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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-K



(Mark One)



|x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ------------------------------------------------------------------------------------



For the fiscal year ended January 26, 2006



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------



For the transition period from
 to



Commission file number 1-8978



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LONGS DRUG STORES CORPORATION

(Exact name of registrant as specified in its charter)



|                                                              |  |                                    
|------------------------------------------------------------- |  | -----------------------------------
|Maryland                                                      |  | 68-0048627                         
|(State or other jurisdictionof incorporation or organization) |  | (I.R.S. EmployerIdentification No.)



|                                              |  |           
|--------------------------------------------- |  | ----------
|141 North Civic DriveWalnut Creek, California |  | 94596     
|(Address of principal executive offices)      |  | (Zip Code)



Registrants
telephone number, including area code: (925) 937-1170



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Securities registered pursuant to Section 12(b) of the Act:



|                    |  |                                          
|------------------- |  | -----------------------------------------
|Title of Each Class |  | Name of Each Exchange on which Registered
|Common stock        |  | New York Stock Exchange                  



Securities
registered pursuant to Section 12(g) of the Act: None



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Indicate by check mark whether the registrant is a well-known seasoned
issuer, as defined in Rule 405 of the Securities Act.    Yes  x    No ̈



Indicate by check mark
whether the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes ̈No  x



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



Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to
this Form 10-K.    x



Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2
of the Exchange Act. (Check one):



Large accelerated
filer    x                Accelerated file ̈Non-accelerated filer ̈



Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2). Yes ̈No  x



The aggregate market value of the registrants common stock held by non-affiliates of the registrant was approximately $1,599,571,000 as of July 28, 2005, based on the closing price of the registrants
common stock on the New York Stock Exchange. For purposes of this calculation, only executive officers and directors are deemed to be the affiliates of the registrant.



There were 37,273,086 shares of common stock outstanding as of February 23, 2006.



DOCUMENTS INCORPORATED BY REFERENCE



The information required by Part III of this Annual Report on Form 10-K, to
the extent not set forth herein, is incorporated by reference from specified portions of our definitive Proxy Statement for our 2006 Annual Meeting of Stockholders.



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CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS



This annual report contains certain forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Such statements relate to, among other things, our strategic initiatives; supply chain upgrades, including the construction of a
new distribution center; Medicare prescription drug benefits; development of our pharmacy benefit services segment; merchandise and marketing efforts; operational improvements; safety improvements and workers compensation claims and costs; the
number of store openings, closures and remodels; revenues; gross profits; operating and administrative expenses; depreciation and amortization; liquidity and cash requirements; the level of capital expenditures; share repurchases; dividends;
contractual obligations; the effect of new accounting pronouncements; our goals for self-distribution of our front-end merchandise; and factors affecting front-end sales in fiscal 2007 and are indicated by words or phrases such as
continuing, expects, estimates, believes, plans, anticipates, will and other similar words or phrases.



These forward-looking statements are based on our current plans and expectations and involve risks and uncertainties that
could cause actual events and results to vary materially from those included in or contemplated by forward-looking statements we make. These risks and uncertainties include, but are not limited to, those set forth below:



| |  |  | Our ability to execute our previously announced initiatives and the associated organizational changes;
| | - |  | ------------------------------------------------------------------------------------------------------

| |  |  | Our ability to successfully complete the construction of and transition to a new front-end distribution center;
| | - |  | ---------------------------------------------------------------------------------------------------------------

| |  |  | Our ability to increase self-distribution and improve our purchasing of front-end and pharmacy merchandise;
| | - |  | -----------------------------------------------------------------------------------------------------------

| |  |  | Our ability to successfully implement new technology, including a perpetual inventory system;
| | - |  | ---------------------------------------------------------------------------------------------

| |  |  | Disruption in our supply chain due to system conversions;
| | - |  | ---------------------------------------------------------

| |  |  | The success of our merchandise and marketing strategies;
| | - |  | --------------------------------------------------------

| |  |  | Consumer reaction to our remodeled stores;
| | - |  | ------------------------------------------

| |  |  | The effect of the new Medicare prescription drug benefit on our retail drug store and pharmacy benefit services revenues and profitability;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | Our ability to develop and integrate our pharmacy, mail order and pharmacy benefit services capabilities to take advantage of future growth opportunities;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | The frequency and rate of introduction of successful new prescription drugs;
| | - |  | ----------------------------------------------------------------------------

| |  |  | The introduction of lower priced generic drugs;
| | - |  | -----------------------------------------------

| |  |  | The efforts of third-party health plans, including government-sponsored plans, to reduce prescription drug costs;
| | - |  | -----------------------------------------------------------------------------------------------------------------

| |  |  | Changes in economic conditions, including economic growth and unemployment levels, and in consumer preferences and spending patterns;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------

| |  |  | The impact of rising gasoline prices on economic conditions and consumer spending;
| | - |  | ----------------------------------------------------------------------------------

| |  |  | The effects of war and terrorism on economic conditions and consumer spending;
| | - |  | ------------------------------------------------------------------------------

| |  |  | The impact of state and federal budget deficits on government healthcare spending and on general economic conditions;
| | - |  | ---------------------------------------------------------------------------------------------------------------------

| |  |  | Competition from other drugstore chains, supermarkets, mass merchandisers, discount retailers, on-line retailers, other retailers, pharmacy benefit management companies and
prescription drug plan providers;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | The growth of mail order pharmacies, and changes in some third-party health plans requiring mail order fulfillment of certain medications;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | Continued good relationships with our employees;
| | - |  | ------------------------------------------------

| |  |  | Labor unrest in the same or competitive industries;
| | - |  | ---------------------------------------------------

| |  |  | Interest rate fluctuations and changes in capital market conditions or other events affecting our ability to obtain necessary financing on favorable terms;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | Our relationships with our suppliers;
| | - |  | -------------------------------------

| |  |  | Our ability to hire and retain pharmacists and other store and management personnel;
| | - |  | ------------------------------------------------------------------------------------

| |  |  | The availability and cost of real estate for new stores;
| | - |  | --------------------------------------------------------

| |  |  | The impact of pending or future litigation;
| | - |  | -------------------------------------------

| |  |  | The effectiveness of workers compensation reform efforts, especially in California, and the effect of potential further changes to Californias workers compensation
laws;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | Changes in state or federal legislation or regulations affecting our businesses;
| | - |  | --------------------------------------------------------------------------------

| |  |  | Changes to accounting policies and practices or internal controls; and
| | - |  | ----------------------------------------------------------------------

| |  |  | Other factors discussed in this report under Risk Factors and elsewhere or in any of our other SEC filings.
| | - |  | -------------------------------------------------------------------------------------------------------------



In addition, because we do not have a perpetual inventory system, our ability
to accurately forecast and track our retail drug store gross profit and inventory levels during periods between our quarterly physical inventories is limited. Therefore, our actual retail drug store gross profit and inventory levels may vary
materially from those included in or contemplated by forward-looking statements we make.



We assume no obligation to update our forward-looking statements to reflect subsequent events or circumstances.



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TABLE OF CONTENTS



|           |  |                                                                                                                      |  |     
|---------- |  | -------------------------------------------------------------------------------------------------------------------- |  | ----
|           |  |                                                                                                                      |  | Page
|PART I     |  |                                                                                                                      |  |     
|Item 1     |  | Business                                                                                                             |  | 1   
|Item 1A    |  | Risk Factors                                                                                                         |  | 6   
|Item 1B    |  | Unresolved Staff Comments                                                                                            |  | 8   
|Item 2     |  | Properties                                                                                                           |  | 9   
|Item 3     |  | Legal Proceedings                                                                                                    |  | 10  
|Item 4     |  | Submission of Matters to a Vote of Security Holders                                                                  |  | 10  
|           |  |                                                                                                                     
|PART II    |  |                                                                                                                      |  |     
|Item 5     |  | Market for the Registrants Common Equity, Related Stockholder Matters and Issuer     Purchases of Equity Securities |  | 11  
|Item 6     |  | Selected Financial Data                                                                                              |  | 12  
|Item 7     |  | Managements Discussion and Analysis of Financial Condition and Results of    Operations                             |  | 14  
|Item 7A    |  | Quantitative and Qualitative Disclosures of Market Risk                                                              |  | 29  
|Item 8     |  | Financial Statements and Supplementary Data                                                                          |  | 30  
|           |  | Report of Independent Registered Public Accounting Firm                                                              |  | 53  
|Item 9     |  | Changes in and Disagreements with Accountants on Accounting and Financial     Disclosure                             |  | 55  
|Item 9A    |  | Controls and Procedures                                                                                              |  | 55  
|           |  | Managements Report on Internal Controls Over Financial Reporting                                                    |  | 55  
|Item 9B    |  | Other Information                                                                                                    |  | 55  
|           |  |                                                                                                                     
|PART III   |  |                                                                                                                      |  |     
|Item 10    |  | Directors and Executive Officers of the Registrant                                                                   |  | 56  
|Item 11    |  | Executive Compensation                                                                                               |  | 56  
|Item 12    |  | Security Ownership of Certain Beneficial Owners and Management and Related     Stockholder Matters                   |  | 56  
|Item 13    |  | Certain Relationships and Related Transactions                                                                       |  | 56  
|Item 14    |  | Principal Accountant Fees and Services                                                                               |  | 56  
|           |  |                                                                                                                     
|PART IV    |  |                                                                                                                      |  |     
|Item 15    |  | Exhibits, Financial Statement Schedules, and Reports on Form 8-K                                                     |  | 57  
|Signatures |  | 61                                                                                                                  



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PART I



Item 1.Business



Overview



Longs Drug Stores Corporation was
founded in 1938 in Oakland, California by two brothers, Tom and Joe Long. Today, we operate in two business segments: retail drug stores and, through our RxAmerica subsidiary, pharmacy benefit services. For financial information about these
segments, see Note 11, Segment Information in the accompanying notes to our consolidated financial statements. We operate on a 52/53-week fiscal year ending on the last Thursday in January. Our 2006 fiscal year contained 52 weeks of
operations and ended on January 26, 2006.



Through our
retail drug store segment, we are one of the most recognized retail drug store chains on the West Coast of the United States and in Hawaii, with 476 stores in California, Hawaii, Nevada, Washington, Colorado and Oregon as of January 26, 2006.
Our retail drug stores have a long history of serving the health and well-being needs of customers through customer-oriented pharmacy services and convenient product offerings that focus on health and wellness, beauty and convenience. Our retail
drug store segment also operates a mail order pharmacy business.



Our pharmacy benefit services segment provides a range of services related to pharmacy benefit management, including plan design and implementation, claims administration, formulary management and mail order pharmacy fulfillment to
third-party health plans and other organizations. In addition, effective January 1, 2006, our pharmacy benefit services segment also offers three prescription drug plans that provide prescription drug benefits to Medicare participants in 20
regions encompassing 35 states and the District of Columbia under the Medicare Prescription Drug, Improvement and Modernization Act of 2003.



Our corporate offices are located at 141 North Civic Drive, Walnut Creek, California 94596, telephone (925) 937-1170. Our common stock is listed on
the New York Stock Exchange (NYSE) under the stock symbol LDG. General information, financial news releases and filings with the Securities and Exchange Commission, including annual reports on Form 10-K, quarterly reports on
Form 10-Q, current reports on Form 8-K, and all amendments to these reports are available free of charge on our website at www.longs.com as soon as reasonably practicable after we file them with the Securities and Exchange Commission. We have
submitted our 2005 annual Section 12(a) CEO certification with the NYSE. The certification was not qualified in any respect. Additionally, we filed with the Securities and Exchange Commission as exhibits to our Form 10-K for the year ended
January 27, 2005 the CEO and CFO certifications required under Section 302 of the Sarbanes-Oxley Act of 2002.



Initiatives



More than three years ago, we began working on five broad categories of strategic initiatives designed to make Longs a stronger competitor and more
profitable company:



| |  |  | Supply ChainThe upgrade of our supply chain systems and processes has included centralization of our merchandise procurement and replenishment,
increased self-distribution, and the implementation of new technology, including a new distribution management system in our front-end California distribution centers, a new retail merchandise system in all of our stores, and new procurement and
allocation systems that are more integrated with our distribution management and retail merchandise systems. We plan to begin installing a new system for store ordering, receiving and inventory management in fiscal 2007. We are also constructing a
new front-end distribution center in Patterson, California, scheduled for completion in the summer of fiscal 2007, which will allow us to further increase our self-distribution. Once completed, we ultimately expect these changes to yield benefits in
the form of lower cost of sales and expenses related to procurement and distribution, improved
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| | merchandise replenishment, and increased real-time visibility into our in-stock position, merchandise mix, product movement and gross profit for our retail
drug store segment.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Front-end salesWe have implemented new merchandise and marketing strategies that include enhanced and expanded assortments in our core categories focusing on health,
wellness, beauty and convenience in an effort to emphasize our competitive differentiation. In addition, we have strengthened our everyday and promotional price competitiveness. We also have a remodeling program to upgrade and update existing stores
with a format that emphasizes our merchandise strategies. We continue to make progress on the development of our private brand merchandise and improving our inventory management and in-stock positions.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Pharmacy profitabilityWe operate in an environment of significant structural changes in the pharmacy industry, including new Medicare prescription drug benefits,
declining third-party reimbursement levels, drug re-importation, and mandatory mail-order fulfillment of prescriptions by certain health plans. In this environment, we are making efforts to improve our pharmacy procurement, inventory management,
in-stock position and workflow efficiencies in an effort to lower our cost per prescription. Increased generic utilization, upgraded pharmacy technology and expanded mail order and central fill capabilities have also contributed to improvements in
our pharmacy profitability.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Customer serviceIn order to maintain and improve our reputation for excellent customer service, we have developed customer service standards and are measuring our
performance on service attributes important to our customers.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Operational processesWe are developing new and more efficient operational processes to help us reduce expenses and increase our focus on superior customer service.
These improvements include more efficient workflow processes, better labor scheduling, improved safety practices and increased utilization of technology.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Products and Services



The following table summarizes our product and service types, as a percentage of our total consolidated revenues:



|                                     |  |             |   |  |       |   |  |       |  
|------------------------------------ |  | ----------- | - |  | ----- | - |  | ----- | -
|                                     |  | Fiscal Year |  
|                                     |  | 2006        |   |  | 2005  |   |  | 2004  |  
|Pharmacy sales                       |  | 48.1        | % |  | 47.1  | % |  | 46.0  | %
|Front-end sales                      |  | 50.8        | % |  | 52.2  | % |  | 53.4  | %
|Pharmacy benefit management revenues |  | 0.8         | % |  | 0.7   | % |  | 0.6   | %
|Prescription drug plan revenues      |  | 0.3         | % |  | N/A   |   |  | N/A   |  
|                                     |  |             |   |  |       |   |  |       |  
|Total consolidated revenues          |  | 100.0       | % |  | 100.0 | % |  | 100.0 | %
|                                     |  |             |   |  |       |   |  |       |  



Our retail drug stores
sell prescription drugs and a wide assortment of nationally advertised brand name and private label general merchandise, which we refer to as front-end products. Our core front-end categories include over-the-counter medications, health
and beauty products, cosmetics, photo and photo processing, convenience food and beverage items and greeting cards. In addition, we sell merchandise in non-core front-end categories such as housewares, automotive and sporting goods. Our private
label offerings include over-the-counter, health and beauty, photo and other merchandise offered under various proprietary names, including Longs, Bayside Basics, Pacific Living, Walnut Grove,
Holiday Place, and others. To enhance customer service and build customer loyalty, we seek to consistently maintain in-stock positions in all of our merchandise categories. We will continue to develop our mix of front-end merchandise in
our stores in response to the changing needs and preferences of our customers. In addition, we offer educational information to our customers about their health and well-being concerns through the Wellness Center section of our website,
www.longs.com. We also offer a variety of health screening services in many of our stores, such as blood, glucose, osteoporosis, stroke and cholesterol testing.



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Our RxAmerica subsidiary provides comprehensive pharmacy benefit management services nationwide including
prescription benefit plan design and implementation, claims administration, formulary management and mail order pharmacy fulfillment to third party health plans and other organizations. We have designed these services to help lower prescription
benefit costs for plan providers while improving healthcare access, service and treatment for covered members. We manage prescription benefit plans covering approximately 5.9 million lives with a network of pharmacies in all 50 states as well
as Puerto Rico and the Virgin Islands. In addition, effective January 1, 2006, RxAmerica offers three prescription drug plans that provide prescription drug benefits to approximately 200,000 Medicare participants in 20 regions encompassing 35
states and the District of Columbia under the Medicare Prescription Drug, Improvement and Modernization Act of 2003.



Purchasing and Distribution



As part of our supply chain initiative we have made significant progress in centralizing our merchandise procurement and replenishment over the past
several years in order to achieve greater efficiencies and economies of scale. We now have a centralized purchasing and replenishment structure for a significant portion of our front-end merchandise.



We distribute centrally procured merchandise to our stores through our
distribution centers in California and Hawaii, and merchandise is delivered directly to our stores by our vendors. Store deliveries from our distribution centers take place primarily through a leased fleet and contract drivers.



As a result of our more centralized purchasing approach, we have
substantially increased the volume of merchandise received and delivered through our distribution centers. We are currently constructing an 800,000 square-foot front-end distribution center in Patterson, California, scheduled for completion in the
summer of fiscal 2007, which will allow us to further increase our self-distribution, with a goal to self-distribute approximately 80% of our front-end merchandise by the end of fiscal 2008.



Advertising



We advertise primarily through promotional advertisements and circulars in
major daily newspapers and advertisements on radio and television. We centrally manage the majority of our advertising efforts. Our approach is to regionalize our advertising and use the most efficient media mix within a geographic area. We use
rebates and allowances received from vendors to fund a significant portion of our total advertising spending.



Technology



We are upgrading technology throughout our company in an effort to improve our efficiency, productivity and profitability. All of our stores utilize
pharmacy systems to facilitate filling prescriptions, analyze drug interactions and adjudicate third-party claims, which allows our pharmacists to fill prescriptions accurately and efficiently with reduced risk of error or adverse drug interaction.
We route some of the prescriptions that we receive to our automated central prescription fill centers, which provide increased productivity and reduced prescription fill costs. We have also installed advanced pill-dispensing robotics in many of our
high-volume pharmacies. The fill centers and robotic technology enable our pharmacists to spend more time with customers while maintaining high quality customer service standards.



Our stores also utilize computer-assisted ordering and replenishment systems for certain goods that track sales and
merchandise on hand and plan orders as necessary, and point-of-sale systems that facilitate customer check-out and allow us to process a high volume of transactions efficiently. We also have digital photo technology systems in over 85% of our
stores.



We are making extensive system changes as part of our
efforts to upgrade our supply chain. We have implemented a new distribution management system in our front-end California distribution centers, a new retail



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merchandise system in all of our stores and new procurement and allocation systems that are more integrated with our distribution management and retail
merchandise systems. We also plan to begin installing a new system for store ordering, receiving and inventory management in fiscal 2007.



Mail Order



In April 2003, we added mail-order prescription services through our acquisition of American Diversified Pharmacies, Inc. (ADP). With this acquisition, we
gained entry into one of the fastest growing distribution channels for prescription drugs in the United States. We continue to develop our mail order capabilities to complement our in-store pharmacies as well as our pharmacy benefit services
offerings.



Internet



Through our website, www.longs.com, our customers can access our company
information and extensive health and wellness information, refill prescriptions, order digital photos, and purchase certain over-the-counter medications 24 hours a day, 7 days a week. Customers may have items mailed to them or may pick them up at
their local store. We believe that this sales channel provides customers with added flexibility and convenience.



Trademarks



We hold various trademarks, trade names (including, but not limited to, Longs, Longs Drugs, Longs Pharmacy, E-fills and RxAmerica) and business licenses
that are essential to the operation of our business. These trademarks and licenses have varying terms and are generally renewable indefinitely.



Employees



As of January 26, 2006, we had approximately 22,000 employees, of which approximately 54% were part-time. We hire additional temporary employees as
needed, especially during peak seasons. Most of our employees are non-union, and we believe that our relationship with our employees is good.



Regulation



Our pharmacies and pharmacists are licensed by the appropriate state boards of pharmacy. Our distribution centers are also registered with the Federal
Drug Enforcement Administration. Applicable licensing and registration requirements necessitate our compliance with various state statutes, rules and regulations. We are also subject to numerous federal and state laws and regulations concerning the
protection of confidential patient medical records and information, including the federal Health Insurance Portability and Accountability Act (HIPAA).



As a provider of Medicare prescription drug plan benefits, RxAmerica is subject to various federal regulations promulgated
by the Center for Medicare and Medicaid Services under the Medicare Prescription Drug, Improvement and Modernization Act of 2003. In the future we may also be subject to various state insurance laws and regulations in connection with our
prescription drug plan business.



As a publicly traded
corporation, we are subject to numerous federal securities laws and regulations, including the Securities Act of 1933 and the Securities Exchange Act of 1934 and related rules and regulations promulgated by the SEC, and the Sarbanes-Oxley Act of
2002. These laws and regulations impose significant requirements in the areas of accounting and financial reporting, corporate governance and insider trading, among others.



Competition



The retail drug store industry is highly competitive. We compete with local, regional and national companies, including other drug store chains,
independent drug stores, supermarket chains, discount retailers,



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on-line retailers, mail order pharmacies, and mass merchandisers. We compete on the basis of inclusion of our pharmacies in third-party health plan networks,
quality of pharmacy services, price, front-end merchandise quality, product mix, convenience and customer service. We believe the retail drug store industry will remain highly competitive due to continued consolidation and new store openings.



In the pharmacy benefit services industry, our competitors
include large national and regional providers, some of which are owned by our competitors in the retail drug store industry, as well as insurance companies and other providers of prescription drug benefits under the Medicare Prescription Drug,
Improvement and Modernization Act of 2003. We compete on the basis of our ability to facilitate the management of prescription drug costs for our customers and the provision of low cost, high quality care for their members, as well as our experience
in supporting managed Medicaid and other government programs.



Concentrations



All of our revenues are
generated within the United States. We do not derive revenues from operations in foreign countries or exports. No single customer accounts for 10% or more of our total revenues. We do not believe that the loss of any one customer or group of
customers under common control would have a material effect on our business.



Over 90% of our pharmacy sales are covered by third party health plans. While no single third party health plan accounts for 10% or more of our total revenues, any significant loss of third-party business could
have a material adverse effect on our sales and profitability.



We purchase over 90% of our pharmaceuticals from a single supplier, AmerisourceBergen Drug Corporation (AmerisourceBergen), with whom we have a long-term supply contract. Any significant disruptions in our
relationship with AmerisourceBergen could have a material adverse effect on us.



Our pharmacy benefit services segment offers prescription drug plans under the Medicare Prescription Drug, Improvement and Modernization Act of 2003. These plans are subject to annual bidding and regulatory approval.
Changes in legislative, regulatory or competitive conditions could affect our ability to continue to offer prescription drug plans or to generate profitable prescription drug plan revenues.



Our stores, mail order pharmacy operations, distribution centers and
corporate offices are located in the western United States, with the majority of our stores in California. Risks prevalent in this region include, but are not limited to, the adverse economic effects of significant state budget deficits, legislative
or other governmental actions reducing prescription reimbursement payments to us or increasing our liability with respect to workers compensation, major earthquakes, volatility in energy supplies and costs, and shipping and other
transportation-related disruptions. Because of our geographic concentration, these risks could result in significant disruptions to our business or increased operating expenses.



Seasonality



Our retail drug store business is seasonal, peaking in the fourth fiscal quarter when front-end sales benefit from the holiday season. Pharmacy sales and
over-the-counter medications also benefit in the fourth fiscal quarter from the winter cold and flu season.



Our Medicare prescription drug plan business is also seasonal, with profitability peaking in the second half of our fiscal year based on our expected
claims experience and other factors.



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Item 1A.Risk Factors



You should carefully read the following risk factors.



If we are unable to successfully execute our strategic initiatives and the related organizational changes, our future productivity and profitability may be adversely affected.



We are currently undertaking a series of strategic initiatives designed to
make Longs a stronger competitor and more profitable company. These initiatives address several core elements of our operations, including our supply chain, front-end sales, pharmacy profitability, customer service and operational processes, and
involve significant organizational change. Such organizational changes are complex and could cause disruptions that would adversely affect our revenues and profitability. Our ability to successfully implement these changes, which are significant to
our operations and business, is critical to our future profitability. If we are not successful, we may not achieve the expected benefits from these initiatives, despite having expended significant capital and human effort. Furthermore, we may
encounter difficulties implementing this amount of change in our organization that could have a negative impact on our implementation plans and project budgets.



If the construction of and transition to our new front-end distribution center is not successful, our retail drug store sales and profitability
could be adversely affected.



We are currently
constructing an 800,000 square foot distribution facility for front-end merchandise in Patterson, California, scheduled for completion in the summer of fiscal 2007. If we are unable to successfully complete construction of this facility on a timely
basis, to transition hundreds of front-end vendors to direct supplier relationships, or successfully implement the necessary systems and process changes associated with the transition to the new facility, our supply chain could experience
significant disruptions. Such disruptions could adversely affect our retail drug store sales and increase our cost of sales and operating and administrative expenses. We may also determine that additional investment of time or money is required to
successfully complete the transition to this new facility.



If our new prescription drug plans do not generate the anticipated revenues or profitability, our financial results could be adversely affected.



Effective January 1, 2006, through our pharmacy benefit services subsidiary, we began offering three prescription drug
plans that provide prescription drug benefits under the Medicare Prescription Drug, Improvement and Modernization Act of 2003. Because this is a new federally subsidized benefit and we have not previously offered such plans, it is difficult to
predict the revenues and profitability of this new business. If the revenues we generate from providing these benefits are not sufficient to cover the related prescription drug costs, our profitability will be adversely affected. Furthermore, these
plans are subject to annual bidding and regulatory approval. Changes in legislative, regulatory or competitive conditions could affect our ability to continue to offer prescription drug plans or to generate profitable prescription drug plan
revenues.



Changes in economic conditions could adversely
affect consumer buying practices and reduce our revenues and profitability.



Our performance is affected by economic conditions such as overall economic growth and unemployment, especially in California, our primary market. Higher gasoline prices have also had a significant impact on consumer
spending in our markets. Deterioration in economic conditions, particularly in California, could adversely affect our revenues and profitability. For example, an increase in unemployment could cause consumers to lose their health insurance, which
could in turn adversely affect our pharmacy sales. Further, a decrease in overall consumer spending as a result of changes in economic conditions could adversely affect our front-end sales. Our profit margins are higher on our front-end sales than
our pharmacy sales and therefore any decrease in our sales of front-end products would have a disproportionate negative impact on our profitability.



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The retail drug store and pharmacy benefit services industries are highly competitive and further
increases in competition could adversely affect us.



We
face intense competition with local, regional and national companies, including other drug store chains, independent drug stores, on-line retailers, supermarket chains and mass merchandisers, many of whom are aggressively expanding in markets we
serve. In addition, competition from mail order pharmacies is rapidly intensifying, and some third-party health plans require mail-order fulfillment of certain medications. In the pharmacy benefit services industry, our competitors include large
national and regional pharmacy benefit managers and insurance companies and managed care providers, some of which are owned by or have affiliations with our retail drug store competitors. Many of our competitors have substantially greater resources,
including name recognition and capital resources, than we do. As competition increases in the markets in which we operate, a significant increase in general pricing pressures could occur, which could require us to reduce prices, purchase more
effectively and increase customer service to remain competitive. We may not be able to continue to compete effectively in our markets or increase our revenues or margins in response to further increased competition.



Reductions in third-party, including government, reimbursement levels for
prescription drugs continue to reduce our margins on pharmacy sales and could have a significant effect on our retail drug store sales and gross profits.



Third-party health plans cover more than 90% of all the prescription drugs that we sell. Pharmacy sales covered by third parties have lower gross
margins than non third-party pharmacy sales, and third-party health plans continue to reduce the levels at which they reimburse us for the prescription drugs that we provide to their members. Furthermore, government-sponsored health plans such as
Medicare and Medicaid are making continuing efforts to reduce their costs, including prescription drug reimbursements, and the new Medicare prescription drug benefit resulted in lower reimbursement levels for prescription drugs provided to Medicare
participants. If third-party health plans, including government-sponsored plans, continue to reduce their reimbursement levels, our retail drug store sales and gross profits could be significantly adversely affected.



The significant investments we are making in our stores may not increase
our retail drug store sales and profitability, which could adversely affect our results of operations, financial condition and cash flows.



We have recently made and are continuing to make significant investments in our retail drug stores in an effort to increase our sales and profitability.
These investments include the installation of new digital photo equipment, pharmacy and other technology, and remodels and other improvements to some existing stores. We also plan to significantly increase the rate of new store openings in fiscal
2007. Some of these investments require significant capital expenditures and human effort. We are uncertain about consumer reaction to these changes and therefore these investments may not result in increased sales and profitability. A failure to
increase our retail drug store sales and profitability would adversely affect our results of operations, financial condition and cash flows.



If our insurance-related costs increase significantly, our financial position and results of operations could be adversely affected.



The costs of many types of insurance and self-insurance, especially
workers compensation, employee health care and others have been highly volatile in recent years. These conditions have been exacerbated by rising health care costs, legislative changes, economic conditions, terrorism and heightened scrutiny of
insurance brokers and insurance providers. If our insurance-related costs increase significantly, our financial position and results of operations could be adversely affected.



We are substantially dependent on a single supplier of pharmaceutical products to sell products to us on satisfactory
terms. A disruption in our relationship with this supplier could have a material adverse effect on our business.



We purchase over 90% of our pharmaceuticals from a single supplier, AmerisourceBergen, with whom we have a long-term supply contract. Any significant
disruptions in our relationship with AmerisourceBergen,



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deterioration in AmerisourceBergens financial condition, or industry-wide changes in wholesaler business practices, including those of
AmerisourceBergen, could have a material adverse effect on us.



Our ability to attract and retain pharmacy personnel and develop alternate fill sources is important to the continued success of our business.



The retail drug store industry is continuing to experience a shortage of licensed pharmacists in the markets in which we operate. If we are unable to
attract and retain pharmacists, our business could be adversely affected. In order to mitigate this risk we have established centralized prescription fill centers and have also installed robotic prescription fill equipment in many of our pharmacies.
The success of these efforts, which at this time is uncertain, is important to our ability to address the shortage of pharmacists, but additional efforts may be necessary to address this business issue. Additional investment may be costly, and could
adversely affect our results of operations, financial condition and cash flows.



We are subject to governmental regulations, procedures and requirements. Our noncompliance with, or a significant change in, these regulations could have a material adverse effect on us.



Our retail drug store and pharmacy benefit services businesses are subject
to numerous federal, state and local regulations, many of which are new and developing. These include, but are not limited to, local registrations and regulation of pharmacies in the states where our pharmacies are located or licensed and applicable
Medicare and Medicaid regulations. In addition, the Health Insurance Portability and Accountability Act, or HIPAA, imposes certain requirements regarding the protection of confidential patient medical records and other information. Compliance with
these regulations, particularly HIPAA, requires that we implement complex changes to our systems and processes. In the future we may also be subject to various state insurance laws and regulations in connection with our prescription drug plan
business. Failure to adhere to these and other applicable regulations could result in the imposition of civil and criminal penalties. Furthermore, any new federal or state regulations or reforms, including healthcare reform initiatives or pharmacy
benefit management regulation, could adversely affect us.



Should a product liability issue arise, inadequate insurance coverage against such risks or inability to maintain such insurance may result in a material adverse effect on our business.



Pharmacies are exposed to risks inherent in the packaging and distribution
of pharmaceuticals and other healthcare products and are significantly dependent upon suppliers to provide safe, government-approved and non-counterfeit products. Should a product liability issue arise, the coverage limits under our insurance
programs may not be adequate to protect us against future claims. In addition, we may not be able to maintain this insurance on acceptable terms in the future and damage to our reputation in the event of a product liability issue may have a material
adverse effect on our business.



Our geographic
concentration in the western United States presents certain risks that could adversely affect us.



Our stores, mail order pharmacy operations, distribution centers and corporate offices are located in the western United States, with the majority of our
stores in California. Risks prevalent in this region include, but are not limited to, the adverse economic effects of significant state budget deficits, legislative or other governmental actions reducing prescription reimbursement payments to us or
increasing our liability with respect to workers compensation, major earthquakes, volatility in energy supplies and costs, and shipping and other transportation-related disruptions. Because of our geographic concentration, these risks could
result in significant disruptions to our business or increased operating expenses.



Item 1B.Unresolved Staff Comments



None.



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##### Table of Contents

Item 2.Properties



Stores



|                                      |  |             |   |  |      |   |  |      |  
|------------------------------------- |  | ----------- | - |  | ---- | - |  | ---- | -
|                                      |  | Fiscal Year |  
|                                      |  | 2006        |   |  | 2005 |   |  | 2004 |  
|Number of stores, beginning of period |  | 472         |   |  | 470  |   |  | 455  |  
|Stores opened                         |  | 5           |   |  | 4    |   |  | 18   |  
|Stores closed                         |  | (1          | ) |  | (2   | ) |  | (3   | )
|                                      |  |             |   |  |      |   |  |      |  
|Number of stores, end of period       |  | 476         |   |  | 472  |   |  | 470  |  
|                                      |  |             |   |  |      |   |  |      |  
|Store relocations                     |  | 0           |   |  | 2    |   |  | 1    |  



We also remodeled 41
stores during fiscal 2006, 40 stores during fiscal 2005 and 20 stores during fiscal 2004. We plan to open or relocate approximately 20 to 25 stores and remodel up to 40 additional stores in fiscal 2007.



Our stores are located in the following states:



|           |  |                  |  |                  |  |                 
|---------- |  | ---------------- |  | ---------------- |  | ----------------
|           |  | January 26, 2006 |  | January 27, 2005 |  | January 29, 2004
|           |  |                  | 
|California |  | 402              |  | 397              |  | 394             
|Hawaii     |  | 31               |  | 31               |  | 31              
|Nevada     |  | 17               |  | 17               |  | 17              
|Washington |  | 15               |  | 16               |  | 17              
|Colorado   |  | 9                |  | 9                |  | 9               
|Oregon     |  | 2                |  | 2                |  | 2               
|           |  |                  |  |                  |  |                 
|Total      |  | 476              |  | 472              |  | 470             
|           |  |                  |  |                  |  |                 



Our stores vary in
size, with the majority ranging from 15,000 to 30,000 square feet. Our stores average approximately 23,000 square feet in size, of which approximately 16,000 square feet is devoted to selling space. We lease 58% of our stores from third parties. Of
the remaining stores, 31% are company-owned buildings on company-owned land, and 11% are company-owned buildings on leased land.



Distribution Centers



We operate the following distribution centers:



|                                                 |  |              |  |            
|------------------------------------------------ |  | ------------ |  | -----------
|Location                                         |  | Leased/Owned |  | Square Feet
|Lathrop, California (front-end merchandise)      |  | Leased       |  | 427,000    
|Ontario, California (front-end merchandise)      |  | Owned        |  | 353,000    
|Ontario, California (pharmaceutical inventories) |  | Leased       |  | 36,000     
|Honolulu, Hawaii (front-end merchandise)         |  | Owned        |  | 48,000     



We are currently
constructing a new 800,000 square-foot front-end distribution center in Patterson, California, scheduled for completion in the summer of fiscal 2007. We plan to vacate our Lathrop distribution center when the Patterson distribution center is fully
operational. In the fourth quarter of fiscal 2006, we entered into a sale-leaseback transaction for our Lathrop distribution center. The leaseback agreement has a minimum term of 8 months, with an option for us to extend the lease through September
2007.



We also lease supplemental warehouse space as needed,
especially during our high-volume seasonal periods.



9



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Other Properties



We have two principal company-owned corporate office facilities in California, with a total of 142,000 square feet, and we
lease an additional 61,000 square feet of office space, also in California. We also own a 26,000 square foot corporate office facility and lease an additional 29,000 square feet of corporate office space in Salt Lake City, Utah, for our pharmacy
benefit services segment. In addition, we lease an 11,000 square foot office facility in Las Vegas, Nevada, for our mail order call center operations. Our remaining properties are not material, either individually or in the aggregate.



Item 3.Legal Proceedings



Rankin v. Longs Drug Stores California, Inc., as amended on January 19, 2005, was originally filed in the Superior Court of California, San Diego County on October 13, 2004. The lawsuit was certified
as a class action on July 19, 2005 and alleges that our employment application violates California Labor Code Section 432.8 by inquiring about criminal convictions within the last seven years, without providing an exception for misdemeanor
marijuana convictions more than two years old. The plaintiff seeks to recover statutory damages and attorneys fees for him and all similarly situated individuals who applied for employment with us during the class period. Trial is set for
June 17, 2006. We are vigorously defending this litigation. The financial impact to us, if any, cannot be predicted at this time.



In addition to the lawsuit described above, we are subject to various lawsuits, claims and regulatory reviews arising in the normal course of our
businesses. In the opinion of management, after consultation with counsel, the disposition of these matters arising in the normal course of business is not likely to have a material adverse effect, individually or in the aggregate, on our financial
position or results of operations.



Item 4.Submission of Matters to a Vote of Security Holders



There were no matters submitted to a vote of stockholders during the fourth quarter of fiscal 2006.



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##### Table of Contents

PART II



Item 5.Market for the Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities



The New York Stock Exchange is the principal market for our common stock, which is traded under the symbol LDG.
Our transfer agent is Wells Fargo Shareowner Services, P.O. Box 64854, St. Paul, MN 55164-0854. There were approximately 2,292 stockholders of record as of February 23, 2006.



Quarterly high and low closing stock prices, based on the New York Stock Exchange composite transactions, are shown below:



|            |  |               |       |                |   |               |  |                |       |             |   |       |  |     |       |      |   |       |  |      |       |  |   |       |  |   |       |  |   |      
|----------- |  | ------------- | ----- | -------------- | - | ------------- |  | -------------- | ----- | ----------- | - | ----- |  | --- | ----- | ---- | - | ----- |  | ---- | ----- |  | - | ----- |  | - | ----- |  | - | -----
|            |  | First Quarter |       | Second Quarter |   | Third Quarter |  | Fourth Quarter |       | Fiscal Year
|            |  | Low           |       | High           |   | Low           |  | High           |       | Low         |   | High  |  | Low |       | High |   | Low   |  | High
|Fiscal 2006 |  | $             | 25.88 |                | $ | 37.06         |  | $              | 35.85 |             | $ | 45.97 |  | $   | 39.59 |      | $ | 44.25 |  | $    | 33.74 |  | $ | 44.86 |  | $ | 25.88 |  | $ | 45.97
|Fiscal 2005 |  | $             | 17.75 |                | $ | 22.40         |  | $              | 19.44 |             | $ | 23.95 |  | $   | 20.91 |      | $ | 26.10 |  | $    | 24.70 |  | $ | 27.80 |  | $ | 17.75 |  | $ | 27.80



Quarterly dividends
per share are summarized as follows:



|            |  |              |      |               |   |              |  |               |      |            |   |      |  |   |     
|----------- |  | ------------ | ---- | ------------- | - | ------------ |  | ------------- | ---- | ---------- | - | ---- |  | - | ----
|            |  | FirstQuarter |      | SecondQuarter |   | ThirdQuarter |  | FourthQuarter |      | FiscalYear
|Fiscal 2006 |  | $            | 0.14 |               | $ | 0.14         |  | $             | 0.14 |            | $ | 0.14 |  | $ | 0.56
|Fiscal 2005 |  | $            | 0.14 |               | $ | 0.14         |  | $             | 0.14 |            | $ | 0.14 |  | $ | 0.56



In May 2005, our Board
of Directors authorized the repurchase of shares of our common stock for total consideration up to $150.0 million through May 2008. As of January 26, 2006, we have spent a total of $29.8 million for share repurchases under this program, and we
are authorized to repurchase additional shares of our common stock for a maximum additional expenditure of $120.2 million.



The following is a summary of our common stock repurchases during the fourth quarter of fiscal 2006:



|                                      |  |                               |  |                          |       |                                                                              |         |                                                                                    |   |              
|------------------------------------- |  | ----------------------------- |  | ------------------------ | ----- | ---------------------------------------------------------------------------- | ------- | ---------------------------------------------------------------------------------- | - | -------------
|Period                                |  | TotalNumberof SharesPurchased |  | AveragePricePaidperShare |       | TotalNumber ofSharesPurchasedas Part ofPubliclyAnnouncedPlans orPrograms (1) |         | ApproximateDollar Value ofShares that MayYet bePurchasedUnder the Plansor Programs
|Month #1                              |  |                               |  |                          |       |                                                                              |         |                                                                                    |   |              
|October 28, 2005 - November 24, 2005  |  |                              |  | $                        |      |                                                                              |        |                                                                                    | $ | 134.6 million
|                                      |  |                               |  |                         
|Month #2                              |  |                               |  |                          |       |                                                                              |         |                                                                                    |   |              
|November 25, 2005 - December 29, 2005 |  | 195,000                       |  | $                        | 39.64 |                                                                              | 195,000 |                                                                                    | $ | 126.9 million
|                                      |  |                               |  |                         
|Month #3                              |  |                               |  |                          |       |                                                                              |         |                                                                                    |   |              
|December 30, 2005 - January 26, 2006  |  | 183,000                       |  | $                        | 36.79 |                                                                              | 183,000 |                                                                                    | $ | 120.2 million
|                                      |  |                               |  |                          |       |                                                                              |         |                                                                                    |   |              
|Total                                 |  | 378,000                       |  | $                        | 38.26 |                                                                              | 378,000 |                                                                                    |   |              

---

|(1) | All of the shares repurchased during the quarter ended January 26, 2006 were under the May 2005 authorization by the board of directors.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------



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Item 6.Selected Financial Data



|                                                                                |  |                                            |           |   |                 |   |           |                 |  |   |                 |    |  |                 |           |   |  |   |           |  
|------------------------------------------------------------------------------- |  | ------------------------------------------ | --------- | - | --------------- | - | --------- | --------------- |  | - | --------------- | -- |  | --------------- | --------- | - |  | - | --------- | -
|                                                                                |  | Fiscal Year (1)                            |          
|                                                                                |  | 2006 (52 weeks)                            |           |   | 2005 (52 weeks) |   |           | 2004 (52 weeks) |  |   | 2003 (52 weeks) |    |  | 2002 (53 weeks) |          
|Statement of Consolidated Income data:                                          |  | Dollars in thousands except per share data |          
|Revenues:                                                                       |  |                                            |           |   |                 |   |           |                 |  |   |                 |    |  |                 |           |   |  |   |           |  
|Retail drug store sales                                                         |  | $                                          | 4,616,846 |   |                 | $ | 4,575,051 |                 |  | $ | 4,499,094       |    |  | $               | 4,402,964 |   |  | $ | 4,296,821 |  
|Pharmacy benefit services revenues(2)                                           |  |                                            | 53,457    |   |                 |   | 32,822    |                 |  |   | 27,430          |    |  |                 | 23,309    |   |  |   | 7,913     |  
|                                                                                |  |                                            |           |   |                 |   |           |                 |  |   |                 |    |  |                 |           |   |  |   |           |  
|Total revenues                                                                  |  |                                            | 4,670,303 |   |                 |   | 4,607,873 |                 |  |   | 4,526,524       |    |  |                 | 4,426,273 |   |  |   | 4,304,734 |  
|Costs and expenses:                                                             |  |                                            |           |   |                 |   |           |                 |  |   |                 |    |  |                 |           |   |  |   |           |  
|Cost of retail drug store sales                                                 |  |                                            | 3,430,967 |   |                 |   | 3,421,388 |                 |  |   | 3,382,103       |    |  |                 | 3,289,426 |   |  |   | 3,225,482 |  
|Prescription drug plan benefit costs(2)                                         |  |                                            | 12,232    |   |                 |   |          |                 |  |   |                |    |  |                 |          |   |  |   |          |  
|Operating and administrative expenses                                           |  |                                            | 1,025,224 |   |                 |   | 1,018,560 |                 |  |   | 1,000,994       |    |  |                 | 990,209   |   |  |   | 912,600   |  
|Depreciation and amortization                                                   |  |                                            | 84,072    |   |                 |   | 85,259    |                 |  |   | 83,595          |    |  |                 | 77,736    |   |  |   | 78,193    |  
|Gain on sale of distribution center                                             |  |                                            | (11,049   | ) |                 |   |          |                 |  |   |                |    |  |                 |          |   |  |   |          |  
|Provision (benefit) for store closures and asset impairments, net               |  |                                            | 2,699     |   |                 |   | 1,401     |                 |  |   | 7,438           |    |  |                 | 10,754    |   |  |   | (1,682    | )
|Legal settlements and other disputes, net                                       |  |                                            |          |   |                 |   | 10,773    |                 |  |   | (7,007          | )  |  |                 | 469       |   |  |   | 860       |  
|                                                                                |  |                                            |           |   |                 |   |           |                 |  |   |                 |    |  |                 |           |   |  |   |           |  
|Operating income                                                                |  |                                            | 126,158   |   |                 |   | 70,492    |                 |  |   | 59,401          |    |  |                 | 57,679    |   |  |   | 89,281    |  
|Interest expense, net                                                           |  |                                            | 7,857     |   |                 |   | 13,354    |                 |  |   | 13,379          |    |  |                 | 13,035    |   |  |   | 14,016    |  
|Income taxes                                                                    |  |                                            | 44,417    |   |                 |   | 20,578    |                 |  |   | 16,258          |    |  |                 | 13,317    |   |  |   | 28,097    |  
|                                                                                |  |                                            |           |   |                 |   |           |                 |  |   |                 |    |  |                 |           |   |  |   |           |  
|Income before cumulative effect of accounting changes                           |  |                                            | 73,884    |   |                 |   | 36,560    |                 |  |   | 29,764          |    |  |                 | 31,327    |   |  |   | 47,168    |  
|                                                                                |  |                                            |           |   |                 |   |           |                 |  |   |                 |    |  |                 |           |   |  |   |           |  
|Cumulative effect of accounting change, net of income tax benefit of $16,410(3) |  |                                            |          |   |                 |   |          |                 |  |   |                |    |  |                 | (24,625   | ) |  |   |          |  
|                                                                                |  |                                            |           |   |                 |   |           |                 |  |   |                 |    |  |                 |           |   |  |   |           |  
|Net income                                                                      |  | $                                          | 73,884    |   |                 | $ | 36,560    |                 |  | $ | 29,764          |    |  | $               | 6,702     |   |  | $ | 47,168    |  
|                                                                                |  |                                            |           |   |                 |   |           |                 |  |   |                 |    |  |                 |           |   |  |   |           |  
|Per common share data:                                                          |  |                                            |           |   |                 |   |           |                 |  |   |                 |    |  |                 |           |   |  |   |           |  
|Basic earnings per common share:                                                |  |                                            |           |   |                 |   |           |                 |  |   |                 |    |  |                 |           |   |  |   |           |  
|Income before cumulative effect of accounting change                            |  | $                                          | 1.98      |   |                 | $ | 0.98      |                 |  | $ | 0.80            |    |  | $               | 0.83      |   |  | $ | 1.26      |  
|Net income                                                                      |  |                                            | 1.98      |   |                 |   | 0.98      |                 |  |   | 0.80            |    |  |                 | 0.18      |   |  |   | 1.26      |  
|Diluted earnings per common share:                                              |  |                                            |           |   |                 |   |           |                 |  |   |                 |    |  |                 |           |   |  |   |           |  
|Income before cumulative effect of accounting change                            |  |                                            | 1.93      |   |                 |   | 0.97      |                 |  |   | 0.79            |    |  |                 | 0.82      |   |  |   | 1.25      |  
|Net income                                                                      |  |                                            | 1.93      |   |                 |   | 0.97      |                 |  |   | 0.79            |    |  |                 | 0.18      |   |  |   | 1.25      |  
|Dividends per common share                                                      |  | $                                          | 0.56      |   |                 | $ | 0.56      |                 |  | $ | 0.56            |    |  | $               | 0.56      |   |  | $ | 0.56      |  
|                                                                                |  |                                            |           |   |                 |   |           |                 |  |   |                 |    |  |                 |           |   |  |   |           |  
|Consolidated Balance Sheet and Cash Flows data:                                 |  |                                            |           |   |                 |   |           |                 |  |   |                 |    |  |                 |           |   |  |   |           |  
|Total assets                                                                    |  | $                                          | 1,504,144 |   |                 | $ | 1,421,915 |                 |  | $ | 1,442,112       |    |  | $               | 1,352,071 |   |  | $ | 1,411,591 |  
|Long-term debt                                                                  |  |                                            | 59,818    |   |                 |   | 145,688   |                 |  |   | 114,558         |    |  |                 | 181,429   |   |  |   | 198,774   |  
|Deferred income taxes and other long-term liabilities                           |  |                                            | 83,995    |   |                 |   | 73,298    |                 |  |   | 50,695          |    |  |                 | 34,074    |   |  |   | 43,490    |  
|Equity                                                                          |  |                                            | 767,878   |   |                 |   | 727,137   |                 |  |   | 713,921         |    |  |                 | 716,470   |   |  |   | 721,573   |  
|Operating cash flows                                                            |  |                                            | 203,131   |   |                 |   | 181,338   |                 |  |   | 122,139         |    |  |                 | 43,241    |   |  |   | 202,238   |  
|Capital expenditures and acquisitions                                           |  |                                            | 106,322   |   |                 |   | 91,179    |                 |  |   | 113,999         |    |  |                 | 93,944    |   |  |   | 117,126   |  
|                                                                                |  |                                            |           |   |                 |   |           |                 |  |   |                 |    |  |                 |           |   |  |   |           |  
|Operating statistics:                                                           |  |                                            |           |   |                 |   |           |                 |  |   |                 |    |  |                 |           |   |  |   |           |  
|Number of stores at year end                                                    |  |                                            | 476       |   |                 |   | 472       |                 |  |   | 470             |    |  |                 | 455       |   |  |   | 436       |  
|Average drug store sales per unit(4)                                            |  | $                                          | 9,731     |   |                 | $ | 9,693     |                 |  | $ | 9,662           |    |  | $               | 9,920     |   |  | $ | 10,021    |  
|Same-store sales growth (decline)(5)(52-week basis)                             |  |                                            | 0.6       | % |                 |   | 0.6       | %               |  |   | (0.2            | )% |  |                 | 2.8       | % |  |   | 4.0       | %
|Selling square footage at year end (thousands)                                  |  |                                            | 7,717     |   |                 |   | 7,694     |                 |  |   | 7,657           |    |  |                 | 7,476     |   |  |   | 7,217     |  
|Average drug store sales per selling square foot (52-week basis)                |  | $                                          | 592       |   |                 | $ | 590       |                 |  | $ | 594             |    |  | $               | 601       |   |  | $ | 594       |  
|Number of employees at year end                                                 |  |                                            | 22,000    |   |                 |   | 22,000    |                 |  |   | 22,900          |    |  |                 | 22,200    |   |  |   | 22,200    |  
|                                                                                |  |                                            |           |   |                 |   |           |                 |  |   |                 |    |  |                 |           |   |  |   |           |  



|(1) | We operate on a 52/53-week fiscal year ending on the last Thursday in January.
|--- | ------------------------------------------------------------------------------



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|(2) | Beginning January 1, 2006, through our pharmacy benefit services segment, we began offering prescription drug plans that provide prescription drug benefits to Medicare
participants in 20 regions encompassing 35 states and the District of Columbia under the Medicare Prescription Drug, Improvement and Modernization Act of 2003. In fiscal 2006, prescription drug plan revenues were $16.2 million and the related
prescription drug plan benefit costs were $12.2 million.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(3) | Upon adoption of SFAS No. 142, Goodwill and Other Intangible Assets, in fiscal 2003, we recognized a transitional goodwill impairment charge of $41.0 million ($24.6
million or $0.64 per diluted share after tax), as the cumulative effect of a change in accounting principle. Also as required by SFAS No. 142, in fiscal 2003 we discontinued the amortization of goodwill and certain other intangible assets
deemed to have indefinite lives. In fiscal 2002, amortization expense for these assets, net of the related income tax effects, was $4.1 million, or $0.11 per diluted share.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(4) | Units include our retail drug stores and mail order facility (acquired in April 2003).
|--- | --------------------------------------------------------------------------------------



|(5) | Same-store sales statistics serve as a measure of our sales growth excluding the effect of opening new stores or closing stores. We compute same-store sales growth on a monthly
basis, by comparing sales in the current fiscal month with those of the same fiscal month of the previous fiscal year for those stores that have been open for at least 13 complete consecutive fiscal months. This computation has the effect of
measuring sales increases or decreases each month only for those stores that were open during all of the same month of the previous fiscal year. We compute quarterly and annual same-store sales growth by accumulating the monthly same-store sales
results for those quarterly and annual periods.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Item 7.Managements Discussion and Analysis of Financial Condition and Results of Operations



The following Managements Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our
consolidated financial statements and the related notes. This discussion contains forward-looking statements based upon our current expectations that involve risks and uncertainties, such as our plans, objectives, expectations and intentions, as set
forth under Cautionary Statement Regarding Forward-Looking Statements. Our actual results and the timing of events could differ materially from those anticipated in these forward-looking statements as a result of many factors, including,
but not limited to, those set forth in the following discussion and under Item 1A, Risk Factors and elsewhere in this Form 10-K.



OVERVIEW



In fiscal 2006 we continued to operate in an environment of significant change, including increasing competition, industry consolidation, continued
pricing pressure from third-party health plans, increasing generic drug utilization and rising gasoline prices, among other factors.



In this environment, we have undertaken significant organizational and operational changes. More than three years ago, we began working on five broad
categories of strategic initiatives to make Longs a stronger competitor and more profitable company:



| |  |  | Supply chain
| | - |  | ------------



| |  |  | Front-end sales
| | - |  | ---------------



| |  |  | Pharmacy profitability
| | - |  | ----------------------



| |  |  | Customer service
| | - |  | ----------------



| |  |  | Operational processes
| | - |  | ---------------------



To date we have made progress in several areas to support these initiatives:



| |  |  | We have made significant improvements in technology in our supply chain and our stores. As part of our supply chain upgrade, we have installed a new distribution management system
in our front-end California distribution centers, a new retail merchandise system in all of our stores, and new procurement and allocation systems that are more integrated with our distribution management and retail merchandise systems. We plan to
begin installing a new system for store ordering, receiving and inventory management in fiscal 2007. We are also constructing a new front-end distribution center in Patterson, California, scheduled for completion in the summer of fiscal 2007, which
will allow us to further increase our self-distribution.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We have shifted our front-end merchandise mix toward our core categories of health, wellness, beauty and convenience. We believe this shift strengthens our competitive
differentiation and improves the profitability of our sales. Centralizing our merchandising and promotions has also allowed us to make progress on developing our private brand merchandise and building our capabilities for increased self-distribution
of front-end merchandise. We plan to continue to pursue our front-end merchandise strategy to expand and enhance our core categories and manage toward a more profitable sales mix.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We remodeled 41 additional stores during fiscal 2006, bringing the total number of stores with our new look to 120, or approximately 25% of our chain. We plan to remodel an
additional 40 stores in fiscal 2007, and to continue to make more productive use of our non-selling square footage in our remodeled stores through diagnostic labs, classrooms, walk-in medical clinics and similar offerings.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We have taken several steps to improve our pharmacy profitability in anticipation of continued third-party pricing pressure. These steps include better buying,
increased generic utilization, upgraded pharmacy technology and expanded mail order and central fill capabilities. Our goal is to make
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| | continued progress on pharmacy procurement, inventory management, in-stock position and workflow efficiencies.
| | --------------------------------------------------------------------------------------------------------------



| |  |  | We have increased the capabilities of RxAmerica, our pharmacy benefit services subsidiary, in preparation for our new Medicare prescription drug plan offerings and in order to
pursue additional growth in our pharmacy benefit management business. Our goal is to leverage the investments we have made in RxAmerica in order to achieve additional growth.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We have improved store productivity and efficiency through more efficient workflow processes, better labor scheduling and creating a safer place to work. As a result of these
efforts our operating and administrative expenses have improved, and we plan to return to more substantial store count growth in fiscal 2007, opening or relocating 20 to 25 stores. We will continue to pursue further cost reductions in an effort to
better leverage our operating and administrative expenses.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We have improved the cash flow performance of underperforming stores. The sales, gross profit margin, operating margin and cash flow for these stores as a group continued to improve
in fiscal 2006. We are continuing to monitor the performance of these stores.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We have strengthened the safety culture at Longs, resulting in a further reduction in the number of work-related accidents. Our workers compensation claims decreased 30% in
fiscal 2006 from the previous year, and 45% from two years ago. We intend to continue to improve our safety culture in an effort to preserve the health and welfare of our employees and reduce our workers compensation costs.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The progress we have made on these initiatives
to date has enabled us to improve our operating performance, develop the organizational competence for change and improvement, and build a foundation for more profitable growth. We remain focused on our longer-term goal to reduce the gap between our
operating margin and those of our largest competitors, and plan to continue our efforts to become a stronger competitor and more profitable company.



On January 1, 2006, the new Medicare prescription drug benefit took effect. This new benefit will impact both our retail drug store and pharmacy
benefit services segments. Our retail drug stores are in the networks of all of the major Medicare plan sponsors in our region. RxAmerica, our pharmacy benefit services subsidiary, provides pharmacy benefit management services to Medicare
prescription drug plan sponsors, and began offering three prescription drug plans of its own. Approximately 200,000 participants in 20 regions encompassing 35 states and the District of Columbia are enrolled in one of the three plans that we offer.



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RESULTS OF OPERATIONS



Revenues



|                                                              |  |                      |           |    |      |   |           |      |  |   |           |   
|------------------------------------------------------------- |  | -------------------- | --------- | -- | ---- | - | --------- | ---- |  | - | --------- | --
|                                                              |  | Fiscal Year          |          
|                                                              |  | 2006                 |           |    | 2005 |   |           | 2004 | 
|                                                              |  | Dollars in Thousands |          
|Retail drug store sales:                                      |  |                      |           |    |      |   |           |      |  |   |           |   
|Pharmacy sales                                                |  | $                    | 2,245,296 |    |      | $ | 2,168,049 |      |  | $ | 2,082,024 |   
|Front-end sales                                               |  |                      | 2,371,550 |    |      |   | 2,407,002 |      |  |   | 2,417,070 |   
|                                                              |  |                      |           |    |      |   |           |      |  |   |           |   
|Total                                                         |  | $                    | 4,616,846 |    |      | $ | 4,575,051 |      |  | $ | 4,499,094 |   
|                                                              |  |                      |           |    |      |   |           |      |  |   |           |   
|Pharmacy benefit services revenues:                           |  |                      |           |    |      |   |           |      |  |   |           |   
|Pharmacy benefit management revenues                          |  | $                    | 37,256    |    |      | $ | 32,822    |      |  | $ | 27,430    |   
|Prescription drug plan revenues                               |  |                      | 16,201    |    |      |   |          |      |  |   |          |   
|                                                              |  |                      |           |    |      |   |           |      |  |   |           |   
|Total                                                         |  | $                    | 53,457    |    |      | $ | 32,822    |      |  | $ | 27,430    |   
|                                                              |  |                      |           |    |      |   |           |      |  |   |           |   
|Total revenues                                                |  | $                    | 4,670,303 |    |      | $ | 4,607,873 |      |  | $ | 4,526,524 |   
|                                                              |  |                      |           |    |      |   |           |      |  |   |           |   
|Retail drug store sales:                                      |  |                      |           |    |      |   |           |      |  |   |           |   
|Total sales growth over previous year                         |  |                      | 0.9       | %  |      |   | 1.7       | %    |  |   | 2.2       | % 
|Same-store sales growth (decline)                             |  |                      | 0.6       | %  |      |   | 0.6       | %    |  |   | (0.2      | )%
|                                                              |  |                      |          
|Pharmacy sales growth                                         |  |                      | 3.6       | %  |      |   | 4.1       | %    |  |   | 6.4       | % 
|Same-store pharmacy sales growth                              |  |                      | 3.2       | %  |      |   | 2.7       | %    |  |   | 3.5       | % 
|Pharmacy as a % of total retail drug store sales              |  |                      | 48.6      | %  |      |   | 47.4      | %    |  |   | 46.3      | % 
|% of pharmacy sales covered by third party health plans       |  |                      | 92.6      | %  |      |   | 91.9      | %    |  |   | 91.2      | % 
|                                                              |  |                      |          
|Front-end sales growth (decline)                              |  |                      | (1.5      | )% |      |   | 0.4       | %    |  |   | (1.2      | )%
|Same-store front-end sales decline                            |  |                      | (1.7      | )% |      |   | (1.3      | )%   |  |   | (3.2      | )%
|Front-end as a % of total retail drug store sales             |  |                      | 51.4      | %  |      |   | 52.6      | %    |  |   | 53.7      | % 
|                                                              |  |                      |          
|Pharmacy benefit services revenues:                           |  |                      |           |    |      |   |           |      |  |   |           |   
|Pharmacy benefit management revenue growth over previous year |  |                      | 13.5      | %  |      |   | 19.7      | %    |  |   | 17.7      | % 
|Prescription drug plan revenue growth over previous year      |  |                      | N/A       |    |      |   | N/A       |      |  |   | N/A       |   



Fiscal 2006 versus
Fiscal 2005



Total revenues increased 1.4% in fiscal 2006
over fiscal 2005. Retail drug store sales were $4.62 billion, an increase of 0.9% over fiscal 2005, with same-store sales increasing 0.6%. Growth in the number of stores and higher mail order sales also contributed to total retail drug store sales
growth. Pharmacy benefit services revenues were $53.5 million, compared to $32.8 million in fiscal 2005.



Pharmacy sales increased 3.6% in fiscal 2006 over fiscal 2005, with same-store pharmacy sales increasing 3.2%. The increase in same-store pharmacy sales
was primarily due to continued increases in average retail prescription prices, in addition to higher prescription volumes. Average prescription prices increased due to pharmaceutical cost inflation and the continued introduction and utilization of
newer and more expensive drugs. The increase in average prescription prices was mitigated in part by the increased utilization of lower-priced, high-volume generic drugs. We estimate that generic utilization negatively impacted our same-store
pharmacy sales by approximately 3.8 percentage points. We expect that average retail prices for prescription drugs will continue to rise due to pharmaceutical cost inflation and the continued introduction and utilization of newer and more expensive
drugs, partially offset by continuing increases in utilization of generic drugs.



The increase in our same-store prescription volumes was primarily due to a stronger cold and flu season on the West Coast in fiscal 2006 compared to fiscal 2005. We expect that several favorable industry trends will



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positively impact our prescription volumes over the long term. These trends include an aging U.S. population consuming a greater number of prescription
drugs, the growing use of prescription drugs as preventive therapy by healthcare providers and the introduction of new drugs. Factors that could offset these favorable trends include increasing competition, including the growth of mail-order
pharmacies, and rising prescription drug costs, which could cause consumers to reduce their purchases of prescription drugs or third-party health plans to reduce their coverage of prescription drug costs for their members.



Pharmacy sales were 48.6% of total drug store sales in fiscal 2006, compared
to 47.4% in fiscal 2005. We expect pharmacy sales to continue to increase as a percentage of total drug store sales as pharmacy sales continue to increase faster than front-end sales.



Third-party health plans covered 92.6% of our pharmacy sales in fiscal 2006, compared to 91.9% in fiscal 2005. We expect
third-party sales to remain over 90% of our total pharmacy sales for the foreseeable future due to significant consumer participation in managed care and other third-party plans, including the new Medicare prescription drug plans.



Front-end sales decreased 1.5% in fiscal 2006 from fiscal 2005, with
same-store front-end sales decreasing 1.7%. In an ongoing effort to emphasize our competitive differentiation, we are shifting our front-end merchandise mix toward our core categories of health, wellness, beauty and convenience. The decline in
same-store front-end sales was primarily due to lower sales in non-core categories as a result of these shifts. We will continue to make changes to our front-end merchandise assortments in an effort to further improve our competitive position and
profitability. A continued industry-wide decline in photo processing sales, due to consumers continued migration to digital photography technology, also adversely affected same-store front-end sales in fiscal 2006.



Our performance is affected by economic conditions such as overall economic
growth and unemployment, especially in California, our primary market. Higher gasoline prices have also had a significant impact on consumer spending in our markets. We expect these factors to continue to affect our front-end sales in fiscal 2007.



The increase in pharmacy benefit services revenues in fiscal
2006 was primarily due to $16.2 million in revenues from three new prescription drug plans offered beginning January 1, 2006 under the Medicare Prescription Drug, Improvement and Modernization Act of 2003. The three plans have enrolled
approximately 200,000 Medicare beneficiaries. These new plans will continue to generate increased revenues in our pharmacy benefit services segment throughout fiscal 2007. Future revenues from these plans are uncertain because this is a new
federally subsidized benefit and we have not previously offered such plans, and because plans are subject to annual bidding and regulatory approval.



Fiscal 2005 versus Fiscal 2004



Total revenues increased 1.8% in fiscal 2005 over fiscal 2004. Retail drug store sales increased 1.7% in fiscal 2005 over fiscal 2004, with same-store
sales increasing 0.6%. Growth in the number of stores accounted for most of the total increase in retail drug store sales. Higher mail order sales and pharmacy benefit services revenues also contributed to the total revenue increase.



A strike against three major grocery chains in Southern California that began
in October 2003 and ended in February 2004 resulted in increased sales in some of our Southern California stores, primarily in the fourth quarter of fiscal 2004. We estimate that the strike favorably impacted our fiscal 2004 same-store sales by 0.8
to 1.0 percentage points.



Pharmacy sales increased 4.1% in
fiscal 2005 over fiscal 2004, with same-store pharmacy sales increasing 2.7%. The increase in same-store pharmacy sales was primarily due to an increase in the average retail price per prescription over fiscal 2004, partially offset by a decline in
same-store prescription volume. The increase in the



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average retail price per prescription was mitigated in part by the increased utilization of lower-priced, high-volume generic drugs.



The decrease in our same-store prescription volume was partially due to
declines in allergy and anti-ulcer prescriptions following the conversion of Claritin and Prilosec from prescription to over-the-counter status, continued health concerns over womens hormone replacement therapy drugs, and a mild cold and flu
season on the West Coast.



Pharmacy sales were 47.4% of total
drug store sales in fiscal 2005, compared to 46.3% in fiscal 2004. Third-party health plans covered 91.9% of our pharmacy sales in fiscal 2005, compared to 91.2% in fiscal 2004.



Front-end sales increased 0.4% in fiscal 2005 from fiscal 2004, with same-store front-end sales decreasing 1.3%. The decline
in same-store front-end sales was partially due to the Southern California grocery strike, which favorably affected fiscal 2004 front-end sales. The shift in our front-end merchandise mix toward our core categories and continued industry-wide
decline in photo processing sales also adversely affected same-store front-end sales in fiscal 2005.



Gross Profit



|                                                |  |             |           |   |      |   |           |      |  |   |           |  
|----------------------------------------------- |  | ----------- | --------- | - | ---- | - | --------- | ---- |  | - | --------- | -
|                                                |  | Fiscal Year |          
|                                                |  | 2006        |           |   | 2005 |   |           | 2004 | 
|Retail drug store gross profit (thousands)      |  | $           | 1,185,879 |   |      | $ | 1,153,663 |      |  | $ | 1,116,991 |  
|Retail drug store gross profit margin           |  |             | 25.7      | % |      |   | 25.2      | %    |  |   | 24.8      | %
|LIFO provision (thousands)                      |  | $           | 4,800     |   |      | $ | 5,500     |      |  | $ | 1,400     |  
|Prescription drug plan gross profit (thousands) |  | $           | 3,969     |   |      |   | N/A       |      |  |   | N/A       |  
|Prescription drug plan gross profit margin      |  |             | 24.5      | % |      |   | N/A       |      |  |   | N/A       |  



Fiscal 2006 versus
Fiscal 2005



Retail drug store gross profit was 25.7% of
retail drug store sales in fiscal 2006, compared to 25.2% in fiscal 2005. The increase was primarily due to a more profitable merchandise mix through better buying, lower distribution costs and increased utilization of generic drugs, which generally
have higher gross profit margins than name-brand drugs, partially offset by continued reductions in prescription drug reimbursement levels from third-party health plans.



We will continue to make shifts in our front-end merchandise assortments in an effort to improve the profitability of our
sales mix. Further, our supply chain initiative includes continuing efforts to improve our buying practices and inventory management and reduce our distribution costs. We also expect that the utilization of lower-priced, higher-margin generic drugs
will continue to increase. We expect that continued efforts by third-party health plans, including government-sponsored plans, to reduce prescription drug reimbursement level, will at least partially offset these favorable effects on our gross
profit percentage. We also expect the new Medicare prescription drug benefit to result in lower reimbursement levels for prescription drugs provided to Medicare participants.



Our LIFO provision, which is included in the cost of retail drug store sales, was $4.8 million in fiscal 2006 and $5.5
million in fiscal 2005. The decrease was primarily due to lower net inflation compared to last year. The LIFO provision fluctuates with inflation rates, inventory levels and merchandise mix.



In addition to the acquisition cost of inventory sold (net of merchandise
rebates and allowances), we include in-bound freight, receiving, warehousing, purchasing and distribution costs, and advertising expenses (net of advertising rebates and allowances) in our cost of retail drug store sales. We classify store occupancy
costs as a



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component of operating and administrative expenses. Our retail drug stores gross profit margins may not be comparable to those of some other retailers who
include distribution and advertising costs in their operating expenses, or store occupancy costs in their cost of sales.



Prescription drug plan gross profit was 24.5% of prescription drug plan revenues in fiscal 2006. We began offering prescription drug plans through our
pharmacy benefit services segment on January 1, 2006 under the Medicare Prescription Drug, Improvement and Modernization Act of 2003. Prescription drug plan benefit costs represent our portion of the cost of prescription drugs purchased by
Medicare participants in one of our prescription drug plans. Such costs include benefit payments during the period to pharmacies, and an estimate for benefit costs incurred but not reported as of the end of the period, reduced by associated
manufacturer rebates. Our Medicare prescription drug plan business is also seasonal, with profitability peaking in the second half of our fiscal year. Future gross profit margins from these plans are uncertain because this is a new federally
subsidized benefit and we have not previously offered such plans.



Prescription drug plan benefit costs apply only to prescription drug plan revenues. Revenues generated from pharmacy benefit management services are reported net of reimbursements to participating pharmacies.



Fiscal 2005 versus Fiscal 2004



Retail drug store gross profit was 25.2% of retail drug store sales in
fiscal 2005, compared to 24.8% in fiscal 2004. The increase was primarily due to a more profitable sales mix through better buying, improved inventory management and the increased utilization of generic drugs, partially offset by continued
reductions in prescription drug reimbursement levels from third-party health plans. Retail drug store gross profit in fiscal 2004 also included a benefit of $3.6 million related to the resolution of a pricing dispute with a vendor.



Our LIFO provision, which is included in cost of sales, was $5.5 million in
fiscal 2005, compared to $1.4 million in fiscal 2004. The increase was primarily due to higher net inflation compared to fiscal 2004, when we experienced a deflationary environment in many of our front-end categories.



Operating and Administrative Expenses



|                                                               |  |             |           |   |      |   |           |      |  |   |           |  
|-------------------------------------------------------------- |  | ----------- | --------- | - | ---- | - | --------- | ---- |  | - | --------- | -
|                                                               |  | Fiscal Year |          
|                                                               |  | 2006        |           |   | 2005 |   |           | 2004 | 
|Operating and Administrative Expenses (Thousands)              |  | $           | 1,025,224 |   |      | $ | 1,018,560 |      |  | $ | 1,000,994 |  
|Operating and Administrative Expenses as a Percent of Revenues |  |             | 22.0      | % |      |   | 22.1      | %    |  |   | 22.1      | %



Fiscal 2006 versus
Fiscal 2005



Operating and administrative expenses were
22.0% of revenues in fiscal 2006, compared to 22.1% in fiscal 2005. The decreased expense rate related primarily to lower workers compensation expenses and improved labor productivity, partially offset by increased expenses in our pharmacy
benefit services segment in preparation for our new Medicare prescription drug plan offerings.



Workers compensation expenses in fiscal 2006 included a $9.6 million benefit from favorable actuarial adjustments to the companys self-insured workers compensation reserves. This compares to a $4.7
million benefit from favorable actuarial adjustments in fiscal 2005. Workers compensation expenses were also favorably impacted by lower current-period claims accruals and more favorable insurance premiums and other costs. Workers
compensation expenses reflect a significant decline in claims and lower costs per claim, which have resulted from our focus on a safe work environment, combined with recent changes in Californias workers compensation laws. The number of
our workers compensation claims decreased 30% in fiscal 2006 from the previous year.



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We expect these factors to continue to have a favorable effect on our workers compensation programs
in the near future. However, the California State Legislature is considering further changes to the states workers compensation laws that, if enacted, could adversely affect workers compensation costs in the state. In addition, due
to the inherent volatility involved in determining our self-insurance reserves, especially in California in the past several years, we cannot predict the nature and extent of future actuarial adjustments to those reserves. Future actuarial
adjustments, if any, may not be as significant as those we experienced in fiscal 2006. As a result, our total workers compensation expenses could increase in fiscal 2007 even if we are successful in continuing to reduce the number of claims
and costs per claim.



Fiscal 2005 versus Fiscal 2004



Operating and administrative expenses were 22.1% of
revenues in both fiscal 2005 and fiscal 2004. In fiscal 2004 we took a series of steps to improve our productivity and reduce our costs. These steps included a reduction of our administrative workforce by approximately 170 people in our California
offices, store labor savings through workflow and staffing changes, modifications to many of our incentive compensation arrangements and the closure of certain support facilities. These actions, combined with other ongoing cost reduction efforts,
resulted in lower operating and administrative expenses as a percent of sales beginning in the second half of fiscal 2004 and continuing through the first half of fiscal 2005. Our operating and administrative expense rate began to increase in the
second half of fiscal 2005, primarily due to a lack of leverage on labor and related benefit costs, which increased primarily due to normal annual wage adjustments, against lower than expected sales. Expenses related to our supply chain improvement
efforts and development of our pharmacy benefit services segment and mail-order services to support potential future growth also increased our operating and administrative expense rate.



Workers compensation and other insurance-related expenses in fiscal 2005 included a $4.7 million benefit from
favorable actuarial adjustments, versus $5.5 million of net unfavorable actuarial adjustments in fiscal 2004. The decrease in our insurance-related expenses, including the actuarial reserve adjustments, partially reflected a decline in workers
compensation claims and lower costs per claim. The number of our workers compensation claims decreased 22% in fiscal 2005 from the previous year.



Operating and administrative expenses in fiscal 2004 included net charges of $4.1 million, or 0.1% of sales, for employee termination and other costs
associated with the reduction of our administrative workforce and closure of certain support facilities and a voluntary separation program for store managers announced in July 2003, partially offset by gains on the disposition of certain properties.



Depreciation and Amortization



Depreciation and amortization expenses were $84.1 million in fiscal 2006,
compared to $85.3 million in fiscal 2005 and $83.6 million in fiscal 2004. The fluctuations over the last three fiscal years reflect variations in the timing of capital expenditures for new store investments, remodels and improvements to existing
stores, supply chain improvements and technology; as well as the disposal or replacement of older assets, including those in our remodeled stores.



Our depreciation and amortization expenses include accelerated depreciation for assets to be retired before the completion of their originally estimated
useful lives, including assets to be removed or replaced in our remodeled stores. The amount of accelerated depreciation expenses related to store remodels varies based on the level and timing of our remodel activities.



Gain on Sale of Distribution Center



During fiscal 2006, we entered into a sale-leaseback transaction for our
Northern California front-end distribution center located in Lathrop, California, for net proceeds of $21.5 million. We intend to vacate the



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Lathrop facility when our new distribution center in Patterson, California, which is currently under construction and scheduled for completion in the summer
of fiscal 2007, is fully operational. The leaseback agreement has a minimum term of 8 months, with an option to extend the lease through September 2007.



Provision for Store Closures and Asset Impairments



The provision for store closures and asset impairments is summarized as follows:



|                             |  |             |       |      |   |       |  |   |      
|---------------------------- |  | ----------- | ----- | ---- | - | ----- |  | - | -----
|                             |  | Fiscal Year
|                             |  | 2006        |       | 2005 |   | 2004 
|                             |  | Thousands  
|Asset impairments            |  | $           | 2,699 |      | $ | 1,151 |  | $ | 3,896
|Provision for store closures |  |             |      |      |   | 250   |  |   | 3,542
|                             |  |             |       |      |   |       |  |   |      
|Total                        |  | $           | 2,699 |      | $ | 1,401 |  | $ | 7,438
|                             |  |             |       |      |   |       |  |   |      



Asset Impairments



In each of the last three fiscal years, we have
identified certain underperforming stores with assets whose carrying values exceeded their related undiscounted expected future cash flows. We recorded impairment charges of $2.7 million in fiscal 2006, $1.2 million in fiscal 2005 and $2.4 million
in fiscal 2004 to write the related store assets down to their estimated fair values. In fiscal 2004, we also recorded an impairment charge of $1.5 million related to the write-off of abandoned information technology assets.



Store Closures



The following is a summary of the provision for store closures and the
related reserve, which is included in long-term liabilities:



|                                                                                                                  |  |             |        |   |      |   |        |      |  |   |        |  
|----------------------------------------------------------------------------------------------------------------- |  | ----------- | ------ | - | ---- | - | ------ | ---- |  | - | ------ | -
|                                                                                                                  |  | Fiscal Year |       
|                                                                                                                  |  | 2006        |        |   | 2005 |   |        | 2004 | 
|                                                                                                                  |  | Thousands   |       
|Reserve balancebeginning of year                                                                                 |  | $           | 7,011  |   |      | $ | 9,544  |      |  | $ | 7,827  |  
|Provision for present value of noncancellable lease obligations of stores closed,net of estimated sublease income |  |             |       |   |      |   |       |      |  |   | 1,367  |  
|Changes in assumptions about future sublease income and other lease related costs                                 |  |             |       |   |      |   | 250    |      |  |   | 2,175  |  
|                                                                                                                  |  |             |        |   |      |   |        |      |  |   |        |  
|Total provision for store closures                                                                                |  |             |       |   |      |   | 250    |      |  |   | 3,542  |  
|Reserve accretion                                                                                                 |  |             |       |   |      |   | 71     |      |  |   |       |  
|Cash payments for lease related costs, net of sublease income                                                     |  |             | (4,284 | ) |      |   | (2,854 | )    |  |   | (1,825 | )
|                                                                                                                  |  |             |        |   |      |   |        |      |  |   |        |  
|Reserve balanceend of year                                                                                       |  | $           | 2,727  |   |      | $ | 7,011  |      |  | $ | 9,544  |  
|                                                                                                                  |  |             |        |   |      |   |        |      |  |   |        |  
|Stores closed                                                                                                     |  |             | 1      |   |      |   | 2      |      |  |   | 3      |  



We periodically review
store operating results and projections and make decisions to close stores in the normal course of business. We recognize costs associated with store closures when the related liabilities are incurred.



Our calculation of store closure costs includes significant estimates about
the amounts and timing of future sublease income. These estimates are based on our historical experience, the condition and location of the properties, the lease terms and current real estate leasing market conditions. Many of our previously closed
stores have long remaining lease terms, with the longest lease term ending February 2026. As a result, changes in these assumptions can significantly impact our store closure reserves.



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There was no reserve accretion in fiscal 2006, because all of the remaining stores included in the
reserve were closed prior to the adoption of SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which required that the initial provision for store closures be recorded at the estimated net present value, and
accreted to the full undiscounted value, of the noncancellable lease obligation, net of estimated sublease income. Previous accounting standards required that such provisions be recorded at their full undiscounted values.



Legal Settlements and Other Disputes



In the second quarter of fiscal 2005, we reached an agreement to settle two
purported class action lawsuits related to the calculation of earned overtime wages for certain of our former and current store managers and assistant store managers in California. The lawsuits alleged that we improperly classified such employees as
exempt under Californias wage and hour laws. We denied all liability in these cases, but agreed to the settlement in order to resolve the plaintiffs claims while avoiding protracted litigation. Under the settlement, we made cash payments
of $11 million to cover claims by eligible plaintiffs, plaintiff attorneys fees and costs, payments to the named plaintiffs and costs of a third-party administrator. We recorded a charge of $11.6 million for the total cost of this settlement,
including applicable employer payroll taxes, in the second quarter of fiscal 2005, and paid these settlement costs in the second half of the year.



We also recorded a gain of $0.8 million from the favorable settlement of a separate, unrelated class action lawsuit, for which we had filed a claim as a
member of the plaintiff class, which alleged unlawful price fixing and market allocation by certain vitamin manufacturers. We received the settlement payment in the second quarter of fiscal 2005. The combined net charge resulting from these two
fiscal 2005 settlements was $10.8 million.



In fiscal 2004, we
recorded a combined benefit of $7.0 million related to settlements of a lease-related dispute with one of our landlords and a contract dispute with a former service provider.



Net Interest Expense



Net interest expense was $7.9 million in fiscal 2006 and $13.4 million in both fiscal 2005 and fiscal 2004. The decrease in fiscal 2006 was due to
lower average borrowings.



Income Taxes



Our effective income tax rate varies based on the
level of our pre-tax income and the amount and timing of certain tax deductions and credits. Our effective income tax rates were 37.5% in fiscal 2006, 36.0% in fiscal 2005 and 35.3% in fiscal 2004. We expect that our effective income tax rate will
be approximately 38% in fiscal 2007.



LIQUIDITY AND CAPITAL
RESOURCES



General



Our primary sources of liquidity are operating cash flows and borrowings on
our line of credit. We use cash to provide working capital for our operations, finance capital expenditures and acquisitions, repay debt, repurchase shares of our common stock and pay dividends.



We have a secured $280 million revolving line of credit with a syndication of
banks, which expires in August 2009 and accrues interest at LIBOR-based rates. Borrowings on this line of credit are secured by inventory, accounts receivable and certain intangible assets. As of January 26, 2006, no borrowings were outstanding
on our secured line of credit. The secured revolving line of credit agreement contains customary



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restrictions but no financial covenants and no limitations on capital expenditures or share repurchases if availability of credit remains above a minimum
level. The agreement also includes an option to increase the credit facilitys borrowing and letter-of-credit capacity from $280 million to $345 million, subject to certain conditions. Borrowings on the line of credit do not require repayment
until the expiration date but may be prepaid without penalty. Letters of credit totaling $35.8 million were outstanding under the agreement as of January 26, 2006. We pay a monthly commitment fee of 0.25% per annum on the unused portion of
the line of credit.



Additionally, as of January 26, 2006
we had $105.7 million in outstanding privately placed promissory notes. These notes, which mature at various dates through 2014, bear interest at fixed rates ranging from 5.85% to 7.85%, and are secured on the same basis as the secured revolving
line of credit. The notes include penalties for repayment prior to their scheduled maturities. Current maturities of $45.9 million as of January 26, 2006 constitute regularly scheduled principal payments due in fiscal 2007.



The privately placed promissory notes contain various customary financial
covenants and restrictions. Failure to comply with these covenants and restrictions, or with the restrictions included in our secured revolving line of credit, could adversely affect our ability to manage our cash requirements, and could result in
higher interest costs and potentially accelerated repayment requirements. As of January 26, 2006, we were in compliance with the restrictions and limitations included in these provisions.



We believe that cash on hand, together with cash provided by operating
activities and borrowings on our line of credit, will be sufficient to meet our working capital, capital expenditure and debt service requirements beyond the next 12 months.



Operating Cash Flows



Net cash provided by operating activities was $203.1 million in fiscal 2006, compared to $181.3 million in fiscal 2005 and $122.1 million in fiscal
2004. The increase in our operating cash flows in fiscal 2006 over fiscal 2005 was primarily due to improved operating performance, as reflected by increased net income after adjustments for the non-cash gain on the sale of our distribution center
and non-cash stock-based compensation expenses. The increase in our operating cash flows in fiscal 2005 over fiscal 2004 was primarily due to changes in assets and liabilities and deferred income taxes.



Net changes in assets and liabilities and deferred taxes accounted for $31.7
million of our operating cash flows in fiscal 2006. Current and other liabilities increased $73.2 million primarily as a result of the $28.8 million increase in merchandise inventories and increased pharmacy benefit services payables related to our
new prescription drug plans. Pharmacy and other receivables increased $24.9 million due to higher pharmacy sales and pharmacy benefit services revenues.



Net changes in assets and liabilities and deferred taxes accounted for $49.9 million of our operating cash flows in fiscal 2005. Merchandise inventories
decreased $43.8 million as a result of improved inventory management in our stores and distribution centers. Current and other liabilities decreased $14.7 million primarily as a result of lower merchandise inventory levels, partially offset by
increased accruals for workers compensation and employee compensation and benefits. Pharmacy and other receivables decreased $5.6 million, primarily due to the timing of payments from pharmacy benefit services customers; lease-related
receivables; third-party health plans; and vendors, for amounts associated with our contractual purchase arrangements. Fiscal 2005 operating cash flows also reflect the reclassification of certain income tax amounts from taxes payable to deferred
income taxes as a result of the acceleration of certain income tax deductions resulting from tax planning and optimization efforts.



Net changes in assets and liabilities and deferred taxes unfavorably affected our operating cash flows by $6.8 million in fiscal 2004. Current and other
liabilities increased $54.7 million primarily as a result of higher



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inventory levels and improved payment terms with many of our vendors; increased accruals for workers compensation and employee compensation and
benefits; and increased taxes payable due to increased current taxes due and the effect of income tax credits in fiscal 2003, which had the effect of lowering taxes payable in fiscal 2003. Merchandise inventories increased $33.7 million as a result
of our efforts to remain in-stock during a system conversion in our Northern California distribution center and the Southern California grocery strike. Pharmacy and other receivables increased $28.3 million primarily due to increased amounts owed to
us from vendors as a result of changes in some of our contractual purchase arrangements, the timing of payments from pharmacy benefit services customers and increased pharmacy receivables arising from higher sales.



Investing Cash Flows



Net cash used in investing activities was $78.5 million in fiscal 2006,
compared to $84.2 million in fiscal 2005 and $104.3 million in fiscal 2004. Investing activities primarily consist of capital expenditures for new stores, store remodels and improvements, equipment, technology and supply chain improvements,
including the construction of a new front-end distribution center, partially offset by cash receipts from property dispositions.



Capital expenditures were $106.3 million in fiscal 2006, compared to $91.2 million in fiscal 2005 and $114.0 million in fiscal 2004. Fiscal 2006 capital
expenditures include amounts invested to date for the construction of our new front-end distribution center in Patterson, California. The lower level of capital expenditures in fiscal 2005 was partially due to the timing of expenditures for certain
projects approved in fiscal 2005, which carried over into fiscal 2006. Fiscal 2004 capital expenditures also included investments in store pharmacy robotics and digital photography technology.



Cash receipts from property dispositions were $27.8 million in fiscal 2006,
compared to $7.0 million in fiscal 2005 and $9.7 million in fiscal 2004. Fiscal 2006 receipts include net proceeds of approximately $21.5 million from the sale-leaseback of our Lathrop front-end distribution center, which we plan to vacate when our
new Patterson distribution center, currently under construction, is fully operational. The remainder of our cash receipts from property distributions in fiscal 2006, 2005 and 2004 primarily include the sale of company-owned locations as a result of
closing stores and support facilities.



We opened 5 new stores
in fiscal 2006, opened 4 new stores and relocated 2 stores in fiscal 2005, and opened 18 new stores and relocated one store in fiscal 2004. We also remodeled 41 stores during fiscal 2006, 40 stores during fiscal 2005 and 20 stores during fiscal
2004. We plan to open or relocate approximately 20 to 25 stores and remodel up to 40 stores in fiscal 2007. We are also constructing a new front-end distribution center in Patterson, California, scheduled for completion in the summer of fiscal 2007.
We expect capital expenditures in fiscal 2007 to be between $200 million and $220 million. The increase over fiscal 2006 is primarily due to costs associated with the Patterson distribution center, increased new store growth and the timing of
expenditures for certain projects approved in fiscal 2006, which will carry over into fiscal 2007. In addition, in the ordinary course of business we may acquire stores, store-related assets including pharmacy customer lists, or other complementary
businesses.



Financing Cash Flows



Net cash used in financing activities was $103.8 million in fiscal 2006,
compared to $83.5 million in fiscal 2005 and $17.8 million in fiscal 2004. Our financing activities primarily consist of long-term borrowings and repayments, repurchases of common stock, dividend payments and proceeds from the exercise of stock
options.



Our borrowing levels on our revolving line of credit
fluctuate based largely on the levels of our cash flows from operations, capital expenditures and stock repurchases. We reduced our revolving line of credit borrowings by $40.0 million in fiscal 2006 and $10.0 million in fiscal 2005; and in fiscal
2004, we increased our revolving line of credit borrowings by $25.0 million. As of January 26, 2006, there were no outstanding borrowings on our revolving line of credit. We also made regularly scheduled principal payments on our private
placement notes of



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$8.9 million in fiscal 2006, $41.9 million in fiscal 2005 and $2.3 million in fiscal 2004. We are scheduled to make additional principal payments of $45.9
million on our private placement notes in fiscal 2007.



We have
repurchased shares of our outstanding common stock in each of the last three years, as follows:



|                      |  |             |  |         |  |          
|--------------------- |  | ----------- |  | ------- |  | ---------
|                      |  | Fiscal Year
|                      |  | 2006        |  | 2005    |  | 2004     
|Shares repurchased    |  | 1,420,000   |  | 736,260 |  | 1,362,200
|Total cost (millions) |  | $55.1       |  | $16.9   |  | $20.0    



We repurchased these
shares under various programs authorized by our board of directors, most recently in May 2005. Under the May 2005 share repurchase program, we are authorized to repurchase additional shares of our outstanding common stock for a maximum additional
expenditure of $120.2 million. Any future repurchase of our common stock will depend on existing market conditions, our financial position, and other capital requirements.



Proceeds from employee stock option exercises were $21.0 million in fiscal 2006, compared to $6.2 million in fiscal 2005 and
$0.5 million in fiscal 2004. The increased level of stock option exercises reflects an increasing number of vested options and a higher average stock price.



Our board of directors makes decisions about the declaration of quarterly dividends based on, among other things, our results of operations and financial
position. We have paid regular quarterly dividends of $0.14 per share ($0.56 per share annually) for each of the last three fiscal years. Total dividends were $20.8 million in fiscal 2006, $20.9 million in fiscal 2005 and $21.0 million in fiscal
2004.



Contractual Obligations



The following table summarizes our contractual obligations as of
January 26, 2006:



|                            |  |                        |            |                  |   |           |  |           |           |                  |   |           |  |   |        
|--------------------------- |  | ---------------------- | ---------- | ---------------- | - | --------- |  | --------- | --------- | ---------------- | - | --------- |  | - | -------
|                            |  | Payments due by period
|                            |  | Total                  |            | Less than 1 year |   | 1-3 years |  | 3-5 years |           | More than5 years
|                            |  | Thousands             
|Long-term debt              |  | $                      | 120,147    |                  | $ | 51,948    |  | $         | 49,242    |                  | $ | 6,993     |  | $ | 11,964 
|Operating leases            |  |                        | 993,813    |                  |   | 77,391    |  |           | 148,567   |                  |   | 135,919   |  |   | 631,936
|Capital lease obligations   |  |                        | 22,537     |                  |   | 1,001     |  |           | 2,079     |                  |   | 2,096     |  |   | 17,361 
|Purchase obligations        |  |                        | 9,447,796  |                  |   | 1,774,550 |  |           | 3,713,925 |                  |   | 3,959,321 |  |   |       
|Other long-term liabilities |  |                        |           |                  |   |          |  |           |          |                  |   |          |  |   |       
|                            |  |                        |            |                  |   |           |  |           |           |                  |   |           |  |   |        
|Total                       |  | $                      | 10,584,293 |                  | $ | 1,904,890 |  | $         | 3,913,813 |                  | $ | 4,104,329 |  | $ | 661,261
|                            |  |                        |            |                  |   |           |  |           |           |                  |   |           |  |   |        



See Debt,
Leases and Commitments and Contingencies in the accompanying notes to our consolidated financial statements for further information about the above items.



Purchase obligations include merchandise purchase commitments under various long-term supply contracts, as well as
outstanding commitments under purchase orders issued in the normal course of business. Purchase obligations include estimated amounts to purchase pharmaceutical inventories from AmerisourceBergen, our primary supplier, under a long-term
contract, including a new contract that will take effect in July 2006 upon expiration of the current contract. The contract includes a minimum purchase requirement over the contract term, which is effective for three to seven years depending on
our actual purchase levels and various termination provisions. The amounts included for this contract in the above table represent our best estimate of purchase levels under the contracts terms.



Our other long-term liabilities of $84.0 million as of January 26, 2006
consisted of deferred tax liabilities, deferred rent, capital lease obligations, and store closure reserves. These items either are not of a contractual



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nature, such as deferred rent and deferred income taxes, or are included elsewhere in the above table, such as capital and closed store lease obligations.



We incur substantial cash requirements for the payment of
interest and income taxes each year. Payments for interest fluctuate based on our borrowings and interest rates. Our cash payments for interest, net of amounts capitalized, were $9.2 million in fiscal 2006, $13.7 million in fiscal 2005 and $13.8
million in fiscal 2004. At January 26, 2006, all of our $105.7 million in outstanding debt bears interest at fixed rates. Scheduled interest payments on fixed-interest long-term debt are included in Long-Term Debt in the table
above. Our unsecured revolving line of credit, on which no borrowings were outstanding as of January 26, 2006, bears interest at LIBOR-based rates.



Our cash payments for income taxes were $21.4 million in fiscal 2006, $15.7 million in fiscal 2005 and $8.8 million in fiscal 2004. Payments for income
taxes fluctuate based on our taxable income and the availability and timing of tax deductions and credits.



We also incur obligations for contributions to our Employee Savings and Profit Sharing Plan. We match a portion of our employees voluntary
contributions and provide profit sharing contributions to the plan in some years. Our contributions to the plan, which may be made in cash or in shares of our common stock, fluctuate based on the level of participation in the plan by our employees
as well as our levels of income. Our contributions to this plan were $11.3 million for fiscal 2006, $7.7 million for fiscal 2005 and $7.3 million for fiscal 2004, all of which we funded with shares of our common stock.



OFF-BALANCE SHEET ARRANGEMENTS



We do not make use of any off-balance sheet arrangements that currently have
or that we expect are reasonably likely to have a material effect on our financial condition, results of operations or cash flows. We utilize operating leases for many of our store locations, and from time to time we engage in sale-leaseback
arrangements for financing purposes. We do not use special-purpose entities in any of our leasing arrangements.



CRITICAL ACCOUNTING POLICIES



The preparation of our financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of
our assets and liabilities, disclosure of contingent assets and liabilities and the reported amounts of revenues and expenses during the reporting period. Uncertainties regarding such estimates and assumptions are inherent in the preparation of our
financial statements, and actual results may differ from those estimates and assumptions. We believe the following critical accounting policies require the most significant judgments and estimates used in the preparation of our consolidated
financial statements:



Accounts Receivable and Reserves



Our receivables primarily include amounts due from
third party providers (e.g., pharmacy benefit managers, insurance companies and governmental agencies) and vendors. We maintain an allowance for the amount of these receivables that we estimate to be uncollectible. Our estimates of uncollectible
amounts are based on our historical collection experience, current economic and credit conditions and any information available to us indicating that specific accounts are unlikely to be collected. We have historically collected a relatively high
percentage of our accounts receivable, especially pharmacy receivables, and our credit and collection losses have not materially adversely affected us. However, if the financial condition of our third party providers or vendors deteriorates, we may
increase the allowance for uncollectible accounts and our recovery of recorded receivables may be significantly affected.



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Merchandise Inventories



We record our inventories at the lower of cost or market value. If we do not sell the merchandise at expected prices or if
we make decisions to significantly reduce or eliminate merchandise items or categories, we may need to record adjustments to the carrying value of our merchandise inventories and our realization of recorded inventories may be significantly affected.



We use the last-in, first-out (LIFO) method to determine
inventory cost. The calculation of LIFO inventory costs depends on a number of factors, including annual inflation rates, year-end inventory levels and merchandise mix, which require estimates during interim periods. These estimates are subject to
substantial variability and may result in significant adjustments, particularly during the fourth quarter, when final inflation rates and inventory levels and mix are determined. Our LIFO provision, included in cost of goods sold, was $4.8 million
in fiscal 2006, $5.5 million in fiscal 2005 and $1.4 million in fiscal 2004.



Impairment of Long-Lived Assets



We review long-lived tangible assets and intangible assets with finite useful lives for impairment whenever events or changes in circumstances indicate that their carrying values may not be recoverable. Using our best
estimates based on reasonable assumptions and projections, we record an impairment loss to write the assets down to their estimated fair values if the carrying values of such assets exceed their related undiscounted expected future cash flows.



We review goodwill and other intangible assets with indefinite
useful lives for impairment annually, or more frequently if events or changes in circumstances warrant. We perform our annual impairment testing during the fourth fiscal quarter, when updated financial projections are available. If the carrying
values of such assets exceed their estimated fair values, we record an impairment loss to write the assets down to their estimated fair values.



We generally evaluate store-specific long-lived tangible assets and intangible assets with finite useful lives at an individual store level, which is the
lowest level at which independent cash flows can be identified. We evaluate corporate assets or other long-lived assets that are not store-specific at a consolidated entity or segment level as appropriate. We evaluate goodwill at a reporting unit
level in accordance with SFAS No. 142, Goodwill and Other Intangible Assets. Geographic regional divisions within the retail drug store segment comprise our reporting units.



Since quoted market prices are not typically available for our long-lived tangible and intangible assets, we estimate fair
values for most assets based on the expected present value of future cash flows. We estimate future cash flows based on store-level historical results, current trends and operating and cash flow projections. Our estimates are subject to substantial
uncertainty and may be affected by a number of factors outside of our control, including general economic conditions, the competitive environment and regulatory changes. If actual results differ from our estimates, we may record significant
additional impairment charges in the future. We recorded impairment charges of $2.7 million in fiscal 2006, $1.2 million in fiscal 2005 and $3.9 million in fiscal 2004.



Store Closure Reserves



We recognize a liability for costs associated with closing a store when the liability is incurred. We record the present
value of expected future lease costs, net of estimated future sublease income, when the store is closed. We record severance and other employee-related costs in the period in which we communicate the closure and related severance packages to the
affected employees.



Our calculation of store closure costs
includes significant estimates about the amounts and timing of future sublease income. These estimates are based on our historical experience, the condition and location of the



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property, the lease terms and current real estate leasing market conditions. If actual results differ from our estimates, we may significantly adjust our
store closure reserves in future periods. We recorded no provision for store closures in fiscal 2006, and provisions of $0.3 million in fiscal 2005 and $3.5 million in fiscal 2004.



Insurance Reserves



We maintain insurance coverage for significant exposures as well as those risks that are required to be insured by law. It is generally our policy to
retain a significant portion of certain losses related to workers compensation, general liability, property losses, pharmacist liability, business interruptions and employee health care. We record provisions for these items based on claims
experience, regulatory changes, an estimate of claims incurred but not yet reported and other relevant factors. An independent actuary periodically evaluates our most significant insurance reserves. We discount reserves for workers
compensation and general liability claims to their expected present value using an essentially risk-free interest rate. The projections involved in this estimate are subject to substantial uncertainty because of several unpredictable factors,
including actual claims experience, regulatory changes, litigation trends and changes in inflation and interest rates. If actual claims or costs vary from our estimates, we may need to record significant adjustments to our reserves and expense.



Revenue Recognition



We recognize revenue from retail drug store sales, net of an allowance for
estimated returns, at the time the merchandise is sold or services performed. The allowance for sales returns is estimated based on our historical experience. Historically, our sales returns have not been significant, but changes in our experience
could result in significant additional reserves.



Our pharmacy
benefit services revenues include amounts generated from pharmacy benefit management services and, beginning January 1, 2006, prescription drug plans. We recognize revenue from pharmacy benefit management services, which include plan design and
implementation, claims administration and formulary management, when our RxAmerica subsidiary has completed its service obligations under its contracts, including the approval or denial of the authorization request to the participating pharmacy.
RxAmerica does not take title to prescription drug inventories or assume substantial risks and rewards of inventory ownership or receivable collection associated with the provision of pharmacy benefit management services. Accordingly, under our
existing contracts we recognize pharmacy benefit management revenues from third-party health plans net of the reimbursements due to participating pharmacies. We do not recognize co-payments made to participating pharmacies by health plan members. We
estimate certain rebate revenues in our pharmacy benefit services segment based on our contractual terms and prescription drug utilization mix. These estimates are subject to uncertainty and actual results could differ significantly.



Beginning January 1, 2006, we also earn revenues for the prescription
drug plan benefits we provide to Medicare participants through our pharmacy benefit services segment. These revenues include fixed monthly premiums and certain adjustments based on our claims experience and other factors. We recognize the fixed
monthly premiums on a straight-line basis over the period of coverage, and we estimate the revenue adjustments based on information available to us about our claims experience and other factors. These estimates are subject to substantial
uncertainty, particularly in the first year of this new federal benefit, and actual results could differ significantly.



Vendor Rebates and Allowances



We record merchandise rebates and allowances as a reduction of the cost of inventory and recognize the benefit through the cost of retail drug store sales
when we sell the related inventory. We recognize advertising rebates and allowances as a reduction of advertising expense, a component of cost of retail drug store sales, when we incur the related advertising expense or complete the required
performance. We defer lump-sum payments received from vendors in connection with a contractual arrangement and recognize them over the contract term



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as a reduction of cost of retail drug store sales. Some of our contractual arrangements require estimates of the rebate amounts earned and collectible. If
actual rebates and allowances received differ from our estimates, we may be required to record significant adjustments to our rebates and allowances.



Other Significant Accounting Policies



The above policies are not intended to be a comprehensive list of all of our accounting policies. In many cases, generally accepted accounting principles
specifically dictate the accounting treatment for a particular transaction. There are also certain areas in which managements judgment in selecting any available alternative would not produce a materially different result. See the accompanying
audited consolidated financial statements and notes thereto for a more complete discussion of our accounting policies and other disclosures required by generally accepted accounting principles.



NEW ACCOUNTING PRONOUNCEMENTS



See Note 1, The Company and Significant Accounting Policies, in
the accompanying notes to our consolidated financial statements included in Item 8 of this Form 10-K.



Item 7A.Quantitative and Qualitative Disclosures of Market Risk



Our major market risk exposure is changing interest rates. We use debt financing in combination with operating cash flows to support capital expenditures,
acquisitions, working capital needs, dividend payments, share repurchases and other general corporate purposes. Our revolving line of credit, on which no borrowings were outstanding as of January 26, 2006 bears interest at LIBOR-based rates,
and therefore an increase in interest rates could increase our interest expense. We do not currently undertake any specific actions to cover our exposure to interest rate risk and we are not currently a party to any interest rate risk management
transactions. We have not purchased and do not currently hold any derivative financial instruments. Depending on the interest rate environment and subject to approval by our board of directors, we may make use of derivative financial instruments or
other interest rate management vehicles in the future.



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Item 8.Financial Statements and Supplementary Data



LONGS DRUG STORES CORPORATION



STATEMENTS OF CONSOLIDATED INCOME



|                                                   |  |                                    |           |   |                 |   |           |                 |  |   |           |  
|-------------------------------------------------- |  | ---------------------------------- | --------- | - | --------------- | - | --------- | --------------- |  | - | --------- | -
|                                                   |  | For the Fiscal Year Ended          |          
|                                                   |  | January 26,2006                    |           |   | January 27,2005 |   |           | January 29,2004 | 
|                                                   |  | Thousands Except Per Share Amounts |          
|Revenues:                                          |  |                                    |           |   |                 |   |           |                 |  |   |           |  
|Retail drug store sales                            |  | $                                  | 4,616,846 |   |                 | $ | 4,575,051 |                 |  | $ | 4,499,094 |  
|Pharmacy benefit services revenues                 |  |                                    | 53,457    |   |                 |   | 32,822    |                 |  |   | 27,430    |  
|                                                   |  |                                    |           |   |                 |   |           |                 |  |   |           |  
|Total revenues                                     |  |                                    | 4,670,303 |   |                 |   | 4,607,873 |                 |  |   | 4,526,524 |  
|Costs and expenses:                                |  |                                    |           |   |                 |   |           |                 |  |   |           |  
|Cost of retail drug store sales                    |  |                                    | 3,430,967 |   |                 |   | 3,421,388 |                 |  |   | 3,382,103 |  
|Prescription drug plan benefit costs               |  |                                    | 12,232    |   |                 |   |          |                 |  |   |          |  
|Operating and administrative expenses              |  |                                    | 1,025,224 |   |                 |   | 1,018,560 |                 |  |   | 1,000,994 |  
|Depreciation and amortization                      |  |                                    | 84,072    |   |                 |   | 85,259    |                 |  |   | 83,595    |  
|Gain on sale of distribution center                |  |                                    | (11,049   | ) |                 |   |          |                 |  |   |          |  
|Provision for store closures and asset impairments |  |                                    | 2,699     |   |                 |   | 1,401     |                 |  |   | 7,438     |  
|Legal settlements and other disputes, net          |  |                                    |          |   |                 |   | 10,773    |                 |  |   | (7,007    | )
|                                                   |  |                                    |           |   |                 |   |           |                 |  |   |           |  
|Operating income                                   |  |                                    | 126,158   |   |                 |   | 70,492    |                 |  |   | 59,401    |  
|Interest expense                                   |  |                                    | 9,151     |   |                 |   | 13,993    |                 |  |   | 13,898    |  
|Interest income                                    |  |                                    | (1,294    | ) |                 |   | (639      | )               |  |   | (519      | )
|                                                   |  |                                    |           |   |                 |   |           |                 |  |   |           |  
|Income before income taxes                         |  |                                    | 118,301   |   |                 |   | 57,138    |                 |  |   | 46,022    |  
|Income taxes                                       |  |                                    | 44,417    |   |                 |   | 20,578    |                 |  |   | 16,258    |  
|                                                   |  |                                    |           |   |                 |   |           |                 |  |   |           |  
|Net income                                         |  | $                                  | 73,884    |   |                 | $ | 36,560    |                 |  | $ | 29,764    |  
|                                                   |  |                                    |           |   |                 |   |           |                 |  |   |           |  
|Earnings per common share:                         |  |                                    |           |   |                 |   |           |                 |  |   |           |  
|Basic                                              |  | $                                  | 1.98      |   |                 | $ | 0.98      |                 |  | $ | 0.80      |  
|Diluted                                            |  |                                    | 1.93      |   |                 |   | 0.97      |                 |  |   | 0.79      |  
|Dividends per common share                         |  | $                                  | 0.56      |   |                 | $ | 0.56      |                 |  | $ | 0.56      |  
|Weighted average number of shares outstanding:     |  |                                    |           |   |                 |   |           |                 |  |   |           |  
|Basic                                              |  |                                    | 37,332    |   |                 |   | 37,262    |                 |  |   | 37,213    |  
|Diluted                                            |  |                                    | 38,280    |   |                 |   | 37,591    |                 |  |   | 37,454    |  



See accompanying notes
to consolidated financial statements.



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LONGS DRUG STORES CORPORATION



CONSOLIDATED BALANCE SHEETS



|                                                                                                                      |  |                                    |           |   |                  |   |           |  
|--------------------------------------------------------------------------------------------------------------------- |  | ---------------------------------- | --------- | - | ---------------- | - | --------- | -
|                                                                                                                      |  | January 26, 2006                   |           |   | January 27, 2005 |  
|                                                                                                                      |  | Thousands Except Share Information |          
|ASSETS                                                                                                                |  |                                    |           |   |                  |   |           |  
|Current Assets:                                                                                                       |  |                                    |           |   |                  |   |           |  
|Cash and cash equivalents                                                                                             |  | $                                  | 74,662    |   |                  | $ | 53,890    |  
|Pharmacy and other receivables, net                                                                                   |  |                                    | 183,213   |   |                  |   | 158,345   |  
|Merchandise inventories, net                                                                                          |  |                                    | 462,030   |   |                  |   | 433,280   |  
|Deferred income taxes                                                                                                 |  |                                    | 42,258    |   |                  |   | 43,074    |  
|Prepaid expenses and other current assets                                                                             |  |                                    | 21,204    |   |                  |   | 22,742    |  
|                                                                                                                      |  |                                    |           |   |                  |   |           |  
|Total current assets                                                                                                  |  |                                    | 783,367   |   |                  |   | 711,331   |  
|                                                                                                                      |  |                                    |           |   |                  |   |           |  
|Property:                                                                                                             |  |                                    |           |   |                  |   |           |  
|Land                                                                                                                  |  |                                    | 111,097   |   |                  |   | 108,198   |  
|Buildings and leasehold improvements                                                                                  |  |                                    | 588,540   |   |                  |   | 577,773   |  
|Equipment and fixtures                                                                                                |  |                                    | 601,247   |   |                  |   | 565,161   |  
|                                                                                                                      |  |                                    |           |   |                  |   |           |  
|Total                                                                                                                 |  |                                    | 1,300,884 |   |                  |   | 1,251,132 |  
|Less accumulated depreciation                                                                                         |  |                                    | 676,084   |   |                  |   | 632,778   |  
|                                                                                                                      |  |                                    |           |   |                  |   |           |  
|Property, net                                                                                                         |  |                                    | 624,800   |   |                  |   | 618,354   |  
|                                                                                                                      |  |                                    |           |   |                  |   |           |  
|Goodwill                                                                                                              |  |                                    | 82,085    |   |                  |   | 82,085    |  
|Intangible assets, net                                                                                                |  |                                    | 6,060     |   |                  |   | 6,354     |  
|Other non-current assets                                                                                              |  |                                    | 7,832     |   |                  |   | 3,791     |  
|                                                                                                                      |  |                                    |           |   |                  |   |           |  
|Total                                                                                                                 |  | $                                  | 1,504,144 |   |                  | $ | 1,421,915 |  
|                                                                                                                      |  |                                    |           |   |                  |   |           |  
|LIABILITIES  AND  STOCKHOLDERS  EQUITY                                                                               |  |                                    |           |   |                  |   |           |  
|Current Liabilities:                                                                                                  |  |                                    |           |   |                  |   |           |  
|Accounts payable and accrued expenses                                                                                 |  | $                                  | 349,888   |   |                  | $ | 273,957   |  
|Employee compensation and benefits                                                                                    |  |                                    | 138,202   |   |                  |   | 139,966   |  
|Taxes payable                                                                                                         |  |                                    | 58,493    |   |                  |   | 52,999    |  
|Current maturities of debt                                                                                            |  |                                    | 45,870    |   |                  |   | 8,870     |  
|                                                                                                                      |  |                                    |           |   |                  |   |           |  
|Total current liabilities                                                                                             |  |                                    | 592,453   |   |                  |   | 475,792   |  
|                                                                                                                      |  |                                    |           |   |                  |   |           |  
|Long-term debt                                                                                                        |  |                                    | 59,818    |   |                  |   | 145,688   |  
|Deferred income taxes and other long-term liabilities                                                                 |  |                                    | 83,995    |   |                  |   | 73,298    |  
|Commitments and Contingencies                                                                                         |  |                                    |           |   |                  |   |           |  
|Stockholders Equity:                                                                                                 |  |                                    |           |   |                  |   |           |  
|Common stock: par value $0.50 per share, 120,000,000 shares authorized, 37,216,000, and 37,418,000 shares outstanding |  |                                    | 18,608    |   |                  |   | 18,709    |  
|Additional capital                                                                                                    |  |                                    | 214,745   |   |                  |   | 180,072   |  
|Unearned compensation                                                                                                 |  |                                    | (1,371    | ) |                  |   | (1,528    | )
|Retained earnings                                                                                                     |  |                                    | 535,896   |   |                  |   | 529,884   |  
|                                                                                                                      |  |                                    |           |   |                  |   |           |  
|Total stockholders equity                                                                                            |  |                                    | 767,878   |   |                  |   | 727,137   |  
|                                                                                                                      |  |                                    |           |   |                  |   |           |  
|Total                                                                                                                 |  | $                                  | 1,504,144 |   |                  | $ | 1,421,915 |  
|                                                                                                                      |  |                                    |           |   |                  |   |           |  



See accompanying notes
to consolidated financial statements.



31



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##### Table of Contents

LONGS DRUG STORES CORPORATION



STATEMENTS OF CONSOLIDATED CASH FLOWS



|                                                                                  |  |                           |          |   |                 |   |         |                 |  |   |          |  
|--------------------------------------------------------------------------------- |  | ------------------------- | -------- | - | --------------- | - | ------- | --------------- |  | - | -------- | -
|                                                                                  |  | For the Fiscal Year Ended |         
|                                                                                  |  | January 26,2006           |          |   | January 27,2005 |   |         | January 29,2004 | 
|                                                                                  |  | Thousands                 |         
|Operating Activities:                                                             |  |                           |          |   |                 |   |         |                 |  |   |          |  
|Net income                                                                        |  | $                         | 73,884   |   |                 | $ | 36,560  |                 |  | $ | 29,764   |  
|Adjustments to reconcile net income to net cash provided by operating activities: |  |                           |          |   |                 |   |         |                 |  |   |          |  
|Depreciation and amortization                                                     |  |                           | 84,072   |   |                 |   | 85,259  |                 |  |   | 83,595   |  
|Gain on sale of distribution center                                               |  |                           | (11,049  | ) |                 |   |        |                 |  |   |         |  
|Provision for store closures and asset impairments                                |  |                           | 2,699    |   |                 |   | 1,401   |                 |  |   | 7,438    |  
|Deferred income taxes and other                                                   |  |                           | 9,472    |   |                 |   | 13,826  |                 |  |   | 358      |  
|Stock awards and options, net                                                     |  |                           | 13,714   |   |                 |   | 1,171   |                 |  |   | 702      |  
|Common stock contribution to benefit plan                                         |  |                           | 8,104    |   |                 |   | 7,077   |                 |  |   | 7,476    |  
|Changes in assets and liabilities:                                                |  |                           |          |   |                 |   |         |                 |  |   |          |  
|Pharmacy and other receivables                                                    |  |                           | (24,868  | ) |                 |   | 5,605   |                 |  |   | (28,340  | )
|Merchandise inventories                                                           |  |                           | (28,750  | ) |                 |   | 43,842  |                 |  |   | (33,687  | )
|Other assets                                                                      |  |                           | 2,658    |   |                 |   | 1,256   |                 |  |   | 130      |  
|Current liabilities and other                                                     |  |                           | 73,195   |   |                 |   | (14,659 | )               |  |   | 54,703   |  
|                                                                                  |  |                           |          |   |                 |   |         |                 |  |   |          |  
|Net cash provided by operating activities                                         |  |                           | 203,131  |   |                 |   | 181,338 |                 |  |   | 122,139  |  
|                                                                                  |  |                           |          |   |                 |   |         |                 |  |   |          |  
|                                                                                  |  |                           |         
|Investing Activities:                                                             |  |                           |          |   |                 |   |         |                 |  |   |          |  
|Capital expenditures and acquisitions                                             |  |                           | (106,322 | ) |                 |   | (91,179 | )               |  |   | (113,999 | )
|Proceeds from property dispositions                                               |  |                           | 27,794   |   |                 |   | 6,971   |                 |  |   | 9,727    |  
|                                                                                  |  |                           |          |   |                 |   |         |                 |  |   |          |  
|Net cash used in investing activities                                             |  |                           | (78,528  | ) |                 |   | (84,208 | )               |  |   | (104,272 | )
|                                                                                  |  |                           |          |   |                 |   |         |                 |  |   |          |  
|Financing Activities:                                                             |  |                           |          |   |                 |   |         |                 |  |   |          |  
|Proceeds from (repayments of) revolving line of credit borrowings, net            |  |                           | (40,000  | ) |                 |   | (10,000 | )               |  |   | 25,000   |  
|Repayments of private placement notes and other borrowings                        |  |                           | (8,870   | ) |                 |   | (41,870 | )               |  |   | (2,349   | )
|Repurchase of common stock                                                        |  |                           | (55,129  | ) |                 |   | (16,855 | )               |  |   | (20,023  | )
|Proceeds from exercise of stock options                                           |  |                           | 20,986   |   |                 |   | 6,211   |                 |  |   | 540      |  
|Dividend payments                                                                 |  |                           | (20,818  | ) |                 |   | (20,948 | )               |  |   | (21,008  | )
|                                                                                  |  |                           |          |   |                 |   |         |                 |  |   |          |  
|Net cash used in financing activities                                             |  |                           | (103,831 | ) |                 |   | (83,462 | )               |  |   | (17,840  | )
|                                                                                  |  |                           |          |   |                 |   |         |                 |  |   |          |  
|                                                                                  |  |                           |         
|Increase in cash and cash equivalents                                             |  |                           | 20,772   |   |                 |   | 13,668  |                 |  |   | 27       |  
|Cash and cash equivalents at beginning of year                                    |  |                           | 53,890   |   |                 |   | 40,222  |                 |  |   | 40,195   |  
|                                                                                  |  |                           |          |   |                 |   |         |                 |  |   |          |  
|Cash and cash equivalents at end of year                                          |  | $                         | 74,662   |   |                 | $ | 53,890  |                 |  | $ | 40,222   |  
|                                                                                  |  |                           |          |   |                 |   |         |                 |  |   |          |  
|                                                                                  |  |                           |         
|Supplemental disclosure of cash flow information:                                 |  |                           |          |   |                 |   |         |                 |  |   |          |  
|Cash paid for interest, net of amounts capitalized                                |  | $                         | 9,210    |   |                 | $ | 13,745  |                 |  | $ | 13,823   |  
|Cash paid for income taxes                                                        |  |                           | 21,441   |   |                 |   | 15,692  |                 |  |   | 8,756    |  



See accompanying notes
to consolidated financial statements.



32



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##### Table of Contents

LONGS DRUG STORES CORPORATION



STATEMENTS OF CONSOLIDATED STOCKHOLDERS EQUITY



|                                                                |  |              |   |  |                   |        |   |                      |   |         |                  |  |   |                           |   |  |   |         |   |  |   |         |  
|--------------------------------------------------------------- |  | ------------ | - |  | ----------------- | ------ | - | -------------------- | - | ------- | ---------------- |  | - | ------------------------- | - |  | - | ------- | - |  | - | ------- | -
|                                                                |  |              |   |  |                   |        |   |                      |   |         |                  |  |   |                           |   |  |   |        
|                                                                |  | Common Stock |   |  | AdditionalCapital |        |   | UnearnedCompensation |   |         | RetainedEarnings |  |   | Total StockholdersEquity |  
|                                                                |  | Shares       |   |  | Amount            |        |   |                      |   |        
|                                                                |  | Thousands    |  
|Balance at January 30, 2003                                     |  | 38,501       |   |  | $                 | 19,250 |   |                      | $ | 169,853 |                  |  | $ | (4,562                    | ) |  | $ | 531,929 |   |  | $ | 716,470 |  
|Net income                                                      |  |              |   |  |                   |        |   |                      |   |         |                  |  |   |                           |   |  |   | 29,764  |   |  |   | 29,764  |  
|Dividends ($0.56 per share)                                     |  |              |   |  |                   |        |   |                      |   |         |                  |  |   |                           |   |  |   | (21,008 | ) |  |   | (21,008 | )
|Stock contributions to Employee Savings and Profit Sharing Plan |  | 415          |   |  |                   | 208    |   |                      |   | 7,268   |                  |  |   |                           |   |  |   |         |   |  |   | 7,476   |  
|Stock award forfeitures, net of grants                          |  | (36          | ) |  |                   | (18    | ) |                      |   | (937    | )                |  |   | 356                       |   |  |   |         |   |  |   | (599    | )
|Stock-based compensation expense                                |  |              |   |  |                   |        |   |                      |   |         |                  |  |   | 1,681                     |   |  |   |         |   |  |   | 1,681   |  
|Stock options exercised                                         |  | 26           |   |  |                   | 13     |   |                      |   | 527     |                  |  |   |                           |   |  |   |         |   |  |   | 540     |  
|Tax expense related to stock awards and stock options, net      |  |              |   |  |                   |        |   |                      |   | (380    | )                |  |   |                           |   |  |   |         |   |  |   | (380    | )
|Repurchase of common stock                                      |  | (1,362       | ) |  |                   | (681   | ) |                      |   | (6,010  | )                |  |   |                           |   |  |   | (13,332 | ) |  |   | (20,023 | )
|                                                                |  |              |   |  |                   |        |   |                      |   |         |                  |  |   |                           |   |  |   |         |   |  |   |         |  
|Balance at January 29, 2004                                     |  | 37,544       |   |  |                   | 18,772 |   |                      |   | 170,321 |                  |  |   | (2,525                    | ) |  |   | 527,353 |   |  |   | 713,921 |  
|                                                                |  |              |   |  |                   |        |   |                      |   |         |                  |  |   |                           |   |  |   |         |   |  |   |         |  
|Net income                                                      |  |              |   |  |                   |        |   |                      |   |         |                  |  |   |                           |   |  |   | 36,560  |   |  |   | 36,560  |  
|Dividends ($0.56 per share)                                     |  |              |   |  |                   |        |   |                      |   |         |                  |  |   |                           |   |  |   | (20,948 | ) |  |   | (20,948 | )
|Stock contributions to Employee Savings and Profit Sharing Plan |  | 320          |   |  |                   | 160    |   |                      |   | 6,917   |                  |  |   |                           |   |  |   |         |   |  |   | 7,077   |  
|Stock awards, net of forfeitures                                |  | 2            |   |  |                   | 1      |   |                      |   | (400    | )                |  |   | (267                      | ) |  |   |         |   |  |   | (666    | )
|Stock-based compensation expense                                |  |              |   |  |                   |        |   |                      |   |         |                  |  |   | 1,264                     |   |  |   |         |   |  |   | 1,264   |  
|Stock options exercised                                         |  | 288          |   |  |                   | 144    |   |                      |   | 6,067   |                  |  |   |                           |   |  |   |         |   |  |   | 6,211   |  
|Tax benefit related to stock awards and stock options, net      |  |              |   |  |                   |        |   |                      |   | 573     |                  |  |   |                           |   |  |   |         |   |  |   | 573     |  
|Repurchase of common stock                                      |  | (736         | ) |  |                   | (368   | ) |                      |   | (3,406  | )                |  |   |                           |   |  |   | (13,081 | ) |  |   | (16,855 | )
|                                                                |  |              |   |  |                   |        |   |                      |   |         |                  |  |   |                           |   |  |   |         |   |  |   |         |  
|Balance at January 27, 2005                                     |  | 37,418       |   |  |                   | 18,709 |   |                      |   | 180,072 |                  |  |   | (1,528                    | ) |  |   | 529,884 |   |  |   | 727,137 |  
|                                                                |  |              |   |  |                   |        |   |                      |   |         |                  |  |   |                           |   |  |   |         |   |  |   |         |  
|Net income                                                      |  |              |   |  |                   |        |   |                      |   |         |                  |  |   |                           |   |  |   | 73,884  |   |  |   | 73,884  |  
|Dividends ($0.56 per share)                                     |  |              |   |  |                   |        |   |                      |   |         |                  |  |   |                           |   |  |   | (20,818 | ) |  |   | (20,818 | )
|Stock contributions to Employee Savings and Profit Sharing Plan |  | 228          |   |  |                   | 114    |   |                      |   | 7,990   |                  |  |   |                           |   |  |   |         |   |  |   | 8,104   |  
|Stock awards, net of forfeitures                                |  | 42           |   |  |                   | 21     |   |                      |   | 1,871   |                  |  |   | (3,074                    | ) |  |   |         |   |  |   | (1,182  | )
|Stock-based compensation expense                                |  |              |   |  |                   |        |   |                      |   | 4,632   |                  |  |   | 3,231                     |   |  |   |         |   |  |   | 7,863   |  
|Stock options exercised                                         |  | 948          |   |  |                   | 474    |   |                      |   | 20,512  |                  |  |   |                           |   |  |   |         |   |  |   | 20,986  |  
|Tax benefit related to stock awards and stock options, net      |  |              |   |  |                   |        |   |                      |   | 7,033   |                  |  |   |                           |   |  |   |         |   |  |   | 7,033   |  
|Repurchase of common stock                                      |  | (1,420       | ) |  |                   | (710   | ) |                      |   | (7,365  | )                |  |   |                           |   |  |   | (47,054 | ) |  |   | (55,129 | )
|                                                                |  |              |   |  |                   |        |   |                      |   |         |                  |  |   |                           |   |  |   |         |   |  |   |         |  
|Balance at January 26, 2006                                     |  | 37,216       |   |  | $                 | 18,608 |   |                      | $ | 214,745 |                  |  | $ | (1,371                    | ) |  | $ | 535,896 |   |  | $ | 767,878 |  
|                                                                |  |              |   |  |                   |        |   |                      |   |         |                  |  |   |                           |   |  |   |         |   |  |   |         |  



See accompanying notes
to consolidated financial statements.



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##### Table of Contents

LONGS DRUG STORES CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



1. The Company and Significant Accounting Policies



The CompanyLongs Drug Stores Corporation (Longs or
the Company), through its wholly owned subsidiary, Longs Drug Stores California, Inc., operates retail drug stores in California, Hawaii, Nevada, Washington, Colorado and Oregon under the names Longs, Longs Drugs, Longs Drug Stores and
Longs Pharmacy. The Company also operates a mail order pharmacy under the name American Diversified Pharmacies, Inc. In addition to prescription drugs, the Companys core front-end merchandise categories include over-the-counter medications,
health and beauty products, cosmetics, photo and photo processing, convenience food and beverage items and greeting cards. The Company also sells merchandise in non-core categories such as housewares, automotive and sporting goods.



Longs Drug Stores California, Inc. also provides pharmacy benefit services
through its wholly owned subsidiary, Rx America L.L.C. The pharmacy benefit services segment provides a range of pharmacy benefit management services, including plan design and implementation, claims administration, formulary management and
mail-order fulfillment, to third-party health plans and other organizations. In addition, effective January 1, 2006, the pharmacy benefit services segment offers prescription drug plan benefits to Medicare participants in 20 regions
encompassing 35 states and the District of Columbia under the Medicare Prescription Drug, Improvement and Modernization Act of 2003.



Basis of PresentationThe consolidated financial statements include the Company and its wholly owned subsidiaries. All significant
inter-company accounts and transactions have been eliminated.



Fiscal YearThe Company operates on a 52/53-week fiscal year ending on the last Thursday in January. The fiscal years ended January 26, 2006, January 27, 2005 and January 29, 2004 each contained 52 weeks of
operations.



Reclassifications have been made to certain
prior year amounts to conform to the fiscal 2006 presentation.



Use of EstimatesThe preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities, disclosure of contingent assets and liabilities and the reported amounts of revenues and expenses during the reporting period. Uncertainties regarding such estimates and assumptions are inherent in the preparation
of the Companys financial statements and actual results may differ from those estimates and assumptions. The Companys significant accounting judgments and estimates include the accounts receivable and reserves, merchandise inventories,
impairment of long-lived assets, store closure reserves, insurance reserves, revenue recognition and vendor rebates and allowances.



Concentrations The Company purchases over 90% of its pharmaceuticals from a single supplier, AmerisourceBergen Drug Corporation
(AmerisourceBergen), with whom the Company has a long-term supply contract.



The prescription drug plans offered by the Companys pharmacy benefit services segment are subject to annual bidding and regulatory approval.



The Companys stores, mail order pharmacy operations, distribution centers and corporate offices are located in the
western United States, primarily in California.



Cash and
cash equivalents include investments with original maturities of three months or less when purchased. Also included in cash and cash equivalents are credit card and debit card receivables from banks,



34



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##### Table of Contents

LONGS DRUG STORES CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



which settle within three business days, of $8.4 million as of January 26, 2006 and $6.0 million as of January 27, 2005.



Pharmacy and other receivables primarily include amounts due from
third party providers (e.g., pharmacy benefit managers, insurance companies and governmental agencies) and vendors. Receivables are stated net of allowances for uncollectible accounts, summarized as follows:



|                                                         |  |             |        |   |      |   |       |      |  |   |        |  
|-------------------------------------------------------- |  | ----------- | ------ | - | ---- | - | ----- | ---- |  | - | ------ | -
|                                                         |  | Fiscal Year |       
|                                                         |  | 2006        |        |   | 2005 |   |       | 2004 | 
|                                                         |  | Thousands   |       
|Allowances for uncollectible accounts, beginning of year |  | $           | 5,770  |   |      | $ | 4,524 |      |  | $ | 4,960  |  
|Additions charged to expense                             |  |             | 2,115  |   |      |   | 1,995 |      |  |   | 2,305  |  
|Deductions for accounts written off                      |  |             | (2,106 | ) |      |   | (749  | )    |  |   | (2,741 | )
|                                                         |  |             |        |   |      |   |       |      |  |   |        |  
|Allowances for uncollectible accounts, end of year       |  | $           | 5,779  |   |      | $ | 5,770 |      |  | $ | 4,524  |  
|                                                         |  |             |        |   |      |   |       |      |  |   |        |  



Merchandise
inventories are stated at the lower of cost or market value. Cost is determined using the last-in, first-out (LIFO) method. The excess of current cost over LIFO values was $183.1 million as of January 26, 2006 and $178.3 million as of
January 27, 2005. The liquidation of LIFO inventory layers did not have a material effect on net income in any of the last three fiscal years.



Prepaid expenses and other current assetsinclude participant-directed investments, primarily in exchange-traded money market and mutual funds, of
$10.7 million as of January 26, 2006, and $10.8 million as of January 27, 2005, designated to fund the Companys non-qualified deferred compensation plan.



Property includes the major categories of land, buildings and leasehold improvements, and equipment and fixtures.
Property is recorded at its cost, which is its estimated fair value if the property was acquired as part of an acquisition. The Company capitalizes costs that relate to the application and infrastructure development stage of software development,
and includes such costs in equipment and fixtures. Costs for improvements that enhance the usefulness or extend the useful life of an asset are capitalized, as is interest incurred during asset construction or development periods. The Company
capitalized interest costs of $1.2 million in fiscal 2006, $0.5 million in fiscal 2005 and $0.8 million in fiscal 2004. Repairs and maintenance costs are expensed as incurred.



Property is depreciated using the straight-line method over its estimated useful life. Useful lives are estimated at twenty
to thirty-three years for buildings, the shorter of the estimated useful life or lease term for leasehold improvements and up to twenty years for equipment and fixtures.



Buildings and leasehold improvements include assets under capital leases of $10.6 million as of January 26, 2006 and
January 27, 2005. The corresponding capital lease obligation is included in other current and long-term liabilities, depending on scheduled payment dates. The amount capitalized for assets under capital leases is the present value at the
beginning of the lease term of the aggregate future minimum lease payments. The amortization of such assets is included in depreciation expense. Accumulated amortization on assets under capital leases was $1.8 million as of January 26, 2006 and
$1.3 million as of January 27, 2005.



Goodwill
represents the excess of acquisition cost over the fair value of the net assets of acquired entities. Goodwill is not amortized, but is subject to impairment testing annually, or more frequently if events and circumstances indicate there may be
impairment.



Intangible assets consist primarily of
purchased pharmacy customer lists, non-compete agreements and beverage licenses. Intangible assets with indefinite useful lives are not amortized. Intangible assets with finite useful lives are amortized over those useful lives.



35



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LONGS DRUG STORES CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Impairment of Long-Lived AssetsThe Company reviews long-lived tangible assets and
intangible assets with finite useful lives for impairment whenever events or changes in circumstances indicate that their carrying values may not be recoverable. Using its best estimates based on reasonable assumptions and projections, the Company
records an impairment loss to write such assets down to their estimated fair values if the carrying values of the assets exceed their related undiscounted expected future cash flows.



Goodwill and other intangible assets with indefinite useful lives are reviewed for impairment annually, or more frequently
if events or changes in circumstances warrant. The Company performs its annual impairment testing during the fourth fiscal quarter, when updated financial projections are available. If the carrying values of such assets exceed their estimated fair
values, the Company records an impairment loss to write the assets down to their estimated fair values.



Store-specific long-lived tangible assets and intangible assets with finite useful lives are generally evaluated at an individual store level, which is
the lowest level at which independent cash flows can be identified. Corporate assets or other long-lived assets that are not store-specific are evaluated at a consolidated entity or segment level as appropriate. Goodwill is evaluated at a reporting
unit level in accordance with Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets. Geographic regional divisions within the retail drug store segment comprise the Companys
reporting units. Fair values of beverage licenses are estimated based on quoted market prices. Fair values for all other long-lived assets are estimated based on the expected present value of future cash flows.



Other non-current assets include the Companys 50% interest in a
joint venture with AmerisourceBergen. Through this joint venture, the Company and AmerisourceBergen operate a central prescription fill center in order to reduce prescription fill costs and to address an industry-wide shortage of pharmacists. The
Company uses the equity method of accounting for its investment in the joint venture. The joint ventures results of operations were not material to the Companys consolidated financial statements in any of the past three fiscal years.



Other non-current assets also include deposits for the
purchase of property and equipment, and deferred debt issue costs, net of amortization. Debt issue cost amortization, which is a component of interest expense, was not material in any of the past three fiscal years.



Deferred income taxes and other long-term liabilities consisted of the
following:



|                                             |  |                 |        |                 |   |       
|-------------------------------------------- |  | --------------- | ------ | --------------- | - | ------
|                                             |  | January 26,2006 |        | January 27,2005
|                                             |  | Thousands      
|Deferred income taxes                        |  | $               | 35,973 |                 | $ | 26,611
|Deferred rent                                |  |                 | 35,035 |                 |   | 29,318
|Capital lease obligations, long-term portion |  |                 | 10,260 |                 |   | 10,358
|Store closure reserves                       |  |                 | 2,727  |                 |   | 7,011 
|                                             |  |                 |        |                 |   |       
|Total                                        |  | $               | 83,995 |                 | $ | 73,298
|                                             |  |                 |        |                 |   |       



Store Closure
ReservesThe Company recognizes a liability for costs associated with closing a store when the liability is incurred. The present value of expected future lease costs, net of estimated future sublease income, is recorded when the store is
closed. Severance and other employee-related costs are recorded in the period that the closure and related severance packages are communicated to the affected employees. Accretion of the discounted present value of expected future costs is recorded
in operating and administrative expenses. Store



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LONGS DRUG STORES CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



closure reserves are periodically reviewed and, if necessary, adjusted based on changes in estimates about the amounts and timing of future sublease income.



Fair Value of Financial InstrumentsThe carrying
values of the Companys cash and cash equivalents, receivables and payables approximate their estimated fair values due to their short-term nature. To estimate the fair value of long-term debt, the Company uses those interest rates that are
currently available to it for issuance of debt with similar terms and remaining maturities. As of January 26, 2006 and January 27, 2005, the carrying values and estimated fair values of the Companys long-term debt (including the
current maturities) were as follows:



|                                       |  |                 |         |                 |   |        
|-------------------------------------- |  | --------------- | ------- | --------------- | - | -------
|                                       |  | January 26,2006 |         | January 27,2005
|                                       |  | Thousands      
|Carrying value of long-term debt       |  | $               | 105,688 |                 | $ | 154,558
|Estimated fair value of long-term debt |  |                 | 109,276 |                 |   | 161,599



Revenue
RecognitionThe Company recognizes revenue from retail drug store sales, net of an allowance for estimated returns, at the time the merchandise is sold or services performed. The allowance for sales returns is estimated based on the
Companys historical experience.



Pharmacy benefit
services revenues include amounts generated from pharmacy benefit management services and, beginning January 1, 2006, prescription drug plans. Pharmacy benefit management revenues, which include plan design and implementation, claims
administration and formulary management, are recognized when the Companys RxAmerica subsidiary has completed its service obligations under its contracts, including the approval or denial of the authorization request to the participating
pharmacy. RxAmerica does not take title to prescription drug inventories or assume substantial risks and rewards of inventory ownership or receivable collection associated with the provision of pharmacy benefit management services. Accordingly,
pharmacy benefit management revenues from third-party health plans are recognized net of the reimbursements due to participating pharmacies. The Company does not recognize co-payments made to participating pharmacies by health plan members. Certain
rebate revenues related to pharmacy benefit management services are estimated based on the Companys contractual terms and prescription drug utilization mix.



Beginning January 1, 2006, the Company also earns revenues for prescription drug plan benefits provided to Medicare
participants by its pharmacy benefit services segment. These revenues include fixed monthly premiums and certain adjustments based on the Companys claims experience and other factors. The fixed monthly premiums are recognized on a
straight-line basis over the period of coverage, and revenue adjustments are estimated based on information available to the Company about its claims experience and other factors.



Cost of retail drug store sales includes the acquisition cost of inventory sold (net of merchandise rebates and
allowances), in-bound freight, receiving, warehousing, purchasing and distribution costs and advertising expenses (net of advertising rebates and allowances). Advertising costs are expensed as incurred and were $78.2 million, $82.1 million and
$71.7 million, exclusive of rebates and allowances, in fiscal years 2006, 2005 and 2004, respectively.



Prescription drug plan benefit costsrepresent the Companys portion of the cost of prescription drugs purchased by Medicare participants in
one of its prescription drug plans. Such costs include benefit payments during the period to pharmacies, and an estimate for benefit costs incurred but not reported as of the end of the period, reduced by associated manufacturer rebates.



Vendor Rebates and AllowancesMerchandise rebates and
allowances are recorded as a reduction of the cost of inventory and the benefit is recognized as a reduction of the cost of retail drug store sales when the related



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LONGS DRUG STORES CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



inventory is sold. Advertising rebates and allowances are recognized as a reduction of advertising expense, a component of the cost of retail drug store
sales, when the related advertising expense is incurred or the required performance is completed. Lump-sum payments received from vendors in connection with a contractual arrangement are deferred and recognized as a reduction of the cost of retail
drug store sales over the contract term.



Operating and
administrative expenses include costs for retail drug store, pharmacy benefit services and administrative payroll and benefits; facilities and occupancy; and other miscellaneous expenses.



InsuranceThe Company maintains insurance coverage for
significant exposures and those risks required to be insured by law. It is generally the Companys policy to retain a significant portion of certain losses related to workers compensation, general liability, property losses, pharmacist
liability, business interruptions and employee health care. Provisions for these items are recorded based upon the Companys estimates for claim costs incurred. The provisions are estimated in part by third parties and are based on claims
experience, regulatory changes, an estimate of claims incurred but not yet reported and other relevant factors. Reserves for workers compensation and general liability claims are discounted to their expected present value using an essentially
risk-free interest rate.



New store opening costs,
primarily labor, advertising and store supplies, are charged to expense as incurred.



RentMinimum rent, including fixed escalations, is recorded on a straight-line basis over the lease term. The lease term commences when the Company takes possession of the leased premises, and in most
cases ends upon expiration of the initial non-cancelable term. Renewal option periods are included in the lease term if failure to renew the lease would impose a penalty on the Company in such amount that, at the inception of the lease, renewal
appears to be reasonably assured. When a lease provides for fixed escalations of the minimum rental payments during the lease term, the difference between the recorded straight-line rent and the amount payable under the lease is recognized as
deferred rent. Rent incurred during initial construction of store properties or related improvements is capitalized and included in buildings and leasehold improvements. Such costs are depreciated over the shorter of the estimated useful life of the
related assets or the lease term. Contingent rental payments, typically based on a percentage of sales, are recognized as an expense when incurred, based on actual and projected sales or other results during the measurement period.



Income taxesThe Company accounts for income taxes using the
asset and liability method. Under this method, deferred income taxes are recorded based upon the differences between the financial statement and tax basis of assets and liabilities.



Stock-based compensationThe Company has two stock-based employee compensation plans, as described in Note 10.
The Company accounts for stock-based employee compensation using the intrinsic value method in accordance with the provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, as allowed by SFAS
No. 123, Accounting for Stock-Based Compensation. No compensation expense is recognized for employee stock options, because it is the Companys practice to grant stock options with an exercise price equal to the market price of the
underlying common stock on the date of grant. Time-vest stock awards are valued at fair market value at the date of grant, and are recorded as compensation expense over the vesting period. Performance-based stock awards are valued at fair market
value as of the date on which both the number of shares to be issued and the fair market value of the stock are known. Interim estimates of compensation expense for performance-based stock awards are recorded based on the Companys best
estimate of the number of shares to be issued and the then-current fair market value of the stock.



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LONGS DRUG STORES CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



The following table illustrates the effect on net income and earnings per share if the Company had
applied the fair value recognition provisions of SFAS No. 123 to all stock-based employee compensation:



|                                                                                                                                            |  |                                    |        |   |      |   |        |      |  |   |        |  
|------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------------------------- | ------ | - | ---- | - | ------ | ---- |  | - | ------ | -
|                                                                                                                                            |  | Fiscal Year                        |       
|                                                                                                                                            |  | 2006                               |        |   | 2005 |   |        | 2004 | 
|                                                                                                                                            |  | Thousands Except Per Share Amounts |       
|Net income, as reported                                                                                                                     |  | $                                  | 73,884 |   |      | $ | 36,560 |      |  | $ | 29,764 |  
|Add: Stock-based employee compensation expense included in reported net income, net of related tax effects                                  |  |                                    | 4,197  |   |      |   | 635    |      |  |   | 650    |  
|Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax
effects |  |                                    | (6,745 | ) |      |   | (4,143 | )    |  |   | (3,905 | )
|                                                                                                                                            |  |                                    |        |   |      |   |        |      |  |   |        |  
|Pro forma net income                                                                                                                        |  | $                                  | 71,336 |   |      | $ | 33,052 |      |  | $ | 26,509 |  
|                                                                                                                                            |  |                                    |        |   |      |   |        |      |  |   |        |  
|Basic net income per share:                                                                                                                 |  |                                    |        |   |      |   |        |      |  |   |        |  
|As reported                                                                                                                                 |  | $                                  | 1.98   |   |      | $ | 0.98   |      |  | $ | 0.80   |  
|Pro forma                                                                                                                                   |  | $                                  | 1.91   |   |      | $ | 0.89   |      |  | $ | 0.71   |  
|Diluted net income per share:                                                                                                               |  |                                    |        |   |      |   |        |      |  |   |        |  
|As reported                                                                                                                                 |  | $                                  | 1.93   |   |      | $ | 0.97   |      |  | $ | 0.79   |  
|Pro forma                                                                                                                                   |  | $                                  | 1.86   |   |      | $ | 0.88   |      |  | $ | 0.71   |  



The Company estimates
the fair value of stock option grants using the Black-Scholes option pricing model, with the following weighted average assumptions:



|                        |  |             |   |  |       |   |  |       |  
|----------------------- |  | ----------- | - |  | ----- | - |  | ----- | -
|                        |  | Fiscal Year |  
|                        |  | 2006        |   |  | 2005  |   |  | 2004  |  
|Dividend yield          |  | 2.27        | % |  | 2.56  | % |  | 2.60  | %
|Expected volatility     |  | 38.66       | % |  | 38.87 | % |  | 38.74 | %
|Risk-free interest rate |  | 4.00        | % |  | 3.53  | % |  | 2.94  | %
|Expected life (years)   |  | 5.2         |   |  | 5.0   |   |  | 5.0   |  



Earnings per
shareBasic earnings per share are computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted earnings per share are computed by dividing net income by the weighted average number
of common shares and dilutive common equivalent shares (restricted stock awards and stock options) outstanding during the period. The following is a reconciliation of the number of shares used in the Companys basic and diluted earnings per
share computations:



|                                                      |  |             |  |        |  |       
|----------------------------------------------------- |  | ----------- |  | ------ |  | ------
|                                                      |  | Fiscal Year
|                                                      |  | 2006        |  | 2005   |  | 2004  
|                                                      |  | Thousands  
|Basic weighted average number of shares outstanding   |  | 37,332      |  | 37,262 |  | 37,213
|Effect of dilution from:                              |  |             |  |        |  |       
|Stock options                                         |  | 818         |  | 182    |  | 71    
|Restricted stock awards                               |  | 130         |  | 147    |  | 170   
|                                                      |  |             |  |        |  |       
|Diluted weighted average number of shares outstanding |  | 38,280      |  | 37,591 |  | 37,454
|                                                      |  |             |  |        |  |       



The computations of
diluted earnings per share excluded 0.2 million stock options for fiscal 2006, 1.8 million stock options for fiscal 2005 and 2.6 million stock options for fiscal 2004 because their exercise prices were greater than or equal to the
average share price for the respective periods, and therefore their



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LONGS DRUG STORES CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



inclusion would have been anti-dilutive. These options could be dilutive in the future if the average share price increases and is greater than the exercise
price of these options.



Comprehensive income equals net
income for all periods presented.



New Accounting
PronouncementsIn December 2004, the FASB issued SFAS No. 123R, Share-Based Payment, which revises SFAS No. 123, Accounting for Stock-Based Compensation, and supersedes APB Opinion No. 25, Accounting for
Stock Issued to Employees. SFAS No. 123R requires that the fair value of stock-based employee compensation, including stock options and stock awards, be recognized as expense as the related services are performed. SFAS No. 123R is
effective as of the beginning of the first annual reporting period that begins after June 15, 2005 (the Companys fiscal year ending January 25, 2007), and may also be applied to previous periods retrospectively upon adoption. The
Company currently uses the intrinsic value method of accounting for stock-based employee compensation, in accordance with the provisions of APB No. 25. No compensation expense is recognized for employee stock options because it is the
Companys practice to grant stock options with an exercise price equal to the market price of the underlying common stock on the date of grant. Adoption of SFAS No. 123R will therefore result in an increase in reported operating and
administrative expenses, primarily for employee stock options, and thus a decrease in net income and earnings per share. Management estimates that the adoption of SFAS No. 123R will reduce net income by $0.08 to $0.09 per diluted share in
fiscal 2007.



In March 2005, the FASB issued FASB
Interpretation (FIN) No. 47, Accounting for Conditional Asset Retirement Obligations. FIN No. 47 clarifies that the term conditional asset retirement obligation as used in FASB Statement No. 143,
Accounting for Asset Retirement Obligations, refers to a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control of
the entity. Accordingly, an entity is required to recognize a liability for the fair value of a conditional asset retirement obligation if the fair value of the liability can be reasonably estimated. FIN No. 47 is effective for fiscal years
ending after December 15, 2005. The adoption of FIN No. 47 did not have a material impact on the Companys consolidated financial statements.



In June 2005, the EITF reached a consensus on Issue No. 05-6, Determining the Amortization Period for Leasehold Improvements Purchased after Lease
Inception or Acquired in a Business Combination. Issue No. 05-6 requires that leasehold improvements acquired in a business combination or purchased subsequent to the inception of a lease be amortized over the shorter of the useful life of
the assets or a term that includes required lease periods and renewals that are reasonably assured at the date of the business combination or purchase. This guidance is applicable only to leasehold improvements that are purchased or acquired in
reporting periods beginning after June 29, 2005. The adoption of Issue No. 05-6 had no impact on the Companys consolidated financial statements.



In October 2005, the FASB issued Staff Position (FSP) No. FAS 13-1, Accounting for Rental Costs Incurred during a Construction
Period. FSP No. FAS 13-1 requires rental costs associated with ground or building operating leases that are incurred during a construction period to be recognized as expense. FSP No. FAS 13-1 is effective as of the first reporting period
beginning after December 15, 2005 (the first quarter of the Companys fiscal year ending January 25, 2007), and may also be applied to previous periods retrospectively upon adoption. The Company currently capitalizes rent incurred
during initial construction of store properties or related improvements and includes these costs in buildings and leasehold improvements. Adoption of FSP No. FAS 13-1 will therefore result in an increase in reported operating and administrative
expenses for rental costs incurred during the construction period, offset by a decrease in reported expenses for the remainder of the lease term. Management estimates that the adoption of FSP No. FAS 13-1 will reduce net income by $0.04 to $0.05 per
diluted share in fiscal 2007.



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LONGS DRUG STORES CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



2. Goodwill and Intangible Assets



All of the Companys goodwill and other intangible assets are included in the retail drug store segment. There were no
changes in the net carrying value of goodwill for the fiscal years ended January 26, 2006 and January 27, 2005.



The Companys intangible assets other than goodwill include the following:



|                                               |  |                       |  |                    |       |                         |   |        |                  |  |   |      
|---------------------------------------------- |  | --------------------- |  | ------------------ | ----- | ----------------------- | - | ------ | ---------------- |  | - | -----
|                                               |  | EstimatedUseful Lives |  | GrossCarryingValue |       | AccumulatedAmortization |   |        | NetCarryingValue
|                                               |  | Thousands            
|As of January 26, 2006:                        |  |                       |  |                    |       |                         |   |        |                  |  |   |      
|Intangible assets subject to amortization:     |  |                       |  |                    |       |                         |   |        |                  |  |   |      
|Pharmacy customer lists                        |  | 1-5 years             |  | $                  | 3,481 |                         | $ | (2,342 | )                |  | $ | 1,139
|Non-compete agreements and other               |  | 2-5 years             |  |                    | 35    |                         |   | (29    | )                |  |   | 6    
|                                               |  |                       |  |                    |       |                         |   |        |                  |  |   |      
|Total                                          |  |                       |  |                    | 3,516 |                         |   | (2,371 | )                |  |   | 1,145
|Intangible assets not subject to amortization: |  |                       |  |                    |       |                         |   |        |                  |  |   |      
|Beverage licenses                              |  | N/A                   |  |                    | 4,915 |                         |   |       |                  |  |   | 4,915
|                                               |  |                       |  |                    |       |                         |   |        |                  |  |   |      
|Total                                          |  |                       |  | $                  | 8,431 |                         | $ | (2,371 | )                |  | $ | 6,060
|                                               |  |                       |  |                    |       |                         |   |        |                  |  |   |      
|As of January 27, 2005:                        |  |                       |  |                    |       |                         |   |        |                  |  |   |      
|Intangible assets subject to amortization:     |  |                       |  |                    |       |                         |   |        |                  |  |   |      
|Pharmacy customer lists                        |  | 1-5 years             |  | $                  | 3,020 |                         | $ | (1,502 | )                |  | $ | 1,518
|Non-compete agreements and other               |  | 2-5 years             |  |                    | 50    |                         |   | (32    | )                |  |   | 18   
|                                               |  |                       |  |                    |       |                         |   |        |                  |  |   |      
|Total                                          |  |                       |  |                    | 3,070 |                         |   | (1,534 | )                |  |   | 1,536
|Intangible assets not subject to amortization: |  |                       |  |                    |       |                         |   |        |                  |  |   |      
|Beverage licenses                              |  | N/A                   |  |                    | 4,818 |                         |   |       |                  |  |   | 4,818
|                                               |  |                       |  |                    |       |                         |   |        |                  |  |   |      
|Total                                          |  |                       |  | $                  | 7,888 |                         | $ | (1,534 | )                |  | $ | 6,354
|                                               |  |                       |  |                    |       |                         |   |        |                  |  |   |      



Amortization expense
for intangible assets with finite useful lives was $0.7 million in fiscal 2006, $0.8 million in fiscal 2005 and $0.6 million in fiscal 2004. Estimated future annual amortization expense on these intangibles is as follows (in thousands):



|                    |  |   |      
|------------------- |  | - | -----
|Fiscal year ending: |  |   |      
|2007                |  |   | 601  
|2008                |  |   | 375  
|2009                |  |   | 169  
|                    |  |   |      
|Total               |  | $ | 1,145
|                    |  |   |      



3. Debt



Debt at January 26, 2006 and January 27, 2005 consisted of the
following:



|                                                                                                                |  |                 |         |                 |   |        
|--------------------------------------------------------------------------------------------------------------- |  | --------------- | ------- | --------------- | - | -------
|                                                                                                                |  | January 26,2006 |         | January 27,2005
|                                                                                                                |  | Thousands      
|Private placement notes, fixed interest rates ranging from 5.85% to 7.85%, mature at various dates through 2014 |  | $               | 105,688 |                 | $ | 114,558
|Revolving line of credit, variable interest, expires August 2009                                                |  |                 |        |                 |   | 40,000 
|                                                                                                                |  |                 |         |                 |   |        
|Total debt                                                                                                      |  |                 | 105,688 |                 |   | 154,558
|Less current maturities                                                                                         |  |                 | 45,870  |                 |   | 8,870  
|                                                                                                                |  |                 |         |                 |   |        
|Long-term portion                                                                                               |  | $               | 59,818  |                 | $ | 145,688
|                                                                                                                |  |                 |         |                 |   |        



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LONGS DRUG STORES CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



The Company has a secured $280 million revolving line of credit with a syndication of banks, which
expires in August 2009 and accrues interest at LIBOR-based rates. Borrowings on this line of credit are secured by inventory, accounts receivable and certain intangible assets. The secured revolving line of credit agreement contains customary
restrictions but no financial covenants and no limitations on capital expenditures or share repurchases if availability of credit remains above a minimum level. The agreement also includes an option to increase the credit facilitys borrowing
and letter-of-credit capacity from $280 million to $345 million, subject to certain conditions. Borrowings on the line of credit do not require repayment until the expiration date but may be prepaid without penalty. Letters of credit totaling $36
million were outstanding under the agreement as of January 26, 2006. The Company pays a monthly commitment fee of 0.25% per annum on the unused portion of the line of credit ($244 million as of January 26, 2006).



The private placement notes are secured on the same basis as the secured
revolving line of credit. The private placement notes may be redeemed at the Companys option prior to their scheduled maturities, subject to an early payment premium.



The Companys debt agreements contain customary restrictions, and the private placement notes also include various
customary financial covenants. As of January 26, 2006, the Company was in compliance with the restrictions and limitations included in these provisions.



Future minimum principal payments on long-term debt are as follows (in thousands):



|                    |  |   |        
|------------------- |  | - | -------
|Fiscal year ending: |  |   |        
|2007                |  | $ | 45,870 
|2008                |  |   | 6,727  
|2009                |  |   | 36,727 
|2010                |  |   | 2,727  
|2011                |  |   | 2,727  
|Thereafter          |  |   | 10,910 
|                    |  |   |        
|Total               |  | $ | 105,688
|                    |  |   |        



4. Leases



The Company leases most of its store properties and certain of its
distribution centers and corporate office facilities. Most store leases have original non-cancelable terms of 15 to 25 years and contain renewal options covering up to 30 additional years in 5-year to 10-year increments. Store leases normally
provide for minimum annual rent with provisions for additional rent based on a percentage of sales, and may contain escalation clauses.



Net rental expense is summarized as follows:



|                     |  |             |        |   |      |   |        |      |  |   |        |  
|-------------------- |  | ----------- | ------ | - | ---- | - | ------ | ---- |  | - | ------ | -
|                     |  | Fiscal Year |       
|                     |  | 2006        |        |   | 2005 |   |        | 2004 | 
|                     |  | Thousands   |       
|Minimum rentals      |  | $           | 82,902 |   |      | $ | 81,383 |      |  | $ | 79,053 |  
|Contingent rentals   |  |             | 10,671 |   |      |   | 10,102 |      |  |   | 12,210 |  
|                     |  |             |        |   |      |   |        |      |  |   |        |  
|                     |  |             | 93,573 |   |      |   | 91,485 |      |  |   | 91,263 |  
|Less sublease income |  |             | (2,948 | ) |      |   | (2,492 | )    |  |   | (2,851 | )
|                     |  |             |        |   |      |   |        |      |  |   |        |  
|                     |  | $           | 90,625 |   |      | $ | 88,993 |      |  | $ | 88,412 |  
|                     |  |             |        |   |      |   |        |      |  |   |        |  



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LONGS DRUG STORES CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Minimum rental commitments for non-cancelable leases as of January 26, 2006 are as follows:



|                                           |  |                 |         |               |   |         |  
|------------------------------------------ |  | --------------- | ------- | ------------- | - | ------- | -
|                                           |  | OperatingLeases |         | CapitalLeases |  
|                                           |  | Thousands       |        
|Fiscal year ending:                        |  |                 |         |               |   |         |  
|2007                                       |  | $               | 77,391  |               | $ | 1,001   |  
|2008                                       |  |                 | 76,525  |               |   | 1,031   |  
|2009                                       |  |                 | 72,042  |               |   | 1,048   |  
|2010                                       |  |                 | 69,581  |               |   | 1,048   |  
|2011                                       |  |                 | 66,338  |               |   | 1,048   |  
|Thereafter                                 |  |                 | 631,936 |               |   | 17,361  |  
|                                           |  |                 |         |               |   |         |  
|Total minimum lease payments               |  | $               | 993,813 |               | $ | 22,537  |  
|                                           |  |                 |         |               |   |         |  
|Less amounts representing interest         |  |                 |         |               |   | (12,179 | )
|                                           |  |                 |         |               |   |         |  
|Present value of capital lease obligations |  |                 |         |               | $ | 10,358  |  
|Less current portion                       |  |                 |         |               |   | (98     | )
|                                           |  |                 |         |               |   |         |  
|Long-term portion                          |  |                 |         |               | $ | 10,260  |  
|                                           |  |                 |         |               |   |         |  



Total minimum lease
payments on operating leases have not been reduced by minimum future sublease rentals of $15.8 million under non-cancelable subleases.



During fiscal 2006, the Company entered into a sale-leaseback transaction for its Northern California front-end distribution center located in Lathrop,
California, for net proceeds of $21.5 million. The Company intends to vacate the Lathrop facility when its new distribution center in Patterson, California, which is currently under construction and scheduled for completion in the summer of fiscal
2007, is fully operational. The leaseback agreement has a minimum term of 8 months, with an option for the Company to extend the lease through September 2007. The sale-leaseback transaction transferred substantially all risks and rewards of
ownership to the buyer-lessor, and there are no commitments, obligations, provisions or circumstances that require or result in the Companys continuing involvement other than the normal leaseback terms. Further, the leaseback is considered
minor as defined in SFAS No. 13 Accounting for Leases,and SFAS No. 28, Accounting for Sales with Leasebacks. Therefore, the $11.0 million gain on the transaction was recognized upon completion of the sale in
fiscal 2006.



5. Commitments and Contingencies



As of January 26, 2006, the Company had outstanding commitments to
purchase approximately $9.4 billion of merchandise inventory at various dates over the next five years for use in the normal course of business. This amount primarily represents commitments to our primary supplier, AmerisourceBergen, under a
long-term supply contract, including a new contract that will take effect in July 2006 upon expiration of the current contract. The contract includes a minimum purchase requirement over the contract term, which is effective for three to seven
years depending on the Companys actual purchase levels and various termination provisions.



The Company has entered into agreements with its executive officers and other key employees that provide termination benefits in the event of certain
change in control events. Total contingent termination benefits as of the end of fiscal 2006 were approximately $72 million, plus amounts covering any excise tax on these benefits for certain executive officers. There have been no events that would
trigger these benefits as of January 26, 2006.



Rankin
v. Longs Drug Stores California, Inc., as amended on January 19, 2005, was originally filed in the Superior Court of California, San Diego County on October 13, 2004. The lawsuit was certified as a class action



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LONGS DRUG STORES CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



on July 19, 2005 and alleges that the Companys employment application violates California Labor Code Section 432.8 by inquiring about
criminal convictions within the last seven years, without providing an exception for misdemeanor marijuana convictions more than two years old. The plaintiff seeks to recover statutory damages and attorneys fees for him and all similarly
situated individuals who applied for employment with the Company during the class period. Trial is set for June 17, 2006. The Company is vigorously defending this litigation. The financial impact to the Company, if any, cannot be predicted at
this time.



In February 2004, a purported class action lawsuit
entitled Darien Goddard, et al v. Longs Drug Stores Corporation, et al was filed in the Superior Court of California, Alameda County. In March 2004, another purported class action lawsuit entitled David Robotnick v. Longs Drug Stores
California, Inc. was filed in the Superior Court of California, Los Angeles County. The lawsuits were filed by plaintiffs who were current or former store managers or assistant managers on behalf of themselves and other similarly situated
California store managers and assistant store managers. The lawsuits alleged that the Company improperly classified such employees as exempt under Californias wage and hour and unfair business practice laws and sought damages, penalties,
restitution, reclassification and attorneys fees and costs. In October 2004, the court approved a mediated settlement whereby the Company paid $11 million to settle all claims and causes of action of the plaintiffs. The Company paid the
settlement costs in the third and fourth quarters of fiscal 2005. The Company recorded a provision of $11.6 million in fiscal 2005 for the cost of this settlement and applicable employer payroll taxes. This provision was partially offset by a $0.8
million gain from the favorable settlement of a separate, unrelated class action lawsuit, for which the Company had filed a claim as a member of the plaintiff class, which alleged unlawful price fixing and market allocation by certain vitamin
manufacturers. The Company received the settlement payment during the second quarter of fiscal 2005. The combined net expense resulting from these two settlements was $10.8 million.



In addition to the lawsuits described above, the Company is subject to various lawsuits, claims and regulatory reviews
arising in the normal course of its businesses. In the opinion of management, after consultation with counsel, the disposition of these matters arising in the normal course of business is not likely to have a material adverse effect, individually or
in the aggregate, on the Companys consolidated financial statements taken as a whole.



6. Employee Compensation and Benefits



The Company had approximately 22,000 full-time and part-time employees as of January 26, 2006. Virtually all full-time employees are eligible for medical, dental and life insurance benefits paid primarily by the
Company.



Employees who meet certain eligibility requirements
are entitled to participate in the Longs Drug Stores California, Inc. Employee Savings and Profit Sharing Plan. The plan has a 401(k) component under which employees may make voluntary contributions, which are partially matched by the Company, and a
profit sharing component. Eligible participants are entitled to a profit sharing benefit, funded entirely by the Company, if profits, as defined, call for a payment in excess of the 401(k) match. Company contributions to the plan may be made in
cash or shares of Longs common stock. The portion of the plan that holds Longs common stock is an employee stock ownership plan (ESOP) as defined by the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code (IRC)
of 1986.



Compensation expense for Company contributions to the
plan are measured based on the amount of the contribution called for in the period under the plan. Dividends on ESOP shares are charged to retained earnings, and all shares held by the ESOP are treated as outstanding shares in computing
earnings per share. There were 6.1 million shares of Longs common stock in the ESOP as of January 26, 2006, and 6.9 million shares as of January 27, 2005.



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LONGS DRUG STORES CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



The expense for Company contributions to the plan in each of the last three fiscal years, all of
which have been funded in shares of Longs common stock, were as follows:



|                |  |             |        |      |   |       |  |   |      
|--------------- |  | ----------- | ------ | ---- | - | ----- |  | - | -----
|                |  | Fiscal Year
|                |  | 2006        |        | 2005 |   | 2004 
|                |  | Thousands  
|401(k) matching |  | $           | 6,989  |      | $ | 6,964 |  | $ | 7,264
|Profit sharing  |  |             | 4,280  |      |   | 740   |  |   |     
|                |  |             |        |      |   |       |  |   |      
|Total           |  | $           | 11,269 |      | $ | 7,704 |  | $ | 7,264
|                |  |             |        |      |   |       |  |   |      



The Longs Drug Stores
Corporation Deferred Compensation Plan of 1995 provided eligible employees with the opportunity to defer a specified percentage of their cash compensation. Resulting obligations will be payable on dates selected by the participants in accordance
with the terms of the plan. The plan provided for a total deferred compensation obligation of up to $30.0 million. The Companys deferred compensation obligation was $10.7 million as of January 26, 2006, and $10.8 million as of
January 27, 2005. As of February 1, 2004, current participants were no longer allowed to make contributions to the plan and no future participants will be admitted to the plan.



7. Provision for Store Closures and Asset Impairments



The provision for store closures and asset impairments, a component of operating income, is summarized as follows:



|                             |  |             |       |      |   |       |  |   |      
|---------------------------- |  | ----------- | ----- | ---- | - | ----- |  | - | -----
|                             |  | Fiscal Year
|                             |  | 2006        |       | 2005 |   | 2004 
|                             |  | Thousands  
|Asset impairments            |  | $           | 2,699 |      | $ | 1,151 |  | $ | 3,896
|Provision for store closures |  |             |      |      |   | 250   |  |   | 3,542
|                             |  |             |       |      |   |       |  |   |      
|Total                        |  | $           | 2,699 |      | $ | 1,401 |  | $ | 7,438
|                             |  |             |       |      |   |       |  |   |      



Asset
Impairments



Asset impairments include charges of $2.7
million in fiscal 2006, $1.2 million in fiscal 2005 and $2.4 million in fiscal 2004 to write down assets related to underperforming and closed stores to their estimated fair values. Also during fiscal 2004, the Company recorded asset impairments of
$1.5 million related to the write-off of abandoned information technology assets.



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LONGS DRUG STORES CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Store Closures



The following is a summary of the provision for store closures and related reserves, which are included in long-term
liabilities:



|                                                                                                                   |  |             |        |   |      |   |        |      |  |   |        |  
|------------------------------------------------------------------------------------------------------------------ |  | ----------- | ------ | - | ---- | - | ------ | ---- |  | - | ------ | -
|                                                                                                                   |  | Fiscal Year |       
|                                                                                                                   |  | 2006        |        |   | 2005 |   |        | 2004 | 
|                                                                                                                   |  | Thousands   |       
|Reserve balancebeginning of year                                                                                  |  | $           | 7,011  |   |      | $ | 9,544  |      |  | $ | 7,827  |  
|Provision for present value of noncancellable lease obligations of stores closed, net of estimated sublease income |  |             |       |   |      |   |       |      |  |   | 1,367  |  
|Changes in assumptions about future sublease income and other lease related costs                                  |  |             |       |   |      |   | 250    |      |  |   | 2,175  |  
|                                                                                                                   |  |             |        |   |      |   |        |      |  |   |        |  
|Total provision for store closures                                                                                 |  |             |       |   |      |   | 250    |      |  |   | 3,542  |  
|Reserve accretion                                                                                                  |  |             |       |   |      |   | 71     |      |  |   |       |  
|Cash payments for lease related costs, net of sublease income                                                      |  |             | (4,284 | ) |      |   | (2,854 | )    |  |   | (1,825 | )
|                                                                                                                   |  |             |        |   |      |   |        |      |  |   |        |  
|Reserve balanceend of year                                                                                        |  | $           | 2,727  |   |      | $ | 7,011  |      |  | $ | 9,544  |  
|                                                                                                                   |  |             |        |   |      |   |        |      |  |   |        |  



There was no reserve
accretion in fiscal 2006, because all of the remaining stores included in the reserve were closed prior to the adoption of SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which required that the initial
provision for store closures be recorded at the estimated net present value, and accreted to the full undiscounted value, of the noncancellable lease obligation, net of estimated sublease income. Previous accounting standards required that such
provisions be recorded at their full undiscounted values.



8. Income Taxes



Income tax expense is summarized as follows:



|         |  |             |        |      |   |        |  |   |       
|-------- |  | ----------- | ------ | ---- | - | ------ |  | - | ------
|         |  | Fiscal Year
|         |  | 2006        |        | 2005 |   | 2004  
|         |  | Thousands  
|Current: |  |             |        |      |   |        |  |   |       
|Federal  |  | $           | 26,997 |      | $ | 4,052  |  | $ | 9,174 
|State    |  |             | 7,242  |      |   | 1,045  |  |   | 5,052 
|         |  |             |        |      |   |        |  |   |       
|         |  |             | 34,239 |      |   | 5,097  |  |   | 14,226
|Deferred |  |             | 10,178 |      |   | 15,481 |  |   | 2,032 
|         |  |             |        |      |   |        |  |   |       
|Total    |  | $           | 44,417 |      | $ | 20,578 |  | $ | 16,258
|         |  |             |        |      |   |        |  |   |       



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LONGS DRUG STORES CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



The reconciliation between the federal statutory tax rate and the Companys effective tax rates
is as follows:



|                                                                              |  |             |    |  |      |    |  |      |   
|----------------------------------------------------------------------------- |  | ----------- | -- |  | ---- | -- |  | ---- | --
|                                                                              |  | Fiscal Year |   
|                                                                              |  | 2006        |    |  | 2005 |    |  | 2004 |   
|                                                                              |  | Thousands   |   
|Federal income taxes at statutory rate                                        |  | 35.0        | %  |  | 35.0 | %  |  | 35.0 | % 
|State income tax, net of federal benefits                                     |  | 4.3         | %  |  | 4.5  | %  |  | 4.8  | % 
|Benefits of tax credits                                                       |  | (0.8        | )% |  | (0.8 | )% |  | (0.7 | )%
|Benefits of deductible dividends paid on employee stock ownership plan shares |  | (1.0        | )% |  | (2.3 | )% |  | (3.0 | )%
|Other                                                                         |  | 0.0         | %  |  | (0.4 | )% |  | (0.8 | )%
|                                                                              |  |             |    |  |      |    |  |      |   
|Effective income tax rate                                                     |  | 37.5        | %  |  | 36.0 | %  |  | 35.3 | % 
|                                                                              |  |             |    |  |      |    |  |      |   



Significant components
of the Companys deferred tax assets and liabilities are as follows:



|                                   |  |                 |        |                 |   |       
|---------------------------------- |  | --------------- | ------ | --------------- | - | ------
|                                   |  | January 26,2006 |        | January 27,2005
|                                   |  | Thousands      
|Deferred tax assets:               |  |                 |        |                 |   |       
|Employee compensation and benefits |  | $               | 41,937 |                 | $ | 43,939
|Deferred rent                      |  |                 | 12,214 |                 |   | 6,871 
|Inventories                        |  |                 | 2,588  |                 |   | 3,861 
|Intangible assets                  |  |                 | 1,566  |                 |   | 5,653 
|Other                              |  |                 | 8,095  |                 |   | 5,668 
|                                   |  |                 |        |                 |   |       
|                                   |  |                 | 66,400 |                 |   | 65,992
|                                   |  |                 |        |                 |   |       
|Deferred tax liabilities:          |  |                 |        |                 |   |       
|Property and depreciation          |  |                 | 51,193 |                 |   | 41,148
|Other                              |  |                 | 8,922  |                 |   | 8,381 
|                                   |  |                 |        |                 |   |       
|                                   |  |                 | 60,115 |                 |   | 49,529
|                                   |  |                 |        |                 |   |       
|Net deferred tax asset             |  | $               | 6,285  |                 | $ | 16,463
|                                   |  |                 |        |                 |   |       



The Company has state
tax credits of $1.4 million that may be carried forward for an indefinite period of time to offset future state taxable income.



9. Stockholders Equity



Authorized capital stock consists of 120 million shares of common stock, $.50 par value, and 30 million shares of preferred stock. Each
outstanding share of common stock includes a Preferred Stock Purchase Right (expiring in September 2006), which is exercisable only upon the occurrence of certain change in control events. There have been no events that would allow these rights to
be exercised.



The Company repurchased shares of its
outstanding common stock in each of the last three years, as follows:



|                      |  |             |           |      |   |         |  |   |          
|--------------------- |  | ----------- | --------- | ---- | - | ------- |  | - | ---------
|                      |  | Fiscal Year
|                      |  | 2006        |           | 2005 |   | 2004   
|Shares repurchased    |  |             | 1,420,000 |      |   | 736,260 |  |   | 1,362,200
|Total cost (millions) |  | $           | 55.1      |      | $ | 16.9    |  | $ | 20.0     



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



These shares were repurchased under various programs authorized by the Companys Board of
Directors, most recently in May 2005. Under the May 2005 share repurchase program, the Company is authorized to repurchase additional shares of its outstanding common stock for a maximum additional expenditure of $120.2 million.



10. Stock Incentive Plans



The Company has two separate plans under which it may grant options to
purchase shares of the Companys common stock and other awards of common stock or common stock appreciation rights to key employees. The 1995 Long Term Incentive Plan, as amended, authorized the issuance of 7,400,000 shares of common stock in
the form of stock options and stock awards. The Non-Executive Long Term Incentive Plan, as amended, authorized the issuance of 3,000,000 shares of common stock of the Company and contains similar provisions to those of the 1995 Long Term Incentive
Plan, except that it does not allow for incentive stock options or grants to officers or directors of the Company. Each stock award granted from the 1995 Long Term Incentive Plan reduces the total number of available shares under the plan by 2.75
shares and each stock option granted reduces the total available by one share. For the Non-Executive Long Term Incentive Plan, each stock award or stock option reduces available shares by one share. As of January 26, 2006, there were 5,206,709
shares of common stock available for grant under the two plans.



Stock Options



Generally, stock options
are granted with an exercise price not less than 100% of the closing market price on the date of the grant. The Companys options generally vest in equal annual portions over a period of four years and have a maximum term of ten years. The
Companys stock option award plans contain provisions for accelerated vesting upon a change of control.



Following is a summary of stock option activity:



|                                             |  |                     |   |                     |                                |       |        |           |                                |   |      
|-------------------------------------------- |  | ------------------- | - | ------------------- | ------------------------------ | ----- | ------ | --------- | ------------------------------ | - | -----
|                                             |  | Options Outstanding |   | Options Exercisable
|                                             |  | Shares              |   |                     | Weighted AverageExercise Price |       | Shares |           | Weighted AverageExercise Price
|Outstanding at January 30, 2003              |  | 3,584,950           |   |                     | $                              | 22.68 |        |           |                                |   |      
|Granted (weighted average fair value $5.54)  |  | 827,900             |   |                     |                                | 19.12 |        |           |                                |   |      
|Exercised                                    |  | (26,790             | ) |                     |                                | 20.17 |        |           |                                |   |      
|Forfeited                                    |  | (346,755            | ) |                     |                                | 22.17 |        |           |                                |   |      
|Expired                                      |  | (64,315             | ) |                     |                                | 22.48 |        |           |                                |   |      
|                                             |  |                     |   |                     |                                |       |        |           |                                |   |      
|Outstanding at January 29, 2004              |  | 3,974,990           |   |                     | $                              | 22.00 |        | 978,460   |                                | $ | 22.73
|Granted (weighted average fair value $8.21)  |  | 750,500             |   |                     |                                | 26.36 |        |           |                                |   |      
|Exercised                                    |  | (288,065            | ) |                     |                                | 21.56 |        |           |                                |   |      
|Forfeited                                    |  | (206,765            | ) |                     |                                | 21.41 |        |           |                                |   |      
|Expired                                      |  | (80,135             | ) |                     |                                | 22.31 |        |           |                                |   |      
|                                             |  |                     |   |                     |                                |       |        |           |                                |   |      
|Outstanding at January 27, 2005              |  | 4,150,525           |   |                     | $                              | 22.85 |        | 1,532,075 |                                | $ | 22.46
|Granted (weighted average fair value $12.34) |  | 345,400             |   |                     |                                | 37.77 |        |           |                                |   |      
|Exercised                                    |  | (948,464            | ) |                     |                                | 22.13 |        |           |                                |   |      
|Forfeited                                    |  | (268,225            | ) |                     |                                | 24.06 |        |           |                                |   |      
|Expired                                      |  | (60,335             | ) |                     |                                | 22.22 |        |           |                                |   |      
|                                             |  |                     |   |                     |                                |       |        |           |                                |   |      
|Outstanding at January 26, 2006              |  | 3,218,901           |   |                     | $                              | 24.56 |        | 1,568,191 |                                | $ | 22.79
|                                             |  |                     |   |                     |                                |       |        |           |                                |   |      



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LONGS DRUG STORES CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Following is a summary of options outstanding and exercisable as of January 26, 2006:



|                         |  |                     |  |                                |  |                                |       |                   |           |                                |   |      
|------------------------ |  | ------------------- |  | ------------------------------ |  | ------------------------------ | ----- | ----------------- | --------- | ------------------------------ | - | -----
|                         |  | Options Outstanding |  | Options Exercisable           
|Range of Exercise Prices |  | NumberOutstanding   |  | Weighted AverageRemaining Life |  | Weighted AverageExercise Price |       | NumberExercisable |           | Weighted AverageExercise Price
|$15.11 - $22.45          |  | 956,915             |  | 6.7                            |  | $                              | 20.16 |                   | 590,490   |                                | $ | 20.79
|$23.00 - $30.52          |  | 2,045,486           |  | 7.4                            |  |                                | 24.83 |                   | 977,701   |                                |   | 24.00
|$34.51 - $43.78          |  | 216,500             |  | 9.4                            |  |                                | 41.56 |                   |          |                                |   |     
|                         |  |                     |  |                                |  |                                |       |                   |           |                                |   |      
|                         |  | 3,218,901           |  | 7.3                            |  |                                | 24.56 |                   | 1,568,191 |                                |   | 22.79
|                         |  |                     |  |                                |  |                                |       |                   |           |                                |   |      



Stock Awards



Stock awards with only time-based vesting
requirements are valued at fair market value at the date of grant and are recorded as compensation expense on a straight-line basis over the vesting period. Recipients have voting rights to the shares and dividends are credited to the shares during
the restriction period. However, transfer of ownership of the shares is dependent on continued employment for periods of one to five years.



Stock awards with performance-based vesting requirements, such as a target Company stock price or earnings per share, are valued at fair market value as
of the date on which both the number of shares to be issued and the fair market value of the stock are known. Interim estimates of compensation expense for performance-based stock awards are recorded based on the Companys best estimate of the
number of shares to be issued and the then-current fair market value of the stock. Compensation expense for performance-based stock awards is recognized on straight-line basis over the requisite service period for each separately vesting portion of
the award. Shares are not granted under a performance-based stock award until such time as the performance objective has been met, subject to necessary approvals, at which point additional time-based vesting requirements apply and recipients have
the same rights and restrictions as for stock awards with only time-based vesting requirements.



Unearned compensation expense of $1.4 million as of January 26, 2006 and $1.5 million as of January 27, 2005 represents the value of the
unvested portion of stock awards granted, and is reflected as a reduction of stockholders equity, to be charged to expense over the remaining vesting period. In fiscal 2006, the Company recorded compensation expense of $4.6 million for
performance-based stock awards under which shares had not been granted because the performance conditions had not yet been met with a corresponding credit to paid-in capital.



Following is a summary of stock award activity:



|                                            |  |             |   |  |         |   |  |         |  
|------------------------------------------- |  | ----------- | - |  | ------- | - |  | ------- | -
|                                            |  | Fiscal Year |  
|                                            |  | 2006        |   |  | 2005    |   |  | 2004    |  
|Stock awards outstanding, beginning of year |  | 217,310     |   |  | 283,800 |   |  | 399,500 |  
|Granted                                     |  | 89,009      |   |  | 15,750  |   |  | 10,000  |  
|Vested                                      |  | (134,429    | ) |  | (66,880 | ) |  | (68,871 | )
|Forfeited                                   |  | (39,850     | ) |  | (15,360 | ) |  | (56,829 | )
|                                            |  |             |   |  |         |   |  |         |  
|Stock awards outstanding, end of year       |  | 132,040     |   |  | 217,310 |   |  | 283,800 |  
|                                            |  |             |   |  |         |   |  |         |  



The weighted average
fair value of restricted stock awards granted was $37.34 in fiscal 2006, $23.56 in fiscal 2005 and $16.72 in fiscal 2004.



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LONGS DRUG STORES CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



11. Segment Information



The Company operates in two business segments, retail drug stores and pharmacy benefit services. These segments were
identified based on their separate and distinct products and services, technology, marketing strategies and management reporting. Management evaluates the segments operating performance separately and allocates resources based on their
respective financial condition, results of operations and cash flows. The accounting policies for the segments are the same as those described in Note 1. Inter-segment transactions and balances are eliminated in consolidation.



Pharmacy is the cornerstone of the retail drug store segment, complemented by
such core front-end categories as cosmetics, over-the-counter medications, photo and photo processing, food and beverage items and health and beauty products. As of January 26, 2006, the retail drug store segment operated 476 retail stores in
six western states under the names Longs, Longs Drugs, Longs Drug Stores and Longs Pharmacy. The retail drug store segment also operates a mail order pharmacy business.



The pharmacy benefit services segment, operated through the Companys RxAmerica subsidiary, provides pharmacy benefit
management services whereby RxAmerica contracts with third-party health plans, retail pharmacies and drug manufacturers to provide a range of services to third-party health plan members, including pharmacy benefit plan design and implementation,
claims administration, formulary management and mail order pharmacy fulfillment. In addition, effective January 1, 2006, the pharmacy benefit services segment operates a prescription drug plan that offers prescription drug benefits to Medicare
participants in 20 regions encompassing 35 states and the District of Columbia under the Medicare Prescription Drug, Improvement and Modernization Act of 2003.



The following table summarizes significant financial information by segment:



|                           |  |                 |           |   |                 |   |           |                 |  |   |           |  
|-------------------------- |  | --------------- | --------- | - | --------------- | - | --------- | --------------- |  | - | --------- | -
|                           |  | January 26,2006 |           |   | January 27,2005 |   |           | January 29,2004 | 
|                           |  | Thousands       |          
|Revenues:                  |  |                 |           |   |                 |   |           |                 |  |   |           |  
|Retail Drug Stores         |  | $               | 4,616,846 |   |                 | $ | 4,575,051 |                 |  | $ | 4,499,094 |  
|Pharmacy Benefit Services  |  |                 | 53,457    |   |                 |   | 32,822    |                 |  |   | 27,430    |  
|                           |  |                 |           |   |                 |   |           |                 |  |   |           |  
|Consolidated Totals        |  | $               | 4,670,303 |   |                 | $ | 4,607,873 |                 |  | $ | 4,526,524 |  
|                           |  |                 |           |   |                 |   |           |                 |  |   |           |  
|Operating Income:          |  |                 |           |   |                 |   |           |                 |  |   |           |  
|Retail Drug Stores         |  | $               | 117,681   |   |                 | $ | 57,940    |                 |  | $ | 47,524    |  
|Pharmacy Benefit Services  |  |                 | 8,477     |   |                 |   | 12,552    |                 |  |   | 11,877    |  
|                           |  |                 |           |   |                 |   |           |                 |  |   |           |  
|Consolidated Totals        |  | $               | 126,158   |   |                 | $ | 70,492    |                 |  | $ | 59,401    |  
|                           |  |                 |           |   |                 |   |           |                 |  |   |           |  
|Total Assets:              |  |                 |           |   |                 |   |           |                 |  |   |           |  
|Retail Drug Stores         |  | $               | 1,454,465 |   |                 | $ | 1,383,159 |                 |  | $ | 1,406,752 |  
|Pharmacy Benefit Services  |  |                 | 126,704   |   |                 |   | 87,259    |                 |  |   | 76,222    |  
|Inter-segment Eliminations |  |                 | (77,025   | ) |                 |   | (48,503   | )               |  |   | (40,862   | )
|                           |  |                 |           |   |                 |   |           |                 |  |   |           |  
|Consolidated Totals        |  | $               | 1,504,144 |   |                 | $ | 1,421,915 |                 |  | $ | 1,442,112 |  
|                           |  |                 |           |   |                 |   |           |                 |  |   |           |  



The retail drug store
segment accounts for substantially all of the Companys capital expenditures, depreciation and amortization; and all of the gain on sale of distribution center, provision for store closures and asset impairments, and legal settlements and other
disputes.



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LONGS DRUG STORES CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Consolidated total revenues include the following product and service types:



|                                     |  |                 |           |                 |   |                 |  |   |          
|------------------------------------ |  | --------------- | --------- | --------------- | - | --------------- |  | - | ---------
|                                     |  | January 26,2006 |           | January 27,2005 |   | January 29,2004
|                                     |  | Thousands      
|Pharmacy sales                       |  | $               | 2,245,296 |                 | $ | 2,168,049       |  | $ | 2,082,024
|Front-end sales                      |  |                 | 2,371,550 |                 |   | 2,407,002       |  |   | 2,417,070
|Pharmacy benefit management revenues |  |                 | 37,256    |                 |   | 32,822          |  |   | 27,430   
|Prescription drug plan revenues      |  |                 | 16,201    |                 |   |                |  |   |         
|                                     |  |                 |           |                 |   |                 |  |   |          
|Consolidated total revenues          |  | $               | 4,670,303 |                 | $ | 4,607,873       |  | $ | 4,526,524
|                                     |  |                 |           |                 |   |                 |  |   |          



12. Selected Quarterly Information
(Unaudited)



Summarized quarterly results of operations
for the years ended January 26, 2006 and January 27, 2005 are as follows:



|                                    |  |                                  |           |               |   |              |  |               |           |             |   |           |  |   |          
|----------------------------------- |  | -------------------------------- | --------- | ------------- | - | ------------ |  | ------------- | --------- | ----------- | - | --------- |  | - | ---------
|                                    |  | FirstQuarter                     |           | SecondQuarter |   | ThirdQuarter |  | FourthQuarter |           | Fiscal Year
|                                    |  | Thousands, except per share data
|Year ended January 26, 2006         |  |                                  |           |               |   |              |  |               |           |             |   |           |  |   |          
|Revenues:                           |  |                                  |           |               |   |              |  |               |           |             |   |           |  |   |          
|Retail drug store sales             |  | $                                | 1,140,820 |               | $ | 1,147,895    |  | $             | 1,111,533 |             | $ | 1,216,598 |  | $ | 4,616,846
|Pharmacy benefit services revenues  |  |                                  | 9,608     |               |   | 9,576        |  |               | 8,851     |             |   | 25,422    |  |   | 53,457   
|                                    |  |                                  |           |               |   |              |  |               |           |             |   |           |  |   |          
|Total revenues                      |  |                                  | 1,150,428 |               |   | 1,157,471    |  |               | 1,120,384 |             |   | 1,242,020 |  |   | 4,670,303
|Retail drug store gross profit      |  |                                  | 293,336   |               |   | 299,349      |  |               | 279,886   |             |   | 313,308   |  |   | 1,185,879
|Prescription drug plan gross profit |  |                                  | N/A       |               |   | N/A          |  |               | N/A       |             |   | 3,969     |  |   | 3,969    
|Net income                          |  |                                  | 12,847    |               |   | 16,792       |  |               | 8,945     |             |   | 35,300    |  |   | 73,884   
|Earnings per common share:          |  |                                  |           |               |   |              |  |               |           |             |   |           |  |   |          
|Basic                               |  |                                  | 0.34      |               |   | 0.45         |  |               | 0.24      |             |   | 0.95      |  |   | 1.98     
|Diluted                             |  |                                  | 0.34      |               |   | 0.44         |  |               | 0.23      |             |   | 0.92      |  |   | 1.93     
|                                    |  |                                  |           |               |  
|Year ended January 27, 2005         |  |                                  |           |               |   |              |  |               |           |             |   |           |  |   |          
|Revenues:                           |  |                                  |           |               |   |              |  |               |           |             |   |           |  |   |          
|Retail drug store sales             |  | $                                | 1,151,754 |               | $ | 1,142,129    |  | $             | 1,092,825 |             | $ | 1,188,343 |  | $ | 4,575,051
|Pharmacy benefit services revenues  |  |                                  | 7,942     |               |   | 8,353        |  |               | 8,072     |             |   | 8,455     |  |   | 32,822   
|                                    |  |                                  |           |               |   |              |  |               |           |             |   |           |  |   |          
|Total revenues                      |  |                                  | 1,159,696 |               |   | 1,150,482    |  |               | 1,100,897 |             |   | 1,196,798 |  |   | 4,607,873
|Retail drug store gross profit      |  |                                  | 292,957   |               |   | 295,395      |  |               | 287,712   |             |   | 310,421   |  |   | 1,186,485
|Prescription drug plan gross profit |  |                                  | N/A       |               |   | N/A          |  |               | N/A       |             |   | N/A       |  |   | N/A      
|Net income                          |  |                                  | 9,247     |               |   | 3,378        |  |               | 6,229     |             |   | 17,706    |  |   | 36,560   
|Earnings per common share:          |  |                                  |           |               |   |              |  |               |           |             |   |           |  |   |          
|Basic                               |  |                                  | 0.25      |               |   | 0.09         |  |               | 0.17      |             |   | 0.47      |  |   | 0.98     
|Diluted                             |  |                                  | 0.25      |               |   | 0.09         |  |               | 0.17      |             |   | 0.47      |  |   | 0.97     



Pharmacy benefit
services revenues include pharmacy benefit management revenues and, beginning January 1, 2006, revenues for prescription drug plans offered to Medicare participants under the Medicare Prescription Drug, Improvement and Modernization Act of
2003. Prescription drug plan gross profit is measured based on prescription drug plan benefit costs and prescription drug plan revenues. Pharmacy benefit management revenues are reported net of reimbursements to participating pharmacies.
Prescription drug plan revenues were $16.2 million and prescription drug plan benefit costs were $12.2 million in the fourth quarter of fiscal 2006, all of which were generated in January when the new benefit became effective.



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LONGS DRUG STORES CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Results for the fourth quarter of fiscal 2006 included a pre-tax gain of $11.0 million for the sale
of the Companys front-end distribution center in Lathrop, California.



Results for the second quarter of fiscal 2005 included a pre-tax provision of $10.8 million for legal settlements and other disputes, comprised of the settlement and applicable payroll taxes for two purported class
action lawsuits related to the classification of exempt employees and payment of overtime wages, which was partially offset by a gain related to the favorable settlement of a separate, unrelated class action lawsuit for which the Company had filed a
claim as a member of the plaintiff class.



52



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##### Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM



To the Board of Directors and Stockholders of

Longs Drug Stores Corporation

Walnut Creek, California



We
have audited the accompanying consolidated balance sheets of Longs Drug Stores Corporation and subsidiaries (the Company) as of January 26, 2006 and January 27, 2005, and the related statements of consolidated income,
stockholders equity, and cash flows for each of the three years in the period ended January 26, 2006. We also have audited managements assessment, included in the accompanying Managements Report on Internal Control Over
Financial Reporting, that the Company maintained effective internal control over financial reporting as of January 26, 2006, based on criteria established in Internal ControlIntegrated Frameworkissued by the Committee of
Sponsoring Organizations of the Treadway Commission. The Companys management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness
of internal control over financial reporting. Our responsibility is to express an opinion on these financial statements, an opinion on managements assessment, and an opinion on the effectiveness of the Companys internal control over
financial reporting based on our audits.



We conducted our
audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of
material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audit of financial statements included examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting
included obtaining an understanding of internal control over financial reporting, evaluating managements assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we
considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.



A companys internal control over financial reporting is a process designed by, or under the supervision of, the companys principal executive
and principal financial officers, or persons performing similar functions, and effected by the companys board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and
the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A companys internal control over financial reporting includes those policies and procedures that (1) pertain
to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit
preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and
(3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the companys assets that could have a material effect on the financial statements.



Because of the inherent limitations of internal control over financial
reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the
effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may
deteriorate.



In our opinion, the consolidated financial
statements referred to above present fairly, in all material respects, the financial position of the Company as of January 26, 2006 and January 27, 2005, and the results of its



53



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##### Table of Contents

operations and its cash flows for each of the three years in the period ended January 26, 2006, in conformity with accounting principles generally
accepted in the United States of America. Also in our opinion, managements assessment that the Company maintained effective internal control over financial reporting as of January 26, 2006, is fairly stated, in all material respects,
based on the criteria established in Internal ControlIntegrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission. Furthermore, in our opinion, the Company maintained, in all material
respects, effective internal control over financial reporting as of January 26, 2006, based on the criteria established in Internal ControlIntegrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway
Commission.



/s/ Deloitte & Touche
LLP

San Francisco, California

March 15, 2006



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##### Table of Contents

Item 9.Changes in and Disagreements with Accountants on Accounting and Financial Disclosure



None.



Item 9A.Controls and Procedures



Managements Report on Internal Control Over Financial Reporting



Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control system was
designed to provide reasonable assurance to our management and board of directors regarding the preparation and fair presentation of published financial statements in accordance with generally accepted accounting principles.



All internal control systems, no matter how well designed, have inherent
limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.



Our management assessed the effectiveness of our internal control over financial reporting as of January 26,
2006. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal ControlIntegrated Framework. Based on our assessment we believe
that, as of January 26, 2006, our internal control over financial reporting is effective based on those criteria.



Our independent registered public accounting firm, Deloitte & Touche LLP, has audited our assessment and their report is included herein.



Conclusion Regarding the Effectiveness of Disclosure Controls and
Procedures



We maintain disclosure controls and procedures
that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SECs rules and forms, and that such information is
accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.



As of January 26, 2006, the end of the period covered by this annual report, we carried out an evaluation, under the
supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on that evaluation,
our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective and adequate to provide reasonable assurance that material information relating to the company would be made known to them
on a timely basis.



There have been no changes in our internal
control over financial reporting that occurred during the fourth fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.



Item 9B.Other Information



No events have occurred which would require disclosure under this Item.



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PART III



Item 10.Directors and Executive Officers of the Registrant



Information concerning this item will be in our definitive proxy statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of
1934 for our 2006 annual meeting of stockholders and is incorporated herein by reference.



Item 11.Executive Compensation



Information concerning this item will be in our definitive proxy statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934 for our 2006 annual meeting of stockholders and is
incorporated herein by reference.



Item 12.Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters



Information concerning this item will be in our definitive proxy statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of
1934 for our 2006 annual meeting of stockholders and is incorporated herein by reference.



Item 13.Certain Relationships and Related Transactions



Information concerning this item will be in our definitive proxy statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of
1934 for our 2006 annual meeting of stockholders and is incorporated herein by reference.



Item 14.Principal Accountant Fees and Services



Information concerning this item will be in our definitive proxy statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of
1934 for our 2006 annual meeting of stockholders and is incorporated herein by reference.



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PART IV



Item 15.Exhibits, Financial Statement Schedules, and Reports on Form 8-K



Financial Statements and Schedules



|       |  |                                                                                                                                                             
|------ |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------
|(a)(1) |  | The Financial Statements are filed with this Form 10-K at pages 26-44.                                                                                      
|       | 
|(a)(2) |  | All schedules required by this Item are omitted because they are not applicable or the information is included in the financial statements or related notes.
|       | 
|(a)(3) |  | EXHIBITS                                                                                                                                                    



|            |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|----------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|3.          |  | Articles of Incorporation and By-Laws                                                                                                                                                                                                                                                                                                                                                                                                               
|            | 
|            |  | 1.      Restated Articles of Incorporation, amended June 3, 1997, as incorporated herein by reference, as
previously filed with the Commission on September 12, 1997, as Exhibit 1 to Form 10-Q.                                                                                                                                                                                                                                                    
|            | 
|            |  | 2.      Amended By Laws of Longs Drug Stores Corporation, dated May 25, 2004, is incorporated herein by
reference, as previously filed with the Commission on June 4, 2004, as Exhibit 3 to Form 10-Q.                                                                                                                                                                                                                                              
|            | 
|10.         |  | Material Contracts                                                                                                                                                                                                                                                                                                                                                                                                                                  
|            | 
|            |  | 1.      The Longs Drug Stores Corporation Deferred Compensation Plan of 1995 is incorporated herein by
reference as previously filed with the Commission on June 6, 1995, on Form S-8, Registration No. 033-60005.*                                                                                                                                                                                                                                 
|            | 
|            |  | 2.      Renewals of the Agreements for Termination Benefits dated August 22, 1996, are incorporated herein by
reference as previously filed with the Commission on December 6, 1996, on Form 10-Q as Exhibit 1, as executed by the Chairman, CEO and President; Exhibit 2, as executed by the Senior Vice Presidents, Vice Presidents, District Managers and the
Treasurer; and Exhibit 3, as executed by Select Key Executives and Store Managers.*
|            | 
|            |  | 3.      Shareholder Rights Agreement of Longs Drug Stores Corporation dated August 20, 1996 is incorporated
herein by reference as previously filed with the Commission on September 16, 1996, as Exhibit 1 to Form 8-K.                                                                                                                                                                                                                            
|            | 
|            |  | 4.      Employment agreement between the Company and Steven F. McCann, Senior Vice President, Chief Financial
Officer, and Treasurer, dated April 17, 2000 is incorporated by reference as previously filed with the Commission on September 11, 2000, as Exhibit 10.1 to Form 10-Q.*                                                                                                                                                               
|            | 
|            |  | 5.      Amendment to Shareholder Rights Agreement of Longs Drug Stores Corporation dated August 15, 2000,
between the Company and Chase Mellon Shareholder Services, L.L.C. is incorporated herein by reference as previously filed with the Commission on December 11, 2000, as Exhibit 4(a) to Form 10-Q.                                                                                                                                         
|            | 
|            |  | 6.      Amendments to the Longs Drug Stores Corporation Deferred Compensation Plan of 1995 is incorporated
herein by reference as previously filed with the Commission on April 13, 2001, as Exhibit 10(d) to Form 10-K.*                                                                                                                                                                                                                           
|            | 
|            |  | 7.      Employment agreement between the Company and Linda M. Watt, Senior Vice President of Human Resources,
dated June 7, 2001 is incorporated by reference as previously filed with the Commission on September 7, 2001, as Exhibit 10.1 to Form 10-Q.*                                                                                                                                                                                          



57



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|            |  |                                                                                                                                                                                                                                                                                                                                       
|----------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  |                                                                                                                                                                                                                                                                                                                                       
|            | 
|            |  | 8.      Employment agreement between the Company and Todd J. Vasos, Senior Vice PresidentMarketing,
dated November 21, 2001, is incorporated herein by reference as previously filed with the Commission on April 17, 2002, as Exhibit 10(l) to Form 10-K.*                                                                          
|            | 
|            |  | 9.      Amendment to employment agreement between the Company and Steven F. McCann, Senior Vice President,
Chief Financial Officer and Treasurer, dated May 22, 2002, is incorporated herein by reference as previously filed with the Commission on September 16, 2002, as Exhibit 10.1 to Form 10-Q.*                               
|            | 
|            |  | 10.    The Longs Drug Stores Corporation 1995 Long-Term Incentive Plan, as amended, is incorporated herein by reference
as previously filed with the Commission on August 29, 2002, on Form S-8, Registration No. 333-98913.*                                                                                                         
|            | 
|            |  | 11.    Employment agreement between the Company and Warren F. Bryant, President and Chief Executive Officer, dated
October 30, 2002, is incorporated herein by reference as previously filed with the Commission on December 16, 2002, as Exhibit 10.2 to Form 10-Q.*                                                                 
|            | 
|            |  | 12.    The Longs Drug Stores Corporation Non-Executive Long-Term Incentive Plan, as amended, is incorporated by
reference as previously filed with the Commission on April 18, 2003, as Exhibit (s) on Form 10-K.                                                                                                                     
|            | 
|            |  | 13.    Employment agreement between the Company and Bruce E. Schwallie, Senior Vice PresidentPharmacy and
Business Development, dated as of February 1, 2002, is incorporated herein by reference as previously filed with the Commission on April 18, 2003, as Exhibit (u) to Form 10-K.*                                           
|            | 
|            |  | 14.    Separation agreement between the Company and Terry D. Burnside, Senior Vice President and Chief Operating
Officer, dated March 26, 2003, is incorporated herein by reference, as previously filed with the Commission on June 16, 2003, as Exhibit 10.1 to Form 10-Q.*                                                         
|            | 
|            |  | 15.    Employment agreement between the Company and Michael M. Laddon, Senior Vice President, Chief Information
Officer, dated February 25, 2003, is incorporated herein by reference, as previously filed with the Commission on June 16, 2003, as Exhibit 10.2 to Form 10-Q.*                                                       
|            | 
|            |  | 16.    Employment agreement between the Company and William J. Rainey, Senior Vice President, General Counsel, dated
March 18, 2003, is incorporated herein by reference, as previously filed with the Commission on June 16, 2003, as Exhibit 10.3 to Form 10-Q.*                                                                    
|            | 
|            |  | 17.    Longs Drug Stores Corporation 2003 Executive Incentive Plan, as approved by stockholders on May 20, 2003,
is incorporated herein by reference, as previously filed with the Commission on September 12, 2003, as Exhibit 10.1 to Form 10-Q.*                                                                                   
|            | 
|            |  | 18.    Amendment to the Longs Drug Stores Corporation 1995 Long-Term Incentive Plan, as approved by stockholders on May
20, 2003, is incorporated herein by reference, as previously filed with the Commission on September 12, 2003, as Exhibit 10.2 to Form 10-Q.*                                                                  
|            | 
|            |  | 19.    Form of Agreement for Termination Benefits in the Event of a Change in Corporate Control between Longs Drug
Stores California, Inc. and employees at a Senior Vice President level or above, is incorporated herein by reference, as previously filed with the Commission on September 12, 2003, as Exhibit 10.4 to Form 10-Q.*
|            | 
|            |  | 20.    Form of Retention Agreement between Longs Drug Stores California, Inc. and employees at a Senior Vice President
level or above, is incorporated herein by reference, as previously filed with the Commission on September 12, 2003, as Exhibit 10.5 to Form 10-Q.*                                                             



58



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##### Table of Contents

|            |  |                                                                                                                                                                                                                                                                                                  
|----------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  |                                                                                                                                                                                                                                                                                                  
|            | 
|            |  | 21.    First Amendment to Employment Agreement between Warren F. Bryant, Longs Drug Stores Corporation and Longs Drug
Stores California, Inc., dated March 2, 2004 is incorporated herein by reference as previously filed with the Commission on April 12, 2004, as Exhibit 10.cc to Form 10-K.*
|            | 
|            |  | 22.    Form of Indemnification Agreement between Longs Drug Stores Corporation and directors of Longs Drug Stores
Corporation, is incorporated herein by reference, as previously filed with the Commission on April 12, 2004, as Exhibit 10.dd to Form 10-K.*                                   
|            | 
|            |  | 23.    Form of Indemnification Agreement between Longs Drug Stores Corporation and officers of Longs Drug Stores
Corporation, is incorporated herein by reference, as previously filed with the Commission on April 12, 2004, as Exhibit 10.ee to Form 10-K.*                                    
|            | 
|            |  | 24.    Form of Indemnification Agreement between Longs Drug Stores California, Inc. and directors and officers of Longs
Drug Stores California, Inc, is incorporated herein by reference, as previously filed with the Commission on April 12, 2004, as Exhibit 10.ff to Form 10-K.*             
|            | 
|            |  | 25.    Amendment to employment agreement between the Company and Michael M. Laddon, Senior Vice President, Chief
Information Officer, dated June 1, 2004, is incorporated herein by reference as previously filed with the Commission on June 4, 2004, as Exhibit 10 to Form 10-Q. *             
|            | 
|            |  | 26.    Credit Agreement dated as of August 6, 2004, between Longs Drug Stores California, Inc. and the lenders
thereunder is incorporated herein by reference as previously filed with the Commission on September 3, 2004, as Exhibit 10 to Form 10-Q.                                          
|            | 
|            |  | 27.    Form of stock option agreement for non-employee directors in Longs Drug Stores Corporation 1995 Long-Term
Incentive Plan, is incorporated herein by reference, as previously filed with the Commission on December 3, 2004, as Exhibit 10.1 to Form 10-Q.*                                
|            | 
|            |  | 28.    Form of stock option agreement in Longs Drug Stores Corporation 1995 Long-Term Incentive Plan, is incorporated
herein by reference, as previously filed with the Commission on December 3, 2004, as Exhibit 10.2 to Form 10-Q.*                                                           
|            | 
|            |  | 29.    Form of restricted stock award agreement in Longs Drug Stores Corporation 1995 Long-Term Incentive Plan, is
incorporated herein by reference, as previously filed with the Commission on December 3, 2004, as Exhibit 10.3 to Form 10-Q.*                                                 
|            | 
|            |  | 30.    Form of restricted stock award agreement in Longs Drug Stores Corporation Non-Executive Long-Term Incentive
Plan, is incorporated herein by reference, as previously filed with the Commission on December 3, 2004, as Exhibit 10.4 to Form 10-Q.*                                        
|            | 
|            |  | 31.    Form of stock option agreement in Longs Drug Stores Corporation Non-Executive Long-Term Incentive Plan, is
incorporated herein by reference, as previously filed with the Commission on December 3, 2004, as Exhibit 10.5 to Form 10-Q.*                                                  
|            | 
|            |  | 32.    Form of non-employee directors restricted stock award agreement pursuant to the Longs Drug Stores
Corporation 1995 Long-Term Incentive Plan, is incorporated herein by reference, as previously filed with the Commission on April 11, 2005, as Exhibit 10.35 to Form 10-K.*             
|            | 
|            |  | 33.    Form of restricted stock award agreement for senior officers under the Longs Drug Stores Corporation 1995
Long-Term Incentive Plan, is incorporated herein by reference, as previously filed with the Commission on June 2, 2005, as Exhibit 10.1 to Form 10-Q.*                          



59



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##### Table of Contents

|            |  |                                                                                                                                                                                                                                                                            
|----------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  |                                                                                                                                                                                                                                                                            
|            | 
|            |  | 34.    Form of restricted stock award agreement for non-senior officers under the Longs Drug Stores Corporation 1995
Long-Term Incentive Plan, is incorporated herein by reference, as previously filed with the Commission on June 2, 2005, as Exhibit 10.2 to Form 10-Q.*
|            | 
|            |  | 35.    Form of restricted stock award under the Longs Drug Stores Corporation Non-Executive Long-Term Incentive Plan,
is incorporated herein by reference, as previously filed with the Commission on June 2, 2005, as Exhibit 10.2 to Form 10-Q.*                         
|            | 
|21.         |  | Subsidiaries of the Registrant                                                                                                                                                                                                                                             
|            | 
|23.         |  | Consent of Independent Registered Public Accounting Firm                                                                                                                                                                                                                   
|            | 
|31.         |  | Certification of the Chief Executive Officer and the Chief Financial Officer of Longs Drug Stores Corporation, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. **                                                                                               
|            | 
|32.         |  | Certification of the Chief Executive Officer and the Chief Financial Officer of Longs Drug Stores Corporation, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. **                                                                                               

---

|* | Indicates a management contract or compensatory plan or arrangement.
|- | --------------------------------------------------------------------

|** | These certifications are being furnished solely to accompany this annual report pursuant to 18 U.S.C. §1350, and are not being filed for purposes of Section 18 of the
Securities Exchange Act of 1934, as amended, and are not to be incorporated by reference to any filing of the Company, whether made before or after the date hereof, regardless of any general incorporation language in such filing.
|-- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



(b) REPORTS ON FORM 8-K



On November 3, 2005, we filed a Current Report on Form
8-K related to a press release regarding our October 2005 sales results.



On November 16, 2005, we filed a Current Report on Form 8-K related to a press release regarding our third quarter of fiscal 2006 financial results and fourth quarter and full year fiscal 2006 financial
projections.



On November 17, 2005, we
filed a Current Report on Form 8-K related to restricted stock grants to non-employee members of the board of directors and the approval of changes to the compensation of non-employee members of the board of directors.



On November 21, 2005, we filed a Current Report of Form
8-K related to the resignation of the Companys Chief Operating Officer.



On December 2, 2005, we filed a Current Report on Form 8-K related to a press release regarding our November 2005 sales results.



On January 5, 2006, we filed a Current Report on Form 8-K related to a press release regarding our
December 2005 sales results.



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SIGNATURES



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



|      |  |                |  |  |  |                                                                                                          
|----- |  | -------------- |  |  |  | ---------------------------------------------------------------------------------------------------------
|      |  |                |  |  |  | LONGS DRUG STORES CORPORATION (Registrant)                                                               
|      |  |                | 
|Date: |  | March 17, 2006 |  |  |  | /s/    S. F. MCCANN                                                                                      
|      |  |                |  |  |  | (S. F. McCann) Executive Vice President, Chief Financial Officer and Treasurer                           
|      |  |                | 
|Date: |  | March 17, 2006 |  |  |  | /s/    R. L. CHELEMEDOS                                                                                  
|      |  |                |  |  |  | (R. L. Chelemedos) Group Vice PresidentController and Assistant
Secretary (Principal Accounting Officer)



Pursuant to the
requirements of the Securities Exchange Act of 1934, this report has been duly signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated.



|                                              |  |                                                 |  |               
|--------------------------------------------- |  | ----------------------------------------------- |  | --------------
|Signature                                     |  | Title                                           |  | Date          
|                                              |  |                                                
|/s/    W. F. BRYANT(W. F. Bryant)             |  | Chairman, President and Chief Executive Officer |  | March 17, 2006
|                                              |  |                                                
|/s/    L. T. BARNES,
JR.(L. T. Barnes,
Jr.)   |  | Director                                        |  | March 17, 2006
|                                              |  |                                                
|/s/    M. H. DASHE(M. H. Dashe)               |  | Director                                        |  | March 17, 2006
|                                              |  |                                                
|/s/    L. M. HARPER(L. M. Harper)             |  | Director                                        |  | March 17, 2006
|                                              |  |                                                
|/s/    R. M. LONG(R. M. Long)                 |  | Director                                        |  | March 17, 2006
|                                              |  |                                                
|/s/    M. S. METZ,
PH.D.(M. S. Metz,
Ph.D.)   |  | Director                                        |  | March 17, 2006
|                                              |  |                                                
|/s/    H. R. SOMERSET(H. R. Somerset)         |  | Director                                        |  | March 17, 2006
|                                              |  |                                                
|/s/    D. L. SORBY,
PH.D.(D. L. Sorby,
Ph.D.) |  | Lead Director                                   |  | March 17, 2006



61



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##### Table of Contents

|                                  |  |          |  |               
|--------------------------------- |  | -------- |  | --------------
|Signature                         |  | Title    |  | Date          
|                                  |  |         
|/s/    D. A. TANOUE(D. A. Tanoue) |  | Director |  | March 17, 2006
|                                  |  |         
|/s/    A. G. WAGNER(A. G. Wagner) |  | Director |  | March 17, 2006



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