**UNITED STATESSECURITIES AND EXCHANGE COMMISSION****Washington, D.C. 20549**

**Form 10-Q**

**(MarkOne)**

**x****        ****QUARTERLY REPORT PURSUANT TO SECTION 13 OR15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

**Forthe quarterly period ended May 27, 2006**

 

**OR**

**o****           ****TRANSITION REPORT PURSUANT TO SECTION 13 OR15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**CommissionFile Number       1-6807**

**FAMILY DOLLAR STORES, INC.******(Exact name of registrant as specified in its charter)

 

| **Delaware**                     |   | **56-0942963**       |
|----------------------------------|--------|----------------------|
| (State or other  jurisdiction of |   | (I.R.S. Employer     |
| incorporation or  organization)  |   | Identification  No.) |
|                             |   |                 |

 

 

| **P. O. Box 1017, 10401 Monroe Road**     |   |           |
|-------------------------------------------|--------|----------------|
| **Charlotte,  North Carolina**            |   | **28201-1017** |
| (Address of  principal executive offices) |   | (Zip Code)     |
|                                      |   |           |

 

Registrant’stelephone number, including area code:  **(704) 847-6961**

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

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large AcceleratedFiler x   Accelerated Filer o   Non-Accelerated Filer o

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act).

Yes o   No x

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock, as of thelatest practicable date.

 
| **Class**                      |   | **Outstanding at June 23, 2006** |
|--------------------------------|--------|---------------------------------------|
| Common Stock,  $0.10 par value |   | 151,634,254  shares                   |

 

 

 

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**FAMILY DOLLARSTORES, INC. AND SUBSIDIARIES**

**INDEX**

 
|                                                                                                                       | ** ** | ** ** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|------------|------------|
| Part I —  Financial Information                                                                             |       |       |       |
| Item  1 — Consolidated Condensed Financial Statements:                                                           |       |       |       |
| Consolidated  Condensed Balance Sheets — May 27, 2006 and August 27, 2005                              |       |       |       |
| Consolidated  Condensed Statements of Income — Quarter Ended May 27, 2006 and  May 28, 2005            |       |       |       |
| Consolidated  Condensed Statements of Income — Three Quarters Ended May 27, 2006 and  May 28, 2005     |       |       |       |
| Consolidated  Condensed Statements of Cash Flows — Three Quarters Ended May 27, 2006  and May 28, 2005 |       |       |       |
| Notes  to Consolidated Condensed Financial Statements                                                                 |       |       |       |
| Item 2 — Management’s Discussion and Analysis of  Financial Condition and Results of Operations             |       |       |       |
| Item 3 — Quantitative and Qualitative Disclosures  About Market Risk                                             |       |       |       |
| Item 4 — Controls and Procedures                                                                                 |       |       |       |
| Part II  — Other Information and Signatures                                                                 |       |       |       |
| Item  1 — Legal Proceedings                                                                                      |       |       |       |
| Item 2 — Unregistered Sales of Equity Securities and  Use of Proceeds                                            |       |       |       |
| Item 6 —  Exhibits                                                                                               |       |       |       |
| Signatures                                                                                                            |       |       |       |

 

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**PART I —FINANCIAL INFORMATION**

**Item 1.  Consolidated Condensed Financial Statements**

** **

**FAMILY DOLLARSTORES, INC. AND SUBSIDIARIESCONSOLIDATED CONDENSED BALANCE SHEETS(Unaudited)**
| **(in thousands, except per share and share amounts)**                                                                                                                                                                          | ** ** | **May 27,  2006** | ** ** | **August 27,  2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|---------------------------|------------|
| **Assets**                                                                                                                                                                                                                                                         | ** ** | ** **             | ** ** | ** **                | ** ** |
| Current assets:                                                                                                                                                                                                                                                    |       |                   |       |                      |       |
| Cash and cash  equivalents (Note 2)                                                                                                                                                                                                                                |       | $                      | 69,745     |                      | $          | 105,175 |   |
| Investment  securities (Note 2)                                                                                                                                                                                                                                    |       | 98,400                 |       | 33,530                    |       |
| Merchandise  inventories                                                                                                                                                                                                                                           |       | 1,028,221              |       | 1,090,791                 |       |
| Deferred income  taxes                                                                                                                                                                                                                                             |       | 134,333                |       | 100,493                   |       |
| Prepayments and  other current assets                                                                                                                                                                                                                              |       | 50,775                 |       | 24,779                    |       |
| Total current  assets                                                                                                                                                                                                                                              |       | 1,381,474              |       | 1,354,768                 |       |
|                                                                                                                                                                                                                                                               |       |                   |       |                      |       |
| Property and equipment,  net                                                                                                                                                                                                                                       |       | 1,066,945              |       | 1,027,475                 |       |
| Other assets                                                                                                                                                                                                                                                       |       | 27,582                 |       | 27,258                    |       |
| ** **                                                                                                                                                                                                                                                         |       | $                      | 2,476,001  |                      | $          | 2,409,501 |   |
| **Liabilities and Shareholders’  Equity**                                                                                                                                                                                                                     | ** ** | ** **             | ** ** | ** **                | ** ** |
| Current liabilities:                                                                                                                                                                                                                                               |       |                   |       |                      |       |
| Accounts payable                                                                                                                                                                                                                                                   |       | $                      | 499,278    |                      | $          | 574,831 |   |
| Accrued  liabilities                                                                                                                                                                                                                                               |       | 419,003                |       | 315,508                   |       |
| Income taxes  payable                                                                                                                                                                                                                                              |       | 8,116                  |       | 4,272                     |       |
| Total current  liabilities                                                                                                                                                                                                                                         |       | 926,397                |       | 894,611                   |       |
|                                                                                                                                                                                                                                                               |       |                   |       |                      |       |
| Long-term debt (Note 4)                                                                                                                                                                                                                                            |       | 250,000                |       | —                    |       |
| Deferred income taxes                                                                                                                                                                                                                                              |       | 78,320                 |       | 86,824                    |       |
| Commitments and  contingencies (Note 8)                                                                                                                                                                                                                            |       |                   |       |                      |       |
|                                                                                                                                                                                                                                                               |       |                   |       |                      |       |
| Shareholders’ equity:  (Notes 5 and 6)                                                                                                                                                                                                                        |       |                   |       |                      |       |
|                                                                                                                                                                                                                                                               |       |                   |       |                      |       |
| Preferred stock,  $1 par; authorized and unissued 500,000 shares                                                                                                                                                                                                   |       |                   |       |                      |       |
| Common stock,  $.10 par; authorized 600,000,000 shares; issued 178,483,181 shares at  May 27, 2006, and 188,871,738 shares at August 27, 2005, and  outstanding 151,634,254 shares at May 27, 2006, and 165,262,513 shares  at August 27, 2005 |       | 17,848                 |       | 18,887                    |       |
| Capital in  excess of par                                                                                                                                                                                                                                          |       | 137,094                |       | 133,743                   |       |
| Retained  earnings                                                                                                                                                                                                                                                 |       | 1,529,864              |       | 1,654,861                 |       |
|                                                                                                                                                                                                                                                               |       | 1,684,806              |       | 1,807,491                 |       |
| Less: common  stock held in treasury, at cost (26,848,927 shares at May 27, 2006, and  23,609,225 shares at August 27, 2005) (Note 5)                                                                                                                    |       | 463,522                |       | 379,425                   |       |
| Total  shareholders’ equity                                                                                                                                                                                                                                   |       | 1,221,284              |       | 1,428,066                 |       |
| ** **                                                                                                                                                                                                                                                         |       | $                      | 2,476,001  |                      | $          | 2,409,501 |   |

##  

## Seenotes to the consolidated condensed financial statements.

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** **

**FAMILY DOLLARSTORES, INC. AND SUBSIDIARIESCONSOLIDATED CONDENSED STATEMENTS OF INCOME(Unaudited)**

** **

 
| ** **                                                            | ** ** | **Quarter Ended**          | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------|------------|
| **(in thousands, except per share amounts)** | ** ** | **May 27, 2006** | ** ** | **May 28, 2005** | ** ** |
| Net sales                                                             |       | $                          | 1,569,516  |   | $ | 1,427,966 |   |
|                                                                  |       |                       |       |   |   |
| Cost and expenses:                                                    |       |                       |       |   |   |
| Cost of sales                                                         |       | 1,041,789                  |       | 948,614 |   |
| Selling, general  and administrative expenses                         |       | 435,366                    |       | 395,764 |   |
| Cost of sales and  operating expenses                                 |       | 1,477,155                  |       | 1,344,378 |   |
|                                                                  |       |                       |       |   |   |
| Operating profit                                                      |       | 92,361                     |       | 83,588 |   |
|                                                                  |       |                       |       |   |   |
| Interest income                                                       |       | 2,086                      |       | 1,364 |   |
|                                                                  |       |                       |       |   |   |
| Interest expense (Note  4)                                            |       | 3,093                      |       | — |   |
|                                                                  |       |                       |       |   |   |
| Income before provision  for taxes on income                          |       | 91,354                     |       | 84,952 |   |
|                                                                  |       |                       |       |   |   |
| Provision for taxes on  income                                        |       | 34,440                     |       | 31,178 |   |
|                                                                  |       |                       |       |   |   |
| Net income                                                            |       | $                          | 56,914     |   | $ | 53,774 |   |
|                                                                  |       |                       |       |   |   |
| Net income per common  share — basic (Note 7)                    |       | $                          | 0.37       |   | $ | 0.32 |   |
| Average shares —  basic (Note 7)                                 |       | 154,260                    |       | 166,858 |   |
|                                                                  |       |                       |       |   |   |
| Net income per common  share — diluted (Note 7)                  |       | $                          | 0.37       |   | $ | 0.32 |   |
| Average shares —  diluted (Note 7)                               |       | 154,566                    |       | 167,160 |   |
|                                                                  |       |                       |       |   |   |
| Dividends declared per common share                                   |       | $                          | 0.105      |   | $ | 0.095 |   |

 

See notes to theconsolidated condensed financial statements.

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**FAMILY DOLLARSTORES, INC. AND SUBSIDIARIESCONSOLIDATED CONDENSED STATEMENTS OF INCOME(Unaudited)**

 
| ** **                                                            | ** ** | **Three Quarters Ended**   | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------|------------|
| **(in thousands, except per share amounts)** | ** ** | **May 27, 2006** | ** ** | **May 28, 2005** | ** ** |
| Net sales                                                             |       | $                          | 4,816,656  |   | $ | 4,394,965 |   |
|                                                                  |       |                       |       |   |   |
| Cost and expenses:                                                    |       |                       |       |   |   |
| Cost of sales                                                         |       | 3,210,237                  |       | 2,934,342 |   |
| Selling, general  and administrative expenses                         |       | 1,298,834                  |       | 1,167,106 |   |
| Litigation charge  (Note 8)                                           |       | 45,000                     |       | — |   |
| Cost of sales and  operating expenses                                 |       | 4,554,071                  |       | 4,101,448 |   |
|                                                                  |       |                       |       |   |   |
| Operating profit                                                      |       | 262,585                    |       | 293,517 |   |
|                                                                  |       |                       |       |   |   |
| Interest income                                                       |       | 5,135                      |       | 3,097 |   |
|                                                                  |       |                       |       |   |   |
| Interest expense (Note  4)                                            |       | 8,242                      |       | — |   |
|                                                                  |       |                       |       |   |   |
| Income before provision  for taxes on income                          |       | 259,478                    |       | 296,614 |   |
|                                                                  |       |                       |       |   |   |
| Provision for taxes on  income                                        |       | 96,646                     |       | 108,338 |   |
|                                                                  |       |                       |       |   |   |
| Net income                                                            |       | $                          | 162,832    |   | $ | 188,276 |   |
|                                                                  |       |                       |       |   |   |
| Net income per common  share — basic (Note 7)                    |       | $                          | 1.04       |   | $ | 1.12 |   |
| Average shares —  basic (Note 7)                                 |       | 156,294                    |       | 167,400 |   |
|                                                                  |       |                       |       |   |   |
| Net income per common  share — diluted (Note 7)                  |       | $                          | 1.04       |   | $ | 1.12 |   |
| Average shares —  diluted (Note 7)                               |       | 156,365                    |       | 167,846 |   |
|                                                                  |       |                       |       |   |   |
| Dividends declared per common share                                   |       | $                          | 0.305      |   | $ | 0.275 |   |

 

See notes to theconsolidated condensed financial statements.

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**FAMILY DOLLARSTORES, INC. AND SUBSIDIARIESCONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS(Unaudited)**

 
| ** **                                                                         | ** ** | **Three Quarters Ended**   | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------|------------|
| **(in thousands)**                                                            | ** ** | **May 27, 2006** | ** ** | **May 28, 2005** | ** ** |
| **Cash flows from operating  activities:**                                         | ** ** | ** **                 | ** ** | ** ** | ** ** |
| Net income                                                                         |       | $                          | 162,832    |   | $ | 188,276 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                       |       |   |   |
| Depreciation and  amortization                                                     |       | 99,044                     |       | 83,187 |   |
| Deferred income  taxes                                                             |       | (42,344                    | )          | (7,233 | ) |
| Stock-based  compensation expense                                                  |       | 5,941                      |       | — |   |
| Tax benefit from  stock option exercises                                           |       | 200                        |       | 2,549 |   |
| Excess tax  benefits from stock-based compensation                                 |       | (196                       | )          | — |   |
| Loss on  disposition of property and equipment                                     |       | 4,189                      |       | 1,415 |   |
| Changes in  operating assets and liabilities:                                      |       |                       |       |   |   |
| Merchandise  inventories                                                           |       | 62,570                     |       | (10,704 | ) |
| Income tax  refund receivable                                                      |       | —                     |       | 1,304 |   |
| Prepayments and  other current assets                                              |       | (25,996                    | )          | (31,533 | ) |
| Other assets                                                                       |       | 634                        |       | (7,902 | ) |
| Accounts payable  and accrued liabilities                                          |       | 43,736                     |       | (696 | ) |
| Income taxes  payable                                                              |       | 3,844                      |       | 3,867 |   |
|                                                                               |       | 314,454                    |       | 222,530 |   |
|                                                                               |       |                       |       |   |   |
| **Cash flows from investing activities:**                                          | ** ** | ** **                 | ** ** | ** ** | ** ** |
| Purchases of  investment securities                                                |       | (261,305                   | )          | (234,315 | ) |
| Sales of  investment securities                                                    |       | 196,435                    |       | 256,835 |   |
| Capital  expenditures                                                              |       | (144,378                   | )          | (147,662 | ) |
| Proceeds from  dispositions of property and equipment                              |       | 1,675                      |       | 1,928 |   |
|                                                                               |       | (207,573                   | )          | (123,214 | ) |
|                                                                               |       |                       |       |   |   |
| **Cash flows from financing  activities:**                                         | ** ** | ** **                 | ** ** | ** ** | ** ** |
| Issuance of  long-term debt                                                        |       | 250,000                    |       | — |   |
| Payment of debt  issuance costs                                                    |       | (958                       | )          | — |   |
| Repurchases of  common stock                                                       |       | (334,051                   | )          | (80,498 | ) |
| Changes in cash  overdrafts                                                        |       | (16,016                    | )          | 6,181 |   |
| Exercise of employee  stock options                                                |       | 5,277                      |       | 13,106 |   |
| Excess tax  benefits from stock-based compensation                                 |       | 196                        |       | — |   |
| Payment of  dividends                                                              |       | (46,759                    | )          | (44,409 | ) |
|                                                                               |       | (142,311                   | )          | (105,620 | ) |
|                                                                               |       |                       |       |   |   |
| **Net change in cash and cash  equivalents**                                       |       | (35,430                    | )          | (6,304 | ) |
| **Cash and cash equivalents at  beginning of period**                              |       | 105,175                    |       | 87,023 |   |
| **Cash and cash equivalents at end of period**                                     |       | $                          | 69,745     |   | $ | 80,719 |   |

##  

## Seenotes to the consolidated condensed financial statements.

##  

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##  

**FAMILY DOLLARSTORES, INC. AND SUBSIDIARIESNOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS**

1.               In the opinion of the Company, the accompanyingunaudited consolidated condensed financial statements contain all adjustments(consisting of normal recurring accruals and a litigation charge as describedin Note 8 below) necessary to present fairly the Company’s financial positionas of May 27, 2006; the results of operations for the third quarter andfirst three quarters ended May 27, 2006 (“third quarter and first threequarters of fiscal 2006”), and May 28, 2005 (“third quarter and firstthree quarters of fiscal 2005”); and the cash flows for the first threequarters of fiscal 2006 and first three quarters of fiscal 2005. For furtherinformation, refer to the consolidated financial statements and footnotesincluded in the Company’s Annual Report on Form 10-K for the fiscalyear ended August 27, 2005.

**Theresults of operations for the third quarter and first three quarters of fiscal2006 are not necessarily indicative of the results to be expected for the fullyear.**

Certain reclassifications of the amounts forthe third quarter and first three quarters of fiscal 2005 have been made toconform to the presentation for the third quarter and first three quarters offiscal 2006. These include accounts payable and accrued liabilities,which are now listed separately, and interest income, which was previouslyincluded in selling, general and administrative expenses.

**TheCompany manages its business on the basis of one reportable segment.**

2.               The Companyconsiders all highly liquid investments with an original maturity of threemonths or less to be “cash equivalents.” The carrying amount of the Company’s cash equivalents approximates fairvalue due to the short maturities of these investments and consists primarilyof money market funds and other overnight investments. The Company maintainscash deposits with major banks, which from time to time may exceed federallyinsured limits. The Company periodically assesses the financial condition ofthe institutions and believes that the risk of any loss is minimal.

The itemsclassified as investment securities are principally auction rate securities andvariable rate demand notes. The Company classifies all investment securities asavailable-for-sale. Securities accounted for as available-for-sale are requiredto be reported at fair value with unrealized gains and losses, net of taxes,excluded from net income and shown separately as a component of accumulatedother comprehensive income within shareholders’ equity. The securities that theCompany has classified as available-for-sale generally trade at par and as aresult typically do not have any realized or unrealized gains or losses.

3.               The preparation ofthe Company’s Consolidated Condensed Financial Statements, in conformity withaccounting principles generally accepted in the United States of America,requires management to make estimates and assumptions. These estimates andassumptions affect the reported amounts of assets and liabilities, thedisclosure of contingent assets and liabilities at the date of the financialstatements, and the reported amounts of revenues and expenses during thereporting period. Actual results could differ from these estimates.

4.               The Company had nocurrent or long-term debt as of the fiscal year ended August 27, 2005. Currentand long-term debt consisted of the following at May 27, 2006:

 

| (in thousands)   | ** ** | **May 27, 2006** | ** ** |
|-----------------------|------------|----------------------------|------------|
| 5.24% Notes           |       | $                          | 81,000     |   |
| 5.41% Notes           |       | 169,000                    |       |
|                  |       | 250,000                    |       |
| Less: current portion |       | —                     |       |
| Long-term portion     |       | $                          | 250,000    |   |

 

On September 27,2005, the Company obtained $250 million through a private placement ofunsecured Senior Notes (the “Notes”) to a group of institutional accreditedinvestors. The Notes were issued in two tranches at par and rank *pari passu* in right of payment with the Company’s otherunsecured senior indebtedness. The first 

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tranche has anaggregate principal amount of $169 million, is payable in a single installmenton September 27, 2015, and bears interest at a rate of 5.41% per annumfrom the date of issuance. The second tranche has an aggregate principal amountof $81 million, matures on September 27, 2015, with amortizationcommencing in the sixth year, and bears interest at a rate of 5.24% per annumfrom the date of issuance. The second tranche has a required principal paymentof $16.2 million on September 27, 2011, and on each September 27thereafter to and including September 27, 2015. Interest on the Notes ispayable semi-annually in arrears on the 27th day of March and September ofeach year commencing on March 27, 2006. The sale of the Notes was effectedin transactions not requiring registration under the Securities Act of 1933, asamended. The Notes contain certain restrictive covenants, which include a consolidated debt toconsolidated capitalization ratio, a fixed charges coverage ratio, and apriority debt to consolidated net worth ratio. At the end of the third quarter of fiscal 2006, the Company was incompliance with all such covenants. The proceeds of the Notes were used torepurchase the Company’s outstanding common stock, as discussed in Note 5below.

In addition to theNotes, the Company has unsecured revolving credit facilities with banks forshort-term borrowings of up to $200 million. On May 19, 2006, the Companyextended the terms of these facilities for an additional year. On May 24,2007, $100 million of the facilities will expire, and the remaining $100million will expire on May 31, 2011. Any borrowings under these facilitiesare at a variable interest rate based on short-term market interest rates. TheCompany had no borrowings against these facilities during the first threequarters of fiscal 2006 or during fiscal 2005.

5.               During the first three quarters of fiscal 2005,the Company purchased in the open market 2.9 million shares of its common stockat a cost of $80.6 million. During the first three quarters of fiscal 2006, theCompany purchased 13.9 million shares of its common stock at a cost of $334.2million, as described below.

On October 4, 2005, the Company executedan overnight share repurchase transaction with a bank for the acquisition of 10million shares, or approximately 6%, of the Company’s then outstanding commonstock for an initial purchase price of $19.97 per share. The transaction wasfinanced with the proceeds of the Notes, as discussed in Note 4 above. As partof the overnight share repurchase transaction, the Company simultaneouslyentered into a forward contract with the bank that matured on March 6,2006. In connection with the forward contract, the bank purchased shares of theCompany’s common stock in the open market in order to fulfill its obligationrelated to shares it borrowed from third parties and sold to the Company. Atthe end of the purchase period, the Company could have received from or paid tothe bank a price adjustment based on the volume weighted average purchase priceof the Company’s common stock during the purchase period compared to theinitial purchase price. Such price adjustment could be either in cash or commonstock at the discretion of the Company. On March 9, 2006, the Company paid$32.7 million in cash to the bank to settle the forward contract.

The sharesrepurchased in connection with the overnight share repurchase transaction wereimmediately canceled and returned to the status of authorized but unissuedshares. The total cost of the initial purchase was approximately $201.2million, including a $1.3 million cap premium and $0.2 million in commissionsand other fees. In accordance with Accounting Principles Board (APB) Opinion 6,“Status of Accounting Research Bulletins,” the Company reduced common stock,capital in excess of par, and retained earnings by approximately $1.0 million,$8.1 million, and $192.1 million, respectively. In addition, the Companyreduced retained earnings by approximately $0.3 million in connection with adividend fee paid to the bank on January 17, 2006. The forward contractassociated with the overnight share repurchase transaction was accounted for inaccordance with EITF 00-19, “Accounting for Derivative Financial InstrumentsIndexed to, and Potentially Settled in, a Company’s Own Stock,” as an equityinstrument. The $32.7 million payment made on March 9, 2006, to settle theforward contract was recorded as an adjustment to retained earnings in thethird quarter of fiscal 2006.

Upon completionof the overnight share repurchase transaction and related forward contract, theCompany continued to purchase shares of its common stock pursuant to Rule 10b5-1of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Duringthe third quarter of fiscal 2006, the Company purchased 3.9 million shares ofits common stock at a cost of $100.0 million.

All shares are purchased pursuant to sharerepurchase authorizations approved by the Board of Directors. As of May 27,2006, the Company had outstanding authorizations to purchase a total ofapproximately 2.6 million shares remaining under an authorization approved bythe Board of Directors on April 13, 2005. Shares purchased 

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under the share repurchase authorizations,with the exception of shares purchased with the proceeds of the Notes, are heldin treasury or have been reissued under the Family Dollar 2000 OutsideDirectors Plan. Shares purchased with the proceeds of the Notes were cancelledand returned to the status of authorized but unissued shares.

6.               At the Company’sAnnual Meeting of Shareholders held on January 19, 2006, the Company’sshareholders approved the Family Dollar Stores, Inc. 2006 Incentive Plan(the “2006 Plan”). The 2006 Plan permits the granting of a variety ofcompensatory award types. The Company currently grants non-qualified stockoptions and performance share rights under the 2006 Plan. Prior to the adoptionof the 2006 Plan, the Company issued non-qualified stock options under theCompany’s 1989 Non-Qualified Stock Option Plan (the “1989 Plan”). As a resultof the adoption of the 2006 Plan, no further awards can be granted under the1989 Plan. Shares issued under the 2006 Plan represent new issuances of commonstock. A total of 12.0 million common shares are reserved and available forissuance under the 2006 Plan, plus any shares awarded under the 1989 Plan thatexpire or are cancelled or forfeited after January 19, 2006. As of May 27,2006, there were 11.8 million remaining shares available for granting under the2006 Plan.

Effective August 28,2005, the Company adopted the provisions of Financial Accounting StandardsBoard (FASB) Statement of Financial Accounting Standards No. 123 (revised2004) “Share-Based Payment” (“SFAS 123R”) for its stock-based compensationplans. Under SFAS 123R, all stock-based compensation cost is measured at thegrant date, based on the fair value of the award, and is recognized as anexpense in the income statement over the requisite service period. On March 29,2005, the Securities and Exchange Commission (“SEC”) staff issued StaffAccounting Bulletin (“SAB”) No. 107 to express the views of the staffregarding the interaction between SFAS 123R and certain SEC rules andregulations and to provide the staff’s views regarding the valuation ofstock-based compensation arrangements for public companies. The SAB 107guidance was taken into consideration with the implementation of SFAS 123R.

Prior to August 28,2005, the Company accounted for stock-based compensation using the intrinsicvalue method prescribed in APB Opinion No. 25, “Accounting for StockIssued to Employees” (“APB 25”), and related Interpretations, as permitted bythe original provisions of SFAS 123, “Share-Based Payment.”  The Company did not record compensation expenseunder APB 25 since the exercise price of the stock options equaled the fairmarket value of the underlying common stock on the grant date. The Companyinstead utilized the disclosure-only provisions of SFAS No. 148, “Accountingfor Stock-Based Compensation-Transition and Disclosure.”

The Company adoptedSFAS 123R using the modified prospective transition method. Under the modifiedprospective transition method, the Company is required to record stock-basedcompensation expense for all awards granted after the adoption date and for theunvested portion of previously granted awards outstanding on the adoption date.Compensation cost related to the unvested portion of previously granted awardsis based on the grant-date fair value estimated in accordance with the originalprovisions of SFAS 123. Compensation cost for awards granted after the adoptiondate is based on the grant-date fair value estimated in accordance with theprovisions of SFAS 123R. Results for prior periods have not been restated anddo not reflect the recognition of stock-based compensation.

The Company haselected to adopt the alternative transition method, as permitted by FASB StaffPosition No. FAS 123R-3 “Transition Election Related to Accountingfor Tax Effects of Share-Based Payment Awards,” to calculate the tax effects ofstock-based compensation pursuant to SFAS 123R for those employee awards thatwere outstanding upon adoption of SFAS 123R. The alternative transition methodallows the use of simplified methods to calculate the beginning capital inexcess of par pool related to the tax effects of employee stock-basedcompensation and to determine the subsequent impact of the tax effects ofemployee stock-based compensation awards on the capital in excess of par pooland the Consolidated Condensed Statements of Cash Flows. Prior to the adoptionof SFAS 123R, the Company reported all tax benefits resulting from the exerciseof stock options as operating cash flows in the Consolidated CondensedStatements of Cash Flows. SFAS 123R requires cash flows resulting from the taxdeductions in excess of the related compensation cost recognized in thefinancial statements (excess tax benefits) to be classified as financing cashflows. In accordance with SFAS 123R, excess tax benefits recognized in periodsafter the adoption date have been properly classified as financing cash flows. Excesstax benefits recognized in periods prior to the adoption date are classified asoperating cash flows.

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As a result of theadoption of SFAS 123R, the Company’s results for the third quarter and firstthree quarters of fiscal 2006 include stock-based compensation expense (relatedto stock options and performance share rights) of $2.5 million and $5.9million, respectively. These amounts are included within selling, general, andadministrative expenses on the Consolidated Condensed Statements of Income. Taxbenefits recognized during the third quarter and first three quarters of fiscal2006 were immaterial.

The following tableillustrates the effect on net income and net income per share if the Companyhad adopted the fair value recognition provisions of SFAS 123 during the thirdquarter and first three quarters of fiscal 2005:

 

|                                                                       | ** ** | **Quarter Ended**     | ** ** | **Three Quarters  Ended** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------|------------|--------------------------------|------------|
| **(in thousands, except per share amounts)** | ** ** | **May 28, 2005** | ** ** | **May 28, 2005**     | ** ** |
| Net income — as  reported                                        |       | $                          | 53,774     |                           | 188,276    |   |
| Pro forma stock-based  compensation cost                              |       | (2,237                     | )          | (6,506                         | )          |
| Net income — pro forma                                           |       | $                          | 51,537     |                           | 181,770    |   |
|                                                                  |       |                       |       |                           |       |
| Net income per share —  as reported                              |       |                       |       |                           |       |
| basic                                                                 |       | $                          | .32        |                           | 1.12       |   |
| diluted                                                               |       | $                          | .32        |                           | 1.12       |   |
| Net income per share —  pro forma                                |       |                       |       |                           |       |
| basic                                                                 |       | $                          | .31        |                           | 1.09       |   |
| diluted                                                               |       | $                          | .31        |                           | 1.09       |   |

 

The Company’s stockoption plans contain retirement provisions, effective January 20, 2005,that allow options held by certain qualifying retirees to continue to vestafter retirement without requiring additional service. The retirementprovisions apply to all non-vested stock options as of the effective date, allvested stock options that were “underwater” (i.e. the options had an exerciseprice in excess of the market value of the stock) on the effective date, andall new options granted thereafter. Under SFAS 123R, compensation cost shouldbe recognized over the shorter of the stated vesting period or the period fromthe grant date to the retirement eligibility date, if the employee is able toretire without providing additional service. For awards granted prior to theadoption of SFAS 123R, the Company recognizes compensation cost over the statedvesting period. If the Company had accounted for these awards in accordancewith the provisions of SFAS 123R, compensation expense would have been $1.7million higher during the first three quarters of fiscal 2005 (for pro-formadisclosure purposes only). The impact on the third quarter of fiscal 2005 andthe third and first three quarters of fiscal 2006 is immaterial.

**Stock****Options**

The Company’s stockoption plans provide for grants of stock options to key employees at prices notless than fair market value on the grant date. The Company’s practice for anumber of years has been to make a single annual grant to all employeesparticipating in the stock option program and to generally make other grantsonly in connection with employment or promotions. Options expire five yearsfrom the grant date and are exercisable to the extent of 40% after the secondanniversary of the grant and an additional 30% at each of the following twoanniversary dates on a cumulative basis. Compensation cost is recognized on astraight-line basis, net of estimated forfeitures, over the requisite serviceperiod. The Company uses the Black-Scholes option-pricing model to estimate thegrant-date fair value of each option granted before and after the adoption ofSFAS 123R. The fair values of options granted during the third quarter andfirst three quarters of fiscal 2006 were estimated using the followingweighted-average assumptions:

 

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|                                           | ** ** | **Quarter Ended**     | ** ** | **Three Quarters  Ended** | ** ** |
|-------------------------------------------|------------|----------------------------|------------|--------------------------------|------------|
| ** **                                | ** ** | **May 27, 2006** | ** ** | **May 27, 2006**     | ** ** |
| Expected dividend yield                   |       | 1.91                       | %          | 1.63                           | %          |
| Expected stock price  volatility          |       | 30.00                      | %          | 30.00                          | %          |
| Weighted average  risk-free interest rate |       | 4.86                       | %          | 4.18                           | %          |
| Expected life of options (years)          |       | 4.57                       |       | 4.57                           |       |

 

The expecteddividend yield is based on the projected annual dividend payment per sharedivided by the stock price on the grant date. Expected stock price volatilityis derived from an analysis of the historical and implied volatility of theCompany’s publicly traded stock. The risk-free interest rate is based on theU.S. Treasury rates on the grant date with maturity dates approximating theexpected life of the option on the grant date. The expected life of the optionsis based on an analysis of historical and expected future exercise behavior, aswell as certain demographic characteristics. These assumptions are evaluatedand revised, as necessary, to reflect market conditions and experience. Therewere no material changes made to the methodology used to determine theassumptions during the third quarter of fiscal 2006. Theweighted-average grant-date fair values of stock options granted during thethird quarter and first three quarters of fiscal 2006 were $7.19 and $5.61,respectively. The following table summarizes the transactions under the stockoption plans during the first three quarters of fiscal 2006:

 

| (in thousands, except per share amounts) | ** ** | **Options  Outstanding** | ** ** | **Weighted-Average  Exercise Price**                                                             | ** ** | **Weighted-Average  Remaining  Contractual  Life in Years** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|-------------------------------------------------------------------|------------|--------------------------|------------|-------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|-------------------------------------|------------|
| Balance at  August 27, 2005                                  |       | 6,062                    |       | $              30.44            |       |                                                                  |       |                                |       |
| Granted                                                           |       | 831                      |       |                 20.39 |       |                                                                  |       |                                |       |
| Exercised                                                         |       | (221                     | )          |                 23.84 |       |                                                                  |       |                                |       |
| Cancelled                                                         |       | (715                     | )          |                 28.74 |       |                                                                  |       |                                |       |
| Balance at  May 27, 2006                                     |       | 5,957                    |       | $              29.49            |       | 2.54                                                                  |       | $                                   | 4,961      |   |
| Exercisable at  May 27, 2006                                 |       | 3,438                    |       | $              32.47            |       | 1.88                                                                  |       | $                                   | 656        |   |

 

The total intrinsic value of stock options exercised during the thirdquarter and first three quarters of fiscal 2006 was immaterial. As of May 27,2006, there was approximately $10.1 million of unrecognized compensation costrelated to outstanding stock options. The unrecognized compensation cost willbe recognized over a weighted-average period of 1.4 years.

**Performance****Share Rights**

During the secondquarter of fiscal 2006, the Company began granting performance share rights tokey employees. Grants of performance share rights are made annually andgenerally, in connection with employment or promotion of participants in theprogram. Performance share rights give employees the right to receive shares ofthe Company’s common stock at a future date based on the Company’s performancerelative to a peer group. Performance is measured based on two pre-tax metrics:Return on Equity and Income Growth. The Compensation Committee of the Board ofDirectors establishes the peer group and performance metrics. The performanceshare rights vest at the end of the performance period (generally three years)and the shares are issued shortly thereafter. The actual number of sharesissued can range from 0% to 200% of the employee’s target award depending onthe Company’s performance relative to the peer group.

During the firstthree quarters of fiscal 2006, the Company granted 0.3 million performanceshare rights to employees at a weighted-average grant-date fair value of $24.23.The grant-date fair value of the performance share rights is based on the stockprice on the grant date. As of May 27, 2006, there were 0.3 millionperformance share rights outstanding. Compensation cost is recognized on astraight-line basis, net of estimated forfeitures, over the requisite serviceperiod and adjusted quarterly to reflect the ultimate number of shares expectedto be issued. As of May 27, 2006, there was approximately $5.0million of unrecognized compensation cost related to outstanding performanceshare rights, based on the Company’s most recent performance analysis. The 

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unrecognized compensation cost will be recognized over aweighted-average period of 2.0 years. None of the performance share rightsvested during the first three quarters of fiscal 2006.

7.               Basic net income per common share is computedby dividing net income by the weighted average number of shares outstandingduring each period. Diluted net income per common share gives effect to allsecurities representing potential common shares that were dilutive andoutstanding during the period. The exercise prices for certain of theoutstanding stock options that the Company has awarded exceed the averagemarket price of the Company’s common stock. Such stock options are antidilutive(options for 4.9 million and 5.1 million for the quarter and first threequarters ended May 27, 2006, respectively, and options for 2.2 million and2.1 million for the quarter and first three quarters ended May 28, 2005,respectively) and were not included in the computation of diluted net incomeper share. In the calculation of diluted net income per common share, thedenominator includes the number of additional common shares that would havebeen outstanding if the Company’s outstanding stock options and performanceshare rights had been exercised.

The following tablesets forth the computation of basic and diluted net income per common share:

 

|                                                                   | ** ** | **Quarter  Ended**         | ** ** | **Three  Quarters Ended**  | ** ** |
|-------------------------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| (in thousands, except per share amounts) | ** ** | **May 27, 2006** | ** ** | **May 28, 2005** | ** ** | **May 27, 2006** | ** ** | **May 28, 2005** | ** ** |
| **Basic  Net Income Per Share:**                                  | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net Income                                                        |       | $                          | 56,914     |                       | $          | 53,774 |   | $ | 162,832 |   | $ | 188,276 |   |
| Weighted Average Number of Shares Outstanding                     |       | 154,260                    |       | 166,858                    |       | 156,294 |   | 167,400 |   |
| Net Income Per Common Share — Basic                          |       | $                          | 0.37       |                       | $          | 0.32 |   | $ | 1.04 |   | $ | 1.12 |   |
|                                                              |       |                       |       |                       |       |   |   |   |   |
| **Diluted  Net Income Per Share:**                                | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net Income                                                        |       | $                          | 56,914     |                       | $          | 53,774 |   | $ | 162,832 |   | $ | 188,276 |   |
| Weighted Average Number of Shares Outstanding                     |       | 154,260                    |       | 166,858                    |       | 156,294 |   | 167,400 |   |
| Effect of Dilutive Securities — Stock Options                |       | 129                        |       | 302                        |       | 7 |   | 446 |   |
| Effect of Dilutive Securities — Performance Share  Rights    |       | 177                        |       | —                     |       | 64 |   | — |   |
| Average Shares — Diluted                                     |       | 154,566                    |       | 167,160                    |       | 156,365 |   | 167,846 |   |
| Net Income Per  Common Share — Diluted                       |       | $                          | 0.37       |                       | $          | 0.32 |   | $ | 1.04 |   | $ | 1.12 |   |

** **

8.               On January 30, 2001, Janice Morgan and Barbara Richardson, two individuals whohave held the position of Store Manager for subsidiaries of the Company, fileda Complaint against the Company in the United States District Court for theNorthern District of Alabama. Thereafter, pursuant to the Court’s ruling,notice of the pendency of the lawsuit was sent to approximately 13,000 currentand former Store Managers holding the position on or after July 1, 1999. Approximately2,550 of those receiving such notice filed consent forms and joined the lawsuitas plaintiffs, including approximately 2,300 former Store Managers andapproximately 250 then current employees. After rulings by the Court on motionsto dismiss certain plaintiffs filed by the Company and motions to reconsiderfiled by plaintiffs, 1,424 plaintiffs remained in the case at the commencementof trial.

The case hasproceeded as a collective action under the Fair Labor Standards Act (“FLSA”). TheComplaint alleged that the Company violated the FLSA by classifying the namedplaintiffs and other similarly situated current and former Store Managers as “exempt”employees who are not entitled to overtime compensation.

A jury trial inthis case was held in June 2005, in Tuscaloosa, Alabama and ended with thejudge declaring a mistrial after the jury was unable to reach a unanimousdecision in the matter. The case was subsequently retried beginning in late February 2006to a jury in Tuscaloosa, Alabama which found that the Company should haveclassified the Store Manager plaintiffs as hourly employees entitled toovertime pay rather than as salaried exempt managers and awarded damages in theamount of approximately $19.1 million. The Court ruled that it will double theamount of the final judgment based upon its finding that the Company did notact in good faith in classifying the plaintiffs as employees exempt fromovertime payments. In addition, the Court ruled that it will reconsider theplaintiffs’ motion for an award of attorneys’ fees at the conclusion of theCompany’s appeal. The Court currently has various motions pending before itwith respect to the entry of a final judgment, including motions related to 

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the status ofcertain of the plaintiffs’ claims as a result of personal bankruptcy filings,which will have an impact on the amount of the ultimate judgment awarded by theCourt. The Company plans to appeal the entry of the judgment upon the entry offinal decisions by the Court.

The Companyrecognized $45 million as a litigation charge in the second quarter of fiscal2006 with respect to this litigation. The Company has provided a bond for thepayment of any judgment ultimately entered by the Court. Pending entry of afinal judgment and during the appellate process, the Company does not expect tobe required to pay the amount of the judgment.

In general, theCompany continues to believe that the Store Managers are “exempt” employeesunder the FLSA and have been properly compensated and that the Company hasmeritorious defenses that should enable it ultimately to prevail. However, theoutcome of any litigation is inherently uncertain. Resolution of this mattercould have a material adverse effect on the Company’s financial position,liquidity or results of operation.

The Company isinvolved in numerous other legal proceedings and claims incidental to itsbusiness, including litigation related to alleged personal or property damage,as to which the Company carries insurance coverage and/or, pursuant toStatement of Financial Accounting Standards No. 5, “Accounting forContingencies,” has established reserves as set forth in the Company’sfinancial statements, and litigation related to alleged failures to comply withvarious state and federal employment laws, some of which may be pled as classor collective actions. While the ultimate outcome cannot be determined, theCompany currently believes that these proceedings and claims, both individuallyand in the aggregate, should not have a material adverse effect on the Company’sfinancial position, liquidity or results of operations. However, the outcome ofany litigation is inherently uncertain and, if decided adversely to theCompany, the Company may be subject to liability that could have a materialadverse effect on the Company’s financial position, liquidity or results ofoperations.

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** **

**Item 2.  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

**This discussion summarizes thesignificant factors affecting the consolidated results of operations andfinancial condition of the Company for the thirteen-week periods ended May 27,2006, and May 28, 2005 (“third quarter of fiscal 2006” and “third quarterof fiscal 2005”, respectively) and the thirty-nine-week periods ended May 27,2006, and May 28, 2005 (“first three quarters of fiscal 2006” and “firstthree quarters of fiscal 2005” respectively). This discussion should be read inconjunction with, and is qualified by, the financial statements included inthis quarterly report, the financial statements for the fiscal year ended August 27,2005 (“fiscal 2005”), and Management’s Discussion and Analysis of FinancialCondition and Results of Operations (“MD&A”) contained in the Company’sAnnual Report on Form 10-K for fiscal 2005.**

**This discussion containsforward-looking statements subject to the Cautionary Note RegardingForward-Looking Statements set forth following this MD&A.**

**Results of Operations**

**2006 First Three Quarters Results and Fiscal 2006Outlook**

During the first half of fiscal 2005, the Company began theimplementation of four key initiatives designed to increase sales andprofitability: the installation of refrigerated coolers in selected stores; theintroduction of a “Treasure Hunt” merchandise program; the continuation of anaggressive store opening program; and the Urban Initiative. During the fiscalyear ending August 26, 2006, (“fiscal 2006”), the Company has continuedthese initiatives, as discussed below.

·                              Coolers — The installation of refrigeratedcoolers for the sale of perishable food began in the third quarter of fiscal2005. The customer traffic generated by coolers has increased sales of food andother merchandise throughout the store. At the end of fiscal 2005, refrigeratedcoolers were installed in approximately 1,000 stores. The Company plans toinstall refrigerated coolers in at least 2,500 additional stores by the end offiscal 2006. In addition, the Company is developing a broader food strategy, apart of which involves testing new point-of-sale software in a limited numberof stores to facilitate the acceptance of food stamps in stores withrefrigerated coolers. At the end of the first three quarters of fiscal 2006,approximately 3,100 stores had refrigerated coolers for the sale of perishablefood.

·                              “Treasure Hunt” merchandise program — Duringfiscal 2005, the Company began supplementing its basic assortment ofmerchandise with additional opportunistically purchased goods designed tocreate more excitement in stores throughout the year, with particular emphasison holidays, spring and back-to-school seasons, and to balance gross marginpressure from increased sales of lower-margin consumable merchandise. Duringfiscal 2006, the Company is taking a more process-oriented approach to thisinitiative by focusing on three key components: identifying and selectingexciting values for customers; informing customers of the compelling valuesthrough circulars and in-store handouts and signage; and effectively displayingthe items in stores to attract customer attention.

·                              New Stores — During fiscal 2005, the Companyopened 500 stores and closed 68 stores, with a substantial percentage of thenew store openings occurring in the last months of the fiscal year. In order tobuild processes that will support a more balanced distribution of storeopenings throughout the year and to increase the return on investment from newstores, the Company currently plans to open approximately 350 stores and closeapproximately 70 stores in fiscal 2006. During the first three quarters offiscal 2006, the Company opened 242 stores and closed 67 stores.

·                              Urban Initiative — The Urban Initiative isdesigned to improve the operating performance of high sales volume stores inlarge metropolitan markets through investments in people, process changes andtechnology, including organizational changes to support a more mobile andflexible workforce. During fiscal 2005, the Urban Initiative was implemented inapproximately 1,200 stores. While the Urban Initiative stores experienced solidcomparable store sales growth and continued to be profitable during fiscal2005, the Company’s profitability goals were not achieved. During fiscal 2006,the Company has continued its investments in the current Urban Initiativemarkets (approximately 1,400 stores at the end of the first three quarters offiscal 2006). The Company is focused on three primary goals:  improving financial returns, reducinginventory shrinkage and increasing store manager retention. During the firstthree quarters of fiscal 2006, the Company saw an improvement in profitabilityin most Urban Initiative 

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markets,resulting from positive trends in comparable store sales, better expensecontrol and improvements in inventory shrinkage.

During the first quarter of fiscal 2006, Hurricanes Katrina, Rita andWilma struck the U.S. Gulf Coast and Florida, impacting numerous stores in theafflicted areas. Because the Company’s stores are widely dispersed, lost salesdue to closed stores resulting from damage or power outages were generallylimited and were substantially offset by increased sales in other stores. Themost significant storm-related losses were related to the loss of merchandiseinventories, furniture and fixtures and leasehold improvements at individualstores in the paths of the storms. During the first three quarters of fiscal2006, the Company received payments from its insurance carrier covering amajority of the losses. The net impact of these storms has not had and is notexpected to have a material impact in the aggregate on the Company’s financialposition, liquidity or results of operations.

Fiscal2006 Outlook

Based on operating results for the first three quarters of fiscal 2006,as discussed below, and the Company’s plans for the remainder of the year, theCompany currently expects diluted net income per common share to be between$1.24 and $1.27 for fiscal 2006, compared to $1.30 in fiscal 2005. The diluted net income per common share guidancefor fiscal 2006 includes the impact (approximately $0.18 per diluted share) ofan adverse litigation judgment, as discussed in the Company’s Year-to-dateResults below and Note 8 to the Consolidated Condensed Financial Statementsincluded in this Report. The diluted net income per common shareguidance for fiscal 2006 also includes the impact of the expensing ofstock-based compensation as required by Statement of Financial AccountingStandards (“SFAS”) No. 123R, “Share-Based Payment,” and other new compensationprograms, the interest expense related to the Company’s debt placement, and theaccretive benefit of the Company’s share repurchase program. See Note 6 to theConsolidated Condensed Financial Statements included in this Report andthe  “Third Quarter Results and FourthQuarter Outlook — Selling, General and Administrative Expenses” and “Year-to-dateResults — Selling, General and Administrative Expenses” sections in thisMD&A for more information on SFAS 123R and its impact. See the Liquidity andCapital Resources section in this MD&A for more information on the Company’sshare repurchase program and related debt placement.

**Third QuarterResults and Fourth Quarter Outlook**

# NetSales

Net sales in the third quarter of fiscal 2006 were $1.6 billion, anincrease of approximately 9.9% ($141.6 million), as compared with an increaseof 9.0% ($117.8 million) in the third quarter of fiscal 2005. The increase wasattributable, in part, to increased sales in comparable stores (stores openmore than 13 months) of 3.7% ($52.2 million), with the balance of the increaseprimarily relating to sales from new stores opened as part of the Company’sstore growth program. The comparable store sales calculation for the thirdquarter of fiscal 2006 excludes a limited number of stores that were closed foran extended period of time as a result of the hurricanes as discussed above. The solid sales performance during the thirdquarter of fiscal 2006 was driven primarily by the installation of refrigeratedcoolers, the Urban Initiative and the “Treasure Hunt” merchandise program. Increasedsales in the electronics department also positively impacted sales during thethird quarter of fiscal 2006. Sales of lower-margin basic consumablemerchandise continued to be stronger than sales of higher-margin discretionarygoods during the third quarter of fiscal 2006, reflecting the difficulteconomic environment, including higher energy prices, faced by the Company’slow and lower-middle income customer base.

The 3.7% increase in comparable store sales duringthe third quarter of fiscal 2006 includes an increase of approximately 4.9% inthe sales of hardline merchandise and a decrease of approximately 0.7% in thesales of softline merchandise. In the third quarter of fiscal 2006, the customercount, as measured by the number of register transactions in comparable stores,decreased approximately 1.2%, and the average transaction increasedapproximately 4.8% to $9.54. The Company believes that customers continue toreduce their shopping frequency by consolidating shopping trips around paycycles in response to higher energy costs. Increased sales of hardlinemerchandise have been the primary contributor to the overall sales increases. Hardlinemerchandise, as a percentage of net sales, increased to approximately 79.0% inthe third quarter of fiscal 2006 compared to approximately 78.1% in the thirdquarter of fiscal 2005. Softline merchandise, as a percentage of net sales,decreased to approximately 21.0% in the third quarter of fiscal 2006 comparedto approximately 21.9% in the third quarter of fiscal 2005. The Company did notdistribute any advertising circulars during the third quarter of fiscal 2006,compared with one advertising circular in the third quarter of fiscal 2005.

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**Hardline merchandise includes household chemical andpaper products, candy, snacks and other food, health and beauty aids,electronics, housewares and giftware, pet food and supplies, toys, stationeryand school supplies, seasonal goods, hardware and automotive supplies. Softlinemerchandise includes men’s, women’s, boys’, girls’ and infants’ clothing,shoes, and domestic items such as blankets, sheets and towels.**

**The average number of stores in operation during thethird quarter of fiscal 2006 was 7.1% higher than the average number of storesin operation during the third quarter of fiscal 2005.**

The Company currently expects comparable store sales to increase in themid-single digits during the fourth quarter of fiscal 2006 as a result of theongoing rollout of refrigerated coolers, the impact from “Treasure Hunt”merchandise sales and the operational improvements resulting from the UrbanInitiative program, as well as sales of wireless phones and related air time.

Cost of Sales

Cost of sales increased approximately 9.8% in the third quarter offiscal 2006 compared with the third quarter of fiscal 2005. This increaseprimarily reflected the additional sales volume between years. Cost of sales,as a percentage of net sales, was 66.4% in both the third quarter of fiscal2006 and fiscal 2005. As a percentageof net sales, lower inventory shrinkage and improved initial mark-ups across amajority of departments offset higher transportation expense and markdownexpense during the third quarter of fiscal 2006. The Company will continue tofocus its efforts on lowering inventory shrinkage and improving initialmark-ups. The increase in transportation expense, as a percentage of net sales,was due to higher year-over-year fuel costs. Productivity and efficiencysavings, as well as savings from an overall reduction in shipments resultingfrom better inventory management, offset some of the increase. The increase inmarkdown expense, as a percentage of net sales, resulted from additionalmarkdowns supporting a renewed focus on inventory productivity.

During the fourth quarter of fiscal 2006, theCompany expects that cost of sales, as a percentage of net sales, will increaseas compared to fiscal 2005 due to the continuing effect of the shift in themerchandise mix to more lower-margin basic consumable merchandise and highermarkdowns resulting from a more aggressive merchandising strategy.

**Selling, General and Administrative Expenses**

Selling, general and administrative (“SG&A”) expenses increased10.0% in the third quarter of fiscal 2006, compared with the third quarter offiscal 2005. The increases in these expenses were due primarily to additionalcosts arising from the continued growth in the number of stores in operation. SG&Aexpenses, as a percentage of net sales, were 27.7% in both the third quarter offiscal 2006 and fiscal 2005. Increasedoccupancy costs (approximately 0.2% of net sales) and increased compensationexpense related to the expensing of stock-based compensation as required bySFAS 123R and other compensation programs (approximately 0.5% of net sales)were offset by decreases in store payroll expenses (approximately 0.3% of netsales) and insurance costs (approximately 0.2% of net sales), as well as ashift in the timing of advertising costs (approximately 0.1% of net sales). Theincrease in occupancy costs, as a percentage of net sales, was due primarily tohigher utility costs and higher depreciation charges, especially as it relatesto the urban markets. In addition to the expensing of stock-based compensation,the increase in compensation expense, as a percentage of net sales, was due tohigher costs associated with bonus programs. The reduction in store payrollexpenses, as a percentage of net sales, was the result of refinements in theUrban Initiative and improvements in the store payroll allocation process. Thedecrease in insurance costs, as a percentage of net sales, was due to areduction in health care and workers compensation claims. The Company did notdistribute any advertising circulars during the third quarter of fiscal 2006,resulting in a decrease in advertising costs, as a percentage of net sales.

During the fourth quarter of fiscal 2006, theCompany expects SG&A expenses, as a percentage of net sales, to decrease ascompared to fiscal 2005 due to the leveraging effect of a greater increase incomparable store sales and better expense control.

**Interest Income**

**The increase in interest incomeduring the third quarter of fiscal 2006, compared with the third quarter offiscal 2005 was due to an increase in interest rates and investments.**

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**Interest Expense**

On September 27, 2005, the Company obtained $250 million inaggregate proceeds through a private placement of unsecured Senior Notes (the “Notes”)to a group of institutional accredited investors. During the third quarter offiscal 2006, the Company incurred $3.1 million in interest expense related tothe Notes. See Note 4 to the Consolidated Condensed Financial Statementsincluded in this Report for information on the Company’s current and long-termdebt. The Company did not incur any interest expense during fiscal 2005.

**Provision for Taxes on Income**

The effective tax rate was 37.7% for thethird quarter of fiscal 2006, compared with 36.7% for the third quarter offiscal 2005. The increase in the effective tax rate was primarily the result ofthe effect of changes in state income taxes. In addition, the expiration ofcertain federal jobs tax credits for employees hired after December 31,2005, negatively impacted the effective tax rate during the third quarter of fiscal2006. For the fourth quarter of fiscal 2006, the Company expects the effectivetax rate to remain at 37.7%.

Net Income and Earnings Per Share

Net income for the thirdquarter of fiscal 2006 was $56.9 million compared with net income of $53.8million for the third quarter of fiscal 2005.

Diluted net income percommon share was $0.37 in the third quarter of fiscal 2006, compared with $0.32in the third quarter of fiscal 2005. The increase in diluted net income percommon share is due to the increase in net income as discussed above and theaccretive benefit of the Company’s share repurchase program. The Company currently expects diluted netincome per common share to be between $0.19 and $0.22 for the fourth quarter offiscal 2006.

**Year-to-dateResults**

# NetSales

Net sales in the first three quarters of fiscal 2006 were $4.8 billion,an increase of approximately 9.6% ($421.7 million), as compared with anincrease of 11.1% ($437.3 million) in the first three quarters of fiscal 2005. Theincrease was attributable, in part, to increased sales in comparable stores(stores open more than 13 months) of 3.3% ($141.9 million), with the balance ofthe increases primarily relating to sales from new stores opened as part of theCompany’s store growth program. The comparable store sales calculation for thefirst three quarters of fiscal 2006 excludes a limited number of stores thatwere closed for an extended period of time as a result of the hurricanes asdiscussed above. The solid salesperformance during the first three quarters of fiscal 2006 was driven primarilyby the installation of refrigerated coolers, the Urban Initiative and the “TreasureHunt” merchandise program. Increased sales in the electronics department alsopositively impacted sales during the first three quarters of fiscal 2006. Salesof lower-margin basic consumable merchandise continued to be stronger thansales of higher-margin discretionary goods during the first three quarters offiscal 2006, reflecting the difficult economic environment, including higherenergy prices, faced by the Company’s low and lower-middle income customerbase.

The 3.3% increase in comparable store sales duringthe first three quarters of fiscal 2006 includes an increase of approximately4.7% in the sales of hardline merchandise and a decrease of approximately 1.9%in the sales of softline merchandise. In the first three quarters of fiscal2006, the customer count, as measured by the number of register transactions incomparable stores, decreased approximately 1.4%, and the average transactionincreased approximately 4.6% to $9.73. Increased sales of hardline merchandisehave been the primary contributor to the overall sales increases. Hardlinemerchandise, as a percentage of net sales, increased to approximately 79.7% inthe first three quarters of fiscal 2006 compared to approximately 78.6% in thefirst three quarters of fiscal 2005. Softline merchandise, as a percentage ofnet sales, decreased to approximately 20.3% in the first three quarters offiscal 2006 compared to approximately 21.4% in the first three quarters offiscal 2005. The Company distributed three advertising circulars in both thefirst three quarters of fiscal 2006 and the first three quarters of fiscal 2005.The circulars are designed to stimulate traffic and inform customers about theCompany’s “Treasure Hunt” merchandise, seasonal values and competitive priceson core consumable merchandise.

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**The average number of stores inoperation during the first three quarters of fiscal 2006 was 7.4% higher thanthe average number of stores in operation during the first three quarters offiscal 2005. The Company had 6,073 stores in operation at the end of the firstthree quarters of fiscal 2006, compared with 5,681 stores in operation at theend of the first three quarters of fiscal 2005, representing an increase ofapproximately 6.9%.**

Cost of Sales

Cost of sales increased approximately 9.4% in the first three quartersof fiscal 2006 compared with the first three quarters of fiscal 2005. Thisincrease primarily reflected the additional sales volume between years. Cost ofsales, as a percentage of net sales, decreased slightly to 66.6% in the firstthree quarters of fiscal 2006, compared with 66.8% in the first three quartersof fiscal 2005. The decrease in cost of sales, as a percentage of net sales,during the first three quarters of fiscal 2006 was due primarily to thefavorable impact of lower inventory shrinkage and improved initial mark-ups. Theseimprovements were partially offset by higher freight costs resulting fromhigher fuel costs. The opening of the Company’s eighth distribution center inMarianna, Florida, in the second quarter of fiscal 2005 and its continuedramp-up have positively impacted freight costs by lowering the average distanceto the stores from the distribution centers. Increases in transportationproductivity and efficiency, as well as a reduction in shipments resulting frombetter inventory management have also offset some of the cost increases. However,these savings did not fully offset the impact of higher year-over-year fuelcosts. The Company expects that the opening of the ninth distribution center inRome, New York, during the third quarter of fiscal 2006 will continue to lowerthe average distance to the stores from the distribution centers and willpositively impact freight costs.

**Selling, General and Administrative Expenses**

SG&A expenses increased 11.3% in the first threequarters of fiscal 2006, compared with the first three quarters of fiscal 2005.The increases in these expenses were due primarily to additional costs arisingfrom the continued growth in the number of stores in operation. SG&Aexpenses, as a percentage of net sales, were 27.0% in the first three quartersof fiscal 2006, compared with 26.6% in the first three quarters of fiscal 2005.The increase in the percentage for the first three quarters of fiscal 2006 wasdue primarily to increased occupancy costs (approximately 0.4% of net sales)and increased compensation expense related to the expensing of stock-basedcompensation as required by SFAS 123R and other compensation programs(approximately 0.3% of net sales). The increase in occupancy costs, as apercentage of net sales, was due primarily to higher utility costs and higherdepreciation charges, especially as it relates to urban markets. These increases were partially offset by areduction in store payroll expenses (approximately 0.2% of net sales). Thereduction in store payroll expenses, as a percentage of net sales, was theresult of refinements in the Urban Initiative and improvements in the storepayroll allocation process.

**Litigation Charge**

**During the second quarter offiscal 2006, the Company recorded a $45.0 million (approximately $0.18 perdiluted share) litigation charge associated with an adverse litigation judgmentin a case in Tuscaloosa, Alabama. See Note 8 to the Consolidated CondensedFinancial Statements included in this Report for more information. All otherlegal expenses during the first three quarters of both fiscal 2006 and fiscal2005, including the Company’s defense costs related to the above-referencedcase, were recorded in SG&A.**

**Interest Income**

**The increase in interestincome during the first three quarters of fiscal 2006, compared with the firstthree quarters of fiscal 2005 was due to an increase in interest rates andinvestments.**

**Interest Expense**

On September 27, 2005, the Company obtained $250 million inaggregate proceeds through the private placement of the Notes to a group ofinstitutional accredited investors. During the first three quarters of fiscal2006, the Company incurred $8.2 million in interest expense related to theNotes. See Note 4 to the Consolidated Condensed Financial Statements includedin this Report for information on the Company’s current and long-term debt. TheCompany did not incur any interest expense during fiscal 2005.

**Provision for Taxes on Income**

The effective tax rate was37.2% for the first three quarters of fiscal 2006, compared with 36.5% for thefirst three quarters of fiscal 2005. The increase in the effective tax rate wasprimarily the result of the effect of 

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changes in state income taxes. In addition,the expiration of certain federal jobs tax credits for employees hired after December 31,2005, negatively impacted the effective tax rate for the first three quartersof fiscal 2006.

Net Income and Earnings Per Share

Net income for the firstthree quarters of fiscal 2006 was $162.8 million compared with net income of$188.3 million for the first three quarters of fiscal 2005. Included in theresults for the first three quarters of fiscal 2006 is a litigation charge of$28.3 million, net of taxes, associated with an adverse litigation judgment ina case in Tuscaloosa, Alabama, as described above.

Diluted net income percommon share was $1.04 in the first three quarters of fiscal 2006, comparedwith $1.12 in the first three quarters of fiscal 2005. The decrease in dilutednet income per common share is due to the decrease in net income as discussedabove, partially offset by the accretive benefit of the Company’s sharerepurchase program.

**Liquidity andCapital Resources**

At the end of the third quarter of fiscal 2006, the Company had workingcapital of $455.1 million, compared with $460.2 million as of August 27,2005. Changes in working capital during the first three quarters of fiscal 2006and fiscal 2005 were primarily the result of earnings, changes in merchandiseinventories, capital expenditures and repurchases of the Company’s common stock.The Company’s inventories at the end of the third quarter of fiscal 2006 were3.8% higher than at the end of the third quarter of fiscal 2005. Inventory on aper store basis at the end of the third quarter of fiscal 2006 wasapproximately 3.0% lower than inventory on a per store basis at the end of thethird quarter of fiscal 2005. The decrease in inventory on a per store basis isthe result of the Company’s continued refinement of its replenishment systemand renewed focus on inventory productivity, which includes improved planningand flow of fashion merchandise and the use of more aggressive exit strategies.

**Capital expenditures for thefirst three quarters of fiscal 2006 were approximately $144.4 million and arecurrently expected to be approximately $200 million to $210 million for fiscal2006. The majority of the planned capital expenditures for fiscal 2006 relateto the Company’s new store openings; existing store expansions, relocations andrenovations; construction of distribution centers; expenditures related tostore-focused technology infrastructure; and the continued implementation of arefrigerated cooler program for perishable goods in selected stores. The newstore expansion and new distribution centers also require additional investmentin merchandise inventories.**

**In the first three quarters of fiscal 2006, the Companyopened 242 stores, closed 67 stores and expanded, relocated, or renovated 28stores. The Company currently plans to open approximately 350 stores and closeapproximately 70 stores during fiscal 2006. In addition, the Company currentlyplans to expand, relocate, or renovate approximately 40 stores during fiscal2006. The Company occupies most of its stores under operating leases. Storeopening, closing, expansion, relocation, and renovation plans, as well asoverall capital expenditure plans, are continuously reviewed and are subject tochange.**

During the first threequarters of fiscal 2005, the Company purchased in the open market 2.9 millionshares of its common stock at a cost of $80.6 million. During the first threequarters of fiscal 2006, the Company purchased 13.9 million shares of itscommon stock at a cost of $334.2 million, as described below.

On September 27, 2005, the Company obtained$250 million in aggregate proceeds through the private placement of the Notesto a group of institutional accredited investors. On October 4, 2005, theCompany executed an overnight share repurchase transaction with a bank for theacquisition of 10 million shares, or approximately 6%, of the Company’soutstanding common stock for an initial purchase price of $19.97 per share. Thetransaction was financed with the proceeds of the Notes. As part of the overnight share repurchasetransaction, the Company simultaneously entered into a forward contract withthe bank that matured on March 6, 2006. In connection with the forwardcontract, the bank purchased shares of the Company’s common stock in the openmarket in order to fulfill its obligation related to shares it borrowed fromthird parties and sold to the Company. At the end of the purchase period, theCompany could have received from or paid to the bank a price adjustment basedon the volume weighted average purchase price of the Company’s common stockduring the 

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purchaseperiod compared to the initial purchase price. Such price adjustment could beeither in cash or common stock at the discretion of the Company. On March 9,2006, the Company paid $32.7 million in cash to the bank to settle the forwardcontract. See Note 4 and Note 5 to the Consolidated Condensed Financial Statementsincluded in this Report for more information.

Upon completion of the overnight share repurchasetransaction and related forward contract, the Company continued to purchaseshares of its common stock pursuant to Rule 10b5-1 of the ExchangeAct. During the third quarter of fiscal 2006, the Company purchased 3.9 millionshares of its common stock at a cost of $100.0 million. As of May 27, 2006, the Company hadoutstanding authorizations to purchase a total of approximately 2.6 millionshares remaining under an authorization approved by the Board of Directors on April 13,2005.

The Company has unsecuredrevolving credit facilities with banks for short-term borrowings of up to $200million. On May 19, 2006, the Company extended the terms of thesefacilities for an additional year. On May 24, 2007, $100 million of thefacilities will expire, and the remaining $100 million will expire on May 31,2011. The Company had no outstanding borrowings against these facilities duringthe first three quarters of fiscal 2006 or during fiscal 2005. Cash flow fromcurrent operations and available revolving credit facilities, as discussedabove, are expected to be sufficient to meet planned liquidity and operationalcapital resource needs, including store expansion and other capital spendingprograms, scheduled interest payments, and any further repurchases of theCompany’s common stock.

The following table shows the Company’s obligations and commitments asof the end of the third quarter of 2006 to make future payments undercontractual obligations:

 
| **(in thousands)**               | ** ** | **Payments  Due During One Year Fiscal Period Ending** | ** ** |
|----------------------------------|------------|--------------------------------------------------------|------------|
| **Contractual Obligations** | ** ** | **Total**                                              | ** ** | **May**  2007 | ** ** | **May**  2008 | ** ** | **May**  2009 | ** ** | **May**  2010 | ** ** | **May**  2011 | ** ** | **Thereafter** | ** ** |
| Long-term debt                   |       | $                                                      | 250,000    |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | 250,000 |   |
| Interest                         |       | $                                                      | 116,459    |   | 13,387 |   | 13,387 |   | 13,387 |   | 13,387 |   | 13,387 |   | 49,524 |   |
| Merchandise letters of  credit   |       | $                                                      | 131,761    |   | 131,761 |   | — |   | — |   | — |   | — |   | — |   |
| Operating leases                 |       | $                                                      | 1,165,673  |   | 264,295 |   | 232,915 |   | 196,004 |   | 153,488 |   | 108,481 |   | 210,490 |   |
| Construction  obligations        |       | $                                                      | 12,047     |   | 12,047 |   | — |   | — |   | — |   | — |   | — |   |
| Total                            |       | $                                                      | 1,675,940  |   | $ | 421,490 |   | $ | 246,302 |   | $ | 209,391 |   | $ | 166,875 |   | $ | 121,868 |   | $ | 510,014 |   |

 

At the end of the third quarter of fiscal2006, approximately $17.7 million of the merchandise letters of credit wereincluded in accounts payable on the Company’s Consolidated Condensed BalanceSheet. Most of the Company’s operating leases provide the Company with anoption to extend the term of the lease at designated rates.

The following table shows the Company’sother commercial commitments as of the end of the third quarter of fiscal 2006:

** **

| **Other  Commercial Commitments (in thousands)** | ** ** | **Total Amounts  Committed** | ** ** |
|--------------------------------------------------|------------|-----------------------------------|------------|
| Standby letters of  credit                       |       | $                                 | 116,556    |   |
| Surety bonds                                     |       | 44,929                            |       |
| Total Commercial Commitments                     |       | $                                 | 161,485    |   |

###  

**Asubstantial portion of the outstanding amount of standby letters of credit(which are primarily renewed on an annual basis) are used as surety for futurepremium and deductible payments to the Company’s workers’ compensation andgeneral liability insurance carrier. The Company accrues for these futurepayment liabilities as described in the “Critical Accounting Policies” sectionof this discussion. Included in the outstanding amount of surety bonds is a$41.6 million bond obtained by the Company during the third quarter of fiscal2006 in connection with an adverse litigation judgment, as discussed in Note 8to the Consolidated Condensed Financial Statements included in this Report.**

 

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** **

**CriticalAccounting Policies**

**Management believes the followingaccounting principles are critical because they involve significant judgments,assumptions, and estimates used in the preparation of the Company’sconsolidated condensed financial statements.**

***Merchandise Inventories:***

Inventories are valued using the retail method,based on retail prices less markon percentages, which approximates the lower offirst-in, first-out (FIFO) cost or market. The Company records adjustments toinventory through cost of goods sold when retail price reductions, ormarkdowns, are taken against on-hand inventory. In addition, management makesestimates and judgments regarding, among other things, initial markups,markdowns, future demand for specific product categories and market conditions,all of which can significantly impact inventory valuation. If actual demand ormarket conditions are different than those projected by management, additionalmarkdowns may be necessary. This risk is generally higher for seasonal merchandisethan for non-seasonal goods. The Company also provides for estimated inventorylosses for damaged, lost or stolen inventory for the period from the physicalinventory to the financial statement date. These estimates are based onhistorical experience and other factors.

***Property and Equipment:***

Property and equipment is stated at cost. Depreciationfor financial reporting purposes is calculated using the straight-line methodover the estimated useful lives of the related assets. For leaseholdimprovements, this depreciation is over the shorter of the term of the relatedlease (generally five years) or the asset’s useful economic life. The valuationand classification of these assets and the assignment of useful depreciablelives involves significant judgments and the use of estimates. The Companygenerally assigns no salvage value to property and equipment. Property andequipment is reviewed for impairment whenever events or changes incircumstances indicate that the carrying amount of an asset may not be recoverable.Historically, impairment losses on fixed assets have not been material to theCompany’s financial position and results of operations.

*Insurance Liabilities:*

The Company is primarily self-insured for healthcare, property loss, workers’ compensation and general liability costs. Thesecosts are significant primarily due to the large number of the Company’s retaillocations and employees. Because the nature of these claims is such that therecan be a significant lag from the incurrence of the claim (which is when theexpense is accrued) until payment is made, the percentage increase in theaccrual can differ from the percentage increase in the expense. The Company’sself-insurance liabilities are based on the total estimated costs of claimsfiled and estimates of claims incurred but not reported, less amounts paidagainst such claims, and are not discounted. Management reviews current andhistorical claims data in developing its estimates. The Company also usesinformation provided by outside actuaries with respect to workers’ compensationand general liability claims. If the underlying facts and circumstances of theclaims change or the historical trend is not indicative of future trends, thenthe Company may be required to record additional expense or a reduction toexpense which could be material to its reported financial condition and resultsof operations.

*Contingent Income Tax Liabilities:*

The Company is subject toroutine income tax audits that occur periodically in the normal course ofbusiness. The Company’s contingent income tax liabilities are estimated basedon an assessment of the probability of the income tax related exposures andsettlements, and are influenced by the Company’s historical audit experienceswith various state and federal taxing authorities as well as current income taxtrends. If circumstances change, the Company may be required to recordadjustments that could be material to its reported financial condition andresults of operations.

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*Contingent Legal Liabilities:*

The Company is involvedin numerous legal proceedings and claims. The Company’s reserves, if any,related to these proceedings and claims are based on a determination of whetheror not the loss is both probable and estimable. The Company reviews outstandingclaims and proceedings with external counsel to assess probability andestimates of loss. The claims and proceedings are re-evaluated each quarter oras new and significant information becomes available, and the reserves areadjusted or established, if necessary. If circumstances change, the Company maybe required to record adjustments that could be material to its reportedfinancial condition and results of operations.

*Lease Accounting:*

The Company leases substantially all of its storeproperties and accounts for store leases in accordance with SFAS 13, “Accountingfor Leases.”  For purposes of recognizingincentives, premiums and minimum rental expenses on a straight-line basis overterms of the leases, the Company uses the date of initial possession to begin amortization,which is generally when the Company enters the space and begins to makeimprovements in preparation of intended use. For tenant improvement allowancesand rent holidays, the Company records a deferred rent liability at theinception of the lease term and amortizes the deferred rent over the terms ofthe leases as reductions to rent expense on the Consolidated Statements ofIncome.

*Stock-based Compensation Expense:*

The Company adopted SFAS 123R during the firstquarter of fiscal 2006. SFAS 123R requires the measurement and recognition ofcompensation expense for all stock-based awards made to employees based onestimated fair values. The determination of the fair value of the Company’sstock options on the date of grant using an option-pricing model is affected bythe Company’s stock price as well as assumptions regarding a number of complexand subjective variables. These variables include, but are not limited to, theexpected stock price volatility over the term of the awards, and actual and projectedemployee stock option exercise behaviors. The Company also grants performanceshare rights and adjusts compensation expense each quarter based on theultimate number of shares expected to be issued. If factors change and theCompany employs different assumptions in the application of SFAS 123R in futureperiods, the compensation expense recorded under SFAS 123R may differsignificantly from the amount recorded in the current period.

**Cautionary Statement RegardingForward-Looking Statements**

Certain statements contained in this Report, or inother public filings, press releases, or other written or oral communicationsmade by the Company or its representatives, which are not historical facts areforward-looking statements made pursuant to the safe harbor provisions of thePrivate Securities Litigation Reform Act of 1995. These forward-lookingstatements address the Company’s plans, activities or events which the Companyexpects will or may occur in the future and may include express or impliedprojections of revenue or expenditures, statements of plans and objectives forfuture operations, growth or initiatives, statements of future economicperformance, or statements regarding the outcome or impact of pending orthreatened litigation. These forward-looking statements may be identified bythe use of the words “plan,” “estimate,” “expect,” “anticipate,” “probably,” “should,”“project,” “intend,” “continue,” and other similar terms and expressions. Variousrisks, uncertainties and other factors may cause the Company’s actual resultsto differ materially from those expressed or implied in any forward-lookingstatements. Factors, uncertainties and risks that may result in actual resultsdiffering from such forward-looking information include, but are not limited tothose listed below, as well as other factors discussed throughout this Report,including, without limitation, the factors described under “Critical AccountingPolicies.”  The Company does not intendto update any of the forward looking statements set forth herein, except as maybe required by law.

*Success of merchandising and marketing programs*

The Company undertakes new programs and refinesexisting programs to increase net sales and its customer base. The Company maybe adversely impacted if merchandise and marketing programs fail to attract 

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customers into its stores or if the merchandising programs implementedby the Company are not attractive to its customers.

*Unusual weather or natural disasters that may impact sales and oroperations*

Extreme changes in weather patterns or other naturaldisasters influence customer trends and purchases. Likewise, weather patternsand natural disasters may negatively impact sales, properties and/or operationsof the Company.

*Competitive factors*

The Company is in a highly competitive sector of thediscount retail merchandise sector with numerous competitors, some of whom mayhave greater resources than the Company. The Company competes for customers,merchandise, real estate locations and employees. This competitive environmentsubjects the Company to various risks, including the ability to continue itsstore and sales growth and provide attractive merchandise to its customers atcompetitive prices that allow the Company to maintain its profitability.

*Pricing pressures, including inflation and energy prices*

Increases in the cost of goods and services,including changes resulting from inflationary pressures, may reduce the Company’sprofitability and/or sales. The Company’s ability to pass on incrementalpricing changes may be limited due to operational and/or competitive factors. Increasesin prices, including changes in energy prices, may impact the Company’scustomer base by limiting the amount of discretionary spending of its customersand may impact the Company through increased costs of goods and/or increasedoperating expenses.

*Changes in consumer demand and product mix; and changes in overalleconomic conditions*

A general slowdown in the U.S. economy may adverselyaffect the spending of the Company’s customers, which may result in lower netsales than expected on a quarterly or annual basis. In addition, changes in thetypes of products made available for sale and the selection of the products bycustomers affect sales, product mix and margins. Future economic conditionsaffecting disposable consumer income, such as employment levels, businessconditions, fuel and energy costs, interest rates, and tax rates, could alsoadversely affect the Company’s business by reducing spending or causingcustomers to shift their spending to other products.

*The impact of acts of war or terrorism and transportation anddistribution delays or interruptions*

Significant acts of terrorism, existing U.S.military efforts, as well as the involvement of the U.S. in other militaryengagements, could have an adverse impact on the Company by, among otherthings, disrupting its distribution or information systems, causing dramaticincreases in fuel prices which increase the cost of doing business, or impedingthe flow of imports or domestic products to the Company. Delays orinterruptions in the transportation and distribution of products could have anadverse impact on the Company.

*Merchandise supply and pricing and the interruption of and dependenceon imports*

The Company has generally been able to obtainsufficient quantities of attractive merchandise at prices that allow theCompany to profitably sell such merchandise. Any disruption in that supplyand/or the pricing of such merchandise could negatively impact the Company’soperations and results. A significant amount of the goods sold by the Companyare imported, and changes to the flow of these goods for any reason could havean adverse impact on the Company.

*Delays associated with building and opening of distribution facilitiesand stores and costs of operating distribution facilities and stores*

The Company maintains a network of distributionfacilities in its geographic territory and constructs new facilities to supportits growth. In addition, the Company expands its network of stores throughopening new 

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stores and remodeling existing stores each year. Delays in openingdistribution facilities or stores could adversely affect the Company’s futureoperations by slowing growth, which may in turn reduce revenue growth. Adversechanges in the cost to operate distribution facilities and stores, such aschanges in labor, utility, and other operating costs, could have an adverseimpact on the Company. Adverse changes in inventory shrinkage at thestore-level or in distribution facilities could have a negative impact on theCompany.

*Operational difficulties*

The Company’s stores are decentralized and aremanaged through a network of geographically dispersed management personnel. Inabilityof the Company to effectively and efficiently operate its stores, including theability to control losses resulting from inventory shrinkage, may negativelyimpact the Company’s sales and/or margin. In addition, the Company relies uponits distribution and logistics network to provide goods to stores in a timelyand cost-effective manner; any disruption, unanticipated expense or operationalfailure related to this process could negatively impact store operations. Finally,the Company’s operations are facilitated by the use of various technologies,the disruption or failure of which could negatively impact the Company’soperations.

*Higher costs, potential problems and achievement of targeted resultsassociated with the implementation of new programs, systems and technology,including supply chain systems, store technology, cooler installations andrelated food programs, Urban Initiative programs, and real estate expansiongoals*

The Company is undertaking a variety of operatinginitiatives as well as infrastructure initiatives. The failure to properlyexecute any of these initiatives could have an adverse impact on the futureoperating results of the Company.

*Changes in interpretations or applications ofaccounting principles*

Unanticipated changes in the interpretation orapplication of accounting principles to the Company’s financial statementscould result in material charges and/or restatements of the Company’s financialstatements, which may further result in litigation and/or regulatory actionswhich could have a material adverse effect on the Company.

*Changes in state or federal legislation or regulations, including theeffects of legislation and regulations on wage levels and entitlement programs;changes in currency exchange rates, trade restrictions, tariffs, quotas andfreight rates*

Unanticipated changes in federal or state wagerequirements or other changes in workplace regulation could adversely impactthe Company’s ability to achieve its financial targets. Because a substantialamount of the Company’s imported merchandise comes from China, a change in theChinese currency policy could negatively impact the Company’s merchandise costs.Changes in trade restrictions, new tariffs and quotas, and higher shippingcosts for goods could also adversely impact the ability of the Company toachieve anticipated operating results.

*Success of new store opening program*

The Company’s growth is dependent on both increasesin sales in existing stores and the ability to open new stores. Unavailabilityof store locations that the Company deems attractive, delays in the acquisitionor opening of new stores, difficulties in staffing and operating new storelocations and lack of customer acceptance of stores in expanded market areasall may negatively impact the Company’s new store growth, the costs associatedwith new stores and/or the profitability of new stores.

*The Company’s ability to attract and retain employees, and changes inhealth care and other insurance costs*

The growth of the Company could be adverselyimpacted by its inability to attract and retain employees at the store operationslevel, in distribution facilities, and at the corporate level, including theCompany’s senior management team. Adverse changes in health care costs couldalso adversely impact the Company’s ability to achieve its operational andfinancial goals and to offer attractive benefit programs to its employees.

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*Adverse impacts associated with legal proceedings and claims*

The Company is a party to a variety of legalproceedings and claims, including those described elsewhere in this Report. Operatingresults for the Company could be adversely impacted if such legal proceedingsand claims result in the Company’s obligation to make either material damage orsettlement payments, which are not insured or which have not been reservedagainst, or changes to the operation of the business.

All of the forward-looking statements made by theCompany in this Report and other documents or statements are qualified by theseand other factors, risks and uncertainties. Readers are cautioned not to placeundue reliance on these forward-looking statements, which speak only as of thedate of this Report. The Company does not undertake to publicly update orrevise its forward-looking statements even if experience or future changes makeit clear that projected results expressed or implied in such statements willnot be realized.

**Item 3.Quantitative and Qualitative Disclosures About Market Risk**

The Company is subject to market risk from exposureto changes in interest rates based on its financing, investing and cashmanagement activities. The Company maintains unsecured revolving creditfacilities at variable interest rates to meet the short-term needs of itsexpansion program and seasonal inventory increases. The Company had nooutstanding borrowings against these facilities during the first three quartersof fiscal 2006. The Company’s long-term debt associated with the Notes bearsinterest at fixed rates.

**Item 4. Controlsand Procedures**

Based on an evaluation bymanagement of the Company (with the participation of the Company’s ChiefExecutive Officer and Chief Financial Officer), as of the end of the periodcovered by this report, the Company’s Chief Executive Officer and ChiefFinancial Officer concluded that the Company’s disclosure controls andprocedures (as defined in Rules 13a-15(e) and 15d-15(e) underthe Exchange Act were effective to provide reasonable assurance thatinformation required to be disclosed by the Company in reports that the Companyfiles or submits under the Exchange Act is recorded, processed, summarized andreported within the time periods specified in Securities and ExchangeCommission (“SEC”) rules and forms and that such information isaccumulated and communicated to the Company’s management, including the ChiefExecutive Officer and Chief Financial Officer, to allow timely decisionsregarding required disclosures.

The Company is continuously seeking to improve the efficiency andeffectiveness of its operations and of its internal controls. This results inrefinements to processes throughout the Company. However, there has been nochange in the Company’s internal control over financial reporting (as definedin Exchange Act Rule 13a-15(f)) during the most recent fiscalquarter that has materially affected, or is reasonably likely to materiallyaffect, the Company’s internal control over financial reporting.

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**PART II —OTHER INFORMATION**

**Item 1. LegalProceedings**

**Theinformation in Note 8 to the Consolidated Condensed Financial Statementscontained in Part I, Item 1 of the Form 10-Q is incorporatedherein by this reference.**

**Item 2.Unregistered Sales of Equity Securities and Use of Proceeds**

The following table sets forth information with respect to purchases ofshares of the Company’s common stock made during the quarter ended May 27,2006, by or on behalf of the Company or any “affiliated purchaser” as definedby Rule 10b-18(a)(3) of the Securities Exchange Act of 1934:

 
| **Period**                   | ** ** | **Total  Number of  Shares  Purchased** | ** ** | **Average  Price Paid  Per Share** | ** ** | **Total Number of  Shares Purchased  as Part of Publicly  Announced Plans  or Programs (1)** | ** ** | **Maximum Number  of Shares that May  Yet Be Purchased  Under the Plans or  Programs (1)** | ** ** |
|------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------|------------|
|                         |       |                                         |       |                                         |       |                                                                                                                                      |       |                                                                                                                                         |       |
| March  (02/26/06 - 04/01/06) |       | —                                       |       | —                                       |       | —                                                                                                                                    |       | 6,357,289                                                                                                                                    | (2)        |
|                         |       |                                         |       |                                         |       |                                                                                                                                      |       |                                                                                                                                         |       |
| April  (04/02/06 - 04/29/06) |       | 1,954,415                                    |       | $                                            | 25.58      |                                                                                                                                      | 1,954,415  |                                                                                                                                         | 4,515,631  | (2) |
|                         |       |                                         |       |                                         |       |                                                                                                                                      |       |                                                                                                                                         |       |
| May  (4/30/06 - 5/27/06)     |       | 1,900,800                                    |       | $                                            | 26.30      |                                                                                                                                      | 1,900,800  |                                                                                                                                         | 2,571,254  |   |
|                         |       |                                         |       |                                         |       |                                                                                                                                      |       |                                                                                                                                         |       |
| Total                        |       | 3,855,215                                    |       | $                                            | 25.94      |                                                                                                                                      | 3,855,215  |                                                                                                                                         | 2,571,254  |   |

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(1)          On April 13, 2005,the Company announced that the Board of Directors authorized the purchase of upto five million shares of its outstanding common stock from time to time asmarket conditions warrant. On August 19, 2005, the Company announced thatthe Board of Directors authorized the purchase of an additional $300 million ofthe Company’s common stock from time to time as market conditions warrant. Thereis no expiration date governing the period during which the Company can makeshare repurchases pursuant to the above referenced authorizations. The Companyfully utilized the $300 million authorization during the third quarter offiscal 2006 in connection with the overnight share repurchase transaction andother share repurchases. See Note 4 and Note 5 to the Consolidated CondensedFinancial Statements included in this Report for more information.

(2)          Includes amounts convertedto shares using the Company’s closing stock price as of the end of the fiscalmonth.

**Item 6. Exhibits**

**(a)  Exhibits incorporated by reference:**

**10.1**                                       Fifth Amendment to Amended and Restated Credit Agreement between theCompany and Family Dollar, Inc., as Borrower, and Bank of America, N.A.,dated as of May 19, 2006 (filed as Exhibit 10(a) to the Company’sCurrent Report on Form 8-K filed May 24, 2006)

**10.2**                                       Fifth Amendment to Credit Agreement between the Company and Family Dollar, Inc.,as Borrower, and Wachovia Bank, National Association, dated as of May 19,2006 (filed as Exhibit 10(b) to the Company’s Current Report on Form 8-Kfiled May 24, 2006)

**(b)  Exhibits filed herewith:**

**31.1**                                       Certification of Principal Executive Officer Pursuant to Rules 13a-14(a) and15d-14(a) under the Securities Exchange Act of 1934, as adoptedpursuant to Section 302 of the Sarbanes-Oxley Act of 2002

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**31.2**                                       Certification of Principal Financial Officer Pursuant to Rules 13a-14(a) and15d-14(a) under the Securities Exchange Act of 1934, as adoptedpursuant to Section 302 of the Sarbanes-Oxley Act of 2002

**32.1**                                       Certification of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

**32.2**                                       Certification of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

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** **

SIGNATURES

Pursuant to the requirements of theSecurities Exchange Act of 1934, the registrant has duly caused this report tobe signed on its behalf by the undersigned thereunto duly authorized.

 
|                           |   | FAMILY DOLLAR STORES, INC.            |
|---------------------------|--------|---------------------------------------|
|                      |   | (Registrant)                          |
|                      |   |                                  |
|                      |   |                                  |
| Date:  June 29, 2006 |   | /s/ R. James Kelly                    |
|                      |   | R. JAMES KELLY                        |
|                      |   | Vice Chairman-Chief Financial Officer |
|                      |   |                                  |
|                      |   |                                  |
| Date: June 29,  2006      |   | /s/ C. Martin Sowers                  |
|                      |   | C. MARTIN SOWERS                      |
|                      |   | Senior  Vice President-Finance        |

 

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