**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON, D.C.**

 

**FORM 10-Q**

 

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

 
| **For the  quarterly period ended September 25, 2004.** | **Commission file number 001-13843** |
|--------------------------------------------------------------|--------------------------------------|

 

----

 

**DUANE READE INC.**

(Exact name of registrant as specified in its charter)

 
| **DELAWARE**                                                    | ** ** | **04-3164702**           |
|-----------------------------------------------------------------|------------|--------------------------|
| (State or other jurisdiction of incorporation or  organization) |       | (IRS Employer ID Number) |
|                                                            |       |                     |
| **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)       |

 

----

 

Indicateby check mark whether the registrant: (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.

Yes oNo ý

 

Indicateby check mark whether the registrant is an accelerated filer (as defined in theExchange Act Rule 12b-2):

Yes o  No ý

 

 

----

 

INDEX

 
| PART I – FINANCIAL  INFORMATION |                                                                                                                                                                                                                                                                                                  |
|--------------------------------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                 |                                                                                                                                                                                                                                                                                                  |   |
|                                 | ITEM 1. – FINANCIAL  STATEMENTS                                                                                                                                                                                                                                                                  |   |
|                                 |                                                                                                                                                                                                                                                                                                  |   |
|                                 | Consolidated  Statements of Operations (Unaudited) -                                                                                                                                                                                                                                                  |   |
|                                 | For  the period from July 31, 2004 through September 25, 2004 for the  Successor and the periods from June 27, 2004 through July 30, 2004  and December 28, 2003 through July 30, 2004 and the 13 Weeks and 39  Weeks Ended September 27, 2003 for the Predecessor |   |
|                                 |                                                                                                                                                                                                                                                                                                  |   |
|                                 | Consolidated Balance Sheets-                                                                                                                                                                                                                                                                          |   |
|                                 | As of September 25,  2004 (Unaudited) for the Successor and December 27, 2003 for the  Predecessor                                                                                                                                                                                          |   |
|                                 |                                                                                                                                                                                                                                                                                                  |   |
|                                 | Consolidated  Statements of Cash Flows (Unaudited) -                                                                                                                                                                                                                                                  |   |
|                                 | For  the period from July 30, 2004 through September 25, 2004 for the  Successor and the period from December 28, 2003 through July 30,  2004 and the 39 Weeks Ended September 27, 2003 for the Predecessor                                                                  |   |
|                                 |                                                                                                                                                                                                                                                                                                  |   |
|                                 | Notes  to Consolidated Financial Statements (Unaudited)                                                                                                                                                                                                                                               |   |
|                                 |                                                                                                                                                                                                                                                                                                  |   |
|                                 | ITEM  2. – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS  OF OPERATIONS                                                                                                                                                                                           |   |
|                                 |                                                                                                                                                                                                                                                                                                  |   |
|                                 | ITEM 3. – QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                                                                                                                                                                                                            |   |
|                                 |                                                                                                                                                                                                                                                                                                  |   |
|                                 | ITEM 4. –  CONTROLS AND PROCEDURES                                                                                                                                                                                                                                                               |   |
|                                 |                                                                                                                                                                                                                                                                                                  |
| PART II – OTHER  INFORMATION    |                                                                                                                                                                                                                                                                                                  |
|                                 |                                                                                                                                                                                                                                                                                                  |   |
| SIGNATURES                           |                                                                                                                                                                                                                                                                                                  |   |
|                                      |                                                                                                                                                                                                                                                                                                       |  |  |

 

 

----

 

**SPECIALNOTE REGARDING FORWARD-LOOKING STATEMENTS**

 

Thisand other of our public filings or public statements contain forward-lookingstatements within the meaning of Section 27A of the Securities Act of 1933,Section 21E of the Securities Exchange Act of 1934 and the PrivateSecurities Litigation Reform Act of 1995, that involve a number of risks anduncertainties. These statements relate to future events or our future financialperformance with respect to our financial condition, results of operations,business plans and strategies, operating efficiencies or synergies, competitivepositions, growth opportunities for existing products such as private labelmerchandise, plans and objectives of management, capital expenditures, growth andmaturation of our stores and other matters. These statements involve known andunknown risks, uncertainties and other factors that may cause our or ourindustry’s actual results, levels of activity, performance or achievements tobe materially different from those expressed or implied by any forward-lookingstatements. In some cases, you can identify forward-looking statements byterminology such as “may,” “will,” “could,” “would,” “should,” “expect,” “plan,”“anticipate,” “intend,” “believe,” “estimate,” “predict,” “potential,” “proforma,” “seek,” or “continue” or the negative of those terms or othercomparable terminology. These statements are only predictions and suchexpectations may prove to be incorrect. Some of the things that could cause ouractual results to differ substantially from our expectations are:

 

•                                          thecompetitive environment in the drugstore industry in general and in the NewYork greater metropolitan area;

 

•                                          the abilityto open and operate new stores on a profitable basis and to increase sales inexisting stores;

 

•                                          the continuedefforts of health maintenance organizations, managed care organizations,pharmacy benefit management companies and other third party payers to reduceprescription reimbursement rates;

 

•                                          the continuedefforts of federal, state and municipal government agencies to reduce Medicaidreimbursement rates, modify Medicare benefits and/or reduce prescription drugcosts;

 

•                                          oursignificant indebtedness;

 

•                                          the strengthof the economy in general and the economic conditions in the New York greatermetropolitan area, in particular, including changes in consumer purchasingpower and/or spending patterns;

 

•                                          changes in thecost of goods and services;

 

•                                          trends in thehealthcare industry, including continued conversion of various prescriptiondrugs to over-the-counter medications and the increasing market share on thepart of internet-based and mail-order-based providers;

 

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

 

•                                          changes infederal and state laws and regulations, including the potential impact ofchanges in regulations surrounding the importation of pharmaceuticals fromforeign countries and changes in minimum wage rates;

 

•                                          liability andother claims asserted against us including the items discussed under Part II,Item 1-Legal Proceedings;

 

•                                          changes inour operating strategy or development plans;

 

•                                          our abilityto attract, hire and retain qualified personnel, including our ability toattract qualified pharmacists;

 

•                                          interest ratefluctuations and changes in capital market conditions or other events affectingour ability to obtain necessary financing on favorable terms to fund theanticipated growth of our business;

 

•                                          the outcomeof the legal proceedings that have been instituted against us and othersfollowing announcement             of ourmerger agreement with Duane Reade Acquisition Corp. and Duane ReadeShareholders, LLC;

 

•                                          the continuedimpact of, or new occurrences of, terrorist attacks in the New York greater metropolitanarea and any actions that may be taken by federal, state or municipalauthorities in response to or in anticipation of such occurrences;

 

•                                          changes inour acquisition and capital expenditure plans;

 

•                                          our abilityto continue to secure suitable new store locations under acceptable leaseterms;

 

•                                          our abilityto successfully implement and manage new computer systems and technologies;

 

•                                          ourability to limit fraud and shrink;

 

•                                          demographicchanges; and

 

•                                          other risksand uncertainties detailed from time to time in our filings with the Securitiesand Exchange Commission (the “SEC”).

 

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

 

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

 

2

----

 

 

**PART I -FINANCIAL INFORMATION**

**ITEM 1.FINANCIAL STATEMENTS**

 

**DuaneReade Inc.**

Consolidated Statementsof Operations (Unaudited)

(In thousands)

 
| ** **                                     | ** ** | **Successor**                                                | ** ** | ** ** | **Predecessor**                                                  | ** ** |
|------------------------------------------------|------------|--------------------------------------------------------------|------------|------------|------------------------------------------------------------------|------------|
| ** **                                     | ** ** | **Period from  July 31, 2004  through  Sept. 25, 2004** | ** ** | ** ** | **Period from  June 27, 2004  through  July 30, 2004** | ** ** | **Three Months  Ended  September 27,  2003** | ** ** | **Period from  Dec. 28, 2003  through  July 30, 2004** | ** ** | **Nine Months  Ended  September 27,  2003** | ** ** |
|                                           |       |                                                         |       |       |                                                             |       |   |   |   |   |   |   |
| Net sales                                      |       | $                                                            | 217,556    |       |                                                             | $          | 132,085 |   | $ | 338,630 |   | $ | 846,842 |   | $ | 1,027,398 |   |
| Cost of sales                                  |       | 172,765                                                      |       |       | 104,421                                                          |       | 266,520 |   | 663,223 |   | 808,124 |   |
| Gross profit                                   |       | 44,791                                                       |       |       | 27,664                                                           |       | 72,110 |   | 183,619 |   | 219,274 |   |
| Selling, general & administrative expenses |       | 37,355                                                       |       |       | 23,726                                                           |       | 56,296 |   | 142,293 |   | 167,130 |   |
| Labor contingency expense                      |       | 689                                                          |       |       | 411                                                              |       | — |   | 2,611 |   | — |   |
| Transaction expense                            |       | 37,118                                                       |       |       | 386                                                              |       | — |   | 3,005 |   | — |   |
| Depreciation and amortization                  |       | 7,280                                                        |       |       | 3,596                                                            |       | 8,162 |   | 21,902 |   | 23,874 |   |
| Store pre-opening expenses                     |       | 366                                                          |       |       | 105                                                              |       | 154 |   | 470 |   | 798 |   |
| Other                                          |       | 25,291                                                       |       |       | —                                                           |       | — |   | — |   | — |   |
|                                           |       | 108,099                                                      |       |       | 28,224                                                           |       | 64,612 |   | 170,281 |   | 191,802 |   |
| Operating (loss) income                        |       | (63,308                                                      | )          |       | (560                                                             | )          | 7,498 |   | 13,338 |   | 27,472 |   |
| Interest expense, net                          |       | 6,283                                                        |       |       | 1,283                                                            |       | 3,386 |   | 7,977 |   | 10,452 |   |
| Debt extinguishment                            |       | —                                                       |       |       | —                                                           |       | 707 |   | — |   | 812 |   |
|                                           |       |                                                         |       |       |                                                             |       |   |   |   |   |   |   |
| (Loss) income before income taxes              |       | (69,591                                                      | )          |       | (1,843                                                           | )          | 3,405 |   | 5,361 |   | 16,208 |   |
| Income tax (benefit) provision                 |       | (32,048                                                      | )          |       | (1,325                                                           | )          | 1,499 |   | 1,555 |   | 7,132 |   |
|                                           |       |                                                         |       |       |                                                             |       |   |   |   |   |   |   |
| Net (loss) income                              |       | $                                                            | (37,543    | )          |                                                             | $          | (518 | ) | $ | 1,906 |   | $ | 3,806 |   | $ | 9,076 |   |

 

The accompanyingnotes are an integral part of these financial statements.

 

3

----

 

**DuaneReade Inc.**

Consolidated Balance Sheets

(In thousands, except share and per share data)

 
| ** **                                                                                                              | ** ** | **Successor**                | ** ** | ** ** | **Predecessor**             | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|------------|-----------------------------|------------|
| ** **                                                                                                              | ** ** | **September 25,  2004** | ** ** | ** ** | **December 27,  2003** | ** ** |
| ** **                                                                                                              | ** ** | **(Unaudited)**              | ** ** | ** ** | ** **                  | ** ** |
| ASSETS                                                                                                                  |       |                         |       |       |                        |       |
| Current Assets                                                                                                          |       |                         |       |       |                        |       |
| Cash                                                                                                                    |       | $                            | 1,377      |       |                        | $          | 1,252 |   |
| Receivables, net                                                                                                        |       | 56,686                       |       |       | 53,689                      |       |
| Inventories, net                                                                                                        |       | 264,064                      |       |       | 259,765                     |       |
| Deferred income taxes                                                                                                   |       | 20,590                       |       |       | 8,150                       |       |
| Prepaid expenses and other current assets                                                                               |       | 19,224                       |       |       | 19,504                      |       |
| TOTAL CURRENT ASSETS                                                                                                    |       | 361,941                      |       |       | 342,360                     |       |
|                                                                                                                    |       |                         |       |       |                        |       |
| Property and equipment, net                                                                                             |       | 194,809                      |       |       | 189,469                     |       |
| Goodwill, net                                                                                                           |       | 188,892                      |       |       | 161,318                     |       |
| Deferred income taxes                                                                                                   |       | —                       |       |       | 5,543                       |       |
| Other assets                                                                                                            |       | 217,508                      |       |       | 88,836                      |       |
| TOTAL ASSETS                                                                                                            |       | $                            | 963,150    |       |                        | $          | 787,526 |   |
|                                                                                                                    |       |                         |       |       |                        |       |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                               |       |                         |       |       |                        |       |
| Current Liabilities                                                                                                     |       |                         |       |       |                        |       |
| Accounts payable                                                                                                        |       | $                            | 80,323     |       |                        | $          | 85,258 |   |
| Accrued interest                                                                                                        |       | 3,839                        |       |       | 1,633                       |       |
| Other accrued expenses                                                                                                  |       | 63,747                       |       |       | 27,489                      |       |
| Current portion of capital lease obligations                                                                            |       | 762                          |       |       | 422                         |       |
| TOTAL CURRENT LIABILITIES                                                                                               |       | 148,671                      |       |       | 114,802                     |       |
|                                                                                                                    |       |                         |       |       |                        |       |
| Long-term debt                                                                                                          |       | 502,971                      |       |       | 271,385                     |       |
| Capital lease obligations, less current portion                                                                         |       | 2,209                        |       |       | 1,103                       |       |
| Deferred income taxes                                                                                                   |       | 17,196                       |       |       | —                      |       |
| Other non-current liabilities                                                                                           |       | 90,149                       |       |       | 62,915                      |       |
| TOTAL LIABILITIES                                                                                                       |       | 761,196                      |       |       | 450,205                     |       |
|                                                                                                                    |       |                         |       |       |                        |       |
| Commitments and Contingencies (Note 9)                                                                                  |       |                         |       |       |                        |       |
|                                                                                                                    |       |                         |       |       |                        |       |
| Stockholders’ Equity                                                                                               |       |                         |       |       |                        |       |
| Preferred stock, $0.01 par; authorized 5,000,000  shares;

 issued and outstanding:  none (Predecessor)            |       |                         |       |       | —                      |       |
| Series A preferred stock, $0.01 par; authorized  75,000 shares;

 issued and  outstanding: none (Predecessor)      |       |                         |       |       | —                      |       |
| Common stock, $0.01 par; authorized 75,000,000  shares;

 issued and  outstanding; 24,403,550 shares (Predecessor) |       |                         |       |       | 244                         |       |
| Common stock, $0.01 par; authorized 1,000 shares;

 issued and  outstanding; 100 shares (Successor)                |       | —                       |       |       |                        |       |
| Paid-in capital                                                                                                         |       | 239,497                      |       |       | 331,917                     |       |
| Retained earnings                                                                                                       |       | (37,543                      | )          |       | 5,160                       |       |
| TOTAL STOCKHOLDERS’ EQUITY                                                                                         |       | 201,954                      |       |       | 337,321                     |       |
|                                                                                                                    |       |                         |       |       |                        |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                         |       | $                            | 963,150    |       |                        | $          | 787,526 |   |

 

The accompanyingnotes are an integral part of these financial statements.

 

4

----

 

**Duane Reade Inc.**

ConsolidatedStatements of Cash Flows (Unaudited)

(In thousands)

 
| ** **                                                                                          | ** ** | **Successor**                                                | ** ** | ** ** | **Predecessor**                                             | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|------------|-------------------------------------------------------------|------------|
| ** **                                                                                          | ** ** | **Period from  July 30, 2004  through  Sept. 25, 2004** | ** ** | ** ** | **Period from  Dec. 28, 2003  through  July 30, 2004** | ** ** | **Nine Months  Ended  September 27,  2003** | ** ** |
|                                                                                                |       |                                                         |       |       |                                                        |       |   |   |
| Cash flows (used in) provided by operating  activities:                                             |       |                                                         |       |       |                                                        |       |   |   |
| Net (loss) income                                                                                   |       | $                                                            | (37,543    | )          |                                                        | $          | 3,806 |   | $ | 9,076 |   |
| Adjustments to reconcile net (loss) income to net  cash (used in) provided by operating activities: |       |                                                         |       |       |                                                        |       |   |   |
| Depreciation and amortization                                                                       |       | 8,012                                                        |       |       | 23,002                                                      |       | 25,333 |   |
| Deferred income taxes                                                                               |       | (32,047                                                      | )          |       | 1,480                                                       |       | 5,706 |   |
| Debt extinguishment                                                                                 |       | —                                                       |       |       | —                                                      |       | 730 |   |
| Non-cash rent expense                                                                               |       | 1,252                                                        |       |       | 3,406                                                       |       | 6,380 |   |
| Changes in operating assets and liabilities (net of  the effect of acquisitions):                   |       |                                                         |       |       |                                                        |       |   |   |
| Receivables                                                                                         |       | (2,523                                                       | )          |       | (474                                                        | )          | (1,117 | ) |
| Inventories                                                                                         |       | (6,567                                                       | )          |       | 4,015                                                       |       | (22,767 | ) |
| Accounts payable                                                                                    |       | 14,842                                                       |       |       | (19,777                                                     | )          | 12,057 |   |
| Prepaid and accrued expenses                                                                        |       | 27,207                                                       |       |       | 6,492                                                       |       | (259 | ) |
| Other assets and liabilities, net                                                                   |       | 5,372                                                        |       |       | (400                                                        | )          | (5,375 | ) |
| NET CASH (USED IN) PROVIDED BY OPERATING ACTIVITIES                                                 |       | (21,995                                                      | )          |       | 21,550                                                      |       | 29,764 |   |
|                                                                                                |       |                                                         |       |       |                                                        |       |   |   |
| Cash flows used in investing activities:                                                            |       |                                                         |       |       |                                                        |       |   |   |
| Capital expenditures                                                                                |       | (4,571                                                       | )          |       | (17,552                                                     | )          | (34,523 | ) |
| Lease acquisition, customer file and other costs                                                    |       | (7,633                                                       | )          |       | (14,925                                                     | )          | (11,261 | ) |
| Purchase of Duane Reade                                                                             |       | (413,684                                                     | )          |       | —                                                      |       | — |   |
| NET CASH USED IN INVESTING ACTIVITIES                                                               |       | (425,888                                                     | )          |       | (32,477                                                     | )          | (45,784 | ) |
|                                                                                                |       |                                                         |       |       |                                                        |       |   |   |
| Cash flows from financing activities:                                                               |       |                                                         |       |       |                                                        |       |   |   |
| Repayment of term notes                                                                             |       | —                                                       |       |       | —                                                      |       | (65,091 | ) |
| Retirement of senior subordinated notes                                                             |       | —                                                       |       |       | —                                                      |       | (1,621 | ) |
| Proceeds from term notes                                                                            |       | 155,000                                                      |       |       | —                                                      |       | — |   |
| Proceeds from senior subordinated notes                                                             |       | 195,000                                                      |       |       | —                                                      |       | — |   |
| Repurchase of senior convertible notes                                                              |       | (201,000                                                     | )          |       | —                                                      |       | — |   |
| Borrowing from revolving credit facility                                                            |       | 71,594                                                       |       |       | 10,992                                                      |       | 82,416 |   |
| Proceeds from exercise of stock options                                                             |       | —                                                       |       |       | 1,126                                                       |       | — |   |
| Additional capital                                                                                  |       | 239,498                                                      |       |       | —                                                      |       | — |   |
| Deferred financing costs                                                                            |       | (12,050                                                      | )          |       | (840                                                        | )          | (2,191 | ) |
| Repayments of capital lease obligations                                                             |       | (120                                                         | )          |       | (265                                                        | )          | (373 | ) |
| NET CASH PROVIDED BY FINANCING ACTIVITIES                                                           |       | 447,922                                                      |       |       | 11,013                                                      |       | 13,140 |   |
|                                                                                                |       |                                                         |       |       |                                                        |       |   |   |
| Net increase (decrease) in cash                                                                     |       | 39                                                           |       |       | 86                                                          |       | (2,880 | ) |
| Cash at beginning of period                                                                         |       | 1,338                                                        |       |       | 1,252                                                       |       | 4,183 |   |
| Cash at end of period                                                                               |       | $                                                            | 1,377      |       |                                                        | $          | 1,338 |   | $ | 1,303 |   |

 

The accompanyingnotes are an integral part of these financial statements.

 

5

----

 

**Notes to Unaudited Consolidated InterimFinancial Statements**

**(dollarsin thousands, except per share data)**

 

**1. Basisof Presentation**

 

On July 30,2004, Duane Reade Inc. was acquired through a merger transaction with DuaneReade Acquisition Corp. (“Duane Reade Acquisition”), a wholly owned subsidiaryof Duane Reade Holdings, Inc. and an affiliate of Oak Hill Capital Partners,L.P. (“Oak Hill”), a private equity firm (the “Acquisition”). The Acquisitionwas accomplished through the merger of Duane Reade Acquisition into Duane ReadeInc., with Duane Reade Inc. being the surviving entity.

 

Theaccompanying financial statements designated as the “Successor” are thefinancial statements of Duane Reade Inc. and subsidiaries for periodssubsequent to July 30, 2004.  AlthoughDuane Reade Inc. was the legal entity that remained after the Acquisition, allfinancial statements for periods prior to and including July 30, 2004, thedate of the Acquisition, are referred to as the financial statements of the “Predecessor.”The “Company” refers to the operations of Duane Reade Inc. and subsidiaries forboth the Predecessor and Successor periods.

 

The Acquisitionwas accounted for in accordance with the purchase method of accounting.Accordingly, the purchase price of the Acquisition has been allocated toidentifiable assets acquired and liabilities assumed based upon their estimatedfair values at the acquisition date. This allocation is preliminary andincludes a number of estimates which, upon further evaluation, may requiremodification.

 

TheUnaudited Consolidated Interim Financial Statements included herein reflect alladjustments which, in the opinion of management, are necessary to presentfairly the results of operations, financial position and cash flows of DuaneReade Inc. (the “Company”), and have been prepared, in all material respects,in accordance with the same accounting principles followed in the preparationof the Predecessor’s Annual Consolidated Financial Statements for the yearended December 27, 2003. These Unaudited Consolidated Interim Financial Statementsshould be read in conjunction with the Predecessor’s Consolidated Financial Statementsincluded in its Annual Report on Form 10-K, as amended to date, for the yearended December 27, 2003. The Unaudited Consolidated Interim FinancialStatements include the accounts of the Company and its subsidiaries.  All significant intercompany transactions andbalances have been eliminated. The results for the interim periods presentedare not necessarily indicative of the results expected for the full year.

 

The Company has no assets or operations otherthan its investment in its subsidiaries, each of which, other than Duane Reade,a New York general partnership which is the Companys’ principal operatingcompany and of which the Company is a general partner (“Duane Reade GP”), is aguarantor of the Company’s various debt instruments. Duane Reade GP is aco-obligor under each of the Company’s debt facilities. Accordingly, theUnaudited Consolidated Interim Financial Statements present the consolidatedassets and operations of the subsidiary guarantors.  The guarantees of the subsidiary guarantors,which relate to the Company’s obligations under its debt and credit agreements,are full and unconditional, joint and several.

 

**2.  Acquisition by Oak Hill Capital Partners,L.P.**

 

At the special meeting of the Company’s stockholders heldon July 26, 2004, a total of 15,436,702 shares, representing 62.9 % of thetotal outstanding shares of common stock as of the June 3, 2004 recorddate, were voted in favor of the adoption of the merger agreement. The Acquisitionwas unanimously approved by the independent members of Duane Reade Inc.’s boardof directors, who resigned from the board on July 30, 2004 in anticipationof the completion of the Acquisition. Under the terms of the merger agreement, theCompany’s stockholders received $16.50 per share in cash, without interest. Theaggregate value of the merger transaction was approximately $744 million,including transaction expenses and the repayment of indebtedness. The equityfinancing necessary for the merger was provided by Oak Hill and an affiliateequity fund, Oak Hill Capital Management Partners, L.P. as well as severalco-investors selected by Oak Hill to participate in the transaction. The debtfinancing necessary for the merger was provided by a syndicate of bankinginstitutions led by Banc of America Securities LLC. Mr. Anthony J. Cuti,the Company’s Chairman, President and CEO, the Company’s Senior Vice Presidentsand certain other members of management have equity interests in the acquiringentity and have continued in the same management positions after the Acquisition.  The new board of directors is comprised of certainexecutives of Oak Hill and Mr. Cuti. As a result of the stockholders’ approvalof the merger agreement and the satisfaction of all other conditions to themerger, the merger and related financings were consummated on July 30,2004.

 

The following pro-formafinancial information presents operating data for the quarters and nine monthperiods ended September 25, 2004 and September 27, 2003 as if the Acquisitionhas occurred on December 29, 2002. The pro-forma information assumes that thetransaction occurred as described above and that certain transaction relatedexpenses which are recorded in the 2004 unaudited financial statements wouldhave been incurred in 2003. The pro-forma results are not necessarilyindicative of the financial results that might have occurred had thetransaction actually taken place on December 29, 2002, or future results ofoperations.

 
| ** ** | ** ** | **13 Weeks Ended** | ** ** | **39 Weeks Ended** | ** ** |
|------------|------------|--------------------|------------|--------------------|------------|
| ** ** | ** ** | **Sept 25, 2004**  | ** ** | **Sept 27, 2003**  | ** ** | **Sept 25, 2004** | ** ** | **Sept 27, 2003** | ** ** |
|       |       |               |       |               |       |   |   |   |   |
| Sales      |       | $                  | 349,641    |               | $          | 338,630 |   | $ | 1,064,398 |   | $ | 1,027,398 |   |
|       |       |               |       |               |       |   |   |   |   |
| Net Loss   |       | $                  | (5,657     | )                  | $          | (2,352 | ) | $ | (9,569 | ) | $ | (39,976 | ) |

 

6

----

 

**3. NationalLabor Relations Board Decision**

 

TheCompany is a party to a National Labor Relations Board (“NLRB”) administrativeproceeding regarding a dispute with the Allied Trade Council (“ATC”) overwhether a negotiating impasse was reached between the Company and the union in August of2001. The ATC represents employees in 139 of the Company’s stores pursuant to acollective bargaining agreement that expired on August 31, 2001. Theemployees have been working pursuant to the terms of the Company’s December 6,2001 implemented contract with the ATC, which expired on August 31, 2004.The Company believes an impasse did occur and as a result, the Company had theright to implement its latest contract proposal at that time which includedwage increases, health and welfare benefits, vacation and sick benefits and a401(k) retirement program. The Company discontinued making additional paymentsinto the various funds associated with the union as it was providing many ofthese benefits on a direct basis and because its past contributions to thesefunds had caused these funds to be in a position of excessive overfunding. Inaddition, the Company had concerns that its past payments into these funds werenot being managed in a way to ensure they were being properly utilized for thebenefit of the Company’s employees. On February 18, 2004, anAdministrative Law Judge (“ALJ”) who had reviewed various matters related tothis proceeding issued a decision and related recommendation, which concludedthat the parties were not at impasse. The remedies recommended by the ALJincluded, among other things, a requirement for the Company to make itsemployees whole by reimbursing them for expenses ensuing from the failure tomake contributions to the union funds and to make such funds whole, plusinterest. This recommendation was adopted by the full NLRB on September 15,2004. If it is enforced by the circuit court of appeals, it could result in theCompany being required to contribute amounts that have yet to be determinedinto the union’s pension benefit, health and welfare and vacation funds. Anypotential required contributions resulting from a final judicial determinationof this matter would potentially be subject to offset by the amounts that theCompany had funded since it implemented its final contract proposal for thesesame benefits that were paid for its ATC employees. Because the NLRB decisionrepresents the first phase of a long and complicated administrative process tobe followed by a full judicial review of all of the facts and circumstances,the final outcome cannot be reliably determined at this time. The full NLRB decisionis subject to judicial review by the circuit court of appeals and a compliancehearing before any financial remedy can be determined. While there can be nodefinitive assurance, the Company has been advised by its outside labor counselthat it has numerous meritorious defenses and arguments in response to the NLRB’sdecision.

 

Inlight of the foregoing, while it is the Company’s belief that the finalfinancial outcome of this litigation cannot be determined at this time, underthe provisions of Statement of Financial Accounting Standard (“FAS”) No. 5which addresses contingencies, the Company recorded a pre-tax charge of$12.6 million for the year ended December 27, 2003 and additionalpre-tax charges of $1.1 million in each of the quarters ended March 27,2004 and June 26, 2004, $0.4 million in the period from June 27, 2004through July 30, 2004 and $0.7 million during the period from July 31,2004 through September 25, 2004. These charges represent the current bestestimate of the loss that would result upon application of the NLRB’s decision.The Company notes that such charges were based upon the facts available to it atthe time. In the Company’s opinion, such charges could be subject tosignificant modification in the future, upon review by the Federal CircuitCourt of Appeals, completion of a compliance hearing and any appeals relatingto the outcome of that hearing. These charges reflect the amount ofcontributions that the Company did not make into the union benefit funds forthe period from the August 31, 2001 expiration of the contract through September 25,2004, reduced by a portion of the benefits the Company paid directly to or forthe benefit of these employees over the same period. It also includes aninterest cost for these net contributions from the date they would have beenpaid until September 25, 2004. While this represents the Company’s currentbest estimate of the NLRB’s decision, the Company believes that the actualrange of loss in this matter could be from $0, if the NLRB’s decision is notfollowed, to approximately $30 million, if the NLRB’s decision is upheldand there is no offset for any benefits paid over this period.

 

Untilsuch time as further legal developments warrant a change in the application ofthis accounting standard, or until this matter is resolved, the Company willrecord additional non-cash pre-tax charges, including interest, which arecalculated on the same basis as the charge recorded in the 2003 financialstatements.

 

7

----

 

**4.Recently Issued Accounting Pronouncements**

 

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

 

TheCompany previously adopted FAS No. 123, “Accounting for Stock-BasedCompensation” and, as permitted under FAS No. 123, has elected thedisclosure-only provisions. The Company accounts for its stock-basedcompensation plans under the recognition and measurement principles of APB OpinionNo. 25, “Accounting for Stock Issued to Employees,” and relatedinterpretations. There is no stock-based employee compensation cost reflectedin net income, as all options granted under those plans had an exercise priceequal to or greater than the market value of the underlying common stock on thedate of grant. The following table illustrates the effect on net (loss) incomeif the Company had applied the fair value recognition provisions of FAS No. 123to stock-based employee compensation (dollars in thousands):

 
| ** **                                                                                                                                              | ** ** | **Successor**                                                | ** ** | ** ** | **Predecessor**                                                  | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|------------|------------------------------------------------------------------|------------|
| ** **                                                                                                                                              | ** ** | **Period from  July 31, 2004  through  Sept. 25, 2004** | ** ** | ** ** | **Period from  June 27, 2004  through  July 30, 2004** | ** ** | **3 Months  Ended  Sept. 27,  2003** | ** ** | **Period from  Dec. 28, 2003  through  July 30, 2004** | ** ** | **9 Months  Ended  Sept. 27,  2003** | ** ** |
|                                                                                                                                                    |       |                                                         |       |       |                                                             |       |   |   |   |   |   |   |
| Net (loss) income, as reported                                                                                                                          |       | $                                                            | (37,543    | )          |                                                             | $          | (518 | ) | $ | 1,906 |   | $ | 3,806 |   | $ | 9,076 |   |
|                                                                                                                                                    |       |                                                         |       |       |                                                             |       |   |   |   |   |   |   |
| Adjust: Total stock-based employee compensation  (expense)/income determined under fair value based method for all awards, net  of related tax effects. |       | —                                                       |       |       | (335                                                             | )          | (378 | ) | (2,607 | ) | 8,640 |   |
|                                                                                                                                                    |       |                                                         |       |       |                                                             |       |   |   |   |   |   |   |
| Pro forma net (loss) income                                                                                                                             |       | $                                                            | (37,543    | )          |                                                             | $          | (853 | ) | $ | 1,528 |   | $ | 1,199 |   | $ | 17,716 |   |

 

Asdescribed in previous SEC filings issued during 2003, the Company cancelled1,337,449 outstanding stock options during the first quarter of 2003 inconnection with the Stock Option Exchange Offer. The pro forma income shown inthe table above for the nine months ending September 27, 2003 includes thereversal of pro forma expenses previously disclosed totaling $9.7 million,related to the granting of these original options.  On October 1, 2003, the Company issued1,320,947 options at an exercise price of $16.55 per share to replace thoseoptions exchanged in connection with the Stock Option Exchange Offer. As aresult, beginning in the fourth quarter of 2003, the Company has been incurringpro forma compensation expense which reflects the fair value of the replacementstock options granted.

 

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

 

On July30, 2004, as a result of the Acquisition, all stock options, whether or notthen vested, with an exercise price of $16.50 or more per share were cancelledwithout any payment therefore, and the remaining “in the money” options(excluding certain management options that were forfeited in connection withthe Acquisition), whether or not then vested, with exercise prices of less than$16.50 per share were converted into the right to receive the excess of $16.50per share over the exercise price of each of the options. As a consequence,subsequent to the July 30, 2004 transaction date, all options issued bythe Predecessor to purchase previously existing Duane Reade Inc. common stockceased to exist.

 

8

----

 

 

**5. Inventory and Cost of Sales**

 

At September 25, 2004, inventories, consistingsolely of finished goods, would have been greater by $1.0 million if they hadbeen valued on a lower of first-in, first-out (“FIFO”) cost or market basisinstead of a last-in, first-out (“LIFO”) basis. Cost of sales includes allstore occupancy-related costs and expenses, consisting of lease andsublease-related income and expenses, other recurring real estate-relatedincome and expenses primarily from sales and terminations of leases related tostore closings and relocations, sales of market-related data, store utilitycosts, warehouse expenses and distribution costs. The Company reflectspromotional allowances from vendors as a reduction of cost of sales oradvertising expense, depending on the nature of the allowance, when suchadvertising or promotions have been completed and the related allowances havebeen earned. For the periods from July 31, 2004 through September 25,2004 and June 27, 2004 through July 30, 2004, other realestate-related income amounted to $0.1 million and $0.0 million, respectively, ascompared to $0.1 million in the three months ended September 27, 2003, andfor the periods from July 31, 2004 through September 25, 2004 and December 28,2003 through July 30, 2004, other real estate-related income amounted to$0.1 million and $2.0 million, respectively, as compared to $1.4 million in thenine months ended September 27, 2003. There was no income realized fromthe sale of market-related data in any of the periods presented.

 

**6.Acquisitions**

 

Duringeach of the periods attributable to the “Successor” and “Predecessor” financialstatements, the Company acquired pharmacy customer files, which were mergedinto existing stores, and the operations, including certain lease-relatedassets, of a number of pharmacy establishments, which were operated as newstores.  The table below provides detailsof this acquisition activity for each of the periods presented (dollars inmillions).

 
| ** **                  | ** ** | **Successor**                                                | ** ** | ** ** | **Predecessor**                                                  | ** ** |
|-----------------------------|------------|--------------------------------------------------------------|------------|------------|------------------------------------------------------------------|------------|
| ** **                  | ** ** | **Period from  July 31, 2004  through  Sept. 25, 2004** | ** ** | ** ** | **Period from  June 27, 2004  through  July 30, 2004** | ** ** | **3 Months  Ended  Sept. 27,  2003** | ** ** | **Period from  Dec. 28, 2003  through  July 30, 2004** | ** ** | **9 Months  Ended  Sept. 27,  2003** | ** ** |
|                        |       |                                                         |       |       |                                                             |       |   |   |   |   |   |   |
| Customer prescription files |       | —                                                       |       |       | 1                                                                |       | 1 |   | 6 |   | 7 |   |
| Pharmacy establishments     |       | 4                                                            |       |       | —                                                           |       | — |   | 1 |   | 2 |   |
| Total acquisitions          |       | 4                                                            |       |       | 1                                                                |       | 1 |   | 7 |   | 9 |   |
|                        |       |                                                         |       |       |                                                             |       |   |   |   |   |   |   |
| Cash acquisition cost       |       | $                                                            | 6.4        |       |                                                             | $          | 1.7 |   | $ | 0.1 |   | $ | 9.1 |   | $ | 6.2 |   |
| Total acquisition cost      |       | $                                                            | 6.4        |       |                                                             | $          | 1.7 |   | $ | 0.1 |   | $ | 9.1 |   | $ | 6.2 |   |
|                        |       |                                                         |       |       |                                                             |       |   |   |   |   |   |   |
| Purchase price allocation:  |       |                                                         |       |       |                                                             |       |   |   |   |   |   |   |
| Identifiable intangibles    |       | $                                                            | 5.1        |       |                                                             | $          | 0.8 |   | $ | — |   | $ | 7.2 |   | $ | 3.9 |   |
| Goodwill                    |       | —                                                       |       |       | 0.6                                                              |       | — |   | 0.9 |   | 0.9 |   |
| Inventory                   |       | 1.3                                                          |       |       | 0.3                                                              |       | 0.1 |   | 1.3 |   | 1.1 |   |
| Property and equipment      |       | 0.3                                                          |       |       |                                                             |       | — |   | — |   | 0.5 |   |
| Accruals and liabilities    |       | (0.3                                                         | )          |       |                                                             |       | — |   | (0.3 | ) | (0.2 | ) |
| Total                       |       | $                                                            | 6.4        |       |                                                             | $          | 1.7 |   | $ | 0.1 |   | $ | 9.1 |   | $ | 6.2 |   |

 

The acquiredoperations have been included in the consolidated statement of operations fromthe date of acquisition and did not have a material effect on sales or resultsof operations of the Company for the periods presented.

 

9

----

 

**7. Debt**

 

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

 
| ** **                                | ** ** | **Successor**                  | ** **  | ** ** | **Predecessor**               | ** ** |
|-------------------------------------------|------------|--------------------------------|-------------|------------|-------------------------------|------------|
| **Description of Instrument**             | ** ** | **Balance at  Sept. 25, 2004** | ** **  | ** ** | **Balance at  Dec. 27, 2003** | ** ** |
|                                      |       |                           |        |       |                          |       |
| Revolving Credit Facility                 |       | $                              | 152,939     |       |                          | $          | 70,353 |   |
| Term Loan Facility                        |       | 155,000                        |        |       | —                        |       |
| 9 3/4% Senior Subordinated Notes due 2011 |       | 195,000                        |        |       | —                        |       |
| 2.1478% Senior Convertible Notes due 2022 |       | 32                             |        |       | 201,032                       |       |
|                                      |       | 502,971                        |        |       | 271,385                       |       |
| Less - Current Portion                    |       | —                         |        |       | —                        |       |
| **Total Long Term Debt**                  | ** ** | **$**                          | **502,971** | ** ** | ** **                    | **$**      | **271,385** | ** ** |

 

 

**RevolvingCredit Facility**

 

On July 21,2003, Duane Reade GP entered into a new credit facility (the “Credit Agreement”).This Credit Agreement is an asset-based revolving loan which used a pre-determinedpercentage of the current value of the Company’s inventory and selectedaccounts receivable to calculate the availability of funds eligible to beborrowed up to an aggregate principal amount of $200 million. Prior to theamendment described below, the obligations of the Company under the CreditAgreement were collateralized by substantially all of the assets of theCompany. In addition, the Credit Agreement was guaranteed by each of theCompany’s corporate subsidiaries, and such guarantees were collateralized bysubstantially all assets of such guarantors. The Credit Agreement is scheduled to mature on July 20, 2008.

 

TheCredit Agreement contains a single fixed charge coverage requirement which onlybecomes applicable when borrowings exceed 90 percent of the borrowing base, asdefined in the Credit Agreement. Borrowings under the Credit Agreement have notexceeded 90 percent of the borrowing base and, as a result, the fixed chargecovenant did not become applicable during the period. There are no creditratings related triggers in the Credit Agreement that would impact the cost ofborrowing, annual amortization of principal or related indebtedness maturity.

 

On July 22, 2004, in connection with theAcquisition, the Credit Agreement was amended (the “Amended Credit Agreement”)to increase the Company’s borrowing capacity to an aggregate principal amountof $250 million, subject to an adjusted borrowing base calculation based uponspecified advance rates against the value of the Company’s selected inventory,pharmacy prescription files and selected accounts receivable. The AmendedCredit Agreement includes a $50 million sub-limit for the issuance of lettersof credit.  Obligations under therevolving loan facility are collateralized by a first priority securityinterest in inventory, receivables, pharmacy prescription files, depositaccounts and certain other current assets. Under the amended facility, DuaneReade GP is the borrower. The amended facility is guaranteed by Duane ReadeHoldings, the Company and each of its domestic subsidiaries other than DuaneReade GP. Revolving loans under the Amended Credit Agreement, at the Company’soption, bear interest at either (i) a rate equal to LIBOR (the London InterbankOffered Rate) plus a margin of from 1.50% to 2.00%, determined based on levelsof borrowing availability reset each fiscal quarter or (ii) a rate equal to theprime rate of Banc of America Retail Group Inc. plus a margin of from 0.00% to0.50%, determined based on levels of borrowing availability reset each fiscalquarter. Borrowings under the amended facility continue to be primarilyLIBOR-based.

 

At September 25,2004, there was $152.9 million outstanding under the revolving credit facility,and approximately $93.7 million of remaining availability, net of $2.9 millionreserved for standby letters of credit.

 

10

----

 

**SeniorTerm Loan Facility**

 

On July 30,2004, in connection with the Acquisition, the Company entered into a SeniorTerm Loan in the principal amount of $155 million. This loan will mature on July 30,2010. While there are no scheduled principal payments over its term, theCompany will be required to prepay the senior term loan together with accruedinterest thereon, with (a) all net cash proceeds (i) from sales of property andassets by Duane Reade Holdings and its subsidiaries (excluding sales ofinventory in the normal course of business and certain other exceptionsdescribed in the Senior Term Loan), (ii) of extraordinary receipts, casualtiesand condemnations as defined in the Senior Term Loan and (iii) from theissuance or incurrence of additional debt of Duane Reade Holdings or any of itssubsidiaries other than certain identified indebtedness permitted under theSenior Term Loan, (b) 50.0% of all net cash proceeds from the issuance ofadditional equity of Duane Reade Holdings or any of its subsidiaries (excludingequity issued to Oak Hill and other exceptions specified in the Senior TermLoan) and (c) 50.0% of excess cash flow of Duane Reade Holdings and itssubsidiaries (beginning with the fiscal year ending December 2005).  Loans under the Senior Term Loan facility, atthe Company’s option, bear interest at a rate per annum of (i) thereserve-adjusted LIBOR plus an applicable margin of 3.25%; or (ii) 2.25%, plusthe higher of (a) the prime rate of Bank of America, N.A. and (b) the FederalFunds rate plus 0.50%. Duane Reade GP became a co-obligor under the Senior TermLoan upon the closing of the Acquisition. All obligations under the Senior Term Loan are guaranteed by Duane ReadeHoldings and each of the Company’s existing subsidiaries, other than DuaneReade GP, and will be guaranteed by future subsidiaries except certain foreignsubsidiaries. The Senior Term Loan is collateralized by a first prioritysecurity interest in substantially all of the Company’s assets other than thoseassets in which the lenders under the Amended Credit Agreement have a firstpriority interest.  The Senior Term loanis also collateralized by a second priority security interest in all collateralpledged on a first priority basis to lenders under the Amended CreditAgreement.  The Senior Term Loan alsocontains affirmative and negative covenants customary for a senior term loanfacility, including, among other things, restrictions on indebtedness, liens,mergers and consolidations, sales of assets, loans, acquisitions, jointventures, restricted payments, transactions with affiliates, dividends andother payment restrictions affecting subsidiaries and sale leasebacktransactions.  The Senior Term Loan alsorequires Duane Reade Holdings and its subsidiaries to maintain a maximumleverage ratio and a minimum interest coverage ratio. There are no credit ratingsrelated triggers in the Senior Term Loan Facility that would impact the cost ofborrowing, annual amortization of principal or related indebtedness maturity.

 

**$195Million 9 3/4% Senior Subordinated Notes Due 2011**

 

On July 30,2004, upon completion of the Acquisition, the Company entered into an Indenturefor $195 million of 9 3/4% Senior Subordinated Notes due 2011 (the “Senior SubordinatedNotes”).  The Senior Subordinated Notesmature on August 1, 2011 and bear interest at 9.75% per annum payable insemi-annual installments on February 1 and August 1, commencing February 1,2005, to the holders of record on the immediately preceding January 15 andJuly 15. The Senior Subordinated Notes are uncollateralized obligationsand subordinated in right of payment to all of the Company’s existing andfuture unsubordinated indebtedness, including borrowings under the AmendedCredit Agreement (as defined above) and the Senior Term Loan (as defined above).The Senior Subordinated Notes will rank equally with any future seniorsubordinated indebtedness and senior to any future subordinated indebtedness.The Senior Subordinated Notes are guaranteed on an uncollateralized, seniorsubordinated basis by all of the Company’s existing direct and indirectdomestic subsidiaries other than Duane Reade GP, which is a co-obligor under theSenior Subordinated Notes. The Company may redeem the Senior Subordinated Notes,in whole or in part, at any time on or after August 1, 2008, at aredemption price of 104.875% declining to par on August 1, 2010, plusaccrued and unpaid interest. In addition, the Company, Duane Reade Shareholdersor Duane Reade Holdings, at the Company’s option, can redeem up to 35% of theSenior Subordinated Notes before August 1, 2007 with the net cash proceedsfrom certain equity offerings. Upon the occurrence of specified change ofcontrol events, the Company and Duane Reade GP will be required to make anoffer to repurchase all of the Senior Subordinated Notes at 101% of theoutstanding principal amount of the Senior Subordinated Notes plus accrued andunpaid interest to the date of repurchase. The indenture governing the Senior SubordinatedNotes contains certain affirmative and negative covenants that limit theCompany’s ability to incur additional indebtedness, pay dividends, makerepayments on indebtedness that is subordinated to the Senior Subordinated Notesand to make certain other restricted payments, incur certain liens, useproceeds from sales of assets, enter into business combination transactions(including mergers, consolidations and asset sales), enter into transactionswith affiliates and permit restrictions on the payment of dividends by theCompany’s subsidiaries. Under a registration rights agreement entered into aspart of the offering of the Senior Subordinated Notes, the Company is requiredto (i) file a registration statement with the SEC within 120 days after thecompletion of the Acquisition, (ii) use its reasonable best efforts to causethe registration statement to become

 

11

----

 

effective within 180 daysafter the completion of the Acquisition, and (iii) use its reasonable bestefforts to complete the exchange offer within 210 days after the Acquisition iscompleted.  There are no credit ratingsrelated triggers in the Senior Subordinated Notes that would impact the cost ofborrowing, annual amortization of principal or related indebtedness maturity.

 

**2.1478% Senior Convertible Notes due April 16,2022**

 

On April 16, 2002, the Company completed anoffering of $381.5 million aggregate principal amount of Senior ConvertibleNotes maturing on April 16, 2022 (the “Convertible Notes”). TheConvertible Notes were issued at a price of $572.76 per note (57.276% of theprincipal amount at maturity) and pay cash interest at the rate of 2.1478% peryear on the 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. In December 2002, theCompany repurchased a total of $30.5 million principal value of the ConvertibleNotes at an average purchase price of $486.99 per $1,000 note, resulting in thethen remaining net outstanding balance of $201.0 million. Because theAcquisition constituted a “change of control” under the indenture governing theConvertible Notes, the Company offered to repurchase all of the outstandingConvertible Notes. As a result, on September 13, 2004, the Company repurchasedall but $55,000 aggregate principal amount at maturity of Convertible Notes for$201.0 million plus $3.1 million of accrued and unpaid interest.

 

Holders of the Convertible Notes may require theCompany to purchase all or a portion of their notes on April 16, 2007 at aprice of $572.76 per note plus accrued cash interest, if any; on April 16,2012 at a price of $689.68 per note plus accrued cash interest, if any; and on April 16,2017 at a price of $830.47 per note plus accrued cash interest, if any. 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, each holder mayrequire the Company to purchase for cash all or a portion of such holder’snotes at a price equal to the sum of the issue price plus accrued originalissue discount and accrued cash interest, if any, to the date of purchase ifthe Company experiences a change of control.

 

In connection with the planned consummation of theAcquisition, the Company, Duane Reade Shareholders, LLC, the indirect parent ofDuane Reade Acquisition Corp. and each of the subsidiaries of the Company thatare guarantors of the Convertible Notes entered into a supplementalindenture.  Pursuant to the supplementalindenture, as a result of the merger of Duane Reade Acquisition Corp. with andinto the Company, the Convertible Notes may only be converted into the right toreceive from the Company $16.50 (in cash and without interest) per share of theCompany’s common stock issuable to a holder of Convertible Notes in connectionwith such conversion. These notes are not considered to be potential commonshares, and are not included in the calculation of diluted earnings per share,as the Company intends to settle any conversions in cash.

 

**8. IncomeTaxes**

 

Incometaxes are recorded based on the estimated combined statutory tax rates expectedto be applicable for the full fiscal year less applicable employment relatedtax credits. The effective tax rate is lower than the combined statutory rates,primarily reflecting the impact of these income tax credits. During the predecessorperiod of December 28, 2003 through July 30, 2004, the effective taxrate of 29% reflects the impact of an allocated portion of these tax creditsapplied against the pre-tax income recorded by the predecessor entity.  The effective tax rate of 46% recorded by theCompany during the period following the Acquisition is reflective of thesubstantial pre-tax loss incurred as a result of the transaction-relatedexpenses, plus the impact of the remainder of the tax credits allocated to thepost-Acquisition period. The employment tax credits represent the economicbenefits earned by the Company for its participation in various federal andstate hiring incentive programs. These benefits are based on the number ofqualifying employees hired and retained by the Company for a specified timeperiod. Employees qualify for these hiring programs primarily as a result of theirenrollment in various economic assistance programs.

 

**9.Commitments and Contingencies**

 

TheCompany is a party to legal actions arising in the ordinary course of business.Based on information presently available to management, 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 financial position, results of operation or cash flows of theCompany. In addition, the Company is a party to the following legal actions andmatters:

 

12

----

 

During2002, the Company initiated a legal action against its former propertyinsurance carrier in Federal Court in the Southern District of New York, in anattempt to recover what the Company believes to be a fair and reasonablesettlement for the business interruption portion of its claim originating fromthe September 11, 2001 World Trade Center terrorist attack, during whichthe Company’s single highest volume and most profitable store was completelydestroyed. The claim is pending before the United States District Court for theSouthern District of New York. In September 2003, a trial on certainissues was held regarding some of the matters at issue in the litigation,including whether the Company would have obtained a renewal of its lease at theWorld Trade Center. The Company has received a favorable ruling on this andother legal issues in the case and now the matter has moved into an appraisalprocess. The appraisal process involves two appraisers and an arbitrator (toresolve differences between the two appraisers) who will determine the amountof insured loss the Company has sustained. The insurance carrier has appealed anumber of the rulings by the trial court. In light of both the early state ofthe appraisal process and the inherent uncertainty in litigation relating tothe appeal, the amount of additional insurance proceeds, if any, the Companymay collect under the terms of its insurance contract with the defendant cannotbe reasonably predicted or determined at this time, and therefore, the Companyhas not accrued any additional income related to this potential settlement. Infiscal 2002, the Company received an advance of approximately $9.4 milliontoward its business interruption claim that was recognized as a separatecomponent of income in the Company’s consolidated statement of income. In theevent of an unfavorable outcome to the Company, this amount would not berequired to be returned to the insurance company.

 

TheCompany, Anthony J. Cuti, its Chairman, President and Chief Executive Officer,John K. Henry, its Senior Vice President and Chief Financial Officer, and GaryCharboneau, its Senior Vice President of Sales and Marketing, were named asdefendants in connection with the consolidation of several class actioncomplaints alleging violations of the federal securities laws that were filedfrom August 2002 through October 2002. The action, which was in theUnited States District Court for the Southern District of New York, was onbehalf of shareholders who purchased Duane Reade Inc.’s common stockbetween April 1, 2002 and July 24, 2002, inclusive. The complaint,which sought an unspecified amount of damages, alleged that the defendantsviolated the federal securities laws by issuing materially false and misleadingstatements during the class period. On December 1, 2003, the districtjudge granted the Company’s motion to dismiss the plaintiff’s action, withprejudice. The plaintiffs subsequently filed an appeal. On August 17, 2004,the US Court of Appeals affirmed the district court’s ruling in favor of theCompany.

 

TheCompany is a defendant in a class action suit in the Federal Court for theSouthern District of New York regarding alleged violations of the Fair LaborStandards Act as to a group of individuals who provided delivery services on acontract basis to the Company. In December 2002, the judge in the actionissued a partial summary judgment in favor of a subclass of the plaintiffs andagainst the Company. In December 2003, the Company settled the issue ofthe amount of its liability to the plaintiffs without any admission ofwrongdoing and in an amount consistent with the Company’s previouslyestablished reserves. By a decision dated August 4, 2004, the districtcourt awarded the plaintiffs certain attorneys’ fees in this matter. TheCompany has fully reserved the amount of the fees in question and has appealedthis award to the US Circuit Court of Appeals.

 

TheCompany is a party to related lawsuits, Irving Kroop, et al. v. Duane Reade,NY, NY et al., 00 Civ. 9841, et al., instituted by the trustees of severalunion benefit funds wherein the funds claim that the Company did not makecertain required contributions to these funds from January 2000 through July 31, 2001.By decisions dated August 5, 2004 and September 27, 2004, theDistrict Court awarded judgment to the funds on certain aspects of theircomplaints. These partial judgments, for which the Company has providedadequate reserves, are subject to further appeal by the Company. The remainingunresolved portions of the plaintiffs’ claims are still being litigated andaccordingly, the Company intends to continue to vigorously defend itself inthese matters. At this time, it is not possible to determine the ultimateoutcome of this case or the actual amount of additional liability the Companymay face, if any.

 

TheCompany is involved in an ongoing dispute with Cardinal Health, one of itsformer suppliers of pharmaceutical products. Both parties have claims againstthe other involving, among other things, breach of contract, promissoryestoppel and unjust enrichment. Duane Reade is seeking from Cardinal anunspecified amount of damages and punitive damages of at least $20 million.Cardinal is seeking approximately $18 million in damages plus attorney’s feesand interest. While there can be no definitive assurance, the Company believesit has counterclaims that offset the claims against it by Cardinal, as well asmeritorious defenses to these claims, and plans to vigorously pursue itsaffirmative claims and to vigorously defend itself in this action. Non-party discoveryin this case has been concluded and it is expected to go to trial sometime in2005.

 

13

----

 

TheCompany is involved in litigation related to a dispute with the Allied TradesCouncil, a union representing employees in 139 of its stores. This litigationis more fully described in Note 3 to these Unaudited Consolidated Interim FinancialStatements.

 

A NewYork State Tax Appeals Tribunal ruling in a matter involving another companymay have an adverse impact upon the Company’s New York State Franchise Taxfilings from years 1999 through 2002. This matter relates to the requiredcombination of affiliated subsidiaries in recognizing royalty fee and relatedincome for intangible property. The ruling of the Tribunal is subject tofurther legal appeal and interpretation in light of the Company’s own specificfacts and circumstances. The outcome of this matter, and the resulting amountof additional income tax expense, if any, cannot be determined by the Companyat this time.

 

***Litigation Relating to the MergerTransaction:***  DuaneReade is aware of six purported class action complaints challenging the mergertransaction consummated by the Company and Duane Reade Acquisition that havebeen filed in the Court of Chancery of the State of Delaware, referred to asthe “Delaware Complaints,” and three purported class action complaints thathave been filed in the Supreme Court of the State of New York. Two of the NewYork complaints have been dismissed without prejudice. The other New Yorkcomplaint (the “New York Complaint”) is pending, but has not been served onDuane Reade.  The Delaware Complaintsname Mr. Cuti and certain other members of the Company’s board ofdirectors and executive officers as well as Duane Reade as defendants. Four ofthe Delaware Complaints name Oak Hill as a defendant. The New York Complaintnames Mr. Cuti and certain other members of the Company’s board ofdirectors and executive officers as well as Duane Reade as defendants. One ofthe dismissed New York complaints named Oak Hill as a defendant.

 

TheDelaware Complaints were consolidated on January 28, 2004, and on April 8,2004 the plaintiffs in the Delaware actions filed a consolidated class actioncomplaint. The Company believes these lawsuits are without merit and plans todefend these lawsuits vigorously.

 

 

**ITEM 2****. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF OPERATIONS**

 

**General**

 

Ourbusiness consists of a wide variety of health and beauty care products,convenience oriented food and general merchandise items and a pharmacyoperation managed to supply customers with their prescription needs. We referto the non-prescription portion of our business as front-end sales because mostof these sales are processed through the front main check-out sections of ourstores. This portion of our business consists of brand name and private labelhealth and beauty care items, food and beverages, tobacco products, cosmetics,housewares, greeting cards, photofinishing services, photo supplies andseasonal and general merchandise. Health and beauty care products, includingover-the-counter items, represent our highest volume categories withinfront-end sales. The front-end portion of our business represented 54.1% and54.5% of our sales in the quarter and nine months ended September 25, 2004,respectively, and is characterized by generally higher gross margins that areapproximately twice that of our pharmacy or back-end business.

 

Becauseof our numerous convenient locations in high-traffic commercial and residentialareas and the lack of other convenience oriented retailers in our core marketareas, our front-end business is generally a larger proportion of our totalsales than other major conventional drug store chains, which average between 30%to 40%, but as is the case with most other drug store chains, represents adecreasing share of business year after year due to the faster rate of pharmacysales growth. Our pharmacy sales include all items we sell by prescriptionfilled at our retail locations or by our central fill facility and delivered toour stores or direct to customers. The pharmacy portion of our business isdominated by and dependent upon a number of third party private and government-sponsoredplans that contract with us as an authorized provider of prescriptions.

 

Salesto third party prescription plans represented 92.3% and 92.2% of our pharmacysales in the quarter and nine months ended September 25, 2004,respectively. The pharmacy portion of our business is subject to a number offederal, state and local regulations that govern the conduct of this business. Thehigh rate of growth in pharmacy sales has been due to a number of favorabledemographic and industry trends such as the aging of the population, expandingpenetration of third party private and government-sponsored coverage and theincreasing usage of prescription drugs to

 

14

----

 

improve quality of lifeand in place of medical procedures. Along with the fast pace of growth in thisarea have come generally higher rates of product cost inflation, resulting inan increased focus on the part of both government and private plans to controltheir costs of providing these benefits. As a result, pharmacy gross marginshave been under pressure.

 

During2003, President Bush signed legislation that will expand Medicare coverage of prescriptiondrugs for senior citizens not participating in third party plans, whichrepresent less than 2% of our total revenue. This new Medicare coverage isplanned to take effect in 2006 and is expected to result in decreased pharmacymargins resulting from lower reimbursement rates than our current margins on prescriptionsthat are not subject to third party reimbursement. In June 2004, atemporary senior citizen prescription drug discount program furnished underthis Medicare legislation was implemented and is expected to remain in effectuntil the full Medicare program takes effect in 2006. This temporary program hasalso resulted in lower pharmacy margins than those previously realized onprescriptions that were not subject to third party plan reimbursement. Based onour experience over time, we expect that increased utilization of prescriptiondrugs by senior citizens participating in the new programs will offset theeffect of lower margins on our revenues.

 

Infiscal 2003 and again in fiscal 2004, New York State reduced Medicaid and EPIC prescriptionreimbursement rates, adversely impacting our pharmacy gross margins. The mostrecent reductions became effective on October 1, 2004, and are expected toreduce reimbursements by approximately $1.4 million on an annual basis.

 

While retainingits high rate of growth in 2003, the retail pharmacy industry experiencedsubstantially reduced rates of pharmacy same-store sales growth resulting froma decline in the demand for hormonal replacement drugs, conversion of some highvolume prescription drugs to over-the-counter status, increased levels ofrequired co-payments by insurers, increased utilization of lower priced genericmedications, increased penetration by mail order and internet-based pharmaciesand reductions in coverage resulting from high unemployment rates. While therehas been some improvement in employment trends during 2004, these same factorshave generally continued to restrain pharmacy sales growth.

 

Weoperate approximately 85% of our 255 stores in New York City and therefore ourfinancial performance is heavily influenced by the local economy. We analyze anumber of economic indicators specific to New York City to gauge the health ofthis economy including unemployment rates, job creation, gross city product andbridge and tunnel commuter traffic patterns. We also analyze market share data,same-store sales trends, average store sales and sales per square foot dataamong other key performance indicators to monitor our overall performance.

 

TheNew York City economy continues to experience higher rates of unemployment thanthe national economy overall. The September seasonally adjusted unemploymentdata for New York City indicated an unemployment rate of 6.9% compared to anational average of 5.4%. While still trailing the national averages, the NewYork City unemployment rate does reflect an improvement as compared to themonthly average rate of 8.5% reported for the first quarter of this year. Webelieve that these trends reflect an improved fiscal situation for the cityoverall that is consistent with the early stages of an improving local economy.

 

On July 30,2004 we were acquired through a merger transaction with Duane Reade AcquisitionCorp. (“Duane Reade Acquisition”), a wholly owned subsidiary of Duane ReadeHoldings, Inc. and an affiliate of Oak Hill Capital Partners, L.P. (“Oak Hill”),a private equity firm (the “Acquisition”). The aggregate value of the Acquisitionwas approximately $744 million, including transaction expenses and therepayment of a portion of our indebtedness. As a result of the Acquisition, our shares are no longer listed on theNew York Stock Exchange and Duane Reade has continued its operations as aprivately held company. Each share of Duane Reade’s common stock outstandingimmediately prior to the Acquisition was converted into the right to receive$16.50 per share, without interest, in cash.

 

OakHill, certain related entities and several co-investors funded the equity forthe Acquisition. The funding also included third-party debt financings,including the issuance of 9.75% Senior Subordinated Notes due 2011 in aprincipal amount of $195 million, a new senior secured term loan facility in anaggregate amount of $155 million and an increase of our existing revolvingcredit facility with Banc of America Retail Group to $250 million, thatresulted in approximately $90.4 million of borrowing capacity after completionof the merger. As a result of the Acquisition, on September 13, 2004, wecompleted a Change of Control offer to repurchase our outstanding ConvertibleNotes, and, as a result, all but $55,000 principal amount at maturity of the$351.0 million total outstanding principal amount at maturity were repurchased.

 

15

----

 

The Acquisition wasaccounted for as a purchase, in accordance with the provisions of Statement ofFinancial Accounting Standards No. 141, “Business Combinations”, which resultedin new valuations for our and our subsidiaries’ assets and liabilities based onfair values as of the date of the acquisition. These valuations are preliminary and are based upon information that wasavailable to management at the time the financial statements were prepared.Accordingly, these purchase price allocations may change based upon our finalvaluations, some of which will be based on third party appraisals currentlybeing conducted. The Company fully expects to complete these valuations and thefinal allocation of the purchase price within the allowable one year timeframeafter the closing of the transaction.

 

**Resultsof Operations**

 

As a result of the Acquisition and resulting change incontrol, under U.S. GAAP the Company is required to present separately itsoperating results for the predecessor periods in the 2004 fiscal year (June 27,2004 through July 30, 2004 and December 28, 2003 through July 30,2004) and the successor period in the 2004 fiscal year (July 31, 2004through September 25, 2004). In the following discussion, these arecompared to the full fiscal third quarter and year-to-date predecessor periodsended September 27, 2003. Management believes this is the most practicalway to comment on the results of operations.

 

**ThePeriod from July 31, 2004 through September 25, 2004 for theSuccessor and the period from June 27, 2004 through July 30, 2004 forthe Predecessor Compared to the Three Months Ended September 27, 2003 forthe Predecessor**

 

For the period from July 31, 2004 through September 25,2004, we achieved net sales of $217.6 million and sustained a net loss of $37.5million, and for the period from June 27, 2004 through July 30, 2004,we achieved net sales of $132.1 million and incurred a net loss of $0.5million, as compared to aggregate net sales of $338.6 million and net income of$1.9 million in the third quarter of the previous year. For the 2004 periodssubsequent to and prior to the Acquisition, gross profit margins were 20.6% and20.9%, respectively, as compared to 21.3% in the third quarter of last year.The decrease was primarily attributable to front-end same-store sales declinesin both the predecessor and successor period of the current year’s thirdquarter that resulted in our inability to leverage increased new storeoccupancy expenses. Overall product gross margins which exclude occupancy costswere slightly higher than the previous year in both the predecessor andsuccessor periods. In addition to the decrease in gross profit margins, netincome declined principally due to the following factors:

 

•                  Pre-taxtransaction expenses of $37.1 million in the successor period ended September 25,2004 and $0.4 million in the predecessor period ended July 30, 2004 thatwere related to the Acquisition, including certain change-of-control paymentsto management and contractual fees payable to Oak Hill upon consummation of thetransaction;

•                  Expensesassociated with the CEO Supplemental Executive Retirement Plan termination andother compensation related costs incurred in connection with the Acquisition;

•                  An increase inamortization expense of $2.1 million in the current year’s successor periodattributable to the preliminary acquisition related purchase accountingadjustments to the valuation of store leases and prescription pharmacy filesunder FAS 141. The balance of the increase is attributable to the depreciationof capital expenditures and amortization of intangibles acquired in 2003 and2004 that impact both the successor and predecessor periods of the current year;

•                  Increased storepharmacy labor costs incurred in both the successor and predecessor periodsthat were required to maintain hiring rates in line with the local market;

•                  Pre-tax laborcontingency expenses of $1.1 million related to a National Labor RelationsBoard ruling in a collective bargaining agreement litigation related to the fundingof certain employee benefit funds (see Note 3 to the Unaudited Consolidated InterimFinancial Statements);

•                  Increasedadvertising and promotional expenses in both the successor and predecessorperiods of the current year to stimulate sales; and

•                  Increased legaland litigation related expenses associated with certain labor issues, ourattempt to recover the balance of our World Trade Center business interruptioninsurance claim and various other matters, as well as $0.6 million related to alitigation settlement.

 

16

----

 

Thefollowing sets forth the results of operations for the periods indicated:

 
| ** **                                     | ** ** | **Successor**                                                         | ** ** | ** **     | **Predecessor**                                                  | ** ** |
|------------------------------------------------|------------|-----------------------------------------------------------------------|------------|----------------|------------------------------------------------------------------|------------|
| ** **                                     | ** ** | **Period from  July 31, 2004  through  September 25, 2004** | ** ** | ** **     | **Period from  June 27, 2004  through  July 30, 2004** | ** ** | **3 Months Ended  September 27, 2003** | ** ** |
| **In thousands, except percentages**           | ** ** | **Dollars**                                                           | ** ** | **% of Sales** | ** **                                                       | ** ** | **Dollars** | ** ** | **% of Sales** | ** ** | **Dollars** | ** ** | **% of Sales** | ** ** |
| Net sales                                      |       | $                                                                     | 217,556    |           | 100.0                                                            | %          |   | $ | 132,085 |   | 100.0 | % | $ | 338,630 |   | 100.0 | % |
| Cost of sales                                  |       | 172,765                                                               |       | 79.4           |                                                             |       | 104,421 |   | 79.1 |   | 266,520 |   | 78.7 |   |
| Gross profit                                   |       | 44,791                                                                |       | 20.6           |                                                             |       | 27,664 |   | 20.9 |   | 72,110 |   | 21.3 |   |
| Selling, general & administrative expenses |       | 37,355                                                                |       | 17.2           |                                                             |       | 23,726 |   | 18.0 |   | 56,296 |   | 16.6 |   |
| Labor contingency expense                      |       | 689                                                                   |       | 0.3            |                                                             |       | 411 |   | 0.3 |   | — |   | — |   |
| Transaction expense                            |       | 37,118                                                                |       | 17.1           |                                                             |       | 386 |   | 0.3 |   | — |   | — |   |
| Depreciation and amortization                  |       | 7,280                                                                 |       | 3.3            |                                                             |       | 3,596 |   | 2.7 |   | 8,162 |   | 2.4 |   |
| Store pre-opening expenses                     |       | 366                                                                   |       | 0.2            |                                                             |       | 105 |   | 0.1 |   | 154 |   | 0.0 |   |
| Other                                          |       | 25,291                                                                |       | 11.6           |                                                             |       | — |   | — |   | — |   | — |   |
|                                           |       | 108,099                                                               |       | 49.7           |                                                             |       | 28,224 |   | 21.4 |   | 64,612 |   | 19.1 |   |
| Operating (loss) income                        |       | (63,308                                                               | )          | (29.1          | )                                                                |       | (560 | ) | (0.4 | ) | 7,498 |   | 2.2 |   |
| Interest expense, net                          |       | 6,283                                                                 |       | 2.9            |                                                             |       | 1,283 |   | 1.0 |   | 3,386 |   | 1.0 |   |
| Debt extinguishment                            |       | —                                                                |       | —         |                                                             |       | — |   | — |   | 707 |   | 0.2 |   |
| (Loss) income before income taxes              |       | (69,591                                                               | )          | (32.0          | )                                                                |       | (1,843 | ) | (1.4 | ) | 3,405 |   | 1.0 |   |
| Income tax (benefit) provision                 |       | (32,048                                                               | )          | (14.7          | )                                                                |       | (1,325 | ) | (1.0 | ) | 1,499 |   | 0.4 |   |
| Net (loss) income                              |       | $                                                                     | (37,543    | )              | (17.3                                                            | )%         |   | $ | (518 | ) | (0.4 | )% | $ | 1,906 |   | 0.6 | % |

 

Net sales were $217.6 million in the July 31,2004 through September 25, 2004 period and $132.1 million in the June 27,2004 through July 30, 2004 period. Overall, aggregate net sales increasedby 3.3% as compared to net sales of $338.6 million for the third quarter of 2003.Same-store sales increased by 0.5% over the third quarter last year with thebalance of the increase coming from the full quarterly results of three net newstores opened in the third quarter last year and 16 net new stores opened sincethe end of last year’s third quarter.

 

Pharmacy sales increased from $148.7 million inthe third quarter of 2003 to an aggregate total of $160.4 million in the thirdquarter of 2004, an increase of 7.9%, and represented 45.9% of total sales, ascompared with 43.9% of total sales in the third quarter of 2003. Pharmacysame-store sales increased by 5.1% over last year, and third-party reimbursedpharmacy sales represented 92.3% of total pharmacy sales compared to 91.4% inthe third quarter of 2003. Pharmacy same-store sales continued to experiencethe general industry trend of reduced growth rates experienced during fiscal2003.  The major factors driving theslower sales growth rates in pharmacy were the trends toward increases in thirdparty plan customer co-payments, reduced sales of hormonal replacement drugs,limitations on maximum reimbursements for certain generic medications by thirdparty plans, increased penetration by mail order and internet-based pharmaciesand continued high rates of unemployment that have reduced the number ofcustomers covered by insured plans.

 

Front-end sales decreased from $189.9 million inthe third quarter of 2003 to an aggregate total of $189.2 million in the thirdquarter of 2004, a decrease of 0.4%, and represented 54.1% of total sales, ascompared to 56.1% of total sales in the third quarter of 2003. Front-end same-storesales declined by 3.2%, partly due to declining tobacco sales in metro New YorkCity, which has experienced increased restrictions on smoking in public placesalong with higher taxes on tobacco products. Excluding tobacco sales, front-endsame-store sales decreased by approximately 2.2%. We believe that the remainingdecline in same-store front-end sales is largely attributable to the continuedhigh unemployment rates in New York City that have restrained consumer demand.

 

During the period from July 31, 2004through September 25, 2004, we opened seven stores and closed one store,and from June 27, 2004 through July 30, 2004 we opened two stores, ascompared to three stores opened during the three months ended September 27,2003. At September 25, 2004, we operated 255 stores, as compared to 239stores at September 27, 2003.

 

Costof sales as a percentage of net sales was 79.4% for the period from July 31,2004 through September 25, 2004 and 79.1% for the period from June 27,2004 through July 30, 2004, resulting in gross profit margins of

 

17

----

 

20.6% and 20.9%,respectively.  In the third quarter of2003, cost of sales as a percentage of net sales was 78.7%, resulting in agross profit margin of 21.3%.  This decreasein gross profit margins was primarily attributable to the modest rate of salesgrowth combined with the adverse impact of the limited access and salesdisruptions associated with the Republican National Convention as well as thecontinuing effects of a less than robust local economy. These factors resultedin our inability to leverage increased new store occupancy expenses.  Cost of sales also includes (i) a $0.2million LIFO provision in both the current and prior years and (ii) real-estaterelated income of $0.1 million in the third quarters of both 2004 and 2003.

 

Selling,general and administrative expenses were $37.4 million, or 17.2% of net sales,and $23.7 million, or 18.0% of net sales, in the July 31, 2004 through September 25,2004 period and the June 27, 2004 through July 30, 2004 period,respectively, as compared to $56.3 million, or 16.6% of net sales, in the thirdquarter of 2003.  The increase in theseexpenses as a percentage of sales is primarily attributable to the increasedlabor costs associated with adjustments to pharmacists’ labor rates in responseto increases in market salary rates for these professionals, increased advertisingand promotional expenses to stimulate sales and higher legal and litigationrelated expenses.

 

Depreciationand amortization of intangibles amounted to $7.3 million and $3.6 million forthe July 31, 2004 through September 25, 2004 and June 27, 2004through July 30, 2004 periods, respectively, versus $8.2 million in thethird quarter of 2003.  This increaseresulted from the depreciation of capital expenditures made in 2003 and 2004 aswell as increases in the amortization of identifiable intangibles, a majorportion of which resulted from pharmacy acquisitions completed since the third quarterof 2003. In addition, as at July 30, 2004, in accordance with the purchaseaccounting requirements of FAS 141, certain intangible assets (primarily storeleases and pharmacy customer files) were written-up to their estimated fairvalue, resulting in incremental amortization expense of $2.1 million beingrecorded subsequent to that date.

 

Weincurred store pre-opening expenses of $0.4 million in the July 31, 2004through September 25, 2004 period, and $0.1 million in the June 27,2004 through July 30, 2004 period, related to the opening of seven storesand two stores, respectively. In the third quarter of last year, we incurredpre-opening costs of $0.2 million, attributable to the opening of three stores.

 

Netinterest expense for the July 31, 2004 through September 25, 2004period was $6.3 million, and for the June 27, 2004 through July 30,2004 period was $1.3 million. In the third quarter of 2003, net interestexpense amounted to $3.4 million.  Thisincrease was primarily attributable to the higher interest costs and increaseddebt in the current year’s successor period that was associated with the newdebt structure resulting from the Acquisition, as compared to the lower debtlevels and interest rates incurred on our revolving credit borrowings and convertiblenotes in the prior year.

 

In thethird quarter of 2003, we recorded a debt extinguishment charge of $0.7million, reflecting the accelerated amortization of the remaining deferredfinancing fees related to our term loans and existing revolver facility whichwere fully repaid in connection with the July 2003 refinancing of ourSenior Credit Agreement with an asset-based revolving credit facility.

 

In theperiod from July 31, 2004 through September 25, 2004, we recorded anincome tax benefit of $32.0 million, reflecting an estimated post-acquisitioneffective tax rate of 46.0%, inclusive of the anticipated benefits ofemployment tax credits. In the period from June 27, 2004 through July 30,2004, the income tax benefit of $1.3 million reflects (i) an effective tax rateof 29% applied to the pre-tax performance for that period and (ii) aretroactive adjustment applied to the pre-tax results for the first six monthsof 2004, to reduce the effective tax rate from the 40% rate previously appliedto the adjusted predecessor period 29% effective rate. In the comparable periodlast year, the income tax provision of $1.5 million reflected an estimatedeffective tax rate of 44.0%, inclusive of the anticipated benefits of employmenttax credits. The employment tax credits represent the economic benefits earnedby us for our participation in various federal and state hiring incentiveprograms. The decrease in the current year’s effective rate reflects thecombined impact of the employment tax credits and the reduced levels of pre-taxincome generated by us.

 

18

----

 

**ThePeriod from July 31, 2004 through September 25, 2004 for the Successorand the period from December 28, 2003 through July 30, 2004 for thePredecessor Compared to the Nine Months Ended September 27, 2003 for thePredecessor**

 

For the period from July 31, 2004 through September25, 2004, we achieved sales of $217.6 million and sustained a net loss of $37.5million, and for the period from December 28, 2003 through July 30, 2004, weachieved net sales of $846.8 million and generated net income of $3.8 million,as compared to aggregate net sales of $1.0 billion and net income of $9.1million in the first nine months of the previous year. For the 2004 periodssubsequent to and prior to the Acquisition, gross profit margins were 20.6% and21.7%, respectively, as compared to 21.3% in the first nine months of lastyear. The lower gross profit margin in the successor period compared to thepredecessor periods was primarily attributable to increased occupancy costs fornew stores. Selling gross profit margins excluding store occupancy expensesincreased over the previous year in both the predecessor and successor periods.Although gross profit margins for the predecessor period were higher againstthe prior year, net income declined principally due to the following factors:

 

•                  Pre-taxtransaction expenses of $37.1 million in the successor period ended September 25,2004 and $3.0 million in the predecessor period ended July 30, 2004 thatwere related to the Acquisition, including certain change-of-control paymentsto management and contractual fees payable to Oak Hill upon consummation of thetransaction;

•                  Expensesassociated with the CEO Supplemental Executive Retirement Plan termination andother compensation related costs incurred in connection with the Acquisition;

•                  An increase inamortization expense of $2.1 million in the current year’s successor periodattributable to the preliminary acquisition related purchase accountingadjustments to the valuation of store leases and prescription pharmacy filesunder FAS 141. The balance of the increase is attributable to the depreciationof capital expenditures and amortization of intangibles acquired in 2003 and2004 that impact both the successor and predecessor periods of the currentyear;

•                  Pre-tax laborcontingency expenses of $3.3 million related to a National Labor RelationsBoard ruling in a collective bargaining agreement litigation related to thefunding of certain employee benefit funds (see Note 3 to the UnauditedConsolidated Interim Financial Statements);

•                  Increased advertisingand promotional expenses in both the successor and predecessor periods of thecurrent year to stimulate sales; and

•                  Increased legaland litigation related expenses associated with certain labor issues, ourattempt to recover the balance of our World Trade Center business interruptioninsurance claim and various other matters, as well as $0.6 million related to alitigation settlement.

 

Thefollowing sets forth the results of operations for the periods indicated:

 
| ** **                                     | ** ** | **Successor**                                                         | ** ** | ** **     | **Predecessor**                                                      | ** ** |
|------------------------------------------------|------------|-----------------------------------------------------------------------|------------|----------------|----------------------------------------------------------------------|------------|
| ** **                                     | ** ** | **Period from  July 31, 2004  through  September 25, 2004** | ** ** | ** **     | **Period from  December 28, 2003  through  July 30, 2004** | ** ** | **9 Months Ended  September 27, 2003** | ** ** |
| **In thousands, except percentages**           | ** ** | **Dollars**                                                           | ** ** | **% of Sales** | ** **                                                           | ** ** | **Dollars** | ** ** | **% of Sales** | ** ** | **Dollars** | ** ** | **% of Sales** | ** ** |
| Net sales                                      |       | $                                                                     | 217,556    |           | 100.0                                                                | %          |   | $ | 846,842 |   | 100.0 | % | $ | 1,027,398 |   | 100.0 | % |
| Cost of sales                                  |       | 172,765                                                               |       | 79.4           |                                                                 |       | 663,223 |   | 78.3 |   | 808,124 |   | 78.7 |   |
| Gross profit                                   |       | 44,791                                                                |       | 20.6           |                                                                 |       | 183,619 |   | 21.7 |   | 219,274 |   | 21.3 |   |
| Selling, general & administrative expenses |       | 37,355                                                                |       | 17.2           |                                                                 |       | 142,293 |   | 16.8 |   | 167,130 |   | 16.3 |   |
| Labor contingency expense                      |       | 689                                                                   |       | 0.3            |                                                                 |       | 2,611 |   | 0.3 |   | — |   | — |   |
| Transaction expense                            |       | 37,118                                                                |       | 17.1           |                                                                 |       | 3,005 |   | 0.4 |   | — |   | — |   |
| Depreciation and amortization                  |       | 7,280                                                                 |       | 3.3            |                                                                 |       | 21,902 |   | 2.6 |   | 23,874 |   | 2.3 |   |
| Store pre-opening expenses                     |       | 366                                                                   |       | 0.2            |                                                                 |       | 470 |   | 0.1 |   | 798 |   | 0.1 |   |
| Other                                          |       | 25,291                                                                |       | 11.6           |                                                                 |       | — |   | — |   | — |   | — |   |
|                                           |       | 108,099                                                               |       | 49.7           |                                                                 |       | 170,281 |   | 20.1 |   | 191,802 |   | 18.7 |   |
| Operating (loss) income                        |       | (63,308                                                               | )          | (29.1          | )                                                                    |       | 13,338 |   | 1.6 |   | 27,472 |   | 2.7 |   |
| Interest expense, net                          |       | 6,283                                                                 |       | 2.9            |                                                                 |       | 7,977 |   | 0.9 |   | 10,452 |   | 1.0 |   |
| Debt extinguishment                            |       | —                                                                |       | —         |                                                                 |       | — |   | — |   | 812 |   | 0.1 |   |
| (Loss) income before income taxes              |       | (69,591                                                               | )          | (32.0          | )                                                                    |       | 5,361 |   | 0.6 |   | 16,208 |   | 1.6 |   |
| Income tax (benefit) provision                 |       | (32,048                                                               | )          | (14.7          | )                                                                    |       | 1,555 |   | 0.2 |   | 7,132 |   | 0.7 |   |
| Net (loss) income                              |       | $                                                                     | (37,543    | )              | (17.3                                                                | )%         |   | $ | 3,806 |   | 0.4 | % | $ | 9,076 |   | 0.9 | % |

 

 

19

----

 

Net sales were $217.6 million in the July 31,2004 through September 25, 2004 period and $846.8 million in the December 28,2003 through July 30, 2004 period. Overall, sales increased by 3.6% ascompared to net sales of $1.0 billion for the first nine months of 2003.Same-store sales increased by 0.8% over the comparable period last year withthe balance of the increase coming from the full nine month results of 11 netnew stores opened in the first nine months last year and 16 net new storesopened since the end of last year’s third quarter.

 

Pharmacy sales increased from $447.8 million inthe first nine months of 2003 to $484.3 million in the first nine months of2004, an increase of 8.2%, and represented 45.5% of total sales, as comparedwith 43.6% of total sales in the first nine months of 2003. Pharmacy same-storesales increased by 5.4% over last year, and third-party reimbursed pharmacysales represented 92.2% of total pharmacy sales compared to 91.3% in the sameperiod last year. Pharmacy same-store sales continued to experience the generalindustry trend of reduced growth rates experienced during fiscal 2003.  The major factors driving the slower salesgrowth rates in pharmacy were the trends toward increases in third party plancustomer co-payments, reduced sales of hormonal replacement drugs, limitationson maximum reimbursements for certain generic medications by third party plans,increased penetration by mail order and internet-based pharmacies and continuedhigh rates of unemployment that have reduced the number of customers covered byinsured plans.

 

Front-end sales increased from $579.6 million inthe first nine months of 2003 to $580.1 million in the first nine months of2004, an increase of 0.1%, and represented 54.5% of total sales, as compared to56.4% of total sales in the first nine months of 2003. Front-end same-storesales declined by 2.8%, partly due to declining tobacco sales in metro New YorkCity, which has experienced increased restrictions on smoking in public placesalong with higher taxes on tobacco products. Excluding tobacco sales, front-end same-store sales decreased byapproximately 1.5%. We believe that the remaining decline in same-storefront-end sales is largely attributable to the continued high unemploymentrates in New York City that have restrained consumer demand.

 

During the period from July 31, 2004through September 25, 2004, we opened seven stores and closed one store,and from December 28, 2003 through July 30, 2004 we opened ninestores and closed one store, as compared to fourteen stores opened and threestores closed during the nine months ended September 27, 2003.

 

Costof sales as a percentage of net sales was 79.4% for the period from July 31,2004 through September 25, 2004 and 78.3% for the period from December 28, 2003through July 30, 2004, resulting in gross profit margins of 20.6% and 21.7%,respectively. In the first nine months of 2003, cost of sales as a percentageof net sales was 78.7%, resulting in a gross profit margin of 21.3%. Asdiscussed above, the lower gross profit margin results for the successor periodin the current year are primarily attributable to increased new store occupancycosts that could not be leveraged against the modest sales growth experiencedduring the current year. Cost of sales also includes (i) a $0.7 million LIFOprovision in the current year, as compared to a LIFO provision of $0.5 millionin the prior year, and (ii) real-estate related income of $2.1 million and $1.4million in the first nine months of 2004 and 2003, respectively.

 

Selling,general and administrative expenses were $37.4 million, or 17.2% of net sales,and $142.3 million or 16.8% of net sales, in the July 31, 2004 throughSeptember 25, 2004 period and the December 28, 2003 through July 30, 2004periods, respectively, as compared to $167.1 million, or 16.3% of net sales, inthe first nine months of 2003. The increase in these expenses as a percentageof sales is primarily attributable to (i) increased store labor and relatedexpenses associated with higher salary rates for pharmacists in light ofincreased competition for these professionals that has been caused by anoverall shortage in the available workforce, (ii) increased legal andlitigation related expenses primarily associated with our efforts to recoverour September 11 business interruption insurance claim and various union laborlitigations, (iii) higher promotional and advertising costs to stimulate sales,(iv) increased litigation settlement costs and (v) severance costs associatedwith certain administrative staff reductions incurred during the first quarter.

 

Depreciationand amortization of intangibles amounted to $7.3 million and $21.9 million forthe July 31, 2004 through September 25, 2004 and December 28,2003 through July 30, 2004 periods, respectively, versus $23.9 million inthe first nine months of 2003.  Thisincrease resulted from the depreciation of capital expenditures made in 2003and 2004 as well as increases in the amortization of identifiable intangibles,a major portion of which resulted from pharmacy acquisitions completed sincethe beginning of 2003. In addition, as at July 30, 2004, in accordancewith the purchase accounting requirements of FAS 141, certain intangible assets(primarily store leases and pharmacy customer files) were written-up to theirestimated fair value, resulting in incremental amortization expense of $2.1million being recorded subsequent to that date.

 

Weincurred store pre-opening expenses of $0.4 million in the July 31, 2004through September 25, 2004 period, and $0.5 million in the December 28,2003 through July 30, 2004 period, related to the opening of seven storesand nine stores, respectively. In the comparable nine month period last year,we incurred pre-opening costs of $0.8 million, attributable to the opening of 14stores.

 

20

----

 

Netinterest expense for the July 31, 2004 through September 25, 2004period was $6.3 million, and for the December 28, 2003 through July 30,2004 period was $8.0 million. In the comparable period of 2003, net interestexpense amounted to $10.5 million.  Thisincrease in the current year was primarily attributable to the interest costsassociated with increased debt and higher interest rates associated with our newdebt structure resulting from the Acquisition.

 

In thefirst nine months of 2003, we recorded a debt extinguishment charge of $0.8million, reflecting (i) the payment of early termination premiums related tothe retirement of the $1.6 million outstanding balance of the 9.25% seniornotes and the write-off of the remaining deferred financing costs associatedwith those notes and (ii) the accelerated amortization of the remainingdeferred financing costs related to our term loans and existing revolverfacility which were fully repaid in connection with the July 2003refinancing of our Senior Credit Agreement with an asset-based revolving creditfacility.

 

In theperiod from July 31, 2004 through September 25, 2004, we recorded anincome tax benefit of $32.0 million, reflecting an estimated post-acquisitioneffective tax rate of 46.0%, inclusive of the anticipated benefits ofemployment tax credits. In the period from December 28, 2003 through July 30,2004, the income tax provision of $1.6 million reflects an effective tax rateof 29%, inclusive of the anticipated benefits of employment tax credits. In thecomparable period last year, the income tax provision of $7.1 million reflectedan estimated effective tax rate of 44.0%, inclusive of the anticipated benefitsof employment tax credits. The employment tax credits represent the economicbenefits earned by us for our participation in various federal and state hiringincentive programs.

 

 

**Liquidityand Capital Resources**

 

**WorkingCapital and Cash Flow**

 

Workingcapital was $213.3 million as of September 25, 2004 and $227.6 million asof December 27, 2003. The decrease was primarily due to increased interestand expense accruals reflecting obligations incurred as a result of theAcquisition.  These acquisition relatedaccruals amounted to approximately $23.4 million. Generally, working capital increasesat the beginning of each month when we draw on our asset-based revolving loanfacility to pay operating expenses and decreases at the end of each month as werepay those borrowings.

 

Net cash used in operating activities was $22.0million in the period from July 30, 2004 through September 25, 2004 and net cashprovided by operations was $21.6 million in the period from December 28, 2003through July 30, 2004 compared to cash provided by operations of $29.8 millionin the first nine month of 2003. Cash Acquisition transaction related expensesof $38.2 million accounted for the use of cash in the successor period.

 

Net cash used in investing activities was $425.9million and $32.5 million, in the periods from July 30, 2004 through September25, 2004 and December 28, 2004 through July 30, 2004, respectively, compared to$45.8 million in the first nine months of 2003. The increase in the successorperiod primarily represents the $413.7 million cash cost of acquiring theCompany. In addition, capital expenditures in the current year of $22.1 milliondeclined by $12.4 million while lease acquisition, pharmacy customer file andother costs of $22.6 million increased by $11.3 million versus the previousyear.

 

Net cash provided by financing activities was $447.9million and $11.0 million in the periods from July 30, 2004 through September25, 2004 and December 28, 2003 through July 30, 2004, respectively, compared tonet cash provided by financing activities of $13.1 million in the first ninemonths of 2003. The increase in cash provided by financing activities in the currentyear was primarily attributable to the equity contribution received and the newdebt incurred in connection with the Acquisition.

 

**The Acquisition**

 

The July 30,2004 Acquisition was financed as an all cash transaction whereby our commonstock outstanding immediately prior to the Acquisition was converted into theright to receive $16.50 per share, without interest. The total transactionvalue, including transaction expenses and the repayment of indebtedness wasapproximately $744 million, which was funded through new equity investments ofapproximately $244 million and debt of approximately $500 million.Upon closing of the Acquisition, we had approximately $90.4****million of borrowing availability under our Amended CreditAgreement, net of $2.9 million reserved for standby letters of credit.

 

21

----

 

**Operating Capital Requirements**

 

Our operating capital requirements primarilyresult from opening and stocking new stores, remodeling and renovating existingretail locations, purchasing pharmacy files and the continuing development ofmanagement information systems. We opened a total of 17 stores in 2003, adecline from 32 stores opened in 2002 and 31 stores opened in 2001. We opened16 new stores in the nine month year-to-date period in 2004 and currently planto open approximately 0-2 additional new stores during the remainder of thisyear (a total of 16-18 for all of 2004), and 10-12 new stores in each of fiscal2005 through fiscal 2008. We expect to spend approximately $40.0 million in 2004on capital expenditures, primarily for new, renovated and replacement stores,and an additional $14 million - $17 million for lease acquisition, pharmacycustomer files and other costs. We also require working capital to supportinventory for our existing and new stores. Historically, we have been able tolease almost all of our store locations, so acquisitions of real estate are notexpected to have a significant impact on our capital requirements.

 

**Other Factors Influencing our Liquidity**

 

Ten of our stores which generated approximately 4.1%of our net sales for fiscal 2003 have leases scheduled to expire before the endof fiscal 2005. One of these leases has a renewal option.  We believe that we will be able to renew the otherexpiring leases on economically favorable terms or, alternatively, find othereconomically attractive locations to lease.

 

As of September 25,2004, approximately 4,600 of our approximately 6,500 employees were representedby various labor unions and were covered by collective bargaining agreements.Pursuant to the terms of the collective bargaining agreements covering theseemployees, we are required, in some instances, to pay specified annualincreases in salary and benefits contributions relating to the memberemployees. We do not believe that these increases will have a material impacton our liquidity or results of operations. Our collective bargaining agreementwith Local 340A New York Joint Board, UNITE AFL-CIO (“UNITE”), who representsapproximately 700 of our employees in 113 stores, expired on March 31,2004. The terms of the expired contract have been extended by the mutualconsent of UNITE and Duane Reade through November 30, 2004 while wecontinue to negotiate the terms of a new agreement.

 

Underan employment agreement with our Chairman and CEO originally entered into in1997 and subsequently amended in 2000 and 2001, and then amended and restatedin 2002, and again amended and restated in connection with the completed Acquisition,we were required to fund premiums for a split dollar life insurance policy thatwould provide certain post-retirement benefits. During fiscal 2003 and fiscal2004, the annual premiums amounted to $5.0 million, and were scheduled toremain at $5.0 million per year through 2010. The enactment of theSarbanes-Oxley Act has resulted in the need for additional guidance concerningthe permissibility of split dollar life insurance policies for executives.  While we believe this split dollar policy ispermitted under current interpretations of the legislation, there can be noassurance that further interpretations or guidance to be provided by the SECconcerning this legislation will concur. Upon completion of the Acquisition, under Mr. Cuti’s amended andrestated employment agreement, we elected to terminate the split dollar lifeinsurance contract in exchange for, among other things, the payment to Mr. Cutiof $6.5 million on or prior to December 1, 2004, $14.0 million on or priorto January 1, 2005 and $4.0 million on or prior to June 30, 2005. Theparties to Mr. Cuti’s employment agreement agreed to accelerate a portion ofthe first payment of $6.5 million, in the amount of $1.5 million, which waspaid on August 12, 2004. A portion of these payment obligations will besatisfied either using the cash surrender value of the split dollar lifeinsurance contract at the time we elect to terminate it (approximately $14.0million as of September 30, 2004) or by transferring ownership of thesplit dollar life insurance contract to Mr. Cuti.

 

TheAcquisition resulted in a restructuring of our debt, as well as the eliminationof our obligations under the CEO Split Dollar Life Insurance Policy, inexchange for certain direct payments to our Chief Executive Officer. Thefollowing table presents details of our significant Commitments and Obligationsas at September 25, 2004, except that the data provided with respect tooperating leases is as of December 27, 2003:

 

22

----

 

**Payments due by Period**

(dollars in thousands)

 
| **Contractual Cash Obligations**   | ** ** | **Total** | ** ** | **Within  1 year** | ** ** | **2-3 years** | ** ** | **4-5 years** | ** ** | **After  5 years** | ** ** |
|------------------------------------|------------|-----------|------------|--------------------|------------|---------------|------------|---------------|------------|--------------------|------------|
| Long-Term Debt                     |       | $         | 502,971    |               | $          | —        |       | $             | —     |               | $          | 152,939 |   | $ | 350,032 |   |
| Capital Lease Obligations          |       | 2,970     |       | 762                |       | 1,472         |       | 736           |       | —             |       |
| Operating Leases                   |       | 1,195,902 |       | 111,028            |       | 219,048       |       | 202,006       |       | 663,820            |       |
| CEO SERP Termination               |       | 23,000    |       | 23,000             |       | —        |       | —        |       | —             |       |
| Total Contractual Cash Obligations |       | $         | 1,724,843  |               | $          | 134,790       |       | $             | 220,520    |               | $          | 355,681 |   | $ | 1,013,852 |   |

 

We areparty to multi-year merchandise supply agreements in the normal course ofbusiness. The largest of these agreements is with AmerisourceBergen, ourprimary pharmaceutical supplier. Generally, these agreements provide forcertain volume commitments and may be terminated by us, subject in some cases tospecified termination payments, none of which would constitute a materialadverse effect on our financial position, results of operations or cash flows.It is the opinion of management that if any of these agreements were terminatedor if any contracting party was to experience events precluding fulfillment ofits obligations, we would be able to find a suitable alternative supplier.

 

In connection with theAcquisition, Mr. Cuti was granted equity interests in Duane Reade Shareholdersand Duane Reade Holdings consisting of options to purchase shares of DuaneReade Holdings common stock and a profits interest in Duane ReadeShareholders.  Upon the occurrence ofcertain events, including the fifth anniversary of the effective date of theAcquisition, Mr. Cuti will have the right to require us to purchase for cashover a two year period all or a portion of these equity interests as he maydesignate, at fair market value determined in accordance with a formula.  The profits interest and options will have novalue unless the value of Duane Reade Shareholders and Duane Reade Holdings,respectively, appreciate following the Acquisition.  Mr. Cuti’s purchase right will be suspendedat any time when the exercise of such purchase rights would result in a defaultunder the financing arrangements of us, Duane Reade Shareholders or Duane ReadeHoldings.  Mr. Cuti’s purchase right willalso terminate upon certain public offerings by us, Duane Reade Shareholders orDuane Reade Holdings.

 

At September 25,2004, we recorded a litigation-related non-current liability of $15.9 millionin connection with a National Labor Relations Board decision in a litigation-relatedmatter with the Allied Trades Council, a union representing employees in 139 ofour stores. Because this decision is the initial phase of a complexadministrative and judicial process, the ultimate outcome, financial impact andrelated timing of any future cash disbursement relating to this matter cannotbe determined at this time. This matter is more fully described in Note 3to the Unaudited Consolidated Interim Financial Statements.

 

**Off-BalanceSheet Arrangements**

** **

We arenot a party to any agreements with, or commitments to, any special purposeentities that would constitute material off-balance sheet financing other thanthe operating lease commitments detailed in the Contractual Obligations andCommitments table presented above.

 

**Long TermDebt**

 

Priorto the Acquisition, our debt structure had two primary components, consistingof Convertible Notes and the Credit Agreement.

 

**ConvertibleNotes**

 

The Convertible Notes were issued on April 16,2002 at a discounted value equivalent to 57.276% of face value.  The Convertible Notes paid cash interestsemiannually at a rate of 2.1478% of face value for the first five years andthereafter accrued original issue discount at a semi-annual bond equivalentrate of 3.75% yield to maturity on April 16, 2022. The Convertible Notes wereconvertible into shares of our common stock upon the occurrence of certainspecified events. Holders of the Convertible Notes could require us to purchaseall or a portion of the Convertible Notes on each of the 5, 10 and 15-yearanniversaries of the issuance date at pre-specified prices. We could redeem forcash all or a portion of the Convertible Notes at any time after April 16,2007 at a price equal to the sum of the issue price plus accrued original issuediscount and accrued cash interest, if any, to the redemption date.

 

23

----

 

The Acquisition was deemed to be a “change of control”under the indenture governing the Convertible Notes. As a result, within 15days after the completion of the Acquisition, we were required to notify theholders of the Convertible Notes of their option to require us to purchase thenotes. On August 12, we initiated a cash tender offer in order to satisfy ourrepurchase obligation under the indenture. The tender offer provided that we would pay each holder the purchaseprice of $572.76 per $1,000 of principal value, plus accrued interestcalculated from the previous payment date of April 16, 2004, through theexpiration date of the tender offer. The tender offer expired on September 10,2004, at which point all but $55,000 of principal value of the total $351.0million outstanding principal value of the notes were tendered for repurchase.On September 13, 2004, we paid the paying agent, US Bank NationalAssociation, a total of $204.1 million, representing $201.0 million of purchaseprice redemption and $3.1 million of accrued interest. We used a portion of thefunds raised to finance the Acquisition combined with additional borrowings onour revolving credit agreement to finance the repurchase of these notes.

 

Inconnection with the consummation of the Acquisition, we, Duane ReadeShareholders, LLC, the indirect parent of Duane Reade Inc., and each of oursubsidiaries that are guarantors of the Convertible Notes entered into asupplemental indenture.  Pursuant to thesupplemental indenture, as a result of the merger of Duane Reade AcquisitionCorp. with and into Duane Reade Inc., the Convertible Notes may only beconverted into the right to receive from us $16.50 (in cash and withoutinterest) per share of our common stock issuable to a holder of ConvertibleNotes in connection with such conversion.

 

**CreditAgreement**

 

On July 21,2003, we entered into a new credit facility (the “Credit Agreement”). ThisCredit Agreement is an asset-based revolving loan which used a pre-determinedpercentage of the current value of our inventory and selected accountsreceivable to calculate the availability of funds eligible to be borrowed up toan aggregate principal amount of $200 million. Prior to the amendment describedbelow, our obligations under the Credit Agreement were collateralized by substantiallyall of our assets. In addition, the Credit Agreement was guaranteed by each of ourcorporate subsidiaries, and such guarantees were collateralized bysubstantially all assets of such guarantors. The Credit Agreement is set to mature on July 20, 2008.

 

TheCredit Agreement contains a single fixed charge coverage requirement which onlybecomes applicable when borrowings exceed 90 percent of the borrowing base, asdefined in the Credit Agreement. Borrowings under the Credit Agreement have notexceeded 90 percent of the borrowing base and, as a result, the fixed chargecovenant did not become applicable during the period. There are no creditratings related triggers in the Credit Agreement that would impact the cost ofborrowing, annual amortization of principal or related indebtedness maturity.

 

On July 22, 2004, in connection with theAcquisition, the Credit Agreement was amended (the “Amended Credit Agreement”)to increase our borrowing capacity to an aggregate principal amount of $250million, subject to an adjusted borrowing base calculation based upon specifiedadvance rates against the value of our inventory, customer prescription filesand selected accounts receivable. The Amended Credit Agreement includes a $50million sub-limit for the issuance of letters of credit. Obligations under theamended asset-based revolving loan facility are collateralized by a firstpriority security interest in inventory, receivables, pharmacy prescriptionfiles, deposit accounts and certain other current assets. Under the amendedfacility, Duane Reade GP is the borrower. The amended facility is guaranteed byDuane Reade Holdings, us and each of our domestic subsidiaries other than DuaneReade GP. Revolving loans under the Amended Credit Agreement, at our option, bearinterest at either (i) a rate equal to LIBOR (the London Interbank OfferedRate) plus a margin of from 1.50% to 2.00%, determined based on levels ofborrowing availability reset each fiscal quarter or (ii) a rate equal to theprime rate of Banc of America Retail Group Inc. plus a margin of from 0.00% to0.50%, determined based on levels of borrowing availability reset each fiscalquarter. Borrowings under the amended facility continue to be primarilyLIBOR-based.

 

At September 25,2004 there was $152.9 million outstanding under the revolving credit facility,and approximately $93.7 million of remaining availability, net of $2.9 millionreserved for standby letters of credit.

 

24

----

 

**Acquisition-RelatedDebt Financings**

 

**SeniorTerm Loan Facility**

 

On July 30, 2004, in connection with theAcquisition, we entered into a Senior Term Loan in the principal amount of $155million. This loan will mature on July 30, 2010. While there are noscheduled principal payments over its term, we will be required to prepay thesenior term loan together with accrued interest thereon, with (a) all net cashproceeds (i) from sales of property and assets from Duane Reade Holdings andits subsidiaries (excluding sales of inventory in the normal course of businessand certain other exceptions described in the Senior Term Loan), (ii) of extraordinaryreceipts, casualties and condemnations as defined in the Senior Term Loan and(iii) from the issuance or incurrence of additional debt of Duane ReadeHoldings or any of its subsidiaries other than certain identified indebtednesspermitted under the Senior Term Loan, (b) 50.0% of all net cash proceeds fromthe issuance of additional equity of Duane Reade Holdings or any of itssubsidiaries (excluding equity issued to Oak Hill and other exceptionsspecified in the Term Loan) and (c) 50.0% of excess cash flow of Duane ReadeHoldings and its subsidiaries (beginning with the fiscal year ending December 2005).  Loans under the Senior Term Loan facilitywill, at our option, bear interest at a rate per annum of (i) thereserve-adjusted LIBOR plus an applicable margin of 3.25%; or (ii) 2.25%, plusthe higher of (a) the prime rate of Bank of America, N.A. and (b) the FederalFunds rate plus 0.50%. Duane Reade GP became a co-obligor under the Senior TermLoan upon the closing of the Acquisition. All obligations under the Senior Term Loan are guaranteed by Duane ReadeHoldings and each of our existing subsidiaries, other than Duane Reade GP, andwill be guaranteed by future subsidiaries except certain foreign subsidiaries. TheSenior Term Loan is collateralized by a first priority security interest insubstantially all of our assets other than those assets in which the lendersunder the Amended Credit Agreement have a first priority interest.  The Senior Term Loan is also collateralizedby a second priority security interest in all collateral pledged on a firstpriority basis to lenders under the Amended Credit Agreement.  The Senior Term Loan also contains affirmativeand negative covenants customary for a senior term loan facility, including,among other things, restrictions on indebtedness, liens, mergers andconsolidations, sales of assets, loans, acquisitions, joint ventures,restricted payments, transactions with affiliates, dividends and other paymentrestrictions affecting subsidiaries and sale leaseback transactions.  The Senior Term Loan also requires DuaneReade Holdings and its subsidiaries to maintain a maximum leverage ratio and aminimum interest coverage ratio. We are in compliance with all of these debtrelated financial covenants. There are no credit ratings related triggers inthe Senior Term Loan Facility that would impact the cost of borrowing, annualamortization of principal or related indebtedness maturity.

 

**$195Million 9 3/4% Senior Subordinated Notes Due 2011**

 

On July 30,2004, upon completion of the Acquisition, we entered into an Indenture for $195million of 9 3/4% Senior Subordinated Notes due 2011 (the “Senior Subordinated Notes”).  The Senior Subordinated Notes mature on August 1,2011 and bear interest at 9.75% per annum payable in semi-annual installmentson February 1 and August 1, commencing February 1, 2005, to theholders of record on the immediately preceding January 15 and July 15.The Senior Subordinated Notes are uncollateralized obligations and subordinatedin right of payment to all of our existing and future unsubordinatedindebtedness, including borrowings under the Amended Credit Agreement (asdefined above) and the Senior Term Loan (as defined above). The SeniorSubordinated Notes will rank equally with any future senior subordinatedindebtedness and senior to any future subordinated indebtedness. The SeniorSubordinated Notes are guaranteed on an uncollateralized, senior subordinatedbasis by all of our existing direct and indirect subsidiaries other than DuaneReade GP, which is a co-obligor under the Senior Subordinated Notes. We mayredeem the Senior Subordinated Notes, in whole or in part, at any time on orafter August 1, 2008, at a redemption price of 104.875% declining to paron August 1, 2010 plus accrued and unpaid interest. In addition, we, DuaneReade Shareholders or Duane Reade Holdings, at our option, can redeem up to 35%of the Senior Subordinated Notes before August 1, 2007 with the net cashproceeds from certain equity offerings. Upon the occurrence of specified changeof control events, we and Duane Reade GP will be required to make an offer torepurchase all of the Senior Subordinated Notes at 101% of the outstandingprincipal amount of the Senior Subordinated Notes plus accrued and unpaidinterest to the date of repurchase. The indenture governing the Senior SubordinatedNotes contains certain affirmative and negative covenants that limit ourability to incur additional indebtedness, pay dividends, make repayments onindebtedness that is subordinated to the Senior Subordinated Notes and to makecertain other restricted payments, incur certain liens, use proceeds from salesof assets, enter into business combination transactions (including mergers,consolidations and asset sales), enter into transactions with affiliates andpermit restrictions on the payment of dividends by our subsidiaries. Under aregistration rights agreement entered into as part of the offering of theSenior Subordinated Notes, we are required to (i) file a registration statementwith the SEC within 120 days after the completion of the Acquisition, (ii) use ourreasonable best efforts to cause the registration statement to become effectivewithin 180 days after the completion of the Acquisition, and (iii) use ourreasonable best efforts to complete the exchange offer within 210 days afterthe Acquisition is completed. There are no credit ratings related triggers inthe Senior Subordinated Notes that would impact the cost of borrowing, annualamortization of principal or related indebtedness maturity.

 

25

----

 

**Liquidity Assessment**

 

Webelieve that, based on current levels of operations and anticipated growth,cash flow from operations, together with other available sources of funds,including the initial equity contribution of approximately $240 milliondiscussed above, revolving loan borrowings under our Amended Credit Agreement,our $155 million Senior Term Loan and the $195 million Senior Subordinated Noteswill be adequate for the payment of all of our obligations in connection withthe Acquisition and, for at least the next two years, to make required paymentson our indebtedness, to fund anticipated capital expenditures and to satisfyour working capital requirements. We base this belief on our recent levels ofcash flow from operations of approximately $47.4 million and $42.5 million infiscal 2003 and fiscal 2002, respectively, as well as our cash flow fromoperations, excluding cash costs attributable to the Acquisition, of $38.2million in the 39 weeks ended September 25, 2004, and the significantadditional borrowing capacity under our Amended Credit Agreement which amountedto approximately $90.4 million upon the completion of the Acquisition andapproximately $93.7 million at September 25, 2004. Our ability to meet ourdebt service obligations and reduce our total debt will depend 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, our operating results, cash flow andcapital resources may not be sufficient for repayment of our indebtedness inthe future. Some risks that could adversely affect our ability to meet our debtservice obligations include, but are not limited to, reductions in third partyprescription reimbursement rates, further declines in the New York Cityeconomy, increases in competitive activity, additional adverse legislativechanges or a major disruption of our business in our markets from a terroristevent or natural disaster. Our borrowings under our Amended Credit Agreement andSenior Term Loan bear interest at floating rates. Therefore, our financialcondition will be affected by changes in prevailing interest rates.

 

**CriticalAccounting Policies**

 

Our discussion of results of operations andfinancial condition relies on our consolidated financial statements that areprepared based on certain critical accounting policies that require managementto make judgments and estimates that are subject to varying degrees ofuncertainty. We believe that investors need to be aware of these policies andhow they impact our financial reporting to gain a more complete understandingof our consolidated financial statements as a whole, as well as our relateddiscussion and analysis presented herein. While we believe that theseaccounting policies are grounded on sound measurement criteria, actual futureevents can and often do result in outcomes that can be materially differentfrom these estimates or forecasts. The accounting policies and related risksdescribed in our Annual Report on Form 10-K, as amended, for the year ended December 27,2003 are those that depend most heavily on these judgments and estimates.  At September 25, 2004, there have beenno material changes to any of the Critical Accounting Policies containedtherein.

 

**Seasonality**

 

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

 

**Inflation**

 

We believe that inflationhas not had a material impact on our results of operations during the threeyears ended December 27, 2003 or the nine months ended September 25,2004.

 

**Recently Issued Accounting Pronouncements**

 

In December 2002,SFAS No. 148, “Accounting for Stock-Based Compensation — Transition andDisclosure” was issued. This statement provides alternative methods oftransition for a voluntary change to the fair value based method of accountingfor stock-based employee compensation. We have not adopted such voluntarychange to the fair value based method. In addition, this statement amends thedisclosure requirements of SFAS No. 123 to require prominent disclosures aboutthe method of accounting for stock-based compensation and the effect of themethod used on reported results. As required, we adopted the disclosure-onlyprovisions of FAS No. 148 effective in 2002.

 

26

----

 

**ITEM 3****. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

Our financial results are subject to risk frominterest rate fluctuations on debt, which carries variable interest rates.Variable rate debt outstanding at September 25, 2004 included $152.9million of borrowings under our Amended Credit Agreement and $155.0 million ofterm loans. At September 25, 2004, the weighted average combined interestrate in effect on all variable rate debt outstanding was 4.09%. A 0.50% changein interest rates applied to the $307.9 million balance of floating rate debtwould affect pre-tax annual results of operations by approximately $1.5million. In addition, we also have $195.0 million of Senior Subordinated Notes and$32,000 of Senior Convertible Notes outstanding at September 25, 2004. TheSenior Subordinated Notes and Senior Convertible Notes bear interest payablesemi-annually at fixed rates of 9.75% and 3.75%, respectively, and aretherefore not subject to risk from interest rate fluctuations.

 

The principal objective of our investmentmanagement activities is to maintain acceptable levels of interest rate andliquidity risk to facilitate our funding needs. As part of our risk management,we may use derivative financial products such as interest rate hedges andinterest rate swaps in the future.

 

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

 

(a)          *Evaluation of Disclosure Controls and Procedures*.  Our Chief Executive Officer and ChiefFinancial Officer have evaluated the effectiveness of our disclosure controlsand procedures (as such term is defined in Rules 13a-14(c) and 15d-14(c) underthe Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of theend of the period covered by this quarterly report (the “Evaluation Date”).Based on such evaluation, such officers have concluded that, as of theEvaluation Date, our disclosure controls and procedures are effective inalerting them on a timely basis to material information relating to our Company(including our consolidated subsidiaries) required to be included in ourreports filed or submitted under the Exchange Act.

 

(b)         *Changes inInternal Controls over Financial Reporting*.  During the most recent fiscal quarter, therehave not been any significant changes in our internal controls over financialreporting, or in other factors that have materially affected, or are reasonablylikely to materially affect, our internal controls over financial reporting.

 

 

**PART II**

 

**OTHER INFORMATION**

 

**ITEM 1. Legal Proceedings**

 

We areparty to legal actions arising in the ordinary course of business. Based oninformation presently available to us, we believe that we have adequate legaldefenses or insurance coverage for these actions and that the ultimate outcomeof these actions will not have a materially adverse effect on the financialposition, results of operations or cash flows of our company. In addition, weare a party to the following legal actions and matters:

 

During2002, we initiated a legal action against our former property insurancecarrier, in an attempt to recover what we believe to be a fair and reasonablesettlement for the business interruption portion of our claim originating fromthe September 11, 2001 World Trade Center terrorist attack, during whichour single highest volume and most profitable store was completely destroyed. Theclaim is pending before the United States District Court for the SouthernDistrict of New York. In September 2003, a trial on certain issues washeld regarding some of the matters at issue in the litigation, includingwhether we would have obtained a renewal of our lease at the World TradeCenter. We have received a favorable ruling on this and other legal issues inthe case and now the matter has moved into an appraisal process. The appraisalprocess involves two appraisers and an arbitrator (to resolve differencesbetween the two appraisers) who will determine the amount of insured loss wehave sustained. The insurance carrier has appealed a number of rulings by thetrial court. In light of both the early stage of the appraisal process and theinherent uncertainty

 

27

----

 

in litigation relating toour appeal, the amount of additional insurance proceeds, if any, that we maycollect under the terms of our insurance contract with the defendant cannot bereasonable predicted or determined at this time, and therefore, the Company hasnot accrued any additional income related to this potential settlement. Infiscal 2002, we received an advance of approximately $9.4 million towardthe business interruption claim that was recognized as a separate component ofincome in the consolidated statement of income. In the event of an unfavorableoutcome to us, this amount would not be required to be returned to theinsurance company.

 

DuaneReade Inc., Anthony J. Cuti, our Chairman, President and Chief ExecutiveOfficer, John K. Henry, our Senior Vice President and Chief Financial Officerand Gary Charboneau, our Senior Vice President of Sales and Marketing werenamed as defendants in connection with the consolidation of several classaction complaints alleging violations of the federal securities laws that werefiled from August 2002 through October 2002. The action, which was inthe United States District Court for the Southern District of New York, was onbehalf of shareholders who purchased our common stock between April 1,2002 and July 24, 2002, inclusive. The complaint, which sought anunspecified amount of damages, alleged that the defendants violated the federalsecurities laws by issuing materially false and misleading statements duringthe class period. On December 1, 2003, the district judge granted ourmotion to dismiss the plaintiff’s action, with prejudice. The plaintiffs subsequentlyfiled an appeal. On August 17, 2004, the US Court of Appeals affirmed thedistrict court’s ruling in our favor.

 

We area defendant in a class action suit in the Federal Court for the SouthernDistrict of New York regarding alleged violations of the Fair Labor StandardsAct as to a group of individuals who provided delivery services on a contractbasis to us. In December 2002, the judge in the action issued a partialsummary judgment in favor of a subclass of the plaintiffs and against us. In December 2003,we settled the issue of the amount of our liability to the plaintiffs withoutany admission of wrongdoing and in an amount consistent with our previouslyestablished reserves. By a decision dated August 4, 2004, the districtcourt awarded the plaintiffs certain attorneys’ fees in this matter. We havefully reserved the amount of the fees in question and have appealed this awardto the US Circuit Court of Appeals

 

We area party to related lawsuits, Irving Kroop, et al. v. Duane Reade, NY, NY et al.,00 Civ. 9841, et al., instituted by the trustees of several union benefit fundswherein the funds claim that we did not make certain required contributions tothese funds from January 2000 through July 31, 2001. By decisionsdated August 5, 2004 and September 27, 2004, the District Courtawarded judgment to the funds on certain aspects of their complaints. Thesepartial judgments, for which we have provided adequate reserves, are subject tofurther appeal by us. The remaining unresolved portions of the plaintiffs’claims are still being litigated and accordingly, we intend to continue tovigorously defend ourself in these matters. At this time, it is not possible todetermine the ultimate outcome of this case or the actual amount of additionalliability we may face, if any.

 

We area party to a National Labor Relations Board (“NLRB”) administrative proceedingregarding a dispute with the Allied Trade Council (“ATC”) over whether anegotiating impasse was reached between us and the union in August of2001. The ATC represents employees in 139 of our stores in a collectivebargaining agreement that expired on August 31, 2001. Our employees havebeen working pursuant to the terms of our December 6, 2001 implementedcontract with the ATC, which expired on August 31, 2004. We believe animpasse did in fact occur and as a result, we had the right to implement ourlatest contract proposal at that time which included wage increases, health andwelfare benefits, vacation and sick benefits and a 401k retirement program. Wediscontinued making additional payments into the various funds associated withthe union as we were providing many of these benefits on a direct basis andbecause our past contributions to these funds had caused these funds to be in aposition of excessive overfunding. In addition, we had concerns that our pastpayments into these funds were not being managed in a way to ensure they werebeing properly utilized for the benefit of our employees. On February 18,2004, an Administrative Law Judge (“ALJ”) who had reviewed various mattersrelated to this proceeding issued a decision and related recommendation, whichconcluded that the parties were not at impasse. The remedies recommended by theALJ included, among other things, a requirement for us to make our employees wholeby reimbursing them for expenses ensuing from the failure to make contributionsto the union funds and to make such funds whole, plus interest. Thisrecommendation was adopted by the full NLRB on September 15, 2004. If itis enforced by the circuit court of appeals, it could result in our beingrequired to contribute amounts that have yet to be determined into the union’spension benefit, health and welfare and vacation funds. Any potential requiredcontributions resulting from a final judicial determination of this matterwould potentially be subject to offset by the amounts that we had funded sincewe implemented our final contract proposal for these same benefits that werepaid for our ATC employees. Because the NLRB decision represents the firstphase of a long and complicated administrative process to be followed by a fulljudicial review of all of the facts and circumstances, the final outcome cannotbe reliably determined at this time. The full NLRB decision is subject tojudicial review by the circuit court of appeals and a compliance hearing beforeany financial remedy can be determined. While there can be no definitiveassurance, we have been advised by our outside labor counsel that we havenumerous meritorious defenses and arguments in response to the NLRB’s decision.

 

28

----

 

Inlight of the foregoing, while it is our belief that the final financial outcomeof this litigation cannot be determined, under the provisions of Statement of FinancialAccounting Standard (“FAS”) No. 5 which addresses contingencies, we recorded apre-tax charge of $12.6 million for the year ended December 27, 2003and additional pre-tax charges of $1.1 million in each of the quarters ended March 27,2004 and June 26, 2004, $0.4 million in the period from June 27, 2004through July 30, 2004 and $0.7 million in the period from July 31,2004 through September 25, 2004. These charges represent our current bestestimate of the loss that would result upon application of the NLRB’s decision.We note that such charges were based upon the facts available to us at thetime. In our opinion, such charges could be subject to significant modificationin the future, upon review by the Federal Circuit Court of Appeals, completionof a compliance hearing and any appeals relating to the outcome of that hearing.These charges reflect the amount of contributions that we did not make into theunion benefit funds for the period from the August 31, 2001 expiration ofthe contract through September 25, 2004, reduced by a portion of thebenefits we paid directly to or for the benefit of these employees over thesame period. It also includes an interest cost for these net contributions fromthe date they would have been paid until September 25, 2004. While thisrepresents our current best estimate of the NLRB’s decision, we believe thatthe actual range of loss in this matter could be from $0, if the NLRB’sdecision is not followed, to approximately $30 million, if the NLRB’sdecision is upheld and there is no offset for any benefits paid over thisperiod.

 

Untilsuch time as further legal developments warrant a change in the application ofthis accounting standard, or until this matter is resolved, we will recordadditional non-cash pre-tax charges, including interest, which are calculatedon the same basis as the charge recorded in the 2003 financial statements. Wecurrently estimate that the pre-tax charge recorded during the full 12 monthsof 2004 will approximate $4.4 million.

 

We areinvolved in an ongoing dispute with Cardinal Health, one of our formersuppliers of pharmaceutical products. Both parties have claims against theother involving, among other things, breach of contract, promissory estoppeland unjust enrichment. Duane Reade is seeking from Cardinal an unspecifiedamount of damages and punitive damages of at least $20 million. Cardinal isseeking approximately $18 million in damages plus attorney’s fees and interest.While there can be no definitive assurance, we believe we have counterclaimsthat offset the claims against us by Cardinal, as well as meritorious defensesto these claims, and plan to vigorously pursue our affirmative claims and tovigorously defend ourself in this action. Non-party discovery in the case hasconcluded and it is expected to go to trial sometime in 2005.

 

A NewYork State Tax Appeals Tribunal ruling in a matter involving another companymay have an adverse impact upon our New York State Franchise Tax filings fromyears 1999 through 2002. This matter relates to the required combination ofaffiliated subsidiaries in recognizing royalty fee and related income forintangible property. The ruling of the Tribunal is subject to further legalappeal and interpretation in light of our own specific facts and circumstances.The outcome of this matter, and the resulting amount of additional income taxexpense, if any, cannot be determined by us at this time.

 

***Litigation Relating to the MergerTransaction:*** We are aware of six purported class actioncomplaints challenging the merger transaction consummated by us and Duane ReadeAcquisition that have been filed in the Court of Chancery of the State ofDelaware, referred to as the “Delaware Complaints,” and three purported classaction complaints that have been filed in the Supreme Court of the State of NewYork. Two of the New York complaints have been dismissed without prejudice. Theother New York complaint (the “New York Complaint”) is pending, but has notbeen served on Duane Reade. The Delaware Complaints name Mr. Cuti andcertain other members of our board of directors and executive officers as wellas Duane Reade Inc. as defendants. Four of the Delaware Complaints name OakHill as a defendant. The New York Complaint names Mr. Cuti and certainother members of our board of directors and executive officers as well as DuaneReade Inc. as defendants. One of the dismissed New York complaints named OakHill as a defendant.

 

TheDelaware Complaints were consolidated on January 28, 2004, and on April 8,2004 the plaintiffs in the Delaware actions filed a consolidated class actioncomplaint.We believe these lawsuits are without merit and plan to defend theselawsuits vigorously.

 

**ITEM 2.  UnregisteredSales of Equity Securities and Use of Proceeds**

 

Not applicable.

 

29

----

 

**ITEM 3. Defaults Upon Senior Securities**

 

Not applicable.

 

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

 

Not applicable.

 

**ITEM 5. Other Information**

 

We are a voluntary filer and file annual reports onForm 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K,amendments to those reports and other information with the Securities andExchange Commission (“SEC”). The public can obtain copies of these materials bycontacting the SEC at 1-800-SEC-0330, or by accessing the SEC's website at www.sec.gov.  In addition, a link to our SEC filings isprovided on our website at www.duanereade.com.

 

**ITEM 6. Exhibits**

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                          |
|-----------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|            |       |                                                                                                                                                                                                                                                                                                                                     |
| 2.1             |       | Agreement and  Plan of Merger (the “Merger Agreement”), dated as of December 22, 2003,  by and among Duane Reade Inc., Rex Corner Holdings, LLC and Rex Corner  Acquisition Corp. (incorporated by reference to Exhibit 2.1 to the  Company’s Current Report on Form 8-K filed on December 23, 2003). |
| 2.1(i)          |       | Amendment No. 1  to the Merger Agreement, dated as of June 10, 2004 (incorporated by  reference to the Company’s Current Report on Form 8-K filed on June 14,  2004).                                                                                                                                                     |
| 2.1(ii)         |       | Amendment No. 2  to the Merger Agreement, dated as of June 13, 2004 (incorporated by  reference to the Company’s Current Report on Form 8-K filed on June 14,  2004).                                                                                                                                                     |
| 2.1(iii)        |       | Amendment No. 3  to the Merger Agreement, dated as of June 18, 2004 (incorporated by  reference to the Company’s Current Report on Form 8-K filed on June 21,  2004).                                                                                                                                                     |
| 3.1(i)          | *          | Amended and Restated  Certificate of Incorporation of Duane Reade Inc.                                                                                                                                                                                                                                                                   |
| 3.1(ii)         |       | Amended and  Restated Bylaws of the Company (incorporated by reference to Exhibit 3.1(ii)  to the Common Stock S-1).                                                                                                                                                                                                                     |
| 3.2(i)          |       | Certificate of  Incorporation of DRI I Inc. (incorporated by reference to Exhibit 3.2(i) to  the S-1 Registration Statement No. 333-43313 with respect to the Company’s 9  1¤4%  Senior Subordinated Notes due 2008 (the “Notes S-1”)).                                                                              |
| 3.2(ii)         |       | By-laws of DRI I  Inc. (incorporated by reference to Exhibit 3.2(ii) of the Notes S-1).                                                                                                                                                                                                                                                  |
| 3.3             |       | Third Amended  and Restated Partnership Agreement of Duane Reade (incorporated by reference  to the Company's Quarterly Report on Form 10-Q for the period ended June 28,  2003).                                                                                                                                                        |
| 3.4(i)          |       | Certificate of  Incorporation of Duane Reade International, Inc. (incorporated by reference  to Exhibit 3.4(i) to the Company’s Annual Report on Form 10- K for the year  ended December 25, 1999 (the “1999 10-K”)).                                                                                                |
| 3.4(ii)         |       | By-laws of Duane  Reade International, Inc. (incorporated by reference to Exhibit 3.4(ii) to  the 1999 10-K).                                                                                                                                                                                                                            |
| 3.5(i)          |       | Certificate of  Incorporation of Duane Reade Realty, Inc. (incorporated by reference to  Exhibit 3.5(i) to the 1999 10-K).                                                                                                                                                                                                               |
| 3.5(ii)         |       | By-laws of Duane  Reade Realty, Inc. (incorporated by reference to Exhibit 3.5(ii) to the 1999  10-K).                                                                                                                                                                                                                                   |
| 4.1*            |       | Indenture, dated  as of July 30, 2004, between Duane Reade Acquisition Corp. and U.S. Bank  National Association, as trustee.                                                                                                                                                                                                            |
| 4.2*            |       | Successor  Supplemental Indenture governing the initial notes and exchange notes, dated  as of July 30, 2004, between the Company and U.S. Bank National Association,  as trustee.                                                                                                                                                       |
| 4.3*            |       | Co-obligor  Supplemental Indenture governing the initial notes and exchange notes, dated  as of July 30, 2004, among the Company, Duane Reade and DRI I Inc., Duane Reade  Realty, Inc. and Duane Reade International, Inc. as guarantors and U.S. Bank  National Association, as trustee.                                               |
| 4.4*            |       | Guarantor  Supplemental Indenture governing the initial notes and exchange notes, dated  as of July 30, 2004, among the Company, Duane Reade and DRI I Inc., Duane  Reade Realty, Inc. and Duane Reade International, Inc., as guarantors and  U.S. Bank National Association, as trustee.                                               |
| 4.5*            |       | Form of Exchange  Note (included as Exhibit A1 to Exhibit 4.3 of this 10-Q).                                                                                                                                                                                                                                                             |
| 4.6*            |       | Registration  Rights Agreement, dated as of July 30, 2004, by and among Duane Reade  Acquisition Corp. and Banc of America Securities LLC, Citigroup Global  Markets Inc., Credit Suisse First Boston LLC and UBS Securities LLC, as  Initial Purchasers.                                                                                |
| 4.7             |       | 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”)).                                                                                                                                                                                                                                                                                                                                                                                                                                      |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 4.8    |   | Form of Senior  Convertible Notes due 2022 (incorporated by reference to Exhibit 4.2 to the  Convertible Notes S-3).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 4.9*   |   | First  Supplemental Indenture, dated as of July 30, 2004, among the Company, as  issuer, DRI I Inc., Duane Reade Realty, Inc. and Duane Reade International,  Inc. as guarantors and U.S. Bank National Association, as trustee.                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.1*  |   | Duane Reade Inc.  Phantom Stock Plan.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 10.2*  |   | Duane Reade  Holdings, Inc. Management Stock Option Plan.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.3*  |   | Stockholders and  Registration Rights Agreement, dated as of July 30, 2004, among Duane Reade  Holdings, Inc., Duane Reade Shareholders, LLC and certain members of the  management of Duane Reade Inc.                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.4*  |   | Tax Sharing  Agreement, dated as of July 30, 2004, among Duane Reade Holdings, Inc., and  the Subsidiaries as defined therein, Duane Reade and any parties which become  parties thereto.                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.5*  |   | Services  Agreement, dated as of July 30, 2004, between Oak Hill Capital Management,  Inc. and Duane Reade Acquisition Corp.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.6*  |   | $155,000,000  Senior Secured Term Credit Agreement, dated as of July 30, 2004 among Duane  Reade Holdings, Inc., Duane Reade Inc., Duane Reade and Bank of America,  N.A., as Administrative Agent, Credit Suisse First Boston, Cayman Islands  Branch, as Syndication Agent, Citicorp North America Inc., Wells Fargo Bank,  and National Association, as Co-Documentation Agents, Banc of America  Securities LLC and Credit Suisse First Boston, Cayman Islands Branch, as  Joint Lead Arrangers and Banc of America Securities LLC, Credit Suisse First  Boston, Cayman Islands Branch and Citroen Global Markets Inc., as Joint Book  Managers.    |
| 10.7*  |   | First Amendment  to Credit Agreement, dated as of July 22, 2004, among Duane Reade, Duane  Reade Inc., DRI I Inc., Duane Reade International, Inc., Duane Reade Realty,  Inc., Fleet National Bank, as Issuing Bank and Administrative Agent, Fleet  Retail Group, Inc., as Collateral Agent, Congress Financial Corporation, as  Documentation Agent, General Electric Capital Corporation as Syndication  Agent and Wells Fargo Retail Finance, LLC, as Syndication Agent and Co-Lead  Arranger.                                                                                                                                                      |
| 10.8   |   | Letter  Agreement, dated as of March 19, 2004, by and among Duane Reade Shareholders,  LLC, Duane Reade Acquisition Corp. and Duane Reade Inc. (incorporated by  reference to Amendment No. 3 to the Company's Schedule 13-E3, filed July 30,  2004).                                                                                                                                                                                                                                                                                                                                                                                                   |
| 10.9   |   | Amended and  Restated Employment Agreement, dated as of March 16, 2004, by and among  Anthony J. Cuti, Duane Reade Acquisition Corp., Duane Reade Holdings, Inc.  and Duane Reade Shareholders, LLC. (incorporated by reference to Amendment  No. 3 to the Company's Schedule 13-E3, filed July 30, 2004).                                                                                                                                                                                                                                                                                                                                              |
| 10.10  |   | Letter  Agreement, dated as of March 16, 2004, by and between John K. Henry and Duane  Reade Acquisition Corp. (incorporated by reference to Amendment No. 3 to the Company's  Schedule 13-E3, filed July 30, 2004).                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.11  |   | Letter  Agreement, dated as of March 16, 2004, by and between Gary Charboneau and  Duane Reade Acquisition Corp. (incorporated by reference to Amendment No. 3  to the Company's Schedule 13-E3, filed July 30, 2004).                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.12  |   | Letter  Agreement, dated as of March 16, 2004, by and between Timothy R. LaBeau and  Duane Reade Acquisition Corp. (incorporated by reference to Amendment No. 3  to the Company's Schedule 13-E3, filed July 30, 2004).                                                                                                                                                                                                                                                                                                                                                                                                                                |
| 10.13  |   | Letter Agreement,  dated as of March 16, 2004, by and between Jerry M. Ray and Duane Reade  Acquisition Corp. (incorporated by reference to Amendment No. 3 to the  Company's Schedule 13-E3, filed July 30, 2004).                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.14  |   | Agreement and  Plan of Merger, dated as of December 22, 2003, as amended among Rex Corner  Holdings, LLC (now known as Duane Reade Shareholders, LLC), Rex Corner  Acquisition Corp. (now known as Duane Reade Acquisition Corp.) and Duane  Reade Inc. (incorporated by reference to Amendment No. 3 to the Company's Schedule  13-E3, filed July 30, 2004).                                                                                                                                                                                                                                                                                           |
| 10.15  |   | Credit  Agreement, dated as of July 21, 2003, among Duane Reade, as the  Borrower, Duane Reade Inc. and corporate subsidiaries as the Facility  Guarantors, Various Financial Institutions set forth therein, as the Lenders,  Fleet National Bank as the Administrative Agent and Issuing Bank, Fleet  Retail Finance Inc. as the Collateral Agent, General Electric Capital  Corporation as the Syndication Agent for the Lenders and Congress Financial  Corporation as the Documentation Agent for the Lenders (incorporated by  reference to the Company’s Quarterly Report on Form 10-Q for the period  ended June 28, 2003). |
| 10.16  |   | Facility  Guarantee, dated as of July 21, 2003, among the Facility Guarantors,  Fleet Retail Finance Inc., Fleet National Bank and the Lenders (incorporated  by reference to the Company’s Quarterly Report on Form 10-Q for the  period ended June 28, 2003).                                                                                                                                                                                                                                                                                                                                                                     |
| 10.17  |   | Intellectual  Property Security Agreement, dated as of July 21, 2003, between Duane  Reade, the Facility Guarantors and Fleet Retail Finance Inc., as Collateral  Agent (incorporated by reference to the Company’s Quarterly Report on  Form 10-Q for the period ended June 28, 2003).                                                                                                                                                                                                                                                                                                                                             |
| 10.18  |   | Security  Agreement, dated as of July 21, 2003, among Duane Reade, the Facility Guarantors,  and Fleet Retail Finance Inc., as Collateral Agent (incorporated by reference  to the Company’s Quarterly Report on Form 10-Q for the period ended  June 28, 2003).                                                                                                                                                                                                                                                                                                                                                                    |
| 10.19  |   | Ownership  Interest Pledge Agreement, dated as of July 21, 2003, among Duane Reade  Inc. and DRI I Inc., and Fleet Retail Finance Inc., as Collateral Agent  (incorporated by reference to the Company’s Quarterly Report on  Form 10-Q for the period ended June 28, 2003).                                                                                                                                                                                                                                                                                                                                                        |
| 10.20  |   | 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).                                                                                                                                                                                                                                                                                                                                               |
| 10.21  |   | 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”)).                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.22  |   | 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).                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.23  |   | 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).                                                                                                                                                                                                                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |

 

30

----

 
| 14.1   |   | Code of Business  Conduct and Ethics (incorporated by reference to Exhibit 14.1 to the 2003  10-K).             |
|--------|--------|-----------------------------------------------------------------------------------------------------------------|
| 31.1 * |   | Sarbanes-Oxley Section 302  Certification of the Company’s Chief Executive Officer (“CEO”). |
| 31.2 * |   | Sarbanes-Oxley Section 302  Certification of the Company’s Chief Financial Officer (“CFO”). |

 

----

*  filed herewith

 

31

----

 

**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signed onits behalf by the undersigned thereunto duly authorized.

 

 
| Dated:   November 12,  2004 |
|-------------------------------------------------|
|                                            |
| ** **                                      | **DUANE  READE Inc.** |
|                                            |   |   |
|                                            |   | /s/ Anthony J.  Cuti |
|                                            |   | Anthony J. Cuti |
|                                            |   |   |
|                                            |   | President and  Chief Executive Officer |
|                                            |   | (Principal  Executive Officer) |
|                                            |   |   |
|                                            |   | /s/ John K.  Henry |
|                                            |   | John K. Henry |
|                                            |   |   |
|                                            |   | Senior Vice  President and Chief Financial Officer |
|                                            |   | (Principal  Accounting and Financial Officer) |

 

32

----