| Dated: | November 12, 2002 |            |              |                                               |
|--------|-------------------|-----------------|-------------------|----------------------------------------------------|
|   |              | **DRI I  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 12, 2002 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) |

 

21

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Pursuant to the requirements of Section 13 or 15(d) ofthe Securities Exchange Act of 1934, the registrant has duly caused this reportto be signed on its behalf by the undersigned, thereunto duly authorized.

 

 
| Dated:    November  12, 2002                                              |                                               |                                                                            |             |                                               |
|------------------------------------------------------------------------------------------|----------------------------------------------------|---------------------------------------------------------------------------------|------------------|----------------------------------------------------|
|                                                                                     |                                               |                                                                            | **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 |
|                                                                                          |                                                    |                                                                                 |                  |                                                    |  |  |  |  |  |  |

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, this report has been signed below on November 12, 2002 bythe following persons in the capacities indicated with respect to Duane ReadeInc. and DRI I Inc., the general partners of Duane Reade, on behalf of DuaneReade (except as otherwise indicated):

 
| **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) |

 

22

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Pursuant to the requirements of Section 13 or 15(d) ofthe Securities Exchange Act of 1934, the registrant has duly caused this reportto be signed on its behalf by the undersigned, thereunto duly authorized.

 

 
| Dated:    November 12, 2002 |   |   |                          |              |                                               |
|---------------------------------------|--------|--------|-------------------------------|-------------------|----------------------------------------------------|
|                                  |   |   | **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 12, 2002 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) |

 

23

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Pursuant to the requirements of Section 13 or 15(d) ofthe Securities Exchange Act of 1934, the registrant has duly caused this reportto be signed on its behalf by the undersigned, thereunto duly authorized.

 

 
| Dated:    November 12, 2002 |   |                                 |              |                                               |
|---------------------------------------|--------|--------------------------------------|-------------------|----------------------------------------------------|
|                                  |   |                                 |              |                                               |
|                                  |   | **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 12, 2002 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) |

 

24

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**CERTIFICATIONS**

 

I, Anthony J.Cuti, certify that:

 

1. I have reviewedthis quarterly report on Form 10-Q of Duane Reade Inc;

 

2. Based on myknowledge, this quarterly report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this quarterly report;

 

3. Based on myknowledge, the financial statements, and other financial information includedin this quarterly report, fairly present in all material respects the financialcondition, results of operations and cash flows of the registrant as of, andfor, the periods presented in this quarterly report;

 

4. Theregistrant’s other certifying officers and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and we have:

 

a) Designed suchdisclosure controls and procedures to ensure that material information relatingto the registrant, including its consolidated subsidiaries, is made known to usby others within those entities, particularly during the period in which thisquarterly report is being prepared;

 

b) Evaluated theeffectiveness of the registrant’s disclosure controls and procedures as of adate within 90 days prior to the filing date of this quarterly report (the“Evaluation Date”); and

 

c) Presented inthis quarterly report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of the Evaluation Date;

 

5. Theregistrant’s other certifying officers and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunction):

 

a) All significantdeficiencies in the design or operation of internal controls which couldadversely affect the registrants ability to record, process, summarize andreport financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

b) Any fraud,whether or not material, that involves management or other employees who have asignificant role in the registrant’s internal controls; and

 

6. Theregistrant’s other certifying officers and I have indicated in this quarterlyreport whether or not there were significant changes in internal controls or inother factors that could significantly affect internal controls subsequent tothe date of our most recent evaluation, including any corrective actions withregard to significant deficiencies and material weaknesses.

 

 
| Date:  | November 12, 2002   |   |                          |                                               |
|--------|---------------------|--------|-------------------------------|----------------------------------------------------|
|   |                |   |                          |                                               |
|   |                |   |                          |                                               |
| By:    | /s/ Anthony J. Cuti |   |                          | President and Chief Executive Officer and Director |
|   | Anthony J. Cuti     |   | (Principal Executive Officer) |

 

25

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I, John K. Henry,certify that:

 

1. I have reviewedthis quarterly report on Form 10-Q of Duane Reade Inc;

 

2. Based on myknowledge, this quarterly report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this quarterly report;

 

3. Based on myknowledge, the financial statements, and other financial information includedin this quarterly report, fairly present in all material respects the financialcondition, results of operations and cash flows of the registrant as of, andfor, the periods presented in this quarterly report;

 

4. Theregistrant’s other certifying officers and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and we have:

 

a) Designed suchdisclosure controls and procedures to ensure that material information relatingto the registrant, including its consolidated subsidiaries, is made known to usby others within those entities, particularly during the period in which thisquarterly report is being prepared;

 

b) Evaluated theeffectiveness of the registrant’s disclosure controls and procedures as of adate within 90 days prior to the filing date of this quarterly report (the“Evaluation Date”); and

 

c) Presented inthis quarterly report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of the Evaluation Date;

 

5. Theregistrant’s other certifying officers and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunction):

 

a) All significantdeficiencies in the design or operation of internal controls which couldadversely affect the registrants ability to record, process, summarize andreport financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

b) Any fraud,whether or not material, that involves management or other employees who have asignificant role in the registrant’s internal controls; and

 

6. The registrant’sother certifying officers and I have indicated in this quarterly report whetheror not there were significant changes in internal controls or in other factorsthat could significantly affect internal controls subsequent to the date of ourmost recent evaluation, including any corrective actions with regard tosignificant deficiencies and material weaknesses.

 

 
| Date:  |  November 12,  2002 |   |                           |                                              |
|--------|--------------------------|--------|--------------------------------|---------------------------------------------------|
|   |                     |   |                           |                                              |
|   |                     |   |                           |                                              |
| By:    | /s/ John K. Henry        |   |                           | Senior Vice President and Chief Financial Officer |
|   | John K. Henry            |   | (Principal Accounting Officer) |

 

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