**UNITEDSTATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**Form 10-Q**

 

**(Mark One)**

 

| **ý**                                                | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13  OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|-----------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|
|                                                      |       |                                                                                                    |
| **For the quarterly period ended February 25, 2006** |
|                                                      |       |                                                                                                    |
| **OR**                                                    |
| ** **                                                | ** ** | ** **                                                                                              |
| **o**                                                     | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13  OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**CommissionFile Number       1-6807**

 

**FAMILY DOLLAR STORES, INC.**

(Exact name of registrant asspecified 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**

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes ý  No o

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Checkone):

LargeAccelerated Filer ý   Accelerated Filer o  Non-Accelerated Filer o

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes o   No ý

 

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date.

 

| **Class**                      | ** ** | **Outstanding at March 24,  2006** |
|--------------------------------|------------|-----------------------------------------|
| Common  Stock, $0.10 par value |       | 155,325,449  shares                     |

 

 

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**FAMILYDOLLAR STORES, INC., AND SUBSIDIARIES**

 

**INDEX**

 
| Part I - Financial Information                                                                                         |   |
|-----------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                        |   |
| Item 1 - Consolidated  Condensed Financial Statements:                                                                      |   |
|                                                                                                                        |   |
| Consolidated Condensed  Balance Sheets – February 25, 2006 and August 27, 2005                          |   |
|                                                                                                                        |   |
| Consolidated Condensed  Statements of Income - Quarter Ended February 25, 2006 and February 26,  2005        |   |
|                                                                                                                        |   |
| Consolidated Condensed Statements of Income - First  Half Ended February 25, 2006 and February 26, 2005      |   |
|                                                                                                                        |   |
| Consolidated Condensed  Statements of Cash Flows - First Half Ended February 25, 2006 and February 26,  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 4 - Submission of  Matters to a Vote of Security Holders                                                               |   |
|                                                                                                                        |   |
| Item 6 - Exhibits                                                                                                           |   |
|                                                                                                                        |   |
| Signatures                                                                                                                  |   |

 

2

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**PART I – FINANCIAL INFORMATION**

 

**Item 1. Consolidated Condensed FinancialStatements**

 

**FAMILYDOLLAR STORES, INC., AND SUBSIDIARIES**

**CONSOLIDATED CONDENSED BALANCE SHEETS**

**(Unaudited)**

 
| **(in thousands, except per share and share amounts)**                                                                                                                                                                                                                       | ** ** | **February 25, 2006** | ** ** | **August 27, 2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|--------------------------|------------|
| **Assets**                                                                                                                                                                                                                                                                   |       |                       |       |                     |       |
| Current assets:                                                                                                                                                                                                                                                              |       |                       |       |                     |       |
| Cash and  cash equivalents (Note 2)                                                                                                                                                                                                                                          |       | $                          | 101,182    |                     | $          | 105,175 |   |
| Investment  securities (Note 2)                                                                                                                                                                                                                                              |       | 229,635                    |       | 33,530                   |       |
| Merchandise  inventories                                                                                                                                                                                                                                                     |       | 1,016,511                  |       | 1,090,791                |       |
| Deferred income  taxes                                                                                                                                                                                                                                                       |       | 129,871                    |       | 100,493                  |       |
| Prepayments  and other current assets                                                                                                                                                                                                                                        |       | 51,949                     |       | 24,779                   |       |
| Total  current assets                                                                                                                                                                                                                                                        |       | 1,529,148                  |       | 1,354,768                |       |
|                                                                                                                                                                                                                                                                         |       |                       |       |                     |       |
| Property and equipment, net                                                                                                                                                                                                                                                  |       | 1,056,434                  |       | 1,027,475                |       |
| Other assets                                                                                                                                                                                                                                                                 |       | 27,286                     |       | 27,258                   |       |
|                                                                                                                                                                                                                                                                         |       | $                          | 2,612,868  |                     | $          | 2,409,501 | ** ** |
| ** **                                                                                                                                                                                                                                                                   | ** ** | ** **                 | ** ** | ** **               | ** ** |
| **Liabilities and Shareholders’ Equity**                                                                                                                                                                                                                                |       |                       |       |                     |       |
| Current liabilities:                                                                                                                                                                                                                                                         |       |                       |       |                     |       |
| Accounts  payable                                                                                                                                                                                                                                                            |       | $                          | 549,321    |                     | $          | 574,831 |   |
| Accrued  liabilities                                                                                                                                                                                                                                                         |       | 399,596                    |       | 315,508                  |       |
| Income taxes  payable                                                                                                                                                                                                                                                        |       | 26,804                     |       | 4,272                    |       |
| Total  current liabilities                                                                                                                                                                                                                                                   |       | 975,721                    |       | 894,611                  |       |
|                                                                                                                                                                                                                                                                         |       |                       |       |                     |       |
| Long-term debt (Note 4)                                                                                                                                                                                                                                                      |       | 250,000                    |       | —                   |       |
| Deferred income taxes                                                                                                                                                                                                                                                        |       | 80,947                     |       | 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 178,926,188 shares at February 25,  2006, and 188,871,738 shares at August 27, 2005, and outstanding  155,321,949 shares at February 25, 2006, and 165,262,513 shares at August 27,  2005 |       | 17,893                     |       | 18,887                   |       |
| Capital in  excess of par                                                                                                                                                                                                                                                    |       | 130,358                    |       | 133,743                  |       |
| Retained  earnings                                                                                                                                                                                                                                                           |       | 1,537,294                  |       | 1,654,861                |       |
|                                                                                                                                                                                                                                                                         |       | 1,685,545                  |       | 1,807,491                |       |
| Less: common  stock held in treasury, at cost (23,604,239 shares at February 25, 2006,  and 23,609,225 shares at August 27, 2005) (Note 5)                                                                                                                         |       | 379,345                    |       | 379,425                  |       |
| Total  shareholders’ equity                                                                                                                                                                                                                                             |       | 1,306,200                  |       | 1,428,066                |       |
|                                                                                                                                                                                                                                                                         |       | $                          | 2,612,868  |                     | $          | 2,409,501 |   |

## ** **

## **Seenotes to the consolidated condensed financial statements.**

## ** **

3

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**FAMILYDOLLAR STORES, INC. AND SUBSIDIARIES**

**CONSOLIDATED CONDENSED STATEMENTS OF INCOME**

**(Unaudited)**

 
| ** **                                           | ** ** | **Quarter Ended**          | ** ** |
|------------------------------------------------------|------------|----------------------------|------------|
| **(in thousands, except per share amounts)**         | ** ** | **February 25, 2006** | ** ** | **February 26, 2005** | ** ** |
| Net sales                                            |       | $                          | 1,735,683  |   | $ | 1,586,754 |   |
|                                                 |       |                       |       |   |   |
| Cost and  expenses:                                  |       |                       |       |   |   |
| Cost of  sales                                       |       | 1,165,194                  |       | 1,065,835 |   |
| Selling,  general and administrative expenses        |       | 438,177                    |       | 395,631 |   |
| Litigation  charge (Note 8)                          |       | 45,000                     |       | — |   |
| Cost of  sales and operating expenses                |       | 1,648,371                  |       | 1,461,466 |   |
|                                                 |       |                       |       |   |   |
| Operating  profit                                    |       | 87,312                     |       | 125,288 |   |
|                                                 |       |                       |       |   |   |
| Interest  income                                     |       | 2,198                      |       | 1,209 |   |
|                                                 |       |                       |       |   |   |
| Interest  expense (Note 4)                           |       | 2,956                      |       | — |   |
|                                                 |       |                       |       |   |   |
| Income  before provision for taxes on income         |       | 86,554                     |       | 126,497 |   |
|                                                 |       |                       |       |   |   |
| Provision  for taxes on income                       |       | 32,025                     |       | 46,424 |   |
|                                                 |       |                       |       |   |   |
| Net income                                           |       | $                          | 54,529     |   | $ | 80,073 |   |
|                                                 |       |                       |       |   |   |
| Net income  per common share – basic (Note 7)   |       | $                          | 0.35       |   | $ | 0.48 |   |
| Average  shares – basic (Note 7)                |       | 155,293                    |       | 167,723 |   |
|                                                 |       |                       |       |   |   |
| Net income  per common share – diluted (Note 7) |       | $                          | 0.35       |   | $ | 0.48 |   |
| Average  shares – diluted (Note 7)              |       | 156,755                    |       | 168,361 |   |
|                                                 |       |                       |       |   |   |
| Dividends  declared per common share                 |       | $                          | 0.105      |   | $ | 0.095 |   |

 

See notes to the consolidated condensed financialstatements.

 

4

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**FAMILYDOLLAR STORES, INC. AND SUBSIDIARIES**

**CONSOLIDATEDCONDENSED STATEMENTS OF INCOME**

**(Unaudited)**

 
| ** **                                           | ** ** | **First Half Ended**       | ** ** |
|------------------------------------------------------|------------|----------------------------|------------|
| **(in thousands, except per share amounts)**         | ** ** | **February 25, 2006** | ** ** | **February 26, 2005** | ** ** |
| Net sales                                            |       | $                          | 3,247,140  |   | $ | 2,966,999 |   |
|                                                 |       |                       |       |   |   |
| Cost and  expenses:                                  |       |                       |       |   |   |
| Cost of sales                                        |       | 2,168,448                  |       | 1,985,728 |   |
| Selling,  general and administrative expenses        |       | 863,468                    |       | 771,342 |   |
| Litigation  charge (Note 8)                          |       | 45,000                     |       | — |   |
| Cost of  sales and operating expenses                |       | 3,076,916                  |       | 2,757,070 |   |
|                                                 |       |                       |       |   |   |
| Operating  profit                                    |       | 170,224                    |       | 209,929 |   |
|                                                 |       |                       |       |   |   |
| Interest  income                                     |       | 3,049                      |       | 1,733 |   |
|                                                 |       |                       |       |   |   |
| Interest  expense (Note 4)                           |       | 5,149                      |       | — |   |
|                                                 |       |                       |       |   |   |
| Income  before provision for taxes on income         |       | 168,124                    |       | 211,662 |   |
|                                                 |       |                       |       |   |   |
| Provision  for taxes on income                       |       | 62,206                     |       | 77,160 |   |
|                                                 |       |                       |       |   |   |
| Net income                                           |       | $                          | 105,918    |   | $ | 134,502 |   |
|                                                 |       |                       |       |   |   |
| Net income  per common share – basic (Note 7)   |       | $                          | 0.67       |   | $ | 0.80 |   |
| Average  shares – basic (Note 7)                |       | 157,311                    |       | 167,671 |   |
|                                                 |       |                       |       |   |   |
| Net income  per common share – diluted (Note 7) |       | $                          | 0.67       |   | $ | 0.80 |   |
| Average  shares – diluted (Note 7)              |       | 158,772                    |       | 168,241 |   |
|                                                 |       |                       |       |   |   |
| Dividends  declared per common share                 |       | $                          | 0.20       |   | $ | 0.18 |   |

 

See notes to the consolidated condensed financialstatements.

 

5

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**FAMILYDOLLAR STORES, INC. AND SUBSIDIARIES**

**CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
| ** **                                                                                                        | ** ** | **First Half Ended**       | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|
| **(in thousands)**                                                                                                | ** ** | **February 25, 2006** | ** ** | **February 26, 2005** | ** ** |
| **Cash  flows from operating activities:**                                                                        |       |                       |       |   |   |
| Net income                                                                                                        |       | $                          | 105,918    |   | $ | 134,502 |   |
|                                                                                                              |       |                       |       |   |   |
| Adjustments  to reconcile net income to net cash provided by operating activities: Depreciation  and amortization |       | 64,983                     |       | 53,066 |   |
| Deferred  income taxes                                                                                            |       | (35,255                    | )          | (2,300 | ) |
| Stock-based  compensation expense                                                                                 |       | 3,411                      |       | — |   |
| Tax benefit  from stock option exercises                                                                          |       | 42                         |       | 2,490 |   |
| Excess tax  benefits from stock-based compensation                                                                |       | (41                        | )          | — |   |
| Loss on  disposition of property and equipment                                                                    |       | 3,350                      |       | 1,077 |   |
| Changes in  operating assets and liabilities:                                                                     |       |                       |       |   |   |
| Merchandise  inventories                                                                                          |       | 74,280                     |       | 26,106 |   |
| Income tax  refund receivable                                                                                     |       | 0                          |       | 1,304 |   |
| Prepayments  and other current assets                                                                             |       | (27,170                    | )          | (32,480 | ) |
| Other assets                                                                                                      |       | 930                        |       | (1,660 | ) |
| Accounts  payable and accrued liabilities                                                                         |       | 68,998                     |       | (20,602 | ) |
| Income taxes  payable                                                                                             |       | 22,532                     |       | 17,028 |   |
|                                                                                                              |       | 281,978                    |       | 178,531 |   |
|                                                                                                              |       |                       |       |   |   |
| **Cash  flows from investing activities:**                                                                        |       |                       |       |   |   |
| Purchases of  investment securities                                                                               |       | (248,805                   | )          | (193,200 | ) |
| Sales of  investment securities                                                                                   |       | 52,700                     |       | 110,785 |   |
| Capital  expenditures                                                                                             |       | (97,799                    | )          | (94,787 | ) |
| Proceeds  from dispositions of property and equipment                                                             |       | 507                        |       | 1,804 |   |
|                                                                                                              |       | (293,397                   | )          | (175,398 | ) |
|                                                                                                              |       |                       |       |   |   |
| **Cash  flows from financing activities:**                                                                        |       |                       |       |   |   |
| Issuance of  long-term debt                                                                                       |       | 250,000                    |       | — |   |
| Payment of  debt issuance costs                                                                                   |       | (958                       | )          | — |   |
| Repurchases  of common stock                                                                                      |       | (201,398                   | )          | (19,145 | ) |
| Changes in  cash overdrafts                                                                                       |       | (11,029                    | )          | 25,471 |   |
| Exercise of  employee stock options                                                                               |       | 1,220                      |       | 11,916 |   |
| Excess tax  benefits from stock-based compensation                                                                |       | 41                         |       | — |   |
| Payment of  dividends                                                                                             |       | (30,450                    | )          | (28,503 | ) |
|                                                                                                              |       | 7,426                      |       | (10,261 | ) |
|                                                                                                              |       |                       |       |   |   |
| **Net  change in cash and cash equivalents**                                                                      |       | (3,993                     | )          | (7,128 | ) |
| **Cash and  cash equivalents at beginning of period**                                                             |       | 105,175                    |       | 87,023 |   |
| **Cash and  cash equivalents at end of period**                                                                   |       | $                          | 101,182    |   | $ | 79,895 |   |

## ** **

## **Seenotes to the consolidated condensed financial statements.**

## ** **

6

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## **FAMILY DOLLARSTORES, INC., AND SUBSIDIARIES**

## **NOTES TO CONSOLIDATEDCONDENSED FINANCIAL STATEMENTS**

## ** **

1.               In the opinion of the Company, the accompanyingunaudited consolidated condensed financial statements contain all adjustments(consisting of normal recurring accruals and including a litigation charge asdescribed in Note 8 below) necessary to present fairly the Company’s financialposition as of February 25, 2006; the results of operations for the secondquarter and first half ended February 25, 2006 (“second quarter and firsthalf of fiscal 2006”), and February 26, 2005 (“second quarter and firsthalf of fiscal 2005”); and the cash flows for the first half of fiscal 2006 andfirst half of fiscal 2005. For further information, refer to the consolidatedfinancial statements and footnotes included in the Company’s Annual Report on Form 10-Kfor the fiscal year ended August 27, 2005.

 

**Theresults of operations for the second quarter and first half of fiscal 2006, arenot necessarily indicative of the results to be expected for the full year.**

** **

Certain reclassifications of the amounts for thesecond quarter and first half of fiscal 2005, have been made to conform tothe presentation for the second quarter and first half of fiscal 2006. Theseinclude accounts payable and accrued liabilities, which are now listedseparately, and interest income, which was previously included 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 exceedfederally insured limits. The Company periodically assesses the financialcondition of the institutions and believes that the risk of any loss isminimal.

 

The items classified asinvestment securities are principally auction rate securities and variable ratedemand 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 February 25, 2006:

 
| ** **            | ** ** | **Quarter Ended**          | ** ** |
|-----------------------|------------|----------------------------|------------|
| **(in thousands)**    | ** ** | **February 25, 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

 

7

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tranche has an aggregateprincipal amount of $169 million, is payable in a single installment on September 27,2015, and bears interest at a rate of 5.41% per annum from the date of issuance.The second tranche has an aggregate principal amount of $81 million, matures onSeptember 27, 2015, with amortization commencing in the sixth year, andbears interest at a rate of 5.24% per annum from the date of issuance. Thesecond tranche has a required principal payment of $16.2 million on September 27,2011, and on each September 27 thereafter to and including September 27,2015. Interest on the Notes is payable semi-annually in arrears on the 27th dayof March and September of each year commencing on March 27, 2006.The sale of the Notes was effected in transactions not requiring registrationunder the Securities Act of 1933, as amended. The Notes contain certainrestrictive covenants,which include a consolidated debt to consolidated capitalization ratio, a fixedcharges coverage ratio, and a priority debt to consolidated net worth ratio. At the end of the second quarter of fiscal2006, the Company was in compliance with all such covenants. The proceeds ofthe Notes are being used to repurchase the Company’s outstanding common stock,as discussed in Note 5 below.

 

In addition to the Notes,the Company has unsecured revolving credit facilities with banks for short-termborrowings of up to $200 million. On May 25, 2006, $100 million of thefacilities will expire, and the remaining $100 million will expire on May 31,2010. The Company expects that the facilities expiring on May 25, 2006,will be extended. Any borrowings under these facilities are at a variableinterest rate based on short-term market interest rates. The Company had noborrowings against these facilities during the first half of fiscal 2006 orduring fiscal 2005.

 

5.               During fiscal 2005, the Company purchased inthe open market 3.3 million shares of its common stock at a cost of $92.0million. On October 4, 2005, the Company executed an overnight sharerepurchase transaction with a bank for the acquisition of an additional 10million shares, or approximately 6%, of the Company’s outstanding common stockfor an initial purchase price of $19.97 per share. The transaction was financedwith the proceeds of the Notes, as discussed in Note 4 above. As part ofthe overnight share repurchase transaction, the Company simultaneously enteredinto a forward contract with the bank that matured on March 6, 2006. Inconnection with the forward contract, the bank purchased shares of the Company’scommon stock in the open market in order to fulfill its obligation related toshares it borrowed from third parties and sold to the Company. At the end ofthe purchase period, the Company could receive from or pay to the bank a priceadjustment based on the volume weighted average purchase price of the Company’scommon stock during the purchase period compared to the initial purchase price.Such price adjustment could be either in cash or common stock at the discretionof the Company. On March 9, 2006, at its option, the Company paid $32.7million in cash to the bank to settle the forward contract.

 

The shares repurchased in connection with theovernight share repurchase transaction were immediately canceled and returnedto the status of authorized but unissued shares. The total cost of the initialpurchase was approximately $201.2 million, including a $1.3 million cap premiumand $0.2 million in commissions and other fees. In accordance with AccountingPrinciples Board (APB) Opinion 6, “Status of Accounting Research Bulletins,”the Company reduced common stock, capital in excess of par, and retainedearnings by approximately $1.0 million, $8.1 million, and $192.1 million,respectively. In addition, the Company reduced retained earnings byapproximately $0.3 million in connection with a dividend fee paid to the bankon January 17, 2006. The forward contract associated with the overnightshare repurchase transaction was accounted for in accordance with EITF 00-19, “Accountingfor Derivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock,” as an equity instrument. The $32.7 million payment madeon March 9, 2006, to settle the forward contract will be recorded as anadjustment to retained earnings in the third quarter of fiscal 2006. Thediluted net income per share calculation for the second quarter and first halfof fiscal 2006 assumed that the forward contract would be settled through theissuance of additional shares of common stock as no final decision had beenmade by the Company as to the nature of the settlement as of February 25,2006.

 

There were no other purchasesof common stock during the first half of fiscal 2006. Shares are purchasedpursuant to share repurchase authorizations approved by the Board of Directors.As of February 25, 2006, the Company had outstanding authorizations topurchase a total of approximately 7.7 million shares, consisting ofapproximately 3.8 million shares (based on the closing share price) remainingunder the authorization for $300 million of stock repurchases approved by theBoard of Directors on August 19, 2005, and approximately 3.9 millionshares remaining pursuant to authorizations approved by the Board of Directorsprior to August 19, 2005. Shares purchased prior to the end of fiscal 2005under the share repurchase authorizations are held in treasury or

 

8

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have been reissued under theFamily Dollar 2000 Outside Directors Plan. Shares purchased with the proceedsof the Notes are canceled and returned to the status of authorized but unissuedshares.

 

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 stock optionsand performance share rights under the plan. Prior to the adoption of the 2006Plan, the Company issued non-qualified stock options under the Company’s 1989Non-Qualified Stock Option Plan (the “1989 Plan”). As a result of the adoptionof the 2006 Plan, no further awards can be granted under the 1989 Plan. Sharesissued under the 2006 Plan represent new issuances of common stock. A total of12.0 million common shares are reserved and available for issuance under the2006 Plan, plus any shares awarded under the 1989 Plan that expire or arecancelled or forfeited after January 19, 2006. As of February 25,2006, 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 compensationexpense under APB 25 since the exercise price of the stock options equaled thefair market 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 adopted SFAS123R 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 has elected toadopt the alternative transition method, as permitted by FASB Staff Position No. FAS123R-3 “Transition Election Related to Accounting for Tax Effects ofShare-Based Payment Awards,” to calculate the tax effects of stock-basedcompensation pursuant to SFAS 123R for those employee awards that wereoutstanding 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.

 

As a result of theadoption of SFAS 123R, the Company’s results for the second quarter and firsthalf of fiscal 2006 include stock-based compensation expense of $1.9 millionand $3.4 million, respectively. These amounts

 

9

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are included withinselling, general, and administrative expenses on the Consolidated CondensedStatements of Income. Tax benefits recognized during the second quarter andfirst half of fiscal 2006 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 secondquarter and first half of fiscal 2005:

 
| **(in thousands, except per share amounts)** | ** **                 | **Quarter Ended** | ** ** | **First Half Ended** | ** ** |
|----------------------------------------------|----------------------------|-------------------|------------|----------------------|------------|
| **February 26, 2005**                   | **February 26, 2005** |
| Net income —  as reported               |                       | $                 | 80,073     |                 | $          | 134,502 |   |
| Pro forma  stock-based compensation cost     |                       | (2,272            | )          | (4,360               | )          |
| Net income —  pro forma                 |                       | $                 | 77,801     |                 | $          | 130,142 |   |
|                                         |                       |              |       |                 |       |
| Net income  per share — as reported     |                       |              |       |                 |       |
| Basic                                        |                       | $                 | .48        |                 | $          | .80 |   |
| Diluted                                      |                       | $                 | .48        |                 | $          | .80 |   |
| Net income  per share — pro forma       |                       |              |       |                 |       |
| Basic                                        |                       | $                 | .46        |                 | $          | .78 |   |
| Diluted                                      |                       | $                 | .46        |                 | $          | .78 |   |

 

The Company’s stock optionplans contain retirement provisions, effective January 20, 2005, thatallow employee stock options to continue to vest after retirement withoutrequiring additional service. The retirement provisions apply to all non-vestedstock options as of the effective date, all vested stock options that were “underwater”(i.e. the options had an exercise price in excess of the market value of thestock) on the effective date, and all new options granted thereafter. UnderSFAS 123R, compensation cost should be recognized over the shorter of thestated vesting period or the period from the grant date to the retirementeligibility date, if the employee is able to retire without providingadditional service. For awards granted prior to the adoption of SFAS 123R, theCompany recognizes compensation cost over the stated vesting period. If theCompany had accounted for these awards in accordance with the provisions ofSFAS 123R, compensation expense would have been $1.9 million higher for boththe second quarter and first half of fiscal 2005 (for pro-forma disclosurepurposes only) and would have had an immaterial impact for the second quarterand first half of fiscal 2006.

 

# **Stock Options**

# ** **

The Company grants stockoptions to key employees at prices not less than fair market value on the grantdate. Options expire five years from the grant date and are exercisable to theextent of 40% after the second anniversary of the grant and an additional 30%at each of the following two anniversary dates on a cumulative basis. Compensationcost is recognized on a straight-line basis, net of estimated forfeitures, overthe requisite service period. The Company uses the Black-Scholes option-pricingmodel to estimate the grant-date fair value of each option granted before andafter the adoption of SFAS 123R. The fair values of options granted during thesecond quarter and first half of fiscal 2006 were estimated using the followingweighted-average assumptions:

 
| ** **                                | ** ** | **Quarter Ended**          | ** ** | **First Half Ended**       | ** ** |
|-------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                                | ** ** | **February 25, 2006** | ** ** | **February 25, 2006** | ** ** |
| Expected  dividend yield                  |       | 2.02                       | %          | 1.61                       | %          |
| Expected  stock price volatility          |       | 30.00                      | %          | 30.00                      | %          |
| Weighted  average risk-free interest rate |       | 4.53                       | %          | 4.12                       | %          |
| Expected  life of options (years)         |       | 4.56                       |       | 4.57                       |       |

 

The expected dividendyield is based on the projected annual dividend payment per share divided bythe stock price on the grant date. Expected stock price volatility is derivedfrom an analysis of the historical and implied volatility of the Company’spublicly traded stock. The risk-free interest rate is based on the U.S.Treasury rates on the grant date with maturity dates approximating the expectedlife of the option on the grant date. The expected life of the options is basedon an analysis of historical and expected future exercise behavior, as well ascertain demographic characteristics. These assumptions are evaluated andrevised, as necessary, to reflect market conditions and experience. Therewere no material changes made to the methodology used to determine the

 

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assumptions during the second quarter offiscal 2006. The weighted-average grant-date fair values of stockoptions granted during the second quarter and first half of fiscal 2006 were$6.54 and $5.47, respectively. The following table summarizes the transactionsunder the stock option plan during the first half 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                                      |       | 763                      |       | 19.91                                   |       |                                                          |       |                            |       |
| Exercised                                    |       | (55                      | )          | 22.40                                   |       |                                                          |       |                            |       |
| Cancelled                                    |       | (620                     | )          | 28.61                                   |       |                                                          |       |                            |       |
| Balance at February 25, 2006            |       | 6,150                    |       | $                                       | 29.39      |                                                          | 2.70       |                            | $          | 5,406 |   |
| Exercisable at February 25, 2006        |       | 3,642                    |       | $                                       | 32.09      |                                                          | 2.06       |                            | $          | 952 |   |

 

The total intrinsic value of stock optionsexercised during the second quarter and first half of fiscal 2006 wasimmaterial. As of February 25, 2006, there was approximately $11.2 millionof unrecognized compensation cost related to outstanding stock options. Theunrecognized compensation cost will be recognized over a weighted-averageperiod of 1.4 years.

 

# **Performance Share Rights**

# ** **

During the second quarterof fiscal 2006, the Company began granting performance share rights to keyemployees. Performance share rights give employees the right to receive sharesof the Company’s common stock at a future date based on the Company’sperformance relative to a peer group. Performance is measured based on twopre-tax metrics: Return on Equity and Income Growth. The Compensation Committeeof the Board of Directors establishes the peer group and performance metrics. Theperformance share rights vest at the end of the performance period (generallythree years) and the shares are issued shortly thereafter. The actual number ofshares issued can range from 0% to 200% of the employee’s target awarddepending on the Company’s performance relative to the peer group.

 

During the second quarterof fiscal 2006, the Company granted 0.2 million performance share rights toemployees at a weighted-average grant-date fair value of $24.07. The grant-datefair value of the performance share rights is based on the stock price on thegrant date. Compensation cost is recognized on a straight-line basis, net ofestimated forfeitures, over the requisite service period and adjusted quarterlyto reflect the ultimate number of shares expected to be issued. As of February 25,2006, there was approximately $5.2 million of unrecognized compensation costrelated to outstanding performance share rights, based on the Company’s mostrecent performance analysis. The unrecognized compensation cost will berecognized over a weighted-average period of 2.1 years. None of the performanceshare rights vested during the second quarter 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 all securitiesrepresenting potential common shares that were dilutive and outstanding duringthe period. The exercise prices for certain of the outstanding stock optionsthat the Company has awarded exceed the average market price of the Company’scommon stock. Such stock options are antidilutive (options for 5.3 million and5.4 million for the quarter and first half ended February 25, 2006,respectively, and options for 1.9 million and 2.0 million for the quarter andfirst half ended February 26, 2005, respectively) and were not included inthe computation of diluted net income per share. In the calculation of dilutednet income per common share, the denominator includes the number of additionalcommon shares that would have been outstanding if the Company’s outstandingstock options and performance share rights had been exercised. In addition, forthe quarter and first half ended February 25, 2006, the denominatorincludes the number of additional common shares that could have been issued tosettle the Company’s forward contract related to the overnight share repurchasetransaction.

 

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**Thefollowing table sets forth the computation of basic and diluted net income percommon share:**

** **
| ** **                                                | ** ** | **Quarter Ended**      | ** ** | **First Half Ended**        | ** ** |
|-----------------------------------------------------------|------------|------------------------|------------|-----------------------------|------------|
| **(in thousands, except per share amounts)**              | ** ** | **February 25,  2006** | ** ** | **February 26,  2005** | ** ** | **February 25,  2006** | ** ** | **February 26,  2005** | ** ** |
| **Basic  Net Income Per Share:**                          |       |                   |       |                        |       |   |   |   |   |
| Net Income                                                |       | $                      | 54,529     |                        | $          | 80,073 |   | $ | 105,918 |   | $ | 134,502 |   |
| Weighted  Average Number of Shares Outstanding            |       | 155,293                |       | 167,723                     |       | 157,311 |   | 167,671 |   |
| Net Income  Per Common Share - Basic                      |       | $                      | 0.35       |                        | $          | 0.48 |   | $ | 0.67 |   | $ | 0.80 |   |
|                                                      |       |                   |       |                        |       |   |   |   |   |
| **Diluted  Net Income Per Share:**                        |       |                   |       |                        |       |   |   |   |   |
| Net Income                                                |       | $                      | 54,529     |                        | $          | 80,073 |   | $ | 105,918 |   | $ | 134,502 |   |
| Weighted  Average Number of Shares Outstanding            |       | 155,293                |       | 167,723                     |       | 157,311 |   | 167,671 |   |
| Effect of  Dilutive Securities - Stock Options            |       | —                 |       | 638                         |       | — |   | 570 |   |
| Effect of  Dilutive Securities - Performance Share Rights |       | 105                    |       | —                      |       | 31 |   | — |   |
| Effect of  Dilutive Securities - Forward Contract         |       | 1,357                  |       | —                      |       | 1,430 |   | — |   |
| Average  Shares - Diluted                                 |       | 156,755                |       | 168,361                     |       | 158,772 |   | 168,241 |   |
| Net Income  Per Common Share - Diluted                    |       | $                      | 0.35       |                        | $          | 0.48 |   | $ | 0.67 |   | $ | 0.80 |   |

** **

**8.**               On January 30, 2001, Janice Morgan and Barbara Richardson, twoindividuals who have held the position of Store Manager for subsidiaries of theCompany, filed a Complaint against the Company in the United States DistrictCourt for the Northern District of Alabama. Thereafter, pursuant to the Court’sruling, notice of the pendency of the lawsuit was sent to approximately 13,000current and former Store Managers holding the position on or after July 1,1999. Approximately 2,550 of those receiving such notice filed consent formsand joined the lawsuit as plaintiffs, including approximately 2,300 formerStore Managers and approximately 250 then current employees. After rulings bythe Court on motions to dismiss certain plaintiffs filed by the Company andmotions to reconsider filed by plaintiffs, 1,424 plaintiffs remained in thecase at the commencement of trial.

 

**Thecase has proceeded as a collective action under the Fair Labor Standards Act (“FLSA”).The Complaint alleges that the Company violated the FLSA by classifying thenamed plaintiffs and other similarly situated current and former Store Managersas “exempt” employees who are not entitled to overtime compensation.**

** **

**Ajury trial in this case was first held in June 2005, in Tuscaloosa,Alabama and ended with the judge declaring a mistrial after the jury was unableto reach a unanimous decision in the matter. The case was retried to a jury inTuscaloosa, Alabama commencing on February 21, 2006. On March 3,2006, the jury in this trial found that the Company should have classified theStore Manager plaintiffs as hourly employees entitled to overtime pay ratherthan as salaried exempt managers and awarded damages in the amount ofapproximately $19.1 million. The Court has under submission the issue of theCompany’s good faith and could double the $19.1 million damages award if itdetermines that the Company did not act in good faith in classifying theplaintiffs as employees exempt from overtime payments. The Court also has undersubmission the Company’s motion to dismiss certain plaintiffs’ claims due totheir failure to list such claims in personal bankruptcy proceedings which, ifgranted, could reduce the amount of the damage award. In addition, the Companyanticipates that the plaintiffs’ counsel will request and the Court may approvean award of attorneys’ fees to the plaintiffs’ counsel in an amount to bedetermined. Although the Company plans to appeal the judgment, as a result ofthese matters, the Company recognized $45 million as a litigation charge (exclusiveof the Company’s related legal defense costs) in its second quarter withrespect to this litigation. This charge will not have any impact on cash flowwhile the Company pursues its appellate rights with respect to this judgment asthe Company does not expect to be required to pay the amount of the judgment duringthe appellate process.**

** **

**In general, the Companycontinues to believe that the Store Managers are “exempt” employees under theFLSA and have been properly compensated and that the Company has meritorious**

** **

**12**

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**groundsfor an appeal of this judgment. However, the outcome of any litigation isinherently uncertain. Resolution of this matter could have a material effect onthe Company’s financial position, liquidity or results of operation.**

** **

**TheCompany is involved in numerous other legal proceedings and claims incidentalto its business, including litigation related to alleged failures to complywith various state and federal employment laws. While the ultimate outcomecannot be determined, the Company currently believes that these proceedings andclaims, both individually and in the aggregate, should not have a materialadverse effect on the Company’s financial position, liquidity or results ofoperations. However, the outcome of any litigation is inherently uncertain and,if decided adversely to the Company, the Company may be subject toliability that could have a material adverse effect on the Company’s financialposition, liquidity or results of operations.**

** **

9.     Subsequent Events:

 

As discussed in Note 8above, the Company received an adverse jury verdict on March 3, 2006,associated with a case in Tuscaloosa, Alabama. Since the events that gave riseto the litigation occurred prior to the balance sheet date, the Companyrecorded the estimated $45.0 million litigation charge in the second quarter offiscal 2006.

 

**Asdiscussed in Note 5 above, the Company paid $32.7 million in cash to a bank on March 9,2006, to settle its forward contract associated with the overnight sharerepurchase transaction. The settlement of the forward contract will be recordedas an adjustment to retained earnings in the third quarter of fiscal 2006.**

 

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**Item 2. Management’sDiscussion and Analysis of Financial 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 February 25,2006, and February 26, 2005 (“second quarter of fiscal 2006” and “secondquarter of fiscal 2005”, respectively) and the twenty-six-week periods ended February 25,2006, and February 26, 2005 (“first half of fiscal 2006” and “first halfof fiscal 2005”, respectively). This discussion should be read in conjunctionwith, and is qualified by, the financial statements included in this quarterlyreport and 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 Half Results and Fiscal 2006 Outlook**

** **

During the first half of fiscal 2005, the Companybegan the implementation 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 will continuethese initiatives as discussed below.

 

•                              Coolers – The installation of refrigerated coolers for the sale ofperishable food began in the second quarter of fiscal 2005. The customertraffic generated by coolers has increased sales of food and other merchandisethroughout the store. At the end of fiscal 2005, refrigerated coolers wereinstalled in approximately 1,000 stores. The Company plans to installrefrigerated coolers in approximately 2,500 additional stores by the end offiscal 2006. In addition, the Company is developing a broader food strategy, a part ofwhich involves testing new point-of-sale software in a limited number of storesto facilitate the acceptance of food stamps in stores with refrigerated coolers.At the end of the first half of fiscal 2006, approximately 2,000 stores hadrefrigerated coolers for the sale of perishable food.

•                              “Treasure Hunt” merchandise program – During fiscal 2005, the Companybegan supplementing its basic assortment of merchandise with additionalopportunistically purchased goods designed to create more excitement in storesthroughout the year, with particular emphasis on holidays, spring andback-to-school seasons, and to balance gross margin pressure from increasedsales of lower margin consumables. During fiscal 2006, the Company is taking amore process-oriented approach to this initiative by focusing on three keycomponents: identifying and selecting exciting values for customers; informingcustomers of the compelling values through circulars and in-store handouts andsignage; and effectively displaying the items in stores to attract customerattention.

•                              New Stores – During fiscal 2005, the Company opened 500 stores andclosed 68 stores, with a substantial percentage of the new store openingsoccurring in the last months of the fiscal year. In order to build processesthat will support a more balanced distribution of store openings throughout theyear, the Company plans to open approximately 400 stores and closeapproximately 65 stores in fiscal 2006. During the first half of fiscal 2006,the Company opened 160 stores and closed 56 stores.

•                              Urban Initiative – The Urban Initiative is designed to improve theoperating performance of high sales volume stores in large metropolitan marketsthrough investments in people, process changes and technology, includingorganizational changes to support a more mobile and flexible workforce. Duringfiscal 2005, the Urban Initiative was implemented in approximately 1,200 stores.While the Urban Initiative stores experienced solid comparable store salesgrowth and continued to be profitable during fiscal 2005, the Company’sprofitability goals were not achieved. For fiscal 2006, the Company willcontinue its investments in the current Urban Initiative markets (approximately1,400 stores at the end of the first half of fiscal 2006) but does not expectto expand the initiative into new markets until processes have been refined togenerate improved results. The Company is focused on three primary goals:  improving financial returns, reducinginventory shrinkage and increasing store manager retention. During the firsthalf of fiscal 2006, the Company saw an improvement in profitability in mostUrban Initiative markets, resulting from positive trends in comparable storesales and improvements in inventory shrinkage 

 

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in the stores that implemented the Urban Initiativefirst in fiscal 2005.

 

During the first quarter of fiscal 2006, HurricanesKatrina, Rita and Wilma struck the U.S. Gulf Coast and Florida, impactingnumerous stores in the afflicted areas. Since the Company’s stores are widelydispersed, lost sales due to closed stores resulting from damage or poweroutages were generally limited and continue to be substantially offset byincreased sales in other stores. The most significant storm-related losses wererelated to the loss of merchandise inventories, furniture and fixtures andleasehold improvements at individual stores in the paths of the storms. TheCompany expects the majority of the losses incurred will be covered byinsurance. During the second quarter of fiscal 2006, the Company received aninitial payment from its insurance carrier for a portion of these claims. Thenet impact of these storms has not had and is not expected to have a materialimpact in the aggregate on the Company’s financial position, liquidity orresults of operations.

 

Fiscal 2006 Outlook

Based on operating results for the first half offiscal 2006, as discussed below, and the Company’s plans for the remainder ofthe year, the Company currently expects diluted net income per common share tobe between $1.19 and $1.24 for fiscal 2006, compared to $1.30 in fiscal 2005. The diluted net income per common shareguidance for fiscal 2006 includes the impact ($0.18 per diluted share) of anadverse litigation judgment, as discussed in the Company’s Second QuarterResults and Year-to-date Results below and Note 8 to the Consolidated CondensedFinancial Statements included in this Report. The diluted net income percommon share guidance for fiscal 2006 also includes the impact of the expensingof stock-based compensation as required by Statement of Financial AccountingStandards (“SFAS”) No. 123R, “Share-Based Payment,” and other newcompensation programs, the interest expense related to the Company’s debtplacement, and the accretive benefit of the Company’s share repurchase program.See Note 6 to the Consolidated Condensed Financial Statements included in thisReport and the Selling, General and Administrative Expenses section inthis MD&A for more information on SFAS 123R and its impact. See theLiquidity and Capital Resources section in this MD&A for moreinformation on the Company’s share repurchase program and related debtplacement.

 

**Second Quarter Results and Third Quarter Outlook**

** **

# **NetSales**

Net sales in the second quarter of fiscal 2006 were$1.7 billion, an increase of approximately 9.4% ($148.9 million), as comparedwith an increase of 13.1% ($184.0 million) in the second quarter of fiscal 2005.The increase was attributable, in part, to increased sales in comparable stores(stores open more than 13 months) of 3.2% ($49.5 million), with the balance ofthe increase primarily relating to sales from new stores opened as part ofthe Company’s store growth program. The comparable store sales calculation forthe second quarter of fiscal 2006 excludes a limited number of stores that wereclosed for an extended period of time as a result of the hurricanes asdiscussed above. The solid salesperformance during the second quarter of fiscal 2006 was driven primarily bythe installation of refrigerated coolers, the Urban Initiative and the “TreasureHunt” merchandise program. Sales of lower-margin basic consumables continued tobe stronger than sales of higher-margin discretionary goods during the secondquarter of fiscal 2006, reflecting the difficult economic environment,including higher energy prices, faced by the Company’s low and lower-middleincome customer base. However, holiday sales of higher margin items along withfavorable sales trends in the home department helped offset substantially allof the negative effect of the sales of lower margin items.

 

The 3.2% increase in comparable store sales duringthe second quarter of fiscal 2006 includes an increase of approximately 4.9% inthe sales of hardline merchandise and a decrease of approximately 3.6% in thesales of softline merchandise. In the second quarter of fiscal 2006, thecustomer count, as measured by the number of register transactions incomparable stores, decreased approximately 1.0%, and the average transactionincreased approximately 4.2% to $10.28. Recent research from an independentmarket research group suggests that low-income customers have reduced theirtotal shopping frequency, combining trips and errands in response to highergasoline prices. The Company’s declining customer count trends and increasingtransaction size during the second quarter of fiscal 2006 are consistent withthis research. Increased sales of hardline merchandise have been the primarycontributor to the overall sales increases. Hardline merchandise, as apercentage of net sales, increased to approximately 80.1% in the second quarterof fiscal 2006 compared to approximately 78.7% in the second quarter of fiscal2005. Softline merchandise, as a percentage of net sales, decreased toapproximately 19.9% in the second quarter of fiscal 2006 compared toapproximately 21.3% in the second quarter of fiscal 2005.

 

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TheCompany distributed two advertising circulars in the second quarter of fiscal2006, compared with one advertising circular in the second quarter of fiscal2005. The circulars are designed to stimulate traffic and inform customersabout the Company’s “Treasure Hunt” merchandise, seasonal values and competitiveprices on core consumables.

 

**Hardlinemerchandise includes household chemical and paper products, candy, snacks andother food, health and beauty aids, electronics, housewares and giftware, petfood and supplies, toys, stationery and school supplies, seasonal goods,hardware and automotive supplies. Softline merchandise includes men’s, women’s,boys’, girls’ and infants’ clothing, shoes, and domestic items such asblankets, sheets and towels.**

** **

**Theaverage number of stores in operation during the second quarter of fiscal 2006was 7.3% higher than the average number of stores in operation during thesecond quarter of fiscal 2005.**

** **

The Company currently expects comparable storesales to increase 4% to 6% during the third quarter of fiscal 2006 as a resultof the ongoing rollout of refrigerated coolers, the impact from “Treasure Hunt”merchandise sales and the operational improvements resulting from the UrbanInitiative program.

 

Cost of Sales

Cost of sales increased approximately 9.3% in thesecond quarter of fiscal 2006 compared with the second quarter of fiscal 2005. Thisincrease primarily reflected the additional sales volume between years. Cost ofsales, as a percentage of net sales, decreased slightly to 67.1% in the secondquarter of fiscal 2006, compared with 67.2% in the second quarter of fiscal2005. As a percentage of net sales,transportation expense, markdown expense, merchandise mix, and inventoryshrinkage in the second quarter of fiscal 2006 were all relatively unchangedcompared with the second quarter of fiscal 2005. Higher year-over-year fuelcosts were offset by transportation productivity and efficiency savings, aswell as savings from an overall reduction in shipments resulting from betterinventory management. Sales of higher margin items during the holiday seasonand favorable sales trends in the home area mitigated the negative impact fromsales of lower-margin basic consumables. While the favorable inventoryshrinkage trend experienced in the first quarter of fiscal 2006 slowed duringthe second quarter of fiscal 2006, the stores that implemented the UrbanInitiative first in fiscal 2005 have reported significantly lower inventoryshrinkage results. The Company expects to continue its focus in this area in aneffort to reduce inventory shrinkage.

 

During the third quarter of fiscal 2006, the Companyexpects that cost of sales, as a percentage of net sales, will increase ascompared to fiscal 2005 due to the continuing effect of the shift in themerchandise mix to more lower-margin basic consumables.

 

**Selling, General andAdministrative Expenses**

Selling, general and administrative (“SG&A”)expenses increased 10.8% in the second quarter of fiscal 2006, compared withthe second quarter of fiscal 2005. The increases in these expenses were dueprimarily to additional costs arising from the continued growth in the numberof stores in operation. SG&A expenses, as a percentage of net sales, were25.2% in the second quarter of fiscal 2006, compared with 24.9% in the secondquarter of fiscal 2005. The increase inthe percentage for the second quarter of fiscal 2006 was due primarily toincreased occupancy costs (approximately 0.6% of net sales) and increasedcompensation expense related to the expensing of stock-based compensation asrequired by SFAS 123R and other compensation programs (approximately 0.2% ofnet sales). The increase in occupancy costs was due primarily to higher utilitycosts and higher depreciation charges, especially as it relates to the urbanmarkets. Partially offsetting these increases were decreases in store payrollexpenses (approximately 0.3% of net sales) and insurance costs (approximately0.1% of net sales). Refinements in the Urban Initiative and improvements in thestore payroll allocation process enabled the Company to reduce store payrollexpenses, as a percentage of net sales. The percentage decrease in insurancecosts is primarily due to a corresponding reduction in health care claims.

 

During the third quarter of fiscal 2006, the Companyexpects SG&A expense, as a percentage of net sales, to increase slightly ascompared to fiscal 2005 due to higher occupancy costs, the expanded rollout ofthe cooler program and the continued investments in the existing UrbanInitiative markets. In addition, the required expensing of stock-basedcompensation and other compensation plan changes, as discussed in the Company’s2006 Annual Meeting Proxy Statement, is expected to increase SG&A expenses,as a percentage of net sales.

 

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**Litigation Charge**

**During the second quarter offiscal 2006, the Company recorded a $45.0 million ($0.18 per diluted share)litigation charge associated with an adverse litigation judgment in a case inTuscaloosa, Alabama.**The jury in this particular case found that the Companyshould have classified a number of its store managers as hourly employeesentitled to overtime pay rather than as salaried managers. The Company believesthat it is correct in classifying its store managers as salaried managers andplans to appeal the verdict. See Note 8 to the ConsolidatedCondensed Financial Statements included in this Report for more information. Allother legal expenses during the second quarter 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 interest incomeduring the second quarter of fiscal 2006, compared with the second quarter offiscal 2005 was due to an increase in interest rates and investments.**

** **

**Interest Expense**

On September 27, 2005, the Company obtained$250 million in aggregate proceeds through a private placement of unsecuredSenior Notes (the “Notes”) to a group of institutional accredited investors. Duringthe second quarter of fiscal 2006, the Company incurred $3.0 million ininterest expense related to the Notes. See Note 4 to the Consolidated CondensedFinancial Statements included in this Report for information on the Company’scurrent and long-term debt. The Company did not incur any interest expenseduring fiscal 2005.

 

**Provision for Taxes on Income**

The effective tax rate was37.0% for the second quarter of fiscal 2006, compared with 36.7% for the secondquarter of fiscal 2005. Forthe third quarter of fiscal 2006, the Company’s plan is for the effective taxrate to remain at 37.0%, but could be negatively impacted if a retroactivereinstatement of certain federal jobs tax credits for employees hired after December 31,2005 does not occur.

 

Net Income and Earnings Per Share

Net income for the secondquarter was $54.5 million compared with net income of $80.1 million for thesecond quarter of fiscal 2005. Included in the results for the second quarterof fiscal 2006 is a litigation charge of $28.4 million, net of taxes,associated with an adverse litigation judgment in a case in Tuscaloosa, Alabama.See Note 8 to the Consolidated Condensed Financial Statements included in thisReport for more information. 

 

Diluted net income percommon share was $0.35 in the second quarter of fiscal 2006, compared with$0.48 in the second quarter of fiscal 2005. The decrease in diluted net incomeper common share is due to the decrease in net income as discussed above,partially offset by the accretive benefit of the Company’s share repurchaseprogram. The Companycurrently expects diluted net income per common share to be between $0.33 and$0.36 for the third quarter of fiscal 2006.

 

**Year-to-date Results**

** **

# **NetSales**

Net sales in the first half of fiscal 2006 were $3.2billion, an increase of approximately 9.4% ($280.1 million), as compared withan increase of 12.1% ($319.5 million) in the first half of fiscal 2005. Theincrease was attributable, in part, to increased sales in comparable stores(stores open more than 13 months) of 3.1% ($89.7 million), with the balance ofthe increases primarily relating to sales from new stores opened as part ofthe Company’s store growth program. The comparable store sales calculation forthe first half of fiscal 2006 excludes a limited number of stores that wereclosed for an extended period of time as a result of the hurricanes asdiscussed above. The solid salesperformance during the first half of fiscal 2006 was driven primarily by theinstallation of refrigerated coolers, the Urban Initiative and the “TreasureHunt” merchandise program. Sales of lower-margin basic consumables continued tobe stronger than sales of higher-margin discretionary goods during the firsthalf of fiscal 2006, reflecting the difficult economic environment, includinghigher energy prices, faced by the Company’s low and lower-middle incomecustomer base. However, certain categories of discretionary goods, such as toysand electronics, as well as home products and higher margin seasonal itemsperformed well.

 

The 3.1% increase in comparable store sales duringthe first half of fiscal 2006 includes an increase of approximately 4.6% in thesales of hardline merchandise and a decrease of approximately 2.6% in the salesof

 

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softlinemerchandise. In the first half of fiscal 2006, the customer count, as measuredby the number of register transactions in comparable stores, decreasedapproximately 1.6%, and the average transaction increased approximately 4.6% to$9.83. Increased sales of hardline merchandise have been the primarycontributor to the overall sales increases. Hardline merchandise, as apercentage of net sales, increased to approximately 80.0% in the first half offiscal 2006 compared to approximately 78.9% in the first half of fiscal 2005. Softlinemerchandise, as a percentage of net sales, decreased to approximately 20.0% inthe first half of fiscal 2006 compared to approximately 21.1% in the first halfof fiscal 2005. The Company distributed three advertising circulars in thefirst half of fiscal 2006 and two advertising circulars in the first half offiscal 2005. The circulars are designed to stimulate traffic and inform customersabout the Company’s “Treasure Hunt” merchandise, seasonal values andcompetitive prices on core consumables.

 

**The average number of stores in operation during thefirst half of fiscal 2006 was 7.5% higher that the average number of stores inoperation during the first half of fiscal 2005. The Company had 6,002 stores inoperation at the end of the first half of fiscal 2006, compared with 5,600stores in operation at the end of the first half of fiscal 2005, representingan increase of approximately 7.2%.**

** **

Cost of Sales

Cost of sales increased approximately 9.2% in thefirst half of fiscal 2006 compared with the first half of fiscal 2005. Thisincrease primarily reflected the additional sales volume between years. Cost ofsales, as a percentage of net sales, decreased slightly to 66.8% in the firsthalf of fiscal 2006, compared with 66.9% in the first half of fiscal 2005. Theslight decrease in cost of sales, as a percentage of net sales, during thefirst half of fiscal 2006 was due primarily to the favorable impact of lowerinventory shrinkage and improved initial mark-ups. The initiatives the Companyhas implemented to address inventory shrinkage are having a positive impact,but the Company expects to continue to focus its efforts in this area. Theseimprovements were offset by higher freight costs resulting from higher fuelcosts. The opening of the Company’s eighth distribution center in Marianna,Florida, in the second quarter of fiscal 2005 and its continued ramp-up havepositively impacted freight costs by lowering the average distance to thestores from the distribution centers. Increases in transportation productivityand efficiency, as well as a reduction in shipments resulting from betterinventory 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 andAdministrative Expenses**

SG&A expenses increased 11.9% in the first halfof fiscal 2006, compared with the first half of fiscal 2005. The increases inthese expenses were due primarily to additional costs arising from thecontinued growth in the number of stores in operation. SG&A expenses, as apercentage of net sales, were 26.6% in the first half of fiscal 2006, comparedwith 26.0% in the first half of fiscal 2005. The increase in the percentage forthe first half of fiscal 2006 was due primarily to increased occupancy costs(approximately 0.5% of net sales), increased insurance costs (approximately0.1% of net sales) and increased compensation expense related to the expensingof stock-based compensation as required by SFAS 123R and other compensationprograms (approximately 0.2% of net sales). The increase in occupancy costs wasdue primarily to higher utility costs and higher depreciation charges,especially as it relates to urban markets. The increase in insurance costs wasprimarily a result of a limited number of large claims in the health care andworkers’ compensation areas as well as some hurricane related costs, offsetslightly by a reduction in health care claims during the second quarter offiscal 2006. These increases werepartially offset by a reduction in store payroll expenses (approximately 0.2%of net sales). Refinements in the Urban Initiative and improvements in thestore payroll allocation process enabled the Company to reduce store payrollexpenses, as a percentage of net sales.

 

**Litigation Charge**

**During the first half of fiscal2006, the Company recorded a $45.0 million ($0.18 per diluted share) litigationcharge associated with an adverse litigation judgment in a case in Tuscaloosa,Alabama.**The jury in this particular case found that the Companyshould have classified a number of its store managers as hourly employeesentitled to overtime pay rather than as salaried managers. The Company believesthat it is correct in classifying its store managers as salaried managers andplans to appeal the verdict. See Note 8 to the

 

18

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**Consolidated Condensed FinancialStatements included in this Report for more information. All other legalexpenses during the first half of both fiscal 2006 and fiscal 2005, includingthe Company’s defense costs related to the above-referenced case, were recordedin SG&A.**

** **

**Interest Income**

**The increase ininterest income during the first half of fiscal 2006, compared with the firsthalf of fiscal 2005 was due to an increase in interest rates and investments.**

** **

**Interest Expense**

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. During the first half offiscal 2006, the Company incurred $5.1 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 was37.0% for the first half of fiscal 2006, compared with 36.5% for the first halfof fiscal 2005. A retroactive reinstatement of certain federal jobs tax creditsfor employees hired after December 31, 2003, favorably impacted theeffective tax rate in the first half of fiscal 2005.

 

Net Income and Earnings Per Share

Net income for the firsthalf of fiscal 2006 was $105.9 million compared with net income of $134.5million for the first half of fiscal 2005. Included in the results for thefirst half of fiscal 2006 is a litigation charge of $28.4 million, net oftaxes, associated with an adverse litigation judgment in a case in Tuscaloosa,Alabama. See Note 8 to the Consolidated Condensed Financial Statements includedin this Report for more information. 

 

Diluted net income percommon share was $0.67 in the first half of fiscal 2006, compared with $0.80 inthe first half of fiscal 2005. The decrease in diluted net income per commonshare is due to the decrease in net income as discussed above, partially offsetby the accretive benefit of the Company’s share repurchase program.

 

**Liquidity and Capital Resources**

** **

At the end of the first half of fiscal 2006, the Companyhad working capital of $553.4 million, compared with $460.2 million as of August 27,2005. Changes in working capital during the first half of fiscal 2006 andfiscal 2005 were primarily the result of earnings, changes in merchandiseinventories and capital expenditures. The Company’s inventories at the end ofthe first half of fiscal 2006 were 6.6% higher than at the end of the firsthalf of fiscal 2005. Inventory on a per store basis at the end of the firsthalf of fiscal 2006 was flat compared with inventory on a per store basis atthe end of the first half of fiscal 2005 while overall softline inventory was approximately 7% lower.

 

**Capitalexpenditures for the first half of fiscal 2006 were approximately $97.8 millionand are currently expected to be approximately $210 million to $230 million forfiscal 2006. The majority of the planned capital expenditures for fiscal 2006relate to the Company’s new store openings; existing store expansions,relocations and renovations; construction of distribution centers; expendituresrelated to store-focused technology infrastructure; and the continuedimplementation of a refrigerated cooler program for perishable goods inselected stores. The new store expansion and new distribution centers alsorequire additional investment in merchandise inventories.**

** **

**Inthe first half of fiscal 2006, the Company opened 160 stores, closed 56 storesand expanded, relocated, or renovated 20 stores. The Company plans to openapproximately 400 stores and close approximately 65 stores during fiscal 2006. TheCompany also plans to relocate, expand, or renovate approximately 75 storesduring fiscal 2006. The Company occupies most of its stores under operatingleases. Store opening, closing, expansion, relocation, and renovation plans, aswell as overall capital expenditure plans, are continuously reviewed and aresubject to change.**

 

During fiscal2005 the Company purchased in the open market 3.3 million shares of its commonstock at a cost of $92.0 million. 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,

 

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the Company executed an overnight sharerepurchase transaction with a bank for the acquisition of 10 million shares, orapproximately 6%, of the Company’s outstanding common stock for an initialpurchase price of $19.97 per share. The transaction was financed with theproceeds of the Notes. Aspart of the overnight share repurchase transaction, the Companysimultaneously entered 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 receive from or pay to thebank a price adjustment based on the volume weighted average purchase price ofthe Company’s common stock during the purchase period compared to the initialpurchase price. Such price adjustment could be either in cash or common stockat the discretion of the Company. On March 9, 2006, at its option, the Companypaid $32.7 million in cash to the bank to settle the forward contract. See Note 4 and Note 5to the Consolidated Condensed Financial Statements included in this Report formore information. The shares repurchased in connection with the overnight sharerepurchase transaction were immediately canceled and returned to the status ofauthorized but unissued shares. There were no other purchases of common stockby the Company during the first half of fiscal 2006. As of February 25, 2006, the Company hadoutstanding authorizations to purchase a total of approximately 7.7 millionshares, consisting of approximately 3.8 million shares (based on the closingshare price) remaining under the authorization for $300 million of stockrepurchases approved by the Board of Directors on August 19, 2005, andapproximately 3.9 million shares remaining pursuant to authorizations approvedby the Board of Directors prior to August 19, 2005. The Company plans tocontinue common stock purchases utilizing a 10b5-1 program.

 

The Companyhas unsecured revolving credit facilities with banks for short-term borrowingsof up to $200 million. On May 25, 2006, $100 million of the facilities willexpire, and the remaining $100 million will expire on May 31, 2010. The Companyexpects that the facilities expiring on May 25, 2006, will be extended. TheCompany had no outstanding borrowings against these facilities during the firsthalf of fiscal 2006 or during fiscal 2005. Cash flow from current operationsand available revolving credit facilities, as discussed above, are expected tobe sufficient to meet planned liquidity and operational capital resource needs,including store expansion and other capital spending programs, scheduledinterest payments, and any further repurchase of the Company’s common stock.

 

The following table shows the Company’s obligationsand commitments as of the end of the second quarter of 2006 to make futurepayments under contractual obligations:

 
| ** **                     | ** ** | **Payments Due During One Year  Fiscal Period Ending** | ** ** |
|--------------------------------|------------|--------------------------------------------------------|------------|
| **(in thousands)**             | ** ** | ** **                                             | ** ** | **February** | ** ** | **February** | ** ** | **February** | ** ** | **February** | ** ** | **February** | ** ** | ** ** | ** ** |
| **Contractual Obligations**    | ** ** | **Total**                                              | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** | **Thereafter** | ** ** |
| Long-term  debt                |       | $                                                      | 250,000    |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | 250,000 |   |
| Interest                       |       | $                                                      | 123,151    |   | 13,387 |   | 13,387 |   | 13,387 |   | 13,387 |   | 13,387 |   | 56,216 |   |
| Merchandise  letters of credit |       | $                                                      | 69,095     |   | 69,095 |   | — |   | — |   | — |   | — |   | — |   |
| Operating  leases              |       | $                                                      | 1,167,842  |   | 263,306 |   | 231,697 |   | 195,515 |   | 154,023 |   | 110,487 |   | 212,814 |   |
| Construction  obligations      |       | $                                                      | 18,985     |   | 18,985 |   | — |   | — |   | — |   | — |   | — |   |
| Total                          |       | $                                                      | 1,629,073  |   | $ | 364,773 |   | $ | 245,084 |   | $ | 208,902 |   | $ | 167,410 |   | $ | 123,874 |   | $ | 519,030 |   |

 

Most of the Company’s operating leasesprovide the Company with an option to extend the term of the lease atdesignated rates.

 

The following table shows the Company’s othercommercial commitments as of the end of the second quarter of fiscal 2006:

** **
| **Other Commercial Commitments (in  thousands)** | ** ** | **Total Amounts  Committed** | ** ** |
|--------------------------------------------------|------------|------------------------------|------------|
| Standby letters of credit                        |       | $                            | 111,031    |   |
| Surety bonds                                     |       | 6,511                        |       |
| Total Commercial Commitments                     |       | $                            | 117,542    |   |

 

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**At the end of the second quarterof fiscal 2006, approximately $28.9 million of the merchandise letters ofcredit were included in accounts payable on the Company’s ConsolidatedCondensed Balance Sheet. A substantial portion of the outstanding amount ofstandby letters of credit and surety bonds (which are primarily renewed on anannual basis) are used as surety for future premium and deductible payments tothe Company’s workers’ compensation and general liability insurance carrier. TheCompany accrues for these future payment liabilities as described in the “CriticalAccounting Policies” section of this discussion.**

** **

**Critical Accounting 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 seasonalmerchandise than for non-seasonal goods. The Company also provides forestimated inventory losses for damaged, lost or stolen inventory for the periodfrom the physical inventory to the financial statement date. These estimatesare based on historical experience and other factors.

 

***Propertyand 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 berecoverable. Historically, impairment losses on fixed assets have not been materialto the Company’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 be much more pronounced than the percentage increase in the expense.The Company’s self-insurance liabilities are based on the total estimated costsof claims filed and estimates of claims incurred but not reported, less amountspaid against such claims, and are not discounted. Management reviews currentand historical 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.

 

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*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 beginamortization, which is generally when the Company enters the space and beginsto make improvements in preparation of intended use. For tenant improvementallowances and rent holidays, the Company records a deferred rent liability atthe inception 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 andprojected employee stock option exercise behaviors. 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 orimplied projections of revenue or expenditures, statements of plans andobjectives for future operations, growth or initiatives, statements of futureeconomic performance, or statements regarding the outcome or impact of pendingor threatened litigation. These forward-looking statements may beidentified by the use of the words “plan,” “estimate,” “expect,” “anticipate,” “probably,”“should,” “project,” “intend,” “continue,” and other similar terms andexpressions. Various risks, uncertainties and other factors may cause theCompany’s actual results to differ materially from those expressed or impliedin any forward-looking statements. Factors, uncertainties and risks that may resultin actual results differing from such forward-looking information include, butare not limited to those listed below, as well as other factors discussedthroughout this Report, including, without limitation, the factors describedunder “Critical Accounting Policies.”

 

*Success of merchandising and marketing programs*

 

The Company undertakes new programs and refinesexisting programs to increase net sales and its customer base. The Company may beadversely impacted if merchandise and marketing programs fail to attractcustomers into its stores or if the merchandising programs implemented by theCompany 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 and/or operations of theCompany.

 

*Competitive factors*

 

The Company is in a highly competitive sector of thediscount retail merchandise sector with numerous competitors, some of whom may havegreater resources than the Company. The Company competes for customers,merchandise, real estate locations and employees. This competitive environmentsubjects the

 

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Companyto various risks, including the ability to continue its store and sales growthand provide attractive merchandise to its customers at competitive prices thatallow 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 theCompany’s profitability and/or sales. The Company’s ability to pass onincremental pricing changes may be limited due to operational and/orcompetitive factors. Increases in prices, including changes in energy prices, may impactthe Company’s customer base by limiting the amount of discretionary spending ofits customers and may impact the Company through increased costs of goodsand/or increased operating 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 lowernet sales than expected on a quarterly or annual basis. In addition, changes inthe types of products made available for sale and the selection of the productsby customers 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 or interruptionsin the transportation and distribution of products could have an adverse impacton 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 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

 

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processcould negatively impact store operations. Finally, the Company’s operations arefacilitated by the use of various technologies, the disruption or failure ofwhich could negatively impact the Company’s operations.

 

*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 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 costsassociated with 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 storeoperations level, in distribution facilities, and at the corporate level,including the Company’s senior management team. Adverse changes in health carecosts could also adversely impact the Company’s ability to achieve itsoperational and financial goals and to offer attractive benefit programs to itsemployees.

 

*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 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.

 

# **Item3. 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.

 

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TheCompany had no outstanding borrowings against these facilities during the firsthalf of fiscal 2006. The Company’s long-term debt associated with the Notesbears interest at fixed rates.

 

#### **Item4. Controls and 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 Securities Exchange Act of 1934, as amended (the “Exchange Act”)) wereeffective to provide reasonable assurance that information required to bedisclosed by the Company in reports that the Company files or submits under theExchange Act is recorded, processed, summarized and reported within the timeperiods specified in Securities and Exchange Commission (“SEC”) rules andforms and that such information is accumulated and communicated to the Company’smanagement, including the Chief Executive Officer and Chief Financial Officer,to allow timely decisions regarding required disclosures.

 

The Company is continuously seeking to improve theefficiency and effectiveness of its operations and of its internal controls. Thisresults in refinements to processes throughout the Company. However, there hasbeen no change in the Company’s internal control over financial reportingduring the most recent fiscal quarter that has materially affected, or isreasonably likely to materially affect, the Company’s internal control overfinancial reporting.

 

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**PART II - OTHER INFORMATION**

 

**Item 1. LegalProceedings**

** **

**The information in Note 8 to the Consolidated Condensed FinancialStatements contained in Part I, Item 1 of the Form 10-Q isincorporated herein by this reference.**

** **

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

** **

The following table sets forth information withrespect to purchases of shares of the Company’s common stock made during thequarter ended February 25, 2006, by or on behalf of the Company or any “affiliatedpurchaser” as defined by Rule 10b-18(a)(3) of the Securities ExchangeAct 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** | ** ** | **Maximum Number  of Shares that May  Yet Be Purchased  Under the Plans or  Programs(1)** | ** ** |
|---------------------|------------|----------------------------------------|------------|------------------------------------|------------|-----------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------|------------|
| December            |       |                                   |       |                               |       |                                                                                          |       |                                                                                      |       |
| (11/27/05-12/31/05) |       | —                                 |       | —                             |       | —                                                                                        |       | 7,868,607                                                                                 |       |
| January             |       |                                   |       |                               |       |                                                                                          |       |                                                                                      |       |
| (1/01/06-1/28/06)   |       | —                                 |       | —                             |       | —                                                                                        |       | 7,947,648                                                                                 |       |
| February            |       |                                   |       |                               |       |                                                                                          |       |                                                                                      |       |
| (1/29/06-2/25/06)   |       | —                                 |       | —                             |       | —                                                                                        | ** ** | 7,743,708                                                                                 | **(2)**    |

 

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(1)          Includes amounts converted to shares using the Company’s closing stockprice as of the end of each fiscal month.

(2)          Does not reflect the $32.7 million cash payment made on March 9,2006, to settle the forward contract associated with the overnight sharerepurchase transaction.

 

**As previously reported, on October 4,2005, the Company executed an overnight share repurchase transaction with abank for the acquisition of 10 million shares, or approximately 6%, of theCompany’s outstanding common stock. The transaction was financed with theproceeds of the Company’s Notes. Under the terms of the overnight sharerepurchase transaction, the bank purchased shares in the open market to fulfillits obligations related to shares sold to the Company.  Such purchases by the bank included purchasesduring the quarter ended February 25, 2006. See Note 4 and Note 5 to the Consolidated Condensed Financial Statementsincluded in this Report for more information. There were no other purchases ofcommon stock by the Company during the first half of fiscal 2006. Shares arepurchased pursuant to share repurchase authorizations approved by the Board ofDirectors.**As of February 25, 2006, theCompany had outstanding authorizations to purchase a total of approximately 7.7million shares, consisting of approximately 3.8 million shares (based on theclosing share price) remaining under the authorization for $300 million ofstock repurchases approved by the Board of Directors on August 19, 2005,and approximately 3.9 million shares remaining pursuant to authorizationsapproved by the Board of Directors prior to August 19, 2005. Sharespurchased prior to the end of fiscal 2005 under the share repurchaseauthorizations are held in treasury or have been reissued under the FamilyDollar 2000 Outside Directors Plan. Shares that are purchased with the proceedsof the Notes are canceled and returned to the status of authorized but unissuedshares. There is no expiration date governing the period during which theCompany can make share repurchases pursuant to the above referencedauthorizations. There are no other repurchase programs under which the Companyis authorized to repurchase outstanding shares.

** **

**Item4. Submission of Matters to a Vote of Security Holders**

** **

**At the Annual Meeting ofStockholders of the Company held January 19, 2006, stockholders voted to:**

** **

**(a)**          Elect to the Board of Directors of the Company the seven nominees namedin the Proxy Statement for the Annual Meeting as follows:

** **

**26**

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** **
| **Nominee**                  | ** ** | **Shares  Voting For** | ** ** | **Shares  Withholding  Authority to Vote** | ** ** |
|------------------------------|------------|------------------------|------------|--------------------------------------------|------------|
| Howard R.  Levine            |       | 136,335,065            |       | 2,776,961                                  |       |
| Mark R.  Bernstein           |       | 134,918,774            |       | 4,193,252                                  |       |
| Sharon  Allred Decker        |       | 136,769,199            |       | 2,342,827                                  |       |
| Edward C.  Dolby             |       | 137,299,797            |       | 1,812,229                                  |       |
| Glenn A.  Eisenberg          |       | 137,309,176            |       | 1,802,850                                  |       |
| George R.  Mahoney, Jr. |       | 136,472,023            |       | 2,640,003                                  |       |
| James G.  Martin             |       | 136,723,969            |       | 2,388,057                                  |       |

 

**Therewere no abstentions or broker non-votes with respect to the election to theBoard of Directors.**

** **

**(b)**         Approvethe Family Dollar Stores, Inc. 2006 Incentive Plan, which permits thegranting of a variety of award types, including stock options and performanceshare rights, with 95,312,532 shares voted for, 24,811,374 shares voted againstand 1,179,367 shares abstaining. There were 17,808,753 broker non-votes withrespect to the approval of the 2006 Incentive Plan.

** **

**(c)**          Ratify the action of the Audit Committee of the Board of Directors inappointing PricewaterhouseCoopers LLP as independent registered publicaccountants to audit the consolidated financial statements of the Company andits subsidiaries for the year ending August 26, 2006, with 137,062,802shares voted for, 1,134,909 shares voted against and 914,314 shares abstaining.There were no broker non-votes with respect to the appointment ofPricewaterhouseCoopers LLP.

** **

**Item 6.Exhibits**

** **

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

** **

**10.1**                                       Family Dollar Stores, Inc. 2006 Incentive Plan (filed as Exhibit 10.1to the Company’s Current Report on Form 8-K filed January 25, 2006)

** **

**10.2**                                       2006 Incentive Plan Guidelines for Long Term Incentive Performance ShareRights Awards (filed as Exhibit 10.2 to the Company’s Current Report on Form 8-Kfiled January 25, 2006)

** **

**10.3**                                       2006 Non-Qualified Stock Option Grant Program (filed as Exhibit 10.3to the Company’s Current Report on Form 8-K filed January 25, 2006)

** **

**10.4**                                       Fourth Amendment to Amended and Restated Credit Agreement between theCompany and Family Dollar, Inc., as Borrower, and Bank of America, N.A.,dated as of March 21, 2006 (filed as Exhibit 10(a) to theCompany’s Current Report on Form 8-K filed March 23, 2006)

** **

**10.5**                                       Fourth Amendment to Credit Agreement between the Company and FamilyDollar, Inc., as Borrower, and Wachovia Bank, National Association, datedas of March 21, 2006 (filed as Exhibit 10(b) to the Company’sCurrent Report on Form 8-K filed March 23, 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 adopted pursuantto Section 302 of the Sarbanes-Oxley Act of 2002

** **

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

 

27

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**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

 

28

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SIGNATURES

 

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

 

 
|                       | FAMILY DOLLAR STORES, INC.       |                 |
|----------------------------|---------------------------------------|----------------------|
|                       | (Registrant)                          |
|                       |                                  |
|                       |                                  |
| Date: March 31, 2006  |                                  | /s/ R. James Kelly   |   |
|                       | R. JAMES KELLY                        |
|                       | Vice Chairman-Chief Financial Officer |
|                       |                                  |
|                       |                                  |
| Date: March 31,  2006 |                                  | /s/ C. Martin Sowers |   |
|                       | C. MARTIN SOWERS                      |
|                       | Senior Vice President-Finance         |
|                            |                                       |                      |  |  |

 

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