**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON, D.C.**

** **

**FORM10-Q**

 

**QuarterlyReport Pursuant to Section 13 or 15 (d) of the Securities and Exchange Act of1934**

 

| **For  the quarterly period ended June 26, 2004.** | ** ** | **Commission file number 1-13843** |
|----------------------------------------------------|------------|------------------------------------|

 

----

 

**DUANE READE INC.**

(Exact name of registrant as specified in its charter)

 

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

 

| ** ** | **DRI I  Inc.***                    | ** ** | ** ** | **Delaware**  | ** ** | **04-3166107** |
|------------|-------------------------------------|------------|------------|---------------|------------|----------------|
| ** ** | **Duane  Reade***                   | ** ** | ** ** | **New  York** | ** ** | **11-2731721** |
| ** ** | **Duane Reade International, Inc*** | ** ** | ** ** | **Delaware**  | ** ** | **22-3672347** |
| ** ** | **Duane Reade Realty, Inc ***       | ** ** | ** ** | **Delaware**  | ** ** | **13-4074383** |

 

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

 

| **440 Ninth Avenue  New York, New York**  | ** ** | **10001**  |
|-------------------------------------------|------------|------------|
| (Address of principal  executive offices) |       | (Zip Code) |

 

**(212)273-5700**

(Registrant’s telephone number, including area code)

 

----

 

Indicate by checkmark whether the registrant: (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days. Yes ý No o

 

Indicate by checkmark whether the registrant is an accelerated filer (as defined in the ExchangeAct Rule 12b-2):  Yes ý  No o

 

The number of shares of the Common Stock outstandingas of August 4, 2004:  **24,538,799**

 

 

----

 

INDEX

 
| PART I – FINANCIAL  INFORMATION |                                                                                                            |
|--------------------------------------|-----------------------------------------------------------------------------------------------------------------|
|                                 |                                                                                                            |   |
|                                 | ITEM 1. – FINANCIAL  STATEMENTS                                                                            |   |
|                                 |                                                                                                            |   |
|                                 | Consolidated  Statements of Income (Unaudited) -  For the 13 and 26 Weeks Ended June 26, 2004 and June 28, 2003 |   |
|                                 |                                                                                                            |   |
|                                 | Consolidated Balance Sheets  As of June 26, 2004 (Unaudited) and December 27, 2003                              |   |
|                                 |                                                                                                            |   |
|                                 | Consolidated  Statements of Cash Flows (Unaudited) -  For the 26 Weeks Ended June 26, 2004 and June 28, 2003    |   |
|                                 |                                                                                                            |   |
|                                 | Notes  to Consolidated Financial Statements (Unaudited)                                                         |   |
|                                 |                                                                                                            |   |
|                                 | ITEM 2. – MANAGEMENT’S DISCUSSION  AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |   |
|                                 |                                                                                                            |   |
|                                 | ITEM 3. – MARKET RISK                                                                                      |   |
|                                 |                                                                                                            |   |
|                                 | ITEM 4. – CONTROLS AND PROCEDURES                                                                          |   |
|                                 |                                                                                                            |   |
| PART II – OTHER INFORMATION     |                                                                                                            |
|                                 |                                                                                                            |   |
| SIGNATURES                           |                                                                                                            |

 

This and other of ourpublic filings or public statements contain forward-looking statements withinthe meaning of Section 27A of the Securities Act, Section 21E of theSecurities Exchange Act of 1934 and the Private Securities Litigation Reform Actof 1995, that involve a number of risks and uncertainties. These statementsrelate to future events or our future financial performance with respect to ourfinancial condition, results of operations, business plans and strategies,operating efficiencies or synergies, competitive positions, growthopportunities for existing products such as private label merchandise, plansand objectives of management, capital expenditures, growth and maturation ofour stores and other matters. These statements involve known and unknown risks,uncertainties and other factors that may cause our or our industry’s actualresults, levels of activity, performance or achievements to be materiallydifferent from those expressed or implied by any forward-looking statements. Insome cases, you can identify forward-looking statements by terminology such as“may,” “will,” “could,” “would,” “should,” “expect,” “plan,” “anticipate,”“intend,” “believe,” “estimate,” “predict,” “potential,” “pro forma,” “seek,”or “continue” or the negative of those terms or other comparable terminology.These statements are only predictions and such expectations may prove to beincorrect. Some of the things that could cause our actual results to differsubstantially from our expectations are:

 

•                                          the competitive environment in the drugstore industry ingeneral and in the New York greater metropolitan area;

 

•                                          the ability to open and operate new stores on a profitablebasis and to increase sales in existing stores;

 

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

 

•                                          the continued efforts of federal, state and municipalgovernment agencies to reduce Medicaid reimbursement rates, modify Medicarebenefits and/or reduce prescription drug costs;

 

•                                          our significant indebtedness;

 

2

----

 

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

 

•                                          changes in the cost of goods and services;

 

•                                          trendsin the healthcare industry, including continued conversion of variousprescription drugs to over-the-counter medications and the increasing marketshare on the part of internet-based and mail-order-based providers;

 

•                                          labor disturbances, including any resulting from thesuspension or termination of our collective bargaining agreements;

 

•                                          changes in federal and state laws and regulations, includingthe potential impact of changes in regulations surrounding the importation ofpharmaceuticals from foreign countries and changes in minimum wage rates;

 

•                                          liability and other claims asserted against us including theitems discussed under Part II, Item 1-Legal Proceedings;

 

•                                          changes in our operating strategy or development plans;

 

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

 

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

 

•                                          theoutcome of the legal proceedings that have been instituted against us andothers following announcement of our merger agreement with Duane ReadeAcquisition Corp. and Duane Reade Shareholders, LLC;

 

•                                          the continued impact of, or new occurrences of, terroristattacks in the New York greater metropolitan area and any actions that may betaken by federal, state or municipal authorities in response to or inanticipation of such occurrences;

 

•                                          changes in our acquisition and capital expenditure plans;

 

•                                          our ability to continue to secure suitable new storelocations under acceptable lease terms;

 

•                                          our ability to successfully implement and manage newcomputer systems and technologies;

 

•                                          our ability to limit fraud and shrink;

 

•                                          demographic changes; and

 

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

 

We undertake noobligation to update or revise any forward-looking statements, whether as aresult of new information, future events or otherwise, after the date of thisfiling. We do not, nor does any other person, assume responsibility for theaccuracy and completeness of those statements.

 

We caution you that theareas of risk described above may not be exhaustive. We operate in acontinually changing business environment, and new risks emerge from time totime. Management cannot predict such new risks, nor can it assess the impact,if any, of such risks on our businesses or the extent to which any risk orcombination of risks may cause actual results to differ materially from thoseprojected 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.

 

3

----

 

**PART I -FINANCIAL INFORMATION**

**ITEM 1.****  FINANCIAL STATEMENTS**

 

**Duane ReadeInc.**

Consolidated Statements ofIncome (Unaudited)

(Inthousands, except per share amounts)

 
| ** **                                     | ** ** | **For the 13 Weeks Ended** | ** ** | **For the 26 Weeks Ended** | ** ** |
|------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                                     | ** ** | **June 26,  2004**         | ** ** | **June 28,  2003**         | ** ** | **June 26,  2004** | ** ** | **June 28,  2003** | ** ** |
|                                           |       |                       |       |                       |       |   |   |   |   |
| Net sales                                      |       | $                          | 365,206    |                       | $          | 355,146 |   | $ | 714,756 |   | $ | 688,768 |   |
| Cost of sales                                  |       | 285,018                    |       | 278,171                    |       | 558,802 |   | 541,604 |   |
|                                           |       |                       |       |                       |       |   |   |   |   |
| Gross profit                                   |       | 80,188                     |       | 76,975                     |       | 155,954 |   | 147,164 |   |
|                                           |       |                       |       |                       |       |   |   |   |   |
| Selling, general & administrative expenses |       | 59,924                     |       | 57,260                     |       | 118,567 |   | 110,834 |   |
| Labor contingency expense                      |       | 1,100                      |       | —                     |       | 2,200 |   | — |   |
| Transaction expenses                           |       | 1,516                      |       | —                     |       | 2,619 |   | — |   |
| Depreciation and amortization                  |       | 9,239                      |       | 8,154                      |       | 18,305 |   | 15,712 |   |
| Store pre-opening expenses                     |       | 209                        |       | 229                        |       | 365 |   | 644 |   |
|                                           |       | 71,988                     |       | 65,643                     |       | 142,056 |   | 127,190 |   |
|                                           |       |                       |       |                       |       |   |   |   |   |
| Operating income                               |       | 8,200                      |       | 11,332                     |       | 13,898 |   | 19,974 |   |
| Interest expense, net                          |       | 3,257                      |       | 3,549                      |       | 6,694 |   | 7,066 |   |
| Debt extinguishment                            |       | —                     |       | —                     |       | — |   | 105 |   |
|                                           |       |                       |       |                       |       |   |   |   |   |
| Income before income taxes                     |       | 4,943                      |       | 7,783                      |       | 7,204 |   | 12,803 |   |
| Income taxes                                   |       | 1,976                      |       | 3,725                      |       | 2,880 |   | 5,633 |   |
| Net income                                     |       | $                          | 2,967      |                       | $          | 4,058 |   | $ | 4,324 |   | $ | 7,170 |   |
|                                           |       |                       |       |                       |       |   |   |   |   |
| Per Common Share – Basic                  |       |                       |       |                       |       |   |   |   |   |
|                                           |       |                       |       |                       |       |   |   |   |   |
| Net income                                     |       | $                          | 0.12       |                       | $          | 0.17 |   | $ | 0.18 |   | $ | 0.30 |   |
|                                           |       |                       |       |                       |       |   |   |   |   |
| Weighted Average Common Shares Outstanding     |       | 24,482                     |       | 24,038                     |       | 24,446 |   | 24,038 |   |
|                                           |       |                       |       |                       |       |   |   |   |   |
| Per Common Share – Diluted                |       |                       |       |                       |       |   |   |   |   |
|                                           |       |                       |       |                       |       |   |   |   |   |
| Net income                                     |       | $                          | 0.12       |                       | $          | 0.17 |   | $ | 0.18 |   | $ | 0.29 |   |
|                                           |       |                       |       |                       |       |   |   |   |   |
| Weighted Average Common Shares Outstanding     |       | 24,687                     |       | 24,351                     |       | 24,686 |   | 24,345 |   |

 

The accompanying notes are an integral part of these financialstatements.

 

4

----

 

**Duane Reade Inc.**

Consolidated Balance Sheets

(In thousands, except share and per share data)

 
| ** **                                                                                                                     | ** ** | **June 26,  2004** | ** ** | **December 27,  2003** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|------------------------|------------|
| ** **                                                                                                                     | ** ** | **(Unaudited)**    | ** ** | ** **             | ** ** |
| ASSETS                                                                                                                         | ** ** | ** **         | ** ** | ** **             | ** ** |
| Current Assets                                                                                                                 | ** ** | ** **         | ** ** | ** **             | ** ** |
| Cash                                                                                                                           |       | $                  | 1,328      |                   | $          | 1,252 |   |
| Receivables, net                                                                                                               |       | 55,063             |       | 53,689                 |       |
| Inventories, net                                                                                                               |       | 260,307            |       | 259,765                |       |
| Deferred income taxes                                                                                                          |       | 7,265              |       | 8,150                  |       |
| Prepaid expenses and other current assets                                                                                      |       | 16,233             |       | 19,504                 |       |
| TOTAL CURRENT ASSETS                                                                                                           |       | 340,196            |       | 342,360                |       |
|                                                                                                                           |       |               |       |                   |       |
| Property and equipment, net                                                                                                    |       | 193,174            |       | 189,469                |       |
| Goodwill, net                                                                                                                  |       | 161,625            |       | 161,318                |       |
| Deferred income taxes                                                                                                          |       | 3,623              |       | 5,543                  |       |
| Other assets                                                                                                                   |       | 98,384             |       | 88,836                 |       |
| TOTAL ASSETS                                                                                                                   |       | $                  | 797,002    |                   | $          | 787,526 |   |
|                                                                                                                           |       |               |       |                   |       |
| LIABILITIES AND STOCKHOLDERS’  EQUITY                                                                                     |       |               |       |                   |       |
| Current liabilities                                                                                                            |       |               |       |                   |       |
| Accounts payable                                                                                                               |       | $                  | 77,041     |                   | $          | 85,258 |   |
| Accrued interest                                                                                                               |       | 1,544              |       | 1,633                  |       |
| Other accrued expenses                                                                                                         |       | 28,343             |       | 27,489                 |       |
| Current portion of capital lease obligations                                                                                   |       | 441                |       | 422                    |       |
| TOTAL CURRENT LIABILITIES                                                                                                      |       | 107,369            |       | 114,802                |       |
|                                                                                                                           |       |               |       |                   |       |
| Long-term debt                                                                                                                 |       | 278,339            |       | 271,385                |       |
| Capital lease obligations, less current portion                                                                                |       | 878                |       | 1,103                  |       |
| Other non-current liabilities                                                                                                  |       | 67,645             |       | 62,915                 |       |
| TOTAL LIABILITIES                                                                                                              |       | 454,231            |       | 450,205                |       |
|                                                                                                                           |       |               |       |                   |       |
| Commitments and Contingencies (Note 10)                                                                                        |       |               |       |                   |       |
|                                                                                                                           |       |               |       |                   |       |
| Stockholders’ equity                                                                                                      |       |               |       |                   |       |
| Preferred stock, $0.01 par; authorized 5,000,000  shares;  issued and outstanding: none                                        |       | —             |       | —                 |       |
| Series A preferred stock, $0.01 par; authorized 75,000  shares;  issued and outstanding: none                                  |       | —             |       | —                 |       |
| Common stock, $0.01 par; authorized 75,000,000 shares;  issued and outstanding: 24,538,799 and 24,403,550 shares, respectively |       | 245                |       | 244                    |       |
| Paid-in capital                                                                                                                |       | 333,043            |       | 331,917                |       |
| Retained earnings                                                                                                              |       | 9,483              |       | 5,160                  |       |
| TOTAL STOCKHOLDERS’ EQUITY                                                                                                |       | 342,771            |       | 337,321                |       |
|                                                                                                                           |       |               |       |                   |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                |       | $                  | 797,002    |                   | $          | 787,526 |   |

 

The accompanying notes are an integral part ofthese financial statements.

 

5

----

 

**Duane Reade Inc.**

ConsolidatedStatements of Cash Flows (Unaudited)

(In thousands)

 
| ** **                                                                         | ** ** | **For the 26 Weeks Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                         | ** ** | **June 26,  2004**         | ** ** | **June 28,  2003** | ** ** |
| Cash flows provided by operating activities:                                       |       |                       |       |   |   |
| Net income                                                                         |       | $                          | 4,324      |   | $ | 7,170 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities: |       |                       |       |   |   |
| Depreciation and amortization                                                      |       | 19,260                     |       | 16,727 |   |
| Deferred income taxes                                                              |       | 2,805                      |       | 2,817 |   |
| Debt extinguishment                                                                |       | —                     |       | 31 |   |
| Non-cash rent expense                                                              |       | 3,067                      |       | 4,424 |   |
| Changes in operating assets and liabilities (net of  the effect of acquisitions):  |       |                       |       |   |   |
| Receivables                                                                        |       | (1,374                     | )          | (227 | ) |
| Inventories                                                                        |       | 437                        |       | (10,954 | ) |
| Accounts payable                                                                   |       | (8,217                     | )          | 2,189 |   |
| Prepaid and accrued expenses                                                       |       | 3,400                      |       | (3,229 | ) |
| Other assets and liabilities, net                                                  |       | (3,663                     | )          | (4,968 | ) |
| NET CASH PROVIDED BY OPERATING ACTIVITIES                                          |       | 20,039                     |       | 13,980 |   |
|                                                                               |       |                       |       |   |   |
| Cash flows used in investing activities:                                           |       |                       |       |   |   |
| Capital expenditures                                                               |       | (16,182                    | )          | (25,795 | ) |
| Lease acquisition, customer file and other costs                                   |       | (11,517                    | )          | (9,903 | ) |
| NET CASH USED IN INVESTING ACTIVITIES                                              |       | (27,699                    | )          | (35,698 | ) |
|                                                                               |       |                       |       |   |   |
| Cash flows from financing activities:                                              |       |                       |       |   |   |
| Repayment of term loans                                                            |       | —                     |       | (1,981 | ) |
| Net borrowing of revolving credit facility                                         |       | 6,954                      |       | 23,000 |   |
| Retirement of senior subordinated notes                                            |       | —                     |       | (1,621 | ) |
| Proceeds from exercise of stock options                                            |       | 1,126                      |       | — |   |
| Deferred financing costs                                                           |       | (138                       | )          | (350 | ) |
| Repayments of capital lease obligations                                            |       | (206                       | )          | (271 | ) |
| NET CASH PROVIDED BY FINANCING ACTIVITIES                                          |       | 7,736                      |       | 18,777 |   |
|                                                                               |       |                       |       |   |   |
| Net increase (decrease) in cash                                                    |       | 76                         |       | (2,941 | ) |
| Cash at beginning of period                                                        |       | 1,252                      |       | 4,183 |   |
| Cash at end of period                                                              |       | $                          | 1,328      |   | $ | 1,242 |   |

 

The accompanying notes are an integral part of these financialstatements.

 

6

----

 

**Notes to Unaudited Consolidated Interim FinancialStatements**

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

 

**1. Basis of Presentation**

 

The UnauditedConsolidated Interim Financial Statements included herein reflect all adjustmentswhich, in the opinion of management, are necessary to present fairly theresults of operations, financial position and cash flows of Duane Reade Inc.(the “Company”), and have been prepared, in all material respects, inaccordance with the same accounting principles followed in the preparation ofthe Company’s Annual Consolidated Financial Statements for the year endedDecember 27, 2003. These Unaudited Consolidated Interim Financial Statementsshould be read in conjunction with the Company’s Consolidated FinancialStatements included in its Annual Report on Form 10-K/A for the year endedDecember 27, 2003. The Unaudited Consolidated Interim Financial Statementsinclude the accounts of the Company and its subsidiaries.  All significant intercompany transactions andbalances have been eliminated. Earnings per share amounts are calculated basedon the weighted average number of shares outstanding during the period and maynot add due to rounding. The results for the interim periods presented are notnecessarily indicative of the results expected for the full year.

 

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

 

**2.  Subsequent Event – Acquisition by Oak HillCapital Partners, L.P.**

 

On July 30, 2004,the Company was acquired through a merger transaction with Duane ReadeAcquisition Corp. (“Duane Reade Acquisition”), a wholly owned subsidiary ofDuane Reade Holdings, Inc. and an affiliate of Oak Hill Capital Partners, L.P.(“Oak Hill”), a private equity firm (the “Acquisition”). The Acquisition wasaccomplished through the merger of Duane Reade Acquisition into Duane ReadeInc., with Duane Reade Inc. being the surviving entity. The transaction wasunanimously approved by the independent members of Duane Reade’s board ofdirectors, who resigned from the board on July 30, 2004 in anticipation of thecompletion of the Acquisition. Under the terms of the merger agreement, whichwas approved by the Company’s stockholders at a special meeting on July 26,2004, the Company’s stockholders (other than those who exercise and perfecttheir appraisal rights) will receive $16.50 per share in cash, withoutinterest.  The aggregate value of themerger transaction is approximately $744 million, including transactionexpenses and the repayment of indebtedness. The equity financing necessary forthe merger was provided by Oak Hill and an affiliate equity fund, Oak HillCapital Management Partners, L.P. as well as several co-investors selected byOak Hill to participate in the transaction. The debt financing necessary forthe merger was provided by a syndicate of banking institutions led by Banc ofAmerica Securities LLC. Mr. Anthony J. Cuti, the Company’s Chairman,President and CEO, the Company’s Senior Vice Presidents and certain othermembers of management have equity interests in the acquiring entity and havecontinued in the same management positions after the Acquisition.  The new board of directors is comprised ofcertain executives of Oak Hill and Mr. Cuti. At the special meeting of theCompany’s stockholders on July 26, 2004, a total of 15,436,702 shares,representing 62.9 % of the total outstanding shares of common stock as of theJune 3, 2004 record date, were voted in favor of the adoption of the mergeragreement. As a result of the stockholders’ approval of the merger agreementand the satisfaction of all other conditions to the merger, the merger andrelated financings were consummated on July 30, 2004.

 

7

----

 

**3. National Labor Relations BoardRecommendation**

 

The Company is a party toa National Labor Relations Board (“NLRB”) administrative proceeding regarding adispute with the Allied Trade Council (“ATC”) over whether a negotiatingimpasse was reached between the Company and the union in August of 2001. TheATC 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’sDecember 6, 2001 implemented contract with the ATC, which expires onAugust 31, 2004. The Company believes an impasse did occur and as aresult, the Company had the right to implement its latest contract proposal atthat time which included wage increases, health and welfare benefits, vacationand sick benefits and a 401(k) retirement program. The Company discontinuedmaking additional payments into the various funds associated with the union asit was providing many of these benefits on a direct basis and because its past contributions to these funds had caused these fundsto be in a position of excessive overfunding. In addition, the Company hadconcerns that its past payments into these funds were not being managed in away to ensure they were being properly utilized for the benefit of theCompany’s employees. On February 18, 2004, an Administrative Law Judge(“ALJ”) who had reviewed various matters related to this proceeding issued adecision and related recommendation, which concluded that the parties were notat impasse. The remedies recommended by the ALJ included, among other things, arequirement for the Company to make its employees whole by reimbursing them forexpenses ensuing from the failure to make contributions to the union funds andto make such funds whole, plus interest. If this recommendation is adopted bythe full NLRB and enforced by the circuit court of appeals, it could result inthe Company 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 this is just thefirst phase of a long and complicated administrative process likely to be followedby a full judicial review of all of the facts and circumstances, the finaloutcome cannot be reliably determined at this time. The ALJ’s recommendation isnot a binding order and has no force and effect of law. Rather, it is arecommendation to the full NLRB in Washington D.C., which will conduct acomplete review at some point in the future and decide to uphold, reject ormodify the recommendation. The full NLRB decision is also subject to judicialreview by the circuit court of appeals and a compliance hearing before anyfinancial remedy can be determined. While there can be no definitive assurance,the Company has been advised by its outside labor counsel that it has numerousmeritorious defenses and arguments in response to the ALJ’s recommendation.

 

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

 

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

 

8

----

 

**4.Inventory and Cost of Sales**

 

At June 26, 2004, inventories, consisting solely offinished goods, would have been greater by $0.8 million if they had been valuedon a lower of first-in, first-out (“FIFO”) cost or market basis instead of alast-in, first-out (“LIFO”) basis. Cost of sales includes all storeoccupancy-related costs and expenses, consisting of lease and sublease-relatedincome and expenses, other recurring real estate-related income and expensesprimarily from sales and terminations of leases related to store closings andrelocations, sales of market-related data, store utility costs, warehouseexpenses and distribution costs. The Company reflects promotional allowancesfrom vendors as a reduction of cost of sales or advertising expense, dependingon the nature of the allowance, when such advertising or promotions have beencompleted and the related allowances have been earned. Other realestate-related income amounted to $1.2 million and $2.0 million in the quarterand six months ended June 26, 2004, respectively, as compared to $0.1 millionand $1.3 million in the quarter and six months ended June 28, 2003,respectively. There was no income realized from the sale of market-related datain the second quarter or first six months of either 2004 or 2003.

 

**5. Recently Issued AccountingPronouncements**

 

In December 2002, FAS No.148, “Accounting for Stock-Based Compensation – Transition and Disclosure” wasissued. This statement provides alternative methods of transition for avoluntary change to the fair value based method of accounting for stock-basedemployee compensation. The Company has not adopted such voluntary change to thefair value based method. In addition, this statement amends the disclosurerequirements of FAS No. 123 to require prominent disclosures about the methodof accounting for stock-based compensation and the effect of the method used onreported results. As required, the Company adopted the disclosure-onlyprovisions of FAS No. 148 effective in 2002.

 

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

 
| ** **                                                                                                                                              | ** ** | **For the 13 Weeks Ended** | ** ** | **For the 26 Weeks Ended** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                                                                                                                                              | ** ** | **June 26,  2004**         | ** ** | **June 28,  2003**         | ** ** | **June 26,  2004** | ** ** | **June 28,  2003** | ** ** |
|                                                                                                                                                    |       |                       |       |                       |       |   |   |   |   |
| Net  income, as reported                                                                                                                                |       | $                          | 2,967      |                       | $          | 4,058 |   | $ | 4,324 |   | $ | 7,170 |   |
|                                                                                                                                                    |       |                       |       |                       |       |   |   |   |   |
| Adjust:  Total stock-based employee compensation (expense)/income determined under  fair value based method for all awards, net of related tax effects. |       | (1,136                     | )          | (378                       | )          | (2,272 | ) | 9,018 |   |
|                                                                                                                                                    |       |                       |       |                       |       |   |   |   |   |
| Pro  forma net income                                                                                                                                   |       | $                          | 1,831      |                       | $          | 3,680 |   | $ | 2,052 |   | $ | 16,188 |   |
|                                                                                                                                                    |       |                       |       |                       |       |   |   |   |   |
| Income  per common share:                                                                                                                               |       |                       |       |                       |       |   |   |   |   |
| Basic  - as reported                                                                                                                                    |       | $                          | 0.12       |                       | $          | 0.17 |   | $ | 0.18 |   | $ | 0.30 |   |
| Basic  - pro forma                                                                                                                                      |       | $                          | 0.07       |                       | $          | 0.15 |   | $ | 0.08 |   | $ | 0.67 |   |
|                                                                                                                                                    |       |                       |       |                       |       |   |   |   |   |
| Diluted  - as reported                                                                                                                                  |       | $                          | 0.12       |                       | $          | 0.17 |   | $ | 0.18 |   | $ | 0.29 |   |
| Diluted  - pro forma                                                                                                                                    |       | $                          | 0.07       |                       | $          | 0.15 |   | $ | 0.08 |   | $ | 0.66 |   |
|                                                                                                                                                    |       |                       |       |                       |       |   |   |   |   |
| Basic  shares                                                                                                                                           |       | 24,482                     |       | 24,038                     |       | 24,446 |   | 24,038 |   |
| Diluted  shares                                                                                                                                         |       | 24,687                     |       | 24,351                     |       | 24,686 |   | 24,345 |   |

 

9

----

 

As described in previousSEC filings issued during 2003, the Company cancelled 1,337,449 outstandingstock options during the first quarter of 2003 in connection with the StockOption Exchange Offer. The pro forma income shown in the table above for thesix months ending June 28, 2003 includes the reversal of pro forma expensespreviously disclosed totaling $9.7 million, related to the granting of theseoriginal options.  On October 1, 2003,the Company issued 1,320,947 options at an exercise price of $16.55 per shareto replace those options exchanged in connection with the Stock Option ExchangeOffer. As a result, beginning in the fourth quarter of 2003, the Company hasbeen incurring pro forma compensation expense which reflects the fair value ofthe replacement stock options granted.

 

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

 

On July 30, 2004, as aresult of the Acquisition, all stock options, whether or not then vested, withan exercise price of $16.50 or more per share were cancelled without anypayment therefore, and the remaining “in the money” options (excluding certainmanagement options that were forfeited in connection with the Acquisition),whether or not then vested, with exercise prices of less than $16.50 per sharewere converted into the right to receive the excess of $16.50 per share overthe exercise price of each of the options.

 

**6. Acquisitions**

 

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

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

 

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

 

10

----

 

**7. Debt**

 

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

 
|                                       | ** ** | **Balance at  June 26, 2004** | ** **  | **Balance at  Dec. 27, 2003** | ** ** |
|--------------------------------------------|------------|-------------------------------|-------------|-------------------------------|------------|
| Description of Instrument                  | ** ** | ** **                    | ** **  | ** **                    | ** ** |
|                                       |       |                          |        |                          |       |
| 2.1478%  Senior Convertible Notes due 2022 |       | $                             | 201,032     |                          | $          | 201,032 |   |
| Revolving  credit facility                 |       | 77,307                        |        | 70,353                        |       |
|                                       |       | 278,339                       |        | 271,385                       |       |
| Less  – Current portion               |       | —                        |        | —                        |       |
| **Total Long Term Debt**                   | ** ** | **$**                         | **278,339** | ** **                    | **$**      | **271,385** | ** ** |

 

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

 

On April 16, 2002,the Company completed an offering of $381.5 million aggregate principal amountof Senior Convertible Notes maturing on April 16, 2022 (the “ConvertibleNotes”). The Convertible Notes were issued at a price of $572.76 per note(57.276% of the principal amount at maturity) and pay cash interest at the rateof 2.1478% per year on the principal amount at maturity, payable semi-annuallyin arrears on April 16 and October 16 of each year beginning on October 16,2002, until April 16, 2007. After that date, interest will accrue on the notesas amortization of the original issue discount representing a yield to maturityof 3.75% per year, computed on a semi-annual bond equivalent basis. In December2002, the Company repurchased a total of $30.5 million principal value of theConvertible Notes at an average purchase price of $486.99 per $1,000 note,resulting in the remaining net outstanding balance of $201.0 million.

 

As more fullydetailed in the Registration Statement on Form S-3 filed with the SEC on June21, 2002, holders of the Convertible Notes may convert each $1,000 in principalamount of their Convertible Notes into 14.1265 shares of the Company’s commonstock, subject to adjustment, only if (1) the sale price of the Company’scommon stock reaches the “conversion trigger price,” as defined in theindenture governing the Convertible Notes, of $44.60 per share, (2) the tradingprice of the notes falls below 103% of the “average conversion value,” asdefined in the indenture governing the Convertible Notes, (3) the notesare called for redemption, or (4) specified corporate transactions,including a consolidation, merger, or a transfer of all or substantially all ofthe Company’s assets have occurred. Upon conversion, the Company has the rightto deliver, in lieu of its common stock, cash or a combination of cash andcommon stock in an amount as described in the indenture. These notes are notconsidered to be potential common shares, and are not included in thecalculation of diluted earnings per share, as the Company intends to settle anyconversions in cash.

 

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

 

The Acquisition isdeemed to be a “change of control” under the indenture governing theConvertible Notes. Within 15 days after the completion of the Acquisition, theCompany is required to notify the holders of the Convertible Notes of theiroption to require the Company to purchase the notes. The Company expectssubstantially all holders will exercise these repurchase rights, and theCompany intends to finance the repurchase of these notes from the funds raisedto finance the Acquisition.

 

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

 

11

----

 

**Revolving Credit Facility**

 

On July 21, 2003, theCompany completed the refinancing of the Fourth Amended and Restated CreditAgreement entered into by the Company on July 10, 2001 (the “Senior CreditAgreement”). The new credit facility (the “Credit Agreement”) is an asset-basedrevolving loan which uses a pre-determined percentage of the current value ofthe Company’s inventory, customer prescription files and selected accountsreceivable to calculate the availability of funds eligible to be borrowed up toan aggregate principal amount of $200 million. The obligations of the Companyunder the Credit Agreement are collateralized by substantially all of theassets of the Company. In addition, the Credit Agreement has been guaranteed byeach of the Company’s corporate subsidiaries, and such guarantees arecollateralized by substantially all assets of such guarantors.  The Credit Agreement matures on July 20,2008.

 

The Credit Agreementcontains a single fixed charge coverage requirement which only becomesapplicable when borrowings exceed 90 percent of the borrowing base, as definedin 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 or in the indenture related tothe Convertible Notes.

 

At June 26, 2004, therewas $77.3 million outstanding under the revolving credit facility, andapproximately $119.8 million of remaining availability, net of $2.9 millionreserved for standby letters of credit.

 

On July 22, 2004, inconnection with the anticipated consummation of the Acquisition, the CreditAgreement was amended (the “Amended Credit Agreement”) to increase theCompany’s borrowing capacity to an aggregate principal amount of $250 million,subject to an adjusted borrowing base calculation based upon specified advancerates against the value of the Company’s 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 this revolving loanfacility are secured by a first priority security interest in inventory,receivables, pharmacy prescription files and certain other current assets. TheCompany and Duane Reade, a New York general partnership which is the Company’sprincipal operating company and of which the Company is a general partner(“Duane Reade GP”), are co-obligors under the amended facility.  The amended facility is guaranteed by DuaneReade Holdings and each of Duane Reade Inc.’s domestic subsidiaries other thanDuane Reade GP. Revolving loans under the Amended Credit Agreement will, at theCompany’s option, bear interest at either (i) a rate equal to LIBOR (the LondonInterbank Offered Rate) plus a margin of from 1.50% to 2.00%, to be determinedbased on levels of borrowing availability reset each fiscal quarter or (ii) arate equal to the prime rate of Fleet Retail Group Inc. plus a margin of from0.00% to 0.50%, to be determined based on levels of borrowing availabilityreset each fiscal quarter. Borrowings under the amended facility continue to beprimarily LIBOR-based.

 

**Senior Term Loan Facility**

 

On July 30, 2004, inconnection with the Acquisition, the Company entered into a Senior Term LoanFacility (the “Senior Term Loan”) in the principal amount of $155 million. Thisloan will mature on July 30, 2010. While there are no scheduled principalpayments over its term, the Company will be required to prepay the senior termloan together with accrued interest thereon, with (a) all net cash proceeds (i)from sales of property and assets by Duane Reade Holdings and its subsidiaries(excluding sales of inventory in the normal course of business and certainother exceptions described in the Senior Term Loan), (ii) of extraordinaryreceipts as defined in the Senior Term Loan and (iii) from the issuance orincurrence 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 or its affiliates) and (c) 50.0% of excess cash flowof Duane Reade Holdings and its subsidiaries. Loans under the Senior Term Loan facility will, at the Company’s option,bear interest at a rate per annum of (i) the reserve-adjusted LIBOR plus an applicablemargin of 3.25%; or (ii) 2.25%, plus the higher of (a) the prime rate of Bankof America, N.A. and (b) the Federal Funds rate plus 0.50%.  Duane Reade GP became a co-obligor under theSenior Term Loan upon the closing of the Acquisition.  All obligations under the Senior Term Loanwill be guaranteed by Duane Reade Holdings and each of the Company’s existingand future direct and indirect subsidiaries, other than Duane Reade GP andcertain foreign subsidiaries.  The SeniorTerm Loan is secured by a first priority security interest in substantially allof the Company’s assets other than those assets in which the lenders under theAmended Credit Agreement have a first priority interest.  The Senior Term loan is also secured by asecond priority security interest in all collateral pledged on a first prioritybasis to lenders under the Amended Credit Agreement.  The Senior Term Loan also containsaffirmative and 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

 

12

----

 

anda minimum interest coverage ratio. There are no credit related triggers in theSenior Term Loan Facility or in the senior subordinated notes described below.

 

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

 

On July 30, 2004, uponcompletion of the Acquisition, the Company entered into an Indenture Agreementfor $195 million of 9 3/4% Senior Subordinated Notes due 2011 (the “SeniorNotes”).  These 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. These notes are unsecuredobligations and subordinated in right of payment to all of the Company’sexisting and future unsubordinated indebtedness, including borrowings under theAmended Credit Agreement and the Senior Term Loan. The notes rank equally withthe Company’s senior subordinated indebtedness and senior to the Company’ssubordinated indebtedness. These notes are guaranteed on an unsecured seniorsubordinated basis by all of the Company’s existing direct and indirectdomestic subsidiaries other than Duane Reade GP, which is a co-obligor underthe Senior Notes. The Company may redeem the notes, in whole or in part, at anytime on or after August 1, 2008, at a redemption price of 104.875% declining topar on August 1, 2010, plus accrued and unpaid interest. In addition theCompany can redeem up to 35% of the Senior Notes before August 1, 2007 with thenet cash proceeds from certain equity offerings. Upon the occurrence ofspecified change of control events, the Company will be required to make anoffer to repurchase all of the Senior Notes at 101% of the outstandingprincipal amount of the notes plus accrued and unpaid interest to the date ofrepurchase. The indenture governing the Senior Notes contains certainaffirmative and negative covenants that limit the Company’s ability to incuradditional indebtedness, pay dividends, make repayments on indebtedness that issubordinated to the Senior Notes and to make certain other restricted payments,incur certain liens, use proceeds from sales of assets, enter into business combinationtransactions (including mergers, consolidations and asset sales), enter intotransactions with affiliates and permit restrictions on the payment ofdividends by the Company’s subsidiaries. Under a registration rights agreemententered into as part of the offering of the Senior Notes, the Company isrequired to (i) file a registration statement within 120 days after thecompletion of the Acquisition, (ii) use its reasonable best efforts to causethe registration statement to become effective within 180 days after thecompletion of the Acquisition, and (iii) use its reasonable and best efforts tocomplete the exchange offer within 210 days after the Acquisition is completed.

 

**8. Net Income per Common Share**

 

Net income per commonshare is based on the weighted average shares outstanding during each period inaccordance with the provisions of FAS No. 128 “Earnings per Share.” Basicearnings per share are computed based on the weighted average number of commonshares outstanding during the period. Diluted earnings pershare gives effect to all dilutive potential common shares outstanding duringthe period. Dilutive potential common shares include shares issuableupon exercise of the Company’s “in-the-money” stock options. Of the options topurchase 2,078,590 and 1,221,197 shares of common stock outstanding at June 26,2004 and June 28, 2003, respectively, options to purchase 1,475,932 shares atJune 26, 2004 and 195,970 shares at June 28, 2003 were not included in thecomputation of diluted earnings per share because the exercise prices of suchoptions were greater than the average market price of the common shares andtherefore the impact of these shares would be anti-dilutive. Dilutive potentialcommon shares do not include any potential shares that could be issued relativeto the Company’s 2.1478% Convertible Notes (see Note 7 to these UnauditedConsolidated Interim Financial Statements for a description of the relevantconversion terms of the Convertible Notes).

 

13

----

 

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

 
| ** **                                            | ** ** | **For the 13 Weeks Ended** | ** ** | **For the 26 Weeks Ended** | ** ** |
|-------------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                                            | ** ** | **June 26,  2004**         | ** ** | **June 28,  2003**         | ** ** | **June 26,  2004** | ** ** | **June 28,  2003** | ** ** |
|                                                  |       |                       |       |                       |       |   |   |   |   |
| Net  income                                           |       | $                          | 2,967      |                       | $          | 4,058 |   | $ | 4,324 |   | $ | 7,170 |   |
|                                                  |       |                       |       |                       |       |   |   |   |   |
| Weighted  average common shares outstanding - basic   |       | 24,482                     |       | 24,038                     |       | 24,446 |   | 24,038 |   |
|                                                  |       |                       |       |                       |       |   |   |   |   |
| Potential  dilutive shares                            |       | 205                        |       | 313                        |       | 240 |   | 307 |   |
|                                                  |       |                       |       |                       |       |   |   |   |   |
| Weighted  average common shares outstanding - diluted |       | 24,687                     |       | 24,351                     |       | 24,686 |   | 24,345 |   |
|                                                  |       |                       |       |                       |       |   |   |   |   |
| Per  common share - basic                             |       |                       |       |                       |       |   |   |   |   |
|                                                  |       |                       |       |                       |       |   |   |   |   |
| Net  income                                           |       | $                          | 0.12       |                       | $          | 0.17 |   | $ | 0.18 |   | $ | 0.30 |   |
|                                                  |       |                       |       |                       |       |   |   |   |   |
| Per  common share - diluted                           |       |                       |       |                       |       |   |   |   |   |
|                                                  |       |                       |       |                       |       |   |   |   |   |
| Net  income                                           |       | $                          | 0.12       |                       | $          | 0.17 |   | $ | 0.18 |   | $ | 0.29 |   |

 

**9. Income Taxes**

 

Income taxes are recordedbased on the estimated combined statutory tax rates expected to be applicablefor the full fiscal year less applicable employment related tax credits. Theeffective tax rate is lower than the combined statutory rates, primarilyreflecting the impact of these income tax credits. The effective tax rate of40% recorded in the first six months of 2004 gives effect to the New York Statetax legislation passed in May 2003 with retroactive application to January 1,2003.  This legislation effectivelyeliminated certain royalty fee and related interest expense deductions. Theemployment tax credits represent the economic benefits earned by the Companyfor its participation in various federal and state hiring incentive programs.These benefits are based on the number of qualifying employees hired andretained by the Company for a specified time period. Employees qualify forthese hiring programs primarily as a result of their enrollment in variouseconomic assistance programs.

 

**10. Commitments and Contingencies**

 

The Company is party tolegal actions arising in the ordinary course of business. Based on informationpresently available to management, the Company believes that it has adequatelegal defenses or insurance coverage for these actions and that the ultimateoutcome of these actions will not have a material adverse effect on thefinancial position, results of operation or cash flows of the Company. Inaddition, the Company is a party to the following legal actions and matters:

 

During 2002, the Companyinitiated a legal action against its former property insurance carrier inFederal Court in the Southern District of New York, in an attempt to recoverwhat the Company believes to be a fair and reasonable settlement for thebusiness interruption portion of its claim originating from theSeptember 11, 2001 World Trade Center terrorist attack, during which theCompany’s single highest volume and most profitable store was completelydestroyed.  The claim is pending beforethe United States District Court for the Southern 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 umpire (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

 

14

----

 

settlement.In fiscal 2002, the Company received an advance of approximately$9.4 million toward its business interruption claim that was recognized asa separate component of income in the Company’s consolidated statement ofincome. In the event of an unfavorable outcome to the Company, this amountwould not be required to be returned to the insurance company.

 

The Company, Anthony J.Cuti, its Chairman, President and Chief Executive Officer, John K. Henry, itsSenior Vice President and Chief Financial Officer, and Gary Charboneau, itsSenior Vice President of Sales and Marketing, have been named as defendants inconnection with the consolidation of several class action complaints allegingviolations of the federal securities laws that were filed from August 2002through October 2002. The action, which is in the United States DistrictCourt for the Southern District of New York, is on behalf of shareholders whopurchased Duane Reade Inc.’s common stock between April 1, 2002 andJuly 24, 2002, inclusive. The complaint, which seeks an unspecified amountof damages, alleges that the defendants violated the federal securities laws byissuing materially false and misleading statements during the class period. OnDecember 1, 2003, the district judge granted the Company’s motion todismiss the plaintiff’s action, with prejudice. The plaintiffs have filed anappeal. The Company continues to believe that the plaintiffs’ actions arecompletely baseless and wholly without merit, and intends to continue tovigorously defend itself.

 

The Company is a defendantin a class action suit in the Federal Court for the Southern District of NewYork regarding alleged violations of the Fair Labor Standards Act as to a groupof individuals who provided delivery services on a contract basis to theCompany. In December 2002, the judge in the action issued a partialsummary judgment in favor of a subclass of the plaintiffs and against theCompany. In December 2003, the Company settled the issue of the amount ofits liability to the plaintiffs without any admission of wrongdoing and in anamount consistent with the Company’s previously established reserves. Theamount of attorney’s fees owed to the plaintiffs’ attorneys remains an openissue in the case, and the Company plans to vigorously defend claims by theseattorneys for fees. It is not anticipated that the amount of attorneys’ feesthat would be required to be paid in this matter would be material to thebusiness and operations of the Company.

 

The Company is a party torelated 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 throughAugust 2001. The plaintiffs have recently filed a motion seeking summaryjudgment of $2.29 million of claims for alleged underfunding, including relatedpenalties and interest. In addition, at various times, the plaintiffs havestated that they believe the Company may owe additional amounts. However, anyadditional amounts that the plaintiffs may claim are not known at this time.The Company has filed a motion opposing these claims. The Company believes thatit has made sufficient contributions to these funds and that it has meritoriousdefenses to the claims being made by these funds. Accordingly, the Companyintends to vigorously defend itself in these matters. At this time, it is notpossible to determine the ultimate outcome of this case or the actual amount ofliability the Company may face, if any.

 

The Company is involvedin an ongoing dispute with Cardinal Health, one of its former suppliers ofpharmaceutical products. Both parties have claims against the other involving,among other things, breach of contract, promissory estoppel and unjustenrichment. Duane Reade is seeking from Cardinal an unspecified amount ofdamages and punitive damages of at least $20 million. Cardinal is seekingapproximately $18 million in damages plus attorney’s fees and interest. Whilethere can be no definitive assurance, the Company believes it has counterclaimsthat offset the claims against it by Cardinal, as well as meritorious defensesto these claims, and plans to vigorously pursue its affirmative claims and tovigorously defend itself in this action. Non-party discovery in this case hasbeen concluded and it is expected to go to trial sometime in 2004.

 

The Company is involvedin litigation related to a dispute with the Allied Trades Council, a unionrepresenting employees in 139 of its stores. This litigation is more fullydescribed in Note 3 to these Unaudited Consolidated Interim FinancialStatements.

 

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

 

15

----

 

***Litigation Relating to the Merger Transaction:***  Duane Reade is aware of six purported classaction complaints challenging the merger transaction consummated by the Companyand Duane Reade Acquisition that have been filed in the Court of Chancery ofthe State of Delaware, referred to as the “Delaware Complaints,” and threepurported class action complaints that have been filed in the Supreme Court ofthe State of New York. Two of the New York complaints have been dismissedwithout prejudice. The other New York complaint (the “New York Complaint”) ispending, but has not been served on Duane Reade.  The Delaware Complaints name Mr. Cutiand certain other members of the Company’s board of directors and executiveofficers as well as Duane Reade as defendants. Four of the Delaware Complaintsname Oak Hill as a defendant. The New York Complaint names Mr. Cuti andcertain other members of the Company’s board of directors and executiveofficers as well as Duane Reade as defendants. One of the dismissed New Yorkcomplaints named Oak Hill as a defendant.

 

The Delaware Complaintswere consolidated on January 28, 2004, and on April 8, 2004 the plaintiffsin the Delaware actions filed a consolidated class action complaint (the“Consolidated Complaint”).

 

The ConsolidatedComplaint alleges that defendants failed to disclose material information inthe preliminary proxy statement, which was filed with the SEC on March 19,2004.  Specifically, the ConsolidatedComplaint alleges that the defendants failed to disclose: (1) the precisenature of the “Current Employment Agreement Estimated Payments,” as that termis used in the preliminary proxy, and the reasons for these payments; (2) thematerials and data purportedly used by Bear Stearns in calculating the “CurrentEmployment Agreement Estimated Payments,” instead of the disclosure in thepreliminary proxy statement that these calculations were “approximations basedon various assumptions since the precise amounts payable would requireactuarial or other expert valuation,” even though Bear Stearns allegedly reliedon these calculations; (3) the methodology, projections and other informationused by Bear Stearns to calculate the estimated present value of the company;and (4) that the merger consideration represented an approximately 11.7%premium based upon the trading price of Duane Reade shares on December 22,2003, instead of the disclosure in the preliminary proxy that shareholderswould be receiving a much higher premium of 22.0%.  The Consolidated Complaint and the New YorkComplaint allege, among other things, that the defendants purportedly breachedduties owed to Duane Reade’s stockholders in connection with the transaction byfailing to: (a) appropriately value Duane Reade as a merger candidate; (b) exposeDuane Reade to the marketplace in an effort to obtain the best transactionreasonably available, including to market Duane Reade to industry participants;and (c) adequately ensure that no conflicts of interest exist betweendefendants’ own interests and their fiduciary obligation to maximizestockholder value.  Plaintiffs seek,among other things: an order that the complaints are properly maintainable as aclass action; a declaration that defendants have breached their fiduciaryduties and other duties; injunctive relief; an unspecified amount of monetarydamages; attorneys’ fees, costs and expenses; and such other and further reliefas the court may deem just and proper. Duane Reade believes these lawsuits are without merit and plans todefend these lawsuits vigorously.

 

16

----

 

**ITEM 2****.****         MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**General**

 

Our business consists ofa wide variety of health and beauty care products, convenience oriented foodand general merchandise items and a pharmacy operation managed to supplycustomers with their prescription needs. We refer to the non-prescriptionportion of our business as front-end sales because most of these sales are processedthrough the front main check-out sections of our stores. This portion of ourbusiness consists of over-the-counter medications, health and beauty careitems, food and beverages, tobacco products, cosmetics, housewares, greetingcards, photofinishing, photo supplies, seasonal and general merchandise. Healthand beauty care products, including over-the-counter items, represent ourhighest volume categories within front-end sales. The front-end portion of ourbusiness represented 54.7% of our sales in both the quarter and six monthsended June 26, 2004, and is characterized by generally higher gross marginsthat are approximately twice that of our pharmacy or back-end business.

 

Because of our numerousconvenient locations in high-traffic commercial and residential areas and thelack of other convenience oriented retailers in our core market areas, ourfront-end business is generally a larger proportion of our total sales thanother major conventional drug store chains, which average between 30% to 40%, butas is the case with most other drug store chains, represents a decreasing shareof business year after year due to the faster rate of pharmacy salesgrowth.  Our pharmacy sales include allitems we sell by prescription filled at our retail locations or by our centralfill facility and delivered to our stores or direct to customers. The pharmacyportion of our business is dominated by and dependent upon a number of third party private and government-sponsored plans that contractwith us as an authorized provider of prescriptions.

 

Sales to third partyprescription plans represented 92.2% and 92.1% of our pharmacy sales in thequarter and six months ended June 26, 2004, respectively. The pharmacy portionof our business is subject to a number of federal, state and local regulationsthat govern the conduct of this business. The high rate of growth in pharmacysales has been due to a number of favorable demographic and industry trendssuch as the aging of the population, expanding penetration of third party privateand government-sponsored coverage and the increasing usage of prescriptiondrugs to improve quality of life and in place of medical procedures. Along withthe fast pace of growth in this area have come generally higher rates ofproduct cost inflation, resulting in an increased focus on the part of bothgovernment and private plans to control their costs of providing thesebenefits. As a result, pharmacy gross margins have been under pressure.

 

During 2003, PresidentBush 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 onprescriptions that are not subject to third party reimbursement. InJune 2004, a temporary senior citizen prescription drug discount programfurnished under this Medicare legislation was implemented and is expected toremain in effect until the full Medicare program takes effect in 2006. Thistemporary program is also expected to result in lower pharmacy margins thanthose currently realized on prescriptions that are not subject to third partyplan reimbursement. Based on our experience over time, we expect that increasedutilization of prescription drugs by senior citizens participating in the newprograms will offset the effect of lower margins on our revenues.

 

In fiscal 2003, New YorkState reduced Medicaid prescription reimbursement rates, adversely impactingour pharmacy gross margins. Recent New York State budget proposals also includethe possibility of additional reductions in Medicaid reimbursement rates.

 

While retaining its highrate of growth in 2003, the retail pharmacy industry experienced substantiallyreduced rates of pharmacy same-store sales growth resulting from a decline inthe demand for hormonal replacement drugs, conversion of some high volume prescriptiondrugs to over-the-counter status, increased levels of required co-payments byinsurers, increased utilization of lower priced generic medications andreductions in coverage resulting from high unemployment rates. These trendscontinued to be operative throughout the first half of 2004.

 

We operate approximately85% of our 247 stores in New York City and therefore our financial performanceis heavily influenced by the local economy. We analyze a number of economicindicators specific to New York City to gauge the health of this economyincluding unemployment rates, job creation, gross city product and bridge andtunnel

 

17

----

 

commutertraffic patterns. We also analyze market share data, same-store sales trends,average store sales and sales per square foot data among other key performanceindicators to monitor our overall performance.

 

The New York City economycontinues to experience higher rates of unemployment than the national economyoverall. June unemployment data for New York City indicated an unemploymentrate of 7.4% compared to a national average of 5.6%. While the local economystill lags the national trend, the city did not experience continued job lossesduring the quarter and has begun to report a rising rate of tax revenues. Inaddition, the New York City unemployment rate reflects a significantimprovement as compared to the monthly average rate of 8.5% reported for thefirst quarter of this year. We believe that these trends reflect an improvedfiscal situation for the city overall that is consistent with the early stagesof an improving local economy.

 

On July 30, 2004 we wereacquired through a merger transaction with Duane Reade Acquisition Corp.(“Duane Reade Acquisition”), a wholly owned subsidiary of Duane Reade Holdings,Inc. and an affiliate of Oak Hill Capital Partners, L.P. (“Oak Hill”), aprivate 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 will no longer be listed onthe New York Stock Exchange and Duane Reade will continue 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.

 

Oak Hill financed theacquisition out of their current $1.6 billion private equity fund, along withseveral co-investors. 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 Fleet Retail Group to $250 million, that resulted inapproximately $93.3 million of borrowing capacity after completion of themerger. The high-yield note offering and new debt facility were arranged by agroup of financial institutions led by Banc of America Securities LLC. As aresult of the Acquisition, Duane Reade expects to make a change of controloffer to purchase its outstanding Convertible Notes, in the principal amount of$201 million plus accrued and unpaid interest.

 

TheAcquisition was accounted for as a purchase, in accordance with the provisionsof Statement of Financial Accounting Standards No. 141, “BusinessCombinations,” which will result in new valuations for our and oursubsidiaries’ assets and liabilities based on fair values as of the date of theacquisition.  These new valuations willbe finalized within one year after the closing of the Acquisition and will bethe basis for our future impairment evaluations under Statement of FinancialAccounting Standards No. 142, “Goodwill and Other Intangible Assets.”

 

**Resultsof Operations**

 

Forthe second quarter ended June 26, 2004, we achieved net sales of $365.2 millionand net income of $3.0 million, or $0.12 per diluted share, compared to netsales of $355.1 million and net income of $4.1 million, or $0.17 per dilutedshare, in the second quarter of the previous year. Gross profit marginsincreased from 21.7% last year to 22.0% this year.  The increase was primarilyattributable to favorable selling margins and lower shrink losses that morethan offset the impact of an increased mix of lower margin pharmacy sales.  Despite the increase in gross profit margins,net income declined principally due to the following factors:

 

•                  Pre-tax transaction expenses of $1.5million related to the acquisition of the Company;

•                  A $1.1 million increase indepreciation and amortization expense resulting from the depreciation ofcapital expenditures made in 2003 and 2004 as well as increases in theamortization of identifiable intangibles;

•                  Pre-tax labor contingency expenses of$1.1 million related to a National Labor Relations Board Administrative LawJudge’s recommendation in a collective bargaining agreement litigation relatedto the funding of certain employee benefit funds (see Note 3 to the UnauditedConsolidated Interim Financial Statements); and

•                  Increased legal and professionalexpenses of $0.6 million associated with certain labor issues, our attempt torecover the balance of our World Trade Center business interruption insuranceclaim and various other matters.

 

18

----

 

**ThirteenWeeks Ended June 26, 2004 versus Thirteen Weeks Ended June 28, 2003**

 

The following setsforth the results of operations for the periods indicated:

 
| ** **                                      | ** ** | **13 Weeks Ended** | ** ** |
|-------------------------------------------------|------------|--------------------|------------|
| ** **                                      | ** ** | **June 26, 2004**  | ** ** | **June 28, 2003** | ** ** |
| **In  thousands, except percentages**           | ** ** | **Dollars**        | ** ** | **% of Sales** | ** ** | **Dollars** | ** ** | **% of Sales** | ** ** |
| Net  sales                                      |       | $                  | 365,206    |   | 100.0 | % | $ | 355,146 |   | 100.0 | % |
| Cost  of sales                                  |       | 285,018            |       | 78.0 |   | 278,171 |   | 78.3 |   |
| Gross  profit                                   |       | 80,188             |       | 22.0 |   | 76,975 |   | 21.7 |   |
| Selling,  general & administrative expenses |       | 59,924             |       | 16.4 |   | 57,260 |   | 16.1 |   |
| Labor  contingency expense                      |       | 1,100              |       | 0.3 |   | — |   | 0.0 |   |
| Transaction  expenses                           |       | 1,516              |       | 0.4 |   | — |   | 0.0 |   |
| Depreciation  and amortization                  |       | 9,239              |       | 2.5 |   | 8,154 |   | 2.3 |   |
| Store  pre-opening expenses                     |       | 209                |       | 0.1 |   | 229 |   | 0.1 |   |
| Operating  income                               |       | 8,200              |       | 2.2 |   | 11,332 |   | 3.2 |   |
| Interest  expense, net                          |       | 3,257              |       | 0.9 |   | 3,549 |   | 1.0 |   |
| Debt  extinguishment                            |       | —             |       | 0.0 |   | — |   | 0.0 |   |
| Income  before income taxes                     |       | 4,943              |       | 1.4 |   | 7,783 |   | 2.2 |   |
| Income  taxes                                   |       | 1,976              |       | 0.5 |   | 3,725 |   | 1.0 |   |
| Net  income                                     |       | $                  | 2,967      |   | 0.8 | % | $ | 4,058 |   | 1.1 | % |

 

Netsales were $365.2 million in the second quarter of 2004, an increase of 2.8%over net sales of $355.1 million for the second quarter of 2003. Same-storesales increased by 0.4% over the second quarter last year with the balance ofthe increase coming from the full quarterly results of four net new storesopened in the second quarter last year and 11 net new stores opened since theend of last year’s second quarter.

 

Pharmacysales increased from $155.2 million in the second quarter of 2003 to $165.4million in the second quarter of 2004, an increase of 6.5%, and represented45.3% of total sales, as compared with 43.7% of total sales in the second quarterof 2003. Pharmacy same-store sales increased by 4.6% over last year, andthird-party reimbursed pharmacy sales represented 92.2% of total pharmacy salescompared to 91.3% in the second quarter of 2003. Pharmacy same-store salescontinued to experience the general industry trend of reduced growth ratesexperienced during fiscal 2003.  Themajor factors driving the slower sales growth rates in pharmacy were the trendstoward increases in third party plan customer co-payments, reduced sales ofhormonal replacement drugs, limitations on maximum reimbursements for certaingeneric medications by third party plans, increased penetration by mail orderand internet-based pharmacies and continued high rates of unemployment thathave reduced the number of customers covered by insured plans.

 

Front-endsales decreased from $199.9 million in the second quarter of 2003 to $199.8million in the second quarter of 2004, a decrease of 0.1%, and represented54.7% of total sales, as compared to 56.3% of total sales in the second quarterof 2003. Front-end same-store sales declined by 2.8%, partly due to decliningtobacco sales in metro New York City, which has experienced increasedrestrictions on smoking in public places along with higher taxes on tobaccoproducts.  Excludingtobacco sales, front-end same-store sales decreased by approximately 1.6%.We believe that the remaining decline in same-store front-end sales is largelyattributable to the continued high unemployment rates in New York City thathave restrained consumer demand.

 

Weopened four new stores during the second quarter of both 2004 and 2003. At June26, 2004, we operated 247 stores, as compared to 236 stores at June 28, 2003.

 

19

----

 

Cost of sales as apercentage of net sales decreased to 78.0% for the second quarter of 2004 from78.3% for the second quarter of 2003, resulting in an increase in gross profitmargin to 22.0% for the second quarter of 2004 from 21.7% for the second quarterof 2003.  This increase was primarilyattributable to higher front-end selling margins and reduced shrink losses thatmore than offset the impact of an increased mix of lower margin pharmacy sales.These improvements were also partially offset by higher store occupancy costsprimarily resulting from higher rent expense attributable to new stores andstore relocations. Cost of sales also includes (i) a $0.2 million LIFOprovision in both the current and prior years and (ii) real-estate relatedincome amounting to $1.2 million and $0.1 million in the second quarter of 2004and 2003, respectively.

 

Selling, general andadministrative expenses were $59.9 million, or 16.4% of net sales, and $57.3million, or 16.1% of net sales, in the second quarters of 2004 and 2003,respectively.  The increase in theseexpenses as a percentage of sales is primarily attributable to the higher legaland professional expenses discussed above and higher insurance costs.

 

Depreciation andamortization of intangibles in the second quarters of 2004 and 2003 were $9.2million and $8.2 million, respectively. This increase resulted from the depreciation of capital expendituresmade in 2003 and 2004 as well as increases in the amortization of identifiableintangibles, a major portion of which resulted from pharmacy acquisitionscompleted since the second quarter of 2003.

 

We incurred storepre-opening expenses of $0.2 million, related to the opening of four newstores, during the second quarter of both 2003 and 2004.

 

Net interest expensedecreased 8.2% to $3.3 million in the second quarter of 2004 from $3.5 millionin the second quarter of 2003.  Thisdecline was primarily attributable to the lower average interest rates on ouroutstanding revolving credit borrowings in the current year, as compared to theinterest rates incurred on our revolving credit and term loan borrowings in theprior year.

 

In the second quarter of2004, we recorded an income tax provision of $2.0 million, reflecting anestimated annual effective tax rate of 40.0%, inclusive of the anticipatedbenefits of employment tax credits. In the comparable period last year, theincome tax provision of $3.7 million reflected an estimated effective tax rateof 44.0%, inclusive of the anticipated benefits of employment tax credits, aswell as a retroactive adjustment to the first quarter’s tax expense, which hadbeen previously recorded at an effective rate of 38.0%. The increase in lastyear’s second quarter effective tax rate reflected New York State legislationpassed in May 2003 which retroactively eliminated certain tax deductionsattributable to royalty companies. The employment tax credits represent theeconomic benefits earned by us for our participation in various federal andstate hiring incentive programs. The decrease in the current year’s effectiverate reflects the combined impact of the employment tax credits and the reducedlevels of pre-tax income generated by the Company.

 

20

----

 

**Twenty-Six Weeks Ended June 26,2004 versus Twenty-Six Weeks Ended June 28, 2003**

 

The following setsforth the results of operations for the periods indicated:

 
| ** **                                      | ** ** | **26 Weeks Ended** | ** ** |
|-------------------------------------------------|------------|--------------------|------------|
| ** **                                      | ** ** | **June 26, 2004**  | ** ** | **June 28, 2003** | ** ** |
| **In  thousands, except percentages**           | ** ** | **Dollars**        | ** ** | **% of Sales** | ** ** | **Dollars** | ** ** | **% of Sales** | ** ** |
| Net  sales                                      |       | $                  | 714,756    |   | 100.0 | % | $ | 688,768 |   | 100.0 | % |
| Cost  of sales                                  |       | 558,802            |       | 78.2 |   | 541,604 |   | 78.6 |   |
| Gross  profit                                   |       | 155,954            |       | 21.8 |   | 147,164 |   | 21.4 |   |
| Selling,  general & administrative expenses |       | 118,567            |       | 16.6 |   | 110,834 |   | 16.1 |   |
| Labor  contingency expense                      |       | 2,200              |       | 0.3 |   | — |   | 0.0 |   |
| Transaction  expenses                           |       | 2,619              |       | 0.4 |   | — |   | 0.0 |   |
| Depreciation  and amortization                  |       | 18,305             |       | 2.6 |   | 15,712 |   | 2.3 |   |
| Store  pre-opening expenses                     |       | 365                |       | 0.1 |   | 644 |   | 0.1 |   |
| Operating  income                               |       | 13,898             |       | 1.9 |   | 19,974 |   | 2.9 |   |
| Interest  expense, net                          |       | 6,694              |       | 0.9 |   | 7,066 |   | 1.0 |   |
| Debt  extinguishment                            |       | —             |       | 0.0 |   | 105 |   | 0.0 |   |
| Income  before income taxes                     |       | 7,204              |       | 1.0 |   | 12,803 |   | 1.9 |   |
| Income  taxes                                   |       | 2,880              |       | 0.4 |   | 5,633 |   | 0.8 |   |
| Net  income                                     |       | $                  | 4,324      |   | 0.6 | % | $ | 7,170 |   | 1.0 | % |

 

Netsales were $714.8 million in the first six months of 2004, an increase of 3.8%over net sales of $688.8 million for the first six months of 2003. Same-storesales increased by 1.0% over the first six months last year with the balance ofthe increase coming from the full six month results of eight net new storesopened in the first six months last year and 11 net new stores opened since theend of last year’s second quarter.

 

Pharmacysales increased from $299.1 million in the first six months of 2003 to $323.9million in the first six months of 2004, an increase of 8.3%, and represented45.3% of total sales, as compared with 43.4% of total sales in the first sixmonths of 2003. Pharmacy same-store sales increased by 5.5% over last year, andthird-party reimbursed pharmacy sales represented 92.1% of total pharmacy salescompared to 91.2% in the first six months of 2003. Pharmacy same-store salescontinued to experience the general industry trend of reduced growth ratesexperienced during fiscal 2003.  Themajor factors driving the slower sales growth rates in pharmacy were the trendstoward increases in third party plan customer co-payments, reduced sales ofhormonal replacement drugs, limitations on maximum reimbursements for certaingeneric medications by third party plans, increased penetration of mail orderand internet based pharmacies and continued high rates of unemployment thathave reduced the number of customers covered by insured plans.

 

Front-endsales increased from $389.7 million in the first six months of 2003 to $390.9million in the first six months of 2004, an increase of 0.3%, and represented54.7% of total sales, as compared to 56.6% of total sales in the first sixmonths of 2003. Front-end same-store sales declined by 2.5%, largely due todeclining tobacco sales in metro New York City, which has experienced increasedrestrictions on smoking in public places along with higher taxes on tobaccoproducts.  Excludingtobacco sales, front-end same-store sales decreased by approximately 1.1%.We believe that the remaining decline in same-store front-end sales is largelyattributable to the continued high unemployment rates in New York City thathave restrained consumer demand.

 

Duringthe first six months of 2004, we opened seven new stores and closed one store,as compared to 11 stores opened and three stores closed in the comparableperiod last year.

 

Cost of sales as apercentage of net sales decreased to 78.2% for the first six months of 2004from 78.6% for the first six months of 2003, resulting in an increase in grossprofit margin to 21.8% for the first six months of 2004 from 21.4% for thefirst six months of 2003.  This increasewas primarily attributable to higher front-end selling margins and reducedshrink losses, partially offset by the impact of an increased mix of lowermargin pharmacy sales. These improvements were partially offset by higher storeoccupancy costs primarily resulting from higher rent expense attributable tonew stores and store relocations. Cost of sales also includes (i) a $0.5million

 

21

----

 

LIFO provision in thecurrent year, as compared to a LIFO provision of $0.3 million in the prioryear, and (ii) real-estate related income of $2.0 million and $1.3 million inthe first six months of 2004 and 2003, respectively.

 

Selling, general andadministrative expenses were $118.6 million, or 16.6% of net sales, and $110.8million, or 16.1% of net sales, in the first six months of 2004 and 2003,respectively.  The increase in theseexpenses as a percentage of sales is primarily attributable to the higher legaland professional expenses discussed above, severance costs associated withcertain administrative staff reductions incurred during the first quarter andhigher insurance costs.

 

Depreciation andamortization of intangibles in the first six months of 2004 and 2003 were $18.3million and $15.7 million, respectively. This increase resulted from the depreciation of capital expendituresmade in 2003 and 2004 as well as increases in the amortization of identifiableintangibles, a major portion which resulted from pharmacy acquisitionscompleted since the beginning of 2003.

 

We incurred storepre-opening expenses of $0.4 million during the first six months of 2004related to the opening of seven new stores. During the comparable period last year, we incurred pre-opening expensesof $0.6 million related to the opening of 11 new stores.

 

Net interest expensedecreased 5.3% to $6.7 million in the first six months of 2004 from $7.1million in the first six months of 2003. This decline was primarily attributable to the lower average interestrates on our outstanding revolving credit borrowings in the current year, ascompared to the interest rates incurred on our revolving credit and term loanborrowings in the prior year.

 

In the first six monthsof 2003, we recorded a debt extinguishment charge of $0.1 million, reflectingthe payment of early termination premiums related to the retirement of the $1.6million outstanding balance of the 9.25% senior notes and the write-off of theremaining deferred financing costs associated with those notes.

 

In the first six monthsof 2004, we recorded an income tax provision of $2.9 million, reflecting anestimated annual effective tax rate of 40.0%, inclusive of the anticipatedbenefits of employment tax credits. In the comparable period last year, theincome tax provision of $5.6 million reflected an estimated effective tax rateof 44.0%, inclusive of the anticipated benefits of employment tax credits.  The employment tax credits represent theeconomic benefits earned by us for our participation in various federal andstate hiring incentive programs. The decrease in the effective rate reflectsthe combined impact of the employment tax credits and the reduced levels ofpre-tax income generated by the Company.

 

**Liquidityand Capital Resources**

 

**Working Capital and Cash Flow**

 

Working capital was$232.8 million as of June 26, 2004 and $227.6 million as of December 27, 2003.The increase was primarily due to reduced levels of accounts payable related tothe timing of merchandise purchases. Generally, working capital increases atthe 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.

 

Forthe first six months of 2004, net cash provided by operating activities was$20.0 million, as compared to $14.0 million in the first six months of 2003.The increase was principally due to reduced merchandise purchases during thefirst six months of 2004 and the collection of certain property insuranceclaims amounting to $1.3 million.

 

Net cash used in investing activities was $27.7million during the first six months of 2004, compared to $35.7 million duringthe first six months of 2003.  In thefirst six months of 2004, capital expenditures, primarily related to new storeopenings and the remodeling of existing locations, were $16.2 million, whilelease acquisition, pharmacy customer file and other costs accounted for $11.5million of cash used in investing activities. In the first six months of 2003, we spent $25.8 million on capitalexpenditures and $9.9 million on lease acquisition, pharmacy customer file andother costs.

 

Netcash provided by financing activities was $7.7 million for the first six monthsof 2004, compared to $18.8 million for the first six months of 2003. Thedecrease of $11.1 million reflects the improved level of cash flow generated byreduced investing activities and increased cash flow from operations discussedabove.

 

22

----

 

**TheAcquisition**

 

The July 30, 2004Acquisition was financed as an all cash transaction whereby our common stockoutstanding immediately prior to the Acquisition was converted into the rightto receive $16.50 per share, without interest. The total transaction value,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 $93.3****million of borrowing availability under our amendedasset-based revolving loan facility.

 

**OperatingCapital Requirements**

 

Ouroperating capital requirements primarily result from opening and stocking newstores, remodeling and renovating existing retail locations, purchasingpharmacy files and the continuing development of management informationsystems. We opened a total of 17 stores in 2003, a decline from 32 stores openedin 2002 and 31 stores opened in 2001. We believe that there are significantopportunities to open additional stores, and currently plan to openapproximately 8-10 additional new stores during the remainder of this year (atotal of 15-17 for all of 2004), and 10-12 new stores in each of fiscal 2005through fiscal 2008. We expect to spend approximately $40.0 million in 2004 oncapital expenditures, primarily for new, renovated and replacement stores, and an additional $14 million - $17 million forlease acquisition, pharmacy customer files and other costs. We also requireworking capital to support inventory for our existing and new stores.Historically, we have been able to lease almost all of our store locations, soacquisitions of real estate are not expected to have a significant impact onour capital requirements

 

**OtherFactors Influencing our Liquidity**

 

Tenof our stores that generated 4.1% of our net sales in fiscal 2003 have leasesthat are scheduled to expire before the end of 2005. One of these leases has arenewal option.  We believe that we willbe able to renew the expiring leases on economically favorable terms or,alternatively, find other economically attractive locations to lease.

 

As of June 26, 2004,approximately 4,500 of our approximately 6,300 employees were represented byvarious 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 mutual consent ofUNITE and Duane Reade through August 31, 2004 while we continue to negotiatethe terms of a new agreement.

 

Under an employmentagreement with our Chairman and CEO originally entered into in 1997 andsubsequently amended in 2000 and 2001, and then amended and restated in 2002,and again amended and restated in connection with the completed Acquisition, wewere required to fund premiums for a split dollar life insurance policy thatwill provide certain post-retirement benefits. During fiscal 2003 and fiscal2004, the annual premiums amounted to $5.0 million, and are 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 employmentagreement, we have the opportunity to elect to terminate the split dollar lifeinsurance contract in exchange for, among other things, the payment toMr. Cuti of $6.5 million on or prior to December 1, 2004, $14.0 million onor prior to January 1, 2005 and $4.0 million on or prior to June 30, 2005, andwe expect to make that termination election. The parties to Mr. Cuti’semployment agreement are considering accelerating a portion of the firstpayment of $6.5 million in an amount up to $1.5 million to be paid prior toDecember 1, 2004. A portion of these payment obligations will be satisfiedeither using the cash surrender value of the split dollar life insurancecontract at the time we elect to terminate it (approximately $14.0 million asof August 2, 2004) or by transferring ownership of the split dollar lifeinsurance contract to Mr. Cuti.

 

As of June 26, 2004,there were no material changes in the Contractual Obligations and Commitmentsdisclosed in our Annual Report on Form 10-K/A for the year ended December 27,2003, except that we paid the annual $5.0 million premium due in connectionwith the CEO Split Dollar Life Insurance Policy on January 26, 2004. Theremaining fixed

 

23

----

 

premiumobligation under the terms of this policy amounts to $30.0 million subject tothe early termination provision described above.

 

We are party tomulti-year, merchandise supply agreements in the normal course of business. Thelargest of these agreements is with AmerisourceBergen, our primarypharmaceutical supplier. Generally, these agreements provide for certain volumecommitments and may be terminated by us, subject in some cases to specifiedtermination payments, none of which would constitute a material adverse effecton our financial position, results of operations or cash flows. It is theopinion of management that if any of these agreements were terminated or if anycontracting party was to experience events precluding fulfillment of itsobligations, we would be able to find a suitable alternative supplier.

 

Inconnection with the Acquisition, Mr. Cuti was granted equity interests in DuaneReade Shareholders and Duane Reade Holdings consisting of options to purchaseshares of Duane Reade Holdings common stock and a profits interest in DuaneReade Shareholders.  Upon the occurrenceof certain events, including the fifth anniversary of the effective date of theAcquisition, Mr. Cuti will have the right to require us to purchase for cash overa 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 June 26, 2004 werecorded a litigation-related non-current liability of $14.8 million inconnection with a National Labor Relations Board Administrative Law Judgerecommendation in a litigation-related matter with the Allied Trades Council, aunion representing employees in 139 of our stores. Because this recommendationis only the initial phase of a complex administrative and judicial process, theultimate outcome, financial impact and related timing of any future cashdisbursement relating to this matter can not be determined at this time. Thismatter is more fully described in Note 3 to the Unaudited ConsolidatedInterim Financial Statements.

 

We are not a party to anyagreements with, or commitments to, any special purpose entities that wouldconstitute material off-balance sheet financing other than the operating leasecommitments detailed in the Contractual Obligations and Commitments tablepresented in our Annual Report on Form 10-K/A for the year ended December 27,2003.

 

**Long Term Debt**

 

Prior to the Acquisition,our debt structure had two primary components, consisting of Convertible Notes andthe Credit Agreement.

 

**Convertible Notes**

 

The Convertible Noteswere issued on April 16, 2002 at a discounted value equivalent to 57.276% offace value.  The Convertible Notes paycash interest semiannually at a rate of 2.1478% of face value for the firstfive years and thereafter accrue original issue discount at a semi-annual bondequivalent rate of 3.75% yield to maturity on April 16, 2022. The ConvertibleNotes are convertible into shares of our common stock upon the occurrence ofcertain specified events. Holders of the Convertible Notes may require us topurchase all or a portion of the Convertible Notes on each of the 5, 10 and15-year anniversaries of the issuance date at pre-specified prices. We mayredeem for cash all or a portion of the Convertible Notes at any time afterApril 16, 2007 at a price equal to the sum of the issue price plus accruedoriginal issue discount and accrued cash interest, if any, to the redemptiondate. The Acquisition was deemed a “change of control” under the indenturegoverning the senior convertible notes. Within 15 days after the completion ofthe Acquisition, we will be required to notify the holders of our ConvertibleNotes of their option to require us to purchase the notes within 30 businessdays after the completion of the Acquisition, at a cash price equal to the sumof the issue price plus accrued original issue discount and cash interest, ifany, on such notes to the date of purchase. We expect that the holders of allor substantially all of our Convertible Notes will exercise their repurchaserights and we expect to fund the repurchase price from the funds raised tofinance the Acquisition. Until such Convertible Notes are fully redeemed, ourborrowing availability under our revolving credit facility will be reduced bythe issue price of any unredeemed senior convertible notes less any specificfinancing funds placed into a separate escrow account for the express purposeof redeeming such notes.

 

In connection with the consummation of theAcquisition, we, Duane Reade Shareholders, LLC, the indirect parent of DuaneReade Acquisition Corp. and each of our subsidiaries that are guarantors of theConvertible Notes entered into a supplemental indenture.  Pursuant to the supplemental indenture, as aresult of the merger of Duane Reade Acquisition Corp. with and into Duane ReadeInc., the Convertible Notes may only be converted into the right to receivefrom us $16.50 (in cash and without interest) per share of our common stockissuable to a holder of Convertible Notes in connection with such conversion.

 

**Credit Agreement**

 

On July 21, 2003, wecompleted the refinancing of the Fourth Amended and Restated Credit Agreemententered into by us on July 10, 2001 (the “Senior Credit Agreement”). Thiscredit facility (the “Credit Agreement”) is an asset-based revolving loan whichuses a pre-determined percentage of the current value of our inventory,customer prescription files and selected accounts receivable to calculate theavailability of funds eligible to be borrowed up to an aggregate principalamount of $200 million. Our obligations under the Credit Agreement arecollateralized by substantially all of our assets. In addition, the CreditAgreement has been guaranteed by each of our corporate subsidiaries, and suchguarantees are collateralized by substantially all assets of suchguarantors.  The Credit Agreement matureson July 20, 2008.

 

24

----

 

The Credit Agreementcontains a single fixed charge coverage requirement which only becomesapplicable when borrowings exceed 90 percent of the borrowing base, as definedin 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 or in the indenture related tothe Convertible Notes.

 

At June 26, 2004 therewas $77.3 million outstanding under the revolving credit facility, and approximately$119.8 million of remaining availability, net of $2.9 million reserved forstandby letters of credit.

 

On July 22, 2004, inconnection with the anticipated consummation of the Acquisition, the CreditAgreement was amended (the “Amended Credit Agreement”) to increase ourborrowing capacity to an aggregate principal amount of $250 million, subject toan adjusted borrowing base calculation based upon specified advance ratesagainst the value of our inventory, customer prescription files and selected accountsreceivable. The Amended Credit Agreement includes a $50 million sub-limit forthe issuance of letters of credit. Obligations under this amended asset-based revolving loan facility aresecured by a first priority security interest in inventory, receivables,pharmacy prescription files and certain other current assets. We and DuaneReade, a New York general partnership which is our principal operating companyand of which we are a general partner (“Duane Reade GP”), are co-obligors underthe amended facility. The amended facility is guaranteed by Duane ReadeHoldings and each of our domestic subsidiaries other than Duane Reade GP.Revolving loans under the Amended Credit Agreement will, 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%, to be determined based on levels ofborrowing availability reset each fiscal quarter or (ii) a rate equal to theprime rate of Fleet Retail Group Inc. plus a margin of from 0.00% to 0.50%, tobe determined based on levels of borrowing availability reset each fiscalquarter. Borrowings under the amended facility continue to be primarilyLIBOR-based.

 

**Acquisition-Related DebtFinancings**

 

**Senior Term Loan Facility**

 

On July 30, 2004, in connectionwith the Acquisition, we entered into a Senior Term Loan Facility (the “SeniorTerm Loan”) in the principal amount of $155 million. This loan will mature onJuly 30, 2010. While there are no scheduled principal payments over its term,we will be required to prepay the senior term loans 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 as definedin the Senior Term Loan and (iii) from the issuance or incurrence of additionaldebt of Duane Reade Holdings or any of its subsidiaries other than certainidentified indebtedness permitted under the Senior Term Loan, (b) 50.0% of allnet cash proceeds from the issuance of additional equity of Duane ReadeHoldings or any of its subsidiaries (excluding equity issued to Oak Hill or itsaffiliates) and (c) 50.0% of excess cash flow of Duane Reade Holdings and itssubsidiaries.  Loans under the SeniorTerm Loan facility will, at our option, bear interest at a rate per annum of(i) the reserve-adjusted LIBOR plus an applicable margin of 3.25%; or (ii)2.25%, plus the higher of (a) the prime rate of Bank of America, N.A. and (b)the Federal Funds rate plus 0.50%. Duane Reade GP became a co-obligor under theSenior Term Loan upon the closing of the Acquisition.  All obligations under the Senior Term Loanwill be guaranteed by Duane Reade Holdings and each of our existing and futuredirect and indirect subsidiaries, other than Duane Reade GP and certain foreignsubsidiaries. The Senior Term Loan is secured by a first priority securityinterest in substantially all of our assets other than those assets in whichthe lenders under the Amended Credit Agreement have a first priorityinterest.  The Senior Term Loan is alsosecured by a second priority security interest in all collateral pledged on afirst priority basis to lenders under the Amended Credit Agreement.  The Senior Term Loan also containsaffirmative and 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. There are no credit related triggers in theSenior Term Loan Facility or in the senior subordinated notes described below.

 

25

----

 

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

 

On July 30, 2004, uponcompletion of the Acquisition, we entered into an Indenture Agreement for $195million of 9 3/4% Senior Subordinated Notes due 2011 (the “Senior Notes”).  These notes mature on August 1, 2011 and bearinterest at 9.75% per annum payable in semi-annual installments on February 1and August 1, commencing February 1, 2005. These notes are unsecuredobligations and subordinated in right of payment to all of our existing andfuture unsubordinated indebtedness, including borrowings under the AmendedCredit Agreement and the Senior Term Loan. The notes rank equally with oursenior subordinated indebtedness and senior to our subordinated indebtedness.These notes are guaranteed on an unsecured senior subordinated basis by all ofour existing direct and indirect domestic subsidiaries other than Duane ReadeGP, which is a co-obligor under the Senior Notes. We may redeem the notes, inwhole or in part, at any time on or after August 1, 2008, at a redemption priceof 104.875% declining to par on August 1, 2010, plus accrued and unpaidinterest. In addition we can redeem up to 35% of the Senior Notes before August1, 2007 with the net cash proceeds from certain equity offerings. Upon theoccurrence of specified change of control events, we will be required to makean offer to repurchase all of the Senior Notes at 101% of the outstandingprincipal amount of the notes plus accrued and unpaid interest to the date ofrepurchase. The indenture governing the Senior Notes contains certainaffirmative and negative covenants that limit our ability to incur additionalindebtedness, pay dividends, make repayments on indebtedness that issubordinated to the Senior Notes and to make certain other restricted payments,incur certain liens, to use proceeds from sales of assets, enter into businesscombination transactions (including mergers, consolidations and asset sales),enter into transactions with affiliates and permit restrictions on the paymentof dividends by our subsidiaries. Under a registration rights agreement enteredinto as part of the offering of the Senior Notes, we are required to (i) file aregistration statement within 120 days after the completion of the Acquisition,(ii) use our reasonable best efforts to cause the registration statement tobecome effective within 180 days after the completion of the Acquisition and(iii) use our reasonable and best efforts to complete the exchange offer within210 days after the Acquisition is completed.

 

**LiquidityAssessment**

 

We believe that, based oncurrent levels of operations and anticipated growth, cash flow from operations,together with other available sources of funds, including the Oak Hill equitycontribution of approximately $240 million discussed above, revolving loanborrowings under our Amended Credit Agreement, our $155 million Senior TermLoan and the $195 million Senior Notes will be adequate for the payment of allof our obligations in connection with the Acquisition and for at least the nexttwo years to make required payments on our indebtedness, to fund anticipatedcapital expenditures and to satisfy our working capital requirements. We basethis belief on our recent levels of cash flow from operations of approximately$47.4 million and $42.5 million in fiscal 2003 and fiscal 2002, respectively,as well as our cash flow from operations of $20.0 million in the 26 weeks endedJune 26, 2004, and the significant additional borrowing capacity under ourAmended Credit Agreement which amounted to approximately $93.3 million upon thecompletion of the Acquisition. Our ability to meet our debt service obligationsand reduce our total debt will depend upon our future performance which, inturn, will be subject to general economic, financial, business, competitive,legislative, regulatory and other conditions, many of which are beyond ourcontrol. In addition, our operating results, cash flow and capital resourcesmay not be sufficient for repayment of our indebtedness in the future. Somerisks that could adversely affect our ability to meet our debt serviceobligations 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 Agreementbear interest at floating rates. Therefore, our financial condition will beaffected by changes in prevailing interest rates.

 

**CriticalAccounting Policies**

 

Ourdiscussion of results of operations and financial condition relies on ourconsolidated financial statements that are prepared based on certain criticalaccounting policies that require management to make judgments and estimatesthat are subject to varying degrees of uncertainty. We believe that investorsneed to be aware of these policies and how they impact our financial reportingto gain a more complete understanding of our consolidated financial statementsas a whole, as well as our related discussion and analysis presented herein.While we believe that these accounting policies are grounded on soundmeasurement criteria, actual future events can and often do result in outcomesthat can be materially different from these estimates or forecasts. Theaccounting policies and related risks described in our Annual Report on Form10-K/A for the year ended December 27, 2003

 

26

----

 

are those thatdepend most heavily on these judgments and estimates.  At June 26, 2004, there have been no materialchanges to any of the Critical Accounting Policies contained therein.

 

**Seasonality**

 

Ingeneral, sales of drugstore items such as prescription drugs, over-the-counterdrugs and health and beauty care products exhibit limited seasonality in theaggregate, but do vary by product category. Quarterly results are primarilyaffected by the timing of new store openings and the sale of seasonal products,with the Christmas holiday season generating a higher proportion of sales andearnings than other periods.

 

**Inflation**

 

Webelieve that inflation has not had a material impact on our results ofoperations during the three years ended December 27, 2003 or the 26 weeks endedJune 26, 2004.

 

**RecentlyIssued Accounting Pronouncements**

 

In December 2002, SFASNo. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure”was issued. This statement provides alternative methods of transition for avoluntary change to the fair value based method of accounting for stock-basedemployee compensation. We have not adopted such voluntary change to the fairvalue based method. In addition, this statement amends the disclosurerequirements of SFAS No. 123 to require prominent disclosures about the methodof accounting for stock-based compensation and the effect of the method used onreported results. As required, we adopted the disclosure-only provisions of FASNo. 148 effective in 2002.

 

**ITEM 3****.****MARKET RISK**

 

Ourfinancial results are subject to risk from interest rate fluctuations on debt,which carries variable interest rates. Variable rate debt outstanding under ourCredit Agreement was approximately $77.3 million at June 26, 2004. At June 26,2004, the weighted average combined interest rate in effect on all borrowingsunder the Credit Agreement was 3.12%. A 0.50% change in interest rates appliedto the $77.3 million balance of floating rate debt would affect pre-tax annualresults of operations by approximately $0.4 million. In addition, we also have$201.0 million of Convertible Notes outstanding at June 26, 2004. TheConvertible Notes bear interest payable semi-annually at a fixed rate of 3.75%,and are therefore not subject to risk from interest rate fluctuations.

 

Theprincipal objective of our investment management activities is to maintainacceptable levels of interest rate and liquidity risk to facilitate our fundingneeds. As part of our risk management, we may use derivative financial productssuch as interest rate hedges and interest rate swaps in the future.

 

**ITEM 4****.****CONTROLS AND 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.

 

27

----

 

**PART II**

 

**OTHERINFORMATION**

 

**ITEM 1.****  Legal Proceedings**

 

We are party to legalactions arising in the ordinary course of business. Based on informationpresently available to us, we believe that we have adequate legal defenses orinsurance coverage for these actions and that the ultimate outcome of theseactions will not have a materially adverse effect on the financial position,results of operations or cash flows of our company. In addition, we are a partyto the following legal actions and matters:

 

During 2002, we initiateda legal action against our former property insurance carrier, in an attempt torecover what we believe to be a fair and reasonable settlement for the businessinterruption portion of our claim originating from the September 11, 2001World Trade Center terrorist attack, during which our single highest volume andmost profitable store was completely destroyed. The claim is pending before theUnited States District Court for the Southern District of New York. InSeptember 2003, a trial on certain issues was held regarding some of thematters at issue in the litigation, including whether we would have obtained arenewal of our lease at the World Trade Center. We have received a favorableruling on this and other legal issues in the case and now the matter has movedinto an appraisal process. The appraisal process involves two appraisers and anumpire (to resolve differences between the two appraisers) who will determinethe amount of insured loss we have sustained. The insurance carrier hasappealed a number of rulings by the trial court. In light of both the earlystage of the appraisal process and the inherent uncertainty in litigationrelating to our appeal, the amount of additional insurance proceeds, if any,that we may collect under the terms of our insurance contract with thedefendant cannot be reasonable predicted or determined at this time, andtherefore, the Company has not accrued any additional income related to thispotential settlement. In fiscal 2002, we received an advance of approximately$9.4 million toward the business interruption claim that was recognized asa separate component of income in the consolidated statement of income. In theevent of an unfavorable outcome to us, this amount would not be required to bereturned to the insurance company.

 

Duane Reade Inc.,Anthony J. Cuti, our Chairman, President and Chief Executive Officer, John K.Henry, our Senior Vice President and Chief Financial Officer and GaryCharboneau, our Senior Vice President of Sales and Marketing have been 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 is in theUnited States District Court for the Southern District of New York, is onbehalf of shareholders who purchased our common stock between April 1,2002 and July 24, 2002, inclusive. The complaint, which seeks anunspecified amount of damages, alleges 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 havefiled an appeal. We continue to believe that the plaintiffs’ actions arecompletely baseless and wholly without merit, and intend to continue tovigorously defend ourselves.

 

We are a defendant in aclass action suit in the Federal Court for the Southern District of New Yorkregarding alleged violations of the Fair Labor Standards Act as to a group ofindividuals who provided delivery services on a contract basis to us. InDecember 2002, the judge in the action issued a partial summary judgmentin 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. The amount of attorney’s fees owed to the plaintiffs’attorneys remains an open issue in the case and we plan to vigorously defendclaims by these attorneys for fees. It is not anticipated that the amount ofattorneys’ fees that would be required to be paid in this matter would bematerial to our business and operations.

 

We are a party to relatedlawsuits, 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 we did not make certainrequired contributions to these funds from January 2000 through August 2001.The plaintiffs have recently filed a motion seeking summary judgment of $2.29million of claims for alleged underfunding, including related penalties andinterest. In addition, at various times, the plaintiffs have stated that theybelieve we may owe additional amounts. However, any additional amounts that theplaintiffs may claim are not known at this time. We have filed a motionopposing these claims. We believe that we have made sufficient contributions tothese funds and that we have meritorious defenses to the claims being made bythese funds. Accordingly, we intend to vigorously defend ourselves

 

28

----

 

inthese matters. At this time, it is not possible to determine the ultimateoutcome of this case or the actual amount of liability we may face, if any.

 

We are a party to aNational Labor Relations Board (“NLRB”) administrative proceeding regarding adispute with the Allied Trade Council (“ATC”) over whether a negotiatingimpasse was reached between us and the union in August of 2001. The ATCrepresents employees in 139 of our stores in a collective bargaining agreementthat expired on August 31, 2001. Our employees have been working pursuantto the terms of our December 6, 2001 implemented contract with the ATC,which expires on August 31, 2004. We believe an impasse did in fact occurand as a result, we had the right to implement our latest contract proposal atthat time which included wage increases, health and welfare benefits, vacationand sick benefits and a 401k retirement program. We discontinued makingadditional payments into the various funds associated with the union as we wereproviding many of these benefits on a direct basis and because our past contributionsto these funds had caused these funds to be in a position of excessiveoverfunding. In addition, we had concerns that our past payments into thesefunds were not being managed in a way to ensure they were being properlyutilized for the benefit of our 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 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. If this recommendationis adopted by the full NLRB and enforced by the circuit court of appeals, itcould result in our being required to contribute amounts that have yet to bedetermined into the union’s pension benefit, health and welfare and vacationfunds. Any potential required contributions resulting from a final judicialdetermination of this matter would potentially be subject to offset by theamounts that we had funded since we implemented our final contract proposal forthese same benefits that were paid for our ATC employees. Because this is justthe first phase of a long and complicated administrative process likely to befollowed by a full judicial review of all of the facts and circumstances, thefinal outcome cannot be reliably determined at this time. The ALJ’srecommendation is not a binding order and has no force and effect of law.Rather, it is a recommendation to the full NLRB in Washington D.C., which willconduct a complete review at some point in the future and decide to uphold,reject or modify the recommendation. The full NLRB decision is also subject 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 ALJ’srecommendation.

 

In light of theforegoing, while it is our belief that the final financial outcome of thislitigation 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 March27, 2004 and June 26, 2004. These charges represent our current best estimateof the loss that would result upon application of the ALJ’s recommendation. Wenote that such charges were based upon the facts available to us at the time.In our opinion, such charges could be subject to significant modification inthe future, upon review by the full NLRB, the Federal Circuit Court of Appeals,completion of a compliance hearing and any appeals relating to the outcome ofthat hearing. These charges reflect the amount of contributions that we did notmake into the union benefit funds for the period from the August 31, 2001expiration of the contract through June 26, 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 June 26, 2004. While this representsour current best estimate of the ALJ’s recommendation, we believe that theactual range of loss in this matter could be from $0, if the ALJ’srecommendation is not followed, to approximately $29 million, if the ALJ’srecommendation is upheld and there is no offset for any benefits paid over thisperiod.

 

Until such time asfurther legal developments warrant a change in the application of thisaccounting 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 in 2004 will approximate $4.4million.

 

We are involved in anongoing dispute with Cardinal Health, one of our former suppliers ofpharmaceutical products. Both parties have claims against the other involving,among other things, breach of contract, promissory estoppel and unjustenrichment. Duane Reade is seeking from Cardinal an unspecified amount ofdamages and punitive damages of at least $20 million. Cardinal is seekingapproximately $18 million in damages plus attorney’s fees and interest. Whilethere can be no definitive assurance, we believe we have counterclaims thatoffset the claims against us by Cardinal, as well as meritorious defenses tothese 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 2004.

 

29

----

 

A New York State TaxAppeals Tribunal ruling in a matter involving another company may have anadverse impact upon our New York State Franchise Tax filings from years 1999through 2002. This matter relates to the required combination of affiliatedsubsidiaries in recognizing royalty fee and related income for intangibleproperty. The ruling of the Tribunal is subject to further legal appeal andinterpretation in light of our own specific facts and circumstances. Theoutcome 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 sixpurported class action complaints challenging the merger transactionconsummated by us and Duane Reade Acquisition that have been filed in the Courtof Chancery of the State of Delaware, referred to as the “Delaware Complaints,”and three purported class action complaints that have been filed in the SupremeCourt of the State of New York. Two of the New York complaints have beendismissed without prejudice. The other New York complaint (the “New YorkComplaint”) is pending, but has not been served on Duane Reade. The DelawareComplaints name Mr. Cuti and certain other members of our board ofdirectors and executive officers as well as Duane Reade Inc. as defendants.Four of the Delaware Complaints name Oak Hill as a defendant. The New YorkComplaint names Mr. Cuti and certain other members of our board ofdirectors and executive officers as well as Duane Reade Inc. as defendants. Oneof the dismissed New York complaints named Oak Hill as a defendant.

 

The Delaware Complaintswere consolidated on January 28, 2004, and on April 8, 2004 the plaintiffsin the Delaware actions filed a consolidated class action complaint (the“Consolidated Complaint”).

 

The ConsolidatedComplaint alleges that defendants failed to disclose material information inthe preliminary proxy statement, which was filed with the SEC on March 19,2004.  Specifically, the ConsolidatedComplaint alleges that the defendants failed to disclose: (1) the precisenature of the “Current Employment Agreement Estimated Payments,” as that termis used in the preliminary proxy, and the reasons for these payments; (2) thematerials and data purportedly used by Bear Stearns in calculating the “CurrentEmployment Agreement Estimated Payments,” instead of the disclosure in thepreliminary proxy statement that these calculations were “approximations basedon various assumptions since the precise amounts payable would require actuarialor other expert valuation,” even though Bear Stearns allegedly relied on thesecalculations; (3) the methodology, projections and other information used byBear Stearns to calculate the estimated present value of the company; and (4)that the merger consideration represented an approximately 11.7% premium basedupon the trading price of Duane Reade shares on December 22, 2003, instead ofthe disclosure in the preliminary proxy that shareholders would be receiving amuch higher premium of 22.0%.  The ConsolidatedComplaint and the New York Complaint allege, among other things, that thedefendants purportedly breached duties owed to Duane Reade’s stockholders inconnection with the transaction by failing to: (a) appropriately valueDuane Reade as a merger candidate; (b) expose Duane Reade to themarketplace in an effort to obtain the best transaction reasonably available,including to market Duane Reade to industry participants; and(c) adequately ensure that no conflicts of interest exist betweendefendants’ own interests and their fiduciary obligation to maximizestockholder value.  Plaintiffs seek,among other things: an order that the complaints are properly maintainable as aclass action; a declaration that defendants have breached their fiduciaryduties and other duties; injunctive relief; an unspecified amount of monetarydamages; attorneys’ fees, costs and expenses; and such other and further reliefas the court may deem just and proper. We believe these lawsuits are without merit and plan to defend theselawsuits vigorously.

 

**ITEM 2.****  Changes in Securities and Useof Proceeds**

 

Notapplicable

 

**ITEM 3.****  Defaults UponSenior Securities**

 

Notapplicable

 

30

----

 

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

 

On July 26, 2004,the Company held a special meeting of stockholders to consider the mergeragreement. At that meeting, a total of 17,706,765 shares were voted in personand by proxy, representing 72.2% of the total number of eligible voting shares.Of this amount, 15,436,702 shares were voted in favor of adopting the mergeragreement, 2,267,843 shares were voted in opposition to the adoption of themerger agreement and 2,220 shares abstained from voting.  As a result of the stockholders’ approval ofthe merger agreement and the satisfaction of all other conditions to themerger, the merger and related financings were consummated on July 30, 2004.

 

**ITEM 5.****  Other Information**

 

Notapplicable

 

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

 

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

 

(i)            Financial Statements

 

(ii)           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 the Company (incorporated by reference to  Exhibit 3.1(i) to the Company’s Registration Statement No. 333-41239 (the  “Common Stock S-1”)).                                                                                                                         |
| 3.1(ii)          |       | Certificate of  Amendment of Amended and Restated Certificate of Incorporation (incorporated  by reference to Exhibit 3.1 to Amendment No. 1 to the Company’s Registration  Statement on Form S-3 dated July 22, 2001).                                                                                                             |
| 3.1(iii)         |       | Amended and Restated  Bylaws of the Company (incorporated by reference to Exhibit 3.1(ii) to the  Common Stock S-1).                                                                                                                                                                                                                     |
| 3.2(i)           |       | Certificate of  Incorporation of DRI I Inc. (incorporated by reference to Exhibit 3.2(i) to  the S-1 Registration Statement No. 333-43313 with respect to the Company’s 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              |       | Second Amended and  Restated Partnership Agreement of Duane Reade (incorporated by reference to  Exhibit 3.3 of the Notes S-1).                                                                                                                                                                                                          |
| 3.4(i)           |       | Certificate of  Incorporation of Duane Reade International, Inc. (incorporated by reference  to Exhibit 3.4(i) to the Company’s Annual Report on Form 10- K for the year  ended December 25, 1999 (the “1999 10-K”)).                                                                                                     |
| 3.4(ii)          |       | By-laws of Duane Reade  International, Inc. (incorporated by reference to Exhibit 3.4(ii) to the 1999  10-K).                                                                                                                                                                                                                            |
| 3.5(i)           |       | Certificate of  Incorporation of Duane Reade Realty, Inc. (incorporated by reference to  Exhibit 3.5(i) to the 1999 10-K).                                                                                                                                                                                                               |
| 3.5(ii)          |       | By-laws of Duane Reade  Realty, Inc. (incorporated by reference to Exhibit 3.5(ii) to the 1999 10-K).                                                                                                                                                                                                                                    |
| 4.1              |       | Form of Indenture  (incorporated by reference to Exhibit 4.1 of the Notes S-1).                                                                                                                                                                                                                                                          |
| 4.2              |       | Second Supplemental  Indenture, dated as of May 20, 2002, between Duane Reade Inc., the Subsidiary  Guarantors, and State Street Bank, as trustee (incorporated by reference to  the Company’s Quarterly Report on Form 10-Q for                                                                                                    |

 

31

----

 
|   |   | the  period ended September 28, 2002).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 4.3    |   | Indenture, dated as of  April 16, 2002, between Duane Reade Inc., as issuer, the guarantors named  therein and State Street Bank and Trust Company, as trustee (incorporated by  reference to Exhibit 4.2 to the Company’s Registration Statement on Form S-3  dated June 21, 2002 (the “Convertible Notes S-3”)).                                                                                                                                                                                                                                                                                                                      |
| 4.4    |   | Form of Senior  Convertible Notes due 2022 (incorporated by reference to Exhibit 4.2 to the  Convertible Notes S-3).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 10.1   |   | Duane Reade Inc. 1997  Equity Participation Plan (incorporated by reference to Exhibit 10.1 to  the Common Stock S-1).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.2   |   | Duane Reade Inc.  Holding Corp. 1992 Stock Incentive Plan (incorporated by reference to Exhibit  10.2 to the Common Stock S-1).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.3   |   | Employment Agreement,  dated as of February 22, 1993, as amended, between the Company and Gary  Charboneau (incorporated by reference to Exhibit 10.4 to the Common Stock  S-1).                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.4   |   | Employment Agreement,  dated as of April 10, 1995, as amended, between Duane Reade and Jerry M. Ray  (incorporated by reference to Exhibit 10.5 to the Common Stock S-1).                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.5   |   | Employment Letter  Agreement, dated as of October 9, 1996, between Duane Reade and Joseph Lacko  (incorporated by reference to Exhibit 10.6 to the Common Stock S-1).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.6   |   | Agreement, dated as of  November 22, 1996, as amended, between Duane Reade and Drug, Chemical,  Cosmetic, Plastics and Affiliated Industries Warehouse Employees Local 815  (incorporated by reference to Exhibit 10.8 to the Common Stock S-1).                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.7   |   | Agreement, dated  December 6, 2001, between Duane Reade and Allied Trades Council  (incorporated by reference to Exhibit 10.8 to the Company’s Annual Report on  Form 10-K for the year ended December 29, 2001 (the “2001 10-K”)).                                                                                                                                                                                                                                                                                                                                                                                                |
| 10.8   |   | Employment Letter,  dated June 10, 1999, between the Company and John K. Henry (incorporated by  reference to Exhibit 10.18 to the 1999 10-K).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.9   |   | 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).                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.10  |   | First Amendment to  Stockholders and Registration Rights Agreement, dated as of January 16, 2002,  by and among Duane Reade Inc. and the stockholders party thereto (incorporated by reference to Exhibit 4.9  to the Convertible Notes S-3).                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.11  |   | 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).                                                                                                                                                                                                                                                                                                                                                   |
| 10.12  |   | Amended and Restated  Employment Agreement, dated August 12, 2002, between the Company and Anthony  J. Cuti (incorporated by reference to the Company’s Quarterly Report on Form  10-Q for the period ended June 29, 2002).                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.13  |   | Shareholder Rights  Agreement, dated as of September 12, 2002, between the Company and EquiServe  Trust Company, N.A., as Rights Agent (incorporated by reference to Exhibit  4.1 to the Company’s Current Report on Form 8-K, dated September 12, 2002).                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.14  |   | Third Amendment to the  1997 Equity Participation Plan, dated May 8, 2003 (incorporated by  reference to the Company’s Quarterly Report on Form 10-Q for the period  ended June 28, 2003).                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.15  |   | Employment Letter,  dated June 24, 2003, between the Company and Timothy R. LaBeau  (incorporated by reference to the Company’s Quarterly Report on  Form 10-Q for the period ended June 28, 2003).                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.16  |   | 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). |
| 10.17  |   | 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).                                                                                                                                                                                                                                                                                                                                                                    |
| 10.18  |   | 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).                                                                                                                                                                                                                                                                                                                                            |
| 10.19  |   | 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).                                                                                                                                                                                                                                                                                                                                                                   |
| 10.20  |   | 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                                                                                                                                                                                                                                                                                                                                                                                                  |

 

32

----

 
|   |   | for  the period ended June 28, 2003).                                                                                                                                                                                                                                                                                              |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.21  |   | Amendment No. 1 to  Shareholder Rights Agreement, dated as of December 19, 2003, between the  Company and EquiServe Trust Company, N.A., as Rights Agent Council  (incorporated by reference to Exhibit 10.21 to the Company’s Annual Report on  Form 10-K for the year ended December 27, 2003 (the “2003 10-K”)). |
| 14.1   |   | Code of Business  Conduct and Ethics (incorporated by reference to Exhibit 14.1 to the 2003  10-K).                                                                                                                                                                                                                                     |
| 21.1   |   | Subsidiaries of the  Company (incorporated by reference to Exhibit 21.1 to the 1999 10-K).                                                                                                                                                                                                                                         |
| 23.1   |   | Consent of Independent  Accountants (incorporated by reference to Exhibit 23.1 to the 2003 10-K).                                                                                                                                                                                                                                       |
| 23.2   |   | Consent of Independent  Accountants (incorporated by reference to Exhibit 23.2 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”).                                                                                                                                                                                                                              |
| 32.0 * |   | Sarbanes-Oxley Section  906 Certifications of the Company’s CEO and CFO.                                                                                                                                                                                                                                                           |

 

----

*  filed herewith

 

(b)                                 Reportson Form 8-K:

 

On June 14, 2004, the Company filed a Current Reporton Form 8-K which contained, as an exhibit, a press release providinginformation with respect to the First and Second Amendments to the Agreementand Plan of Merger (the “Merger Agreement”), in connection with the proposedacquisition of the Company by affiliates of Oak Hill Capital Partners L.P.(“Oak Hill”).

 

On June 21, 2004, the Company filed a Current Reporton Form 8-K which contained, as an exhibit, a press release providinginformation with respect to the Third Amendment to the Merger Agreement, inconnection with the proposed acquisition of the Company by affiliates of OakHill.

 

On June 30, 2004, the Company filed a Current Reporton Form 8-K which contained, as an exhibit, a press release providinginformation with respect to the filing of the Company’s definitive proxystatement in connection with the proposed acquisition of the Company byaffiliates of Oak Hill.

 

On July 9, 2004, the Company filed a Current Report onForm 8-K which contained relevant financial information not previously publiclyreleased, such information having been provided to various lenders that sameday in connection with the proposed acquisition of the Company by affiliates ofOak Hill.

 

On July 19, 2004, the Company filed a Current Reporton Form 8-K which contained, as an exhibit, a press release providinginformation with respect to the Company’s actual (unaudited) financial resultsfor the 13 and 26 weeks ended June 26, 2004 and the Company’s projectedfinancial results for the remainder of the 2004 fiscal year.

 

On July 26, 2004, the Company filed a Current Reporton Form 8-K which contained, as an exhibit, a press release providinginformation with respect to the completion of an amendment to the Company’sCredit Agreement and the pricing of the Company’s Senior Subordinated Notes.

 

On July 27, 2004, the Company filed a Current Reporton Form 8-K which contained, as an exhibit, a press release providinginformation with respect to the successful stockholder vote in connection withthe proposed acquisition of the Company by affiliates of Oak Hill.

 

On August 2, 2004, the Company filed a Current Reporton Form 8-K which contained, as an exhibit, a press release providinginformation with respect to the consummation of the Company’s acquisition byaffiliates of Oak Hill.

 

(c)                                  FinancialStatement Schedules:         None

 

Schedules for which provision is made in theapplicable accounting regulations of the Commission are either not requiredunder the related instructions, are inapplicable or not material, or the informationcalled for thereby is otherwise included in the financial statements andtherefore has been omitted.

 

33

----

 

**SIGNATURES**

 

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

 

 
| Dated:     | August 5, 2004 |                  |              |                                       |
|------------|----------------|-----------------------|-------------------|--------------------------------------------|
|       |           |                  |              |                                       |
| ** ** | ** **     | **DUANE READE, Inc.** |
|       |           | (Registrant)          |
|       |           |                  |              |                                       |
|       |           | By:                   | /s/ John K. Henry |                                       |
|       |           |                  | Name:             | John K. Henry                              |
|       |           |                  | Title:            | Senior Vice President  and Chief Financial |
|       |           |                  |              | Officer                                    |
|            |                |                       |                   |                                            |  |  |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant in thecapacities indicated on August 5, 2004.

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

 

34

----

 

**SIGNATURES**

 

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

 
| Dated:     | August 5, 2004 |           |              |                                       |
|------------|----------------|----------------|-------------------|--------------------------------------------|
|       |           |           |              |                                       |
| ** ** | ** **     | **DRI I Inc.** |
|       |           |           |              |                                       |
|       |           | By:            | /s/ John K. Henry |                                       |
|       |           |           | Name:             | John K. Henry                              |
|       |           |           | Title:            | Senior Vice President  and Chief Financial |
|       |           |           |              | Officer                                    |
|            |                |                |                   |                                            |  |  |  |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed on August 5, 2004 by:

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

 

35

----

 

**SIGNATURES**

 

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

 
| Dated: | August 5, 2004                                      |            |                                                |
|--------|-----------------------------------------------------|-----------------|-----------------------------------------------------|
|   |                                                |            |                                                |
|   |                                                | **DUANE READE** |
|   |                                                |            |                                                |
| By:    | DRI I Inc., a general  partner                      | By:             | Duane Reade Inc**.**, a general partner             |
|   |                                                |
|   |                                                |
| By:    | /s/ John K. Henry                                   |            | By:                                                 | /s/ John K. Henry |   |
| Name:  | John K. Henry                                       | Name:           | John K. Henry                                       |
| Title: | Senior Vice President  and Chief Financial  Officer | Title:          | Senior Vice President  and Chief Financial  Officer |
|        |                                                     |                 |                                                     |  |  |  |  |  |

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, this report has been signed below on August 5, 2004 bythe following persons in the capacities indicated with respect to Duane ReadeInc. and DRI I Inc., the general partners of Duane Reade, on behalf of DuaneReade (except as otherwise indicated):

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

 

36

----

 

**SIGNATURES**

 

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

 
| Dated:     | August 5, 2004 |                         |              |                                       |
|------------|----------------|------------------------------|-------------------|--------------------------------------------|
|       |           |                         |              |                                       |
| ** ** | ** **     | **DUANE READE REALTY, Inc.** |
|       |           |                         |              |                                       |
|       |           | By:                          | /s/ John K. Henry |                                       |
|       |           |                         | Name:             | John K. Henry                              |
|       |           |                         | Title:            | Senior Vice President  and Chief Financial |
|       |           |                         |              | Officer                                    |
|            |                |                              |                   |                                            |  |  |  |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed on August 5, 2004 by:

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

 

37

----

 

**SIGNATURES**

 

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

 
| Dated:     | August 5, 2004 |                                |              |                                       |
|------------|----------------|-------------------------------------|-------------------|--------------------------------------------|
|       |           |                                |              |                                       |
| ** ** | ** **     | **DUANE READE INTERNATIONAL, Inc.** |
|       |           |                                |              |                                       |
|       |           | By:                                 | /s/ John K. Henry |                                       |
|       |           |                                | Name:             | John K. Henry                              |
|       |           |                                | Title:            | Senior Vice President  and Chief Financial |
|       |           |                                |              | Officer                                    |
|            |                |                                     |                   |                                            |  |  |  |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed on August 5, 2004 by:

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

 

38

----