**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C.**

**FORM 10-Q**

**Quarterly Report Pursuantto Section 13 or 15(d) of theSecurities and Exchange Act of 1934**

**Forthe quarterly period ended March 31, 2007**

**Commissionfile number 001-13843**

**DUANE READE HOLDINGS, INC.**

(Exact name of registrantas specified in its charter)

| **DELAWARE**                              |   | **05-0599589** |
|-------------------------------------------|--------|----------------|
| (State or other  jurisdiction of          |   | (IRS Employer  |
| incorporation or  organization)           |   | ID Number)     |
| **440 Ninth Avenue**                      |   | ** **     |
| **New  York, New York**                   |   | **10001**      |
| (Address of  principal executive offices) |   | (Zip Code)     |

 

**(212) 273-5700**

(Registrant’s telephonenumber, including area code)

Indicate by check mark whether the registrant: (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.

Yes  x  No  o*

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer or anon-accelerated filer, as defined in Rule 12b-2 of the Exchange Act(check one):

| Large accelerated  filer  o |   | Accelerated filer  o |   | Non-accelerated  filer  x |
|---------------------------------------|--------|--------------------------------|--------|-------------------------------------|

 

Indicate by check mark whether the registrant is ashell company as defined in Rule 12b-2 of the Exchange Act (checkone):

Yes  o  No  x

Indicate the number of shares outstanding of each ofthe issuer’s classes of common stock, as of the latest practicable date:

As of June 30, 2007, there were 2,594,977 sharesof common stock issued and outstanding. None of the registrant’s outstandingvoting stock is held by non-affiliates of the registrant.

*                    The registrantis not subject to the filing requirements of Section 13 or 15(d) of theSecurities Exchange Act of 1934. The registrant is a voluntary filer.

 

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**INDEX**
| PART I—FINANCIAL  INFORMATION                                                                                           |   | 5  |
|-----------------------------------------------------------------------------------------------------------------------------------|--------|----|
| ITEM  1.—FINANCIAL STATEMENTS                                                                                                |   | 5  |
| Consolidated  Statements of Operations (Unaudited)—For the 13 Weeks Ended March 31,  2007 and April 1, 2006   |   | 5  |
| Consolidated  Balance Sheets (Unaudited)—As of March 31, 2007 and December 30,  2006                               |   | 6  |
| Consolidated  Statements of Cash Flows (Unaudited)—For the 13 Weeks Ended March 31,  2007 and April 1, 2006   |   | 7  |
| Consolidated Statements of Comprehensive Loss  (Unaudited)—For the 13 Weeks Ended March 31, 2007 and April 1, 2006 |   | 8  |
| Notes  to Consolidated Financial Statements (Unaudited)                                                                           |   | 9  |
| ITEM  2.—MANAGEMENT’ DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND  RESULTS OF OPERATIONS                     |   | 27 |
| ITEM  3.—QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                                          |   | 37 |
| ITEM  4.—CONTROLS AND PROCEDURES                                                                                             |   | 38 |
| PART II—OTHER  INFORMATION                                                                                              |   | 40 |
| SIGNATURES                                                                                                                        |   | 42 |

 

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**SPECIAL NOTEREGARDING FORWARD-LOOKING STATEMENTS**

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

·       the ability to open andoperate new stores on a profitable basis and the maturation of those stores andthe ability to increase sales in existing stores;

·       the competitive environmentin the drugstore industry in general and in the New York greater metropolitanarea;

·       our significantindebtedness;

·       the continued efforts ofhealth maintenance organizations, managed care organizations, pharmacy benefitmanagement companies and other third party payers to reduce prescriptionreimbursement rates and pricing pressure from internet-based andmail-order-based providers;

·       the continued efforts offederal, state and municipal government agencies to reduce Medicaidreimbursement rates, modify Medicare benefits and/or reduce prescription drug costsand/or coverages;

·       the impact of the MedicarePrescription Drug, Improvement and Modernization Act of 2003 (P.L. 108-179),or, the Medicare Modernization Act, and the Medicare Part D benefitcreated thereunder;

·       changes in pharmacyprescription reimbursement rates attributable to modifications in thedefinition of indexed pricing terms such as “Average Wholesale Price”;

·       the strength of the economyin general and the economic conditions in the New York greater metropolitanarea including, in particular, seasonal and weather-related factors,special events, changes in consumer purchasing power and/or spending patterns;

·       changes in the cost ofgoods and services;

·       trends in the healthcareindustry, including continued conversion of various prescription drugs toover-the-counter medications, negative publicity and the related sales declinesfor certain categories of drugs including, without limitation, certain painmedications and the increasing market share of internet-based andmail-order-based providers;

·       employment disputes andlabor relations;

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·       changes in federal andstate laws and regulations, including the potential impact of changes inregulations surrounding the importation of pharmaceuticals from foreigncountries and changes in laws governing minimum wage requirements;

·       our ability to successfullyexecute the various objectives of the “Duane Reade Full Potential” sales growthand profit enhancement program;

·       the outcome of thearbitration proceeding that has been instituted against us by the formerChairman, President and Chief Executive Officer;

·       the progress and outcome ofthe investigation that has been commenced by the United States DistrictAttorney’s Office for the Southern District of New York, as well as the requestfrom the Securities and Exchange Commission (the “SEC”) for information relatedto this matter;

·       liability and other claimsasserted against us, including the items discussed in Note 9 of the UnauditedConsolidated Interim Financial Statements contained elsewhere in this report;

·       the outcome of the legalproceedings that have been instituted against us and others followingannouncement of the acquisition of Duane Reade Inc.;

·       changes in our operatingstrategy or development plans;

·       our ability to attract,hire and retain qualified personnel, including our ability to attract qualifiedpharmacists at acceptable wage rates;

·       interest rate fluctuationsand changes in capital market conditions or other events affecting our abilityto obtain necessary financing on favorable terms to fund the anticipated growthof our business;

·       natural disasters and thecontinued impact of, or new occurrences of, terrorist attacks in the New Yorkgreater metropolitan area and any actions that may be taken by federal, stateor municipal authorities in response to or in anticipation of such events andoccurrences;

·       changes in levels of vendorrebates, allowances and related payment terms.

·       changes in timing of ouracquisition of stores and prescription files and capital expenditure plans;

·       changes in real estatemarket conditions and our ability to continue to renew expiring leases or tosecure suitable new store locations under acceptable lease terms;

·       our ability to successfullyimplement and manage new computer systems and technologies;

·       our ability to limit fraudand shrink;

·       demographic changes; and

·       otherrisks and uncertainties detailed elsewhere in this filing and from time to timein our other filings with the SEC.

We undertake no obligation to update or revise anyforward-looking statements, whether as a result of new information,future events or otherwise, after the date of this report. We do not, nor doesany other person, assume responsibility for the accuracy and completeness ofthose statements.

We caution you that the areas of risk described abovemay not be exhaustive. We operate in a continually changing businessenvironment, and new risks emerge from time to time. Management cannot predictsuch new risks, nor can it assess the impact, if any, of such risks on ourbusinesses or the extent to which any risk or combination of risks may causeactual results to differ materially from those projected in any forward-lookingstatements. In light of these risks, uncertainties and assumptions, you shouldkeep in mind that any forward-looking statement made in this filing mightnot occur.

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**PART I—FINANCIALINFORMATION**

**ITEM 1.**                FINANCIALSTATEMENTS

**Duane Reade Holdings, Inc.**Consolidated Statements of Operations (Unaudited) (In thousands)

| ** **                                           | ** ** | **Three Months**        | ** ** | **Three Months**       | ** ** |
|------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                           | ** ** | **Ended**                    | ** ** | **Ended**                   | ** ** |
| ** **                                           | ** ** | **March 31, 2007** | ** ** | **April 1, 2006** | ** ** |
| Net sales                                            |       |                         | $          | 414,388                     |       |   |   | $ | 385,869 |   |   |
| Cost of sales                                        |       |                         | 333,379    |                        |       |   | 310,396 |   |   |
| Gross profit                                         |       |                         | 81,009     |                        |       |   | 75,473 |   |   |
| Selling,  general & administrative expenses |       |                         | 72,744     |                        |       |   | 69,464 |   |   |
| Labor contingency  expense                           |       |                         | —     |                        |       |   | (18,004 | ) |   |
| Depreciation and  amortization                       |       |                         | 18,037     |                        |       |   | 18,678 |   |   |
| Store pre-opening  expenses                          |       |                         | 150        |                        |       |   | 50 |   |   |
| Other expense                                        |       |                         | 5,018      |                        |       |   | 1,102 |   |   |
| Operating income  (loss)                             |       |                         | (14,940    | )                           |       |   | 4,183 |   |   |
| Interest expense,  net                               |       |                         | 14,435     |                        |       |   | 13,738 |   |   |
| Loss before  income taxes                            |       |                         | (29,375    | )                           |       |   | (9,555 | ) |   |
| Income tax  expense                                  |       |                         | 1,160      |                        |       |   | 309 |   |   |
| Net loss                                             |       |                         | $          | (30,535                     | )          |   |   | $ | (9,864 | ) |   |

 

The accompanying notes are an integral part of these financial statements.

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**Duane ReadeHoldings, Inc.Consolidated Balance Sheets (Unaudited)** (In thousands, except share and per share data)

| ** **                                                                                                                 | ** ** | **March 31,** | ** ** | **December 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                                                                                 | ** ** | **2007**           | ** ** | **2006**              | ** ** |
| **ASSETS**                                                                                                                 | ** ** | ** **         | ** ** |                  | ** ** | ** ** |   |
| Current Assets                                                                                                             |       |               |       |                  |       |   |   |
| Cash                                                                                                                       |       | $                  | 1,359      |                  |       | $ | 1,395 |   |   |
| Receivables, net                                                                                                           |       | 53,965             |       |                  | 57,181     |   |   |
| Inventories                                                                                                                |       | 220,090            |       |                  | 218,924    |   |   |
| Deferred income  taxes                                                                                                     |       | 888                |       |                  | 2,429      |   |   |
| Prepaid expenses  and other current assets                                                                                 |       | 26,693             |       |                  | 25,659     |   |   |
| **Total Current Assets**                                                                                                   |       | 302,995            |       |                  | 305,588    |   |   |
| Property and  equipment, net                                                                                               |       | 206,081            |       |                  | 208,148    |   |   |
| Goodwill                                                                                                                   |       | 70,384             |       |                  | 70,384     |   |   |
| Other assets, net                                                                                                          |       | 207,745            |       |                  | 214,461    |   |   |
| **Total Assets**                                                                                                           |       | $                  | 787,205    |                  |       | $ | 798,581 |   |   |
| **LIABILITIES AND STOCKHOLDER’S  EQUITY (DEFICIT)**                                                                   | ** ** | ** **         | ** ** |                  | ** ** | ** ** |   |
| Current  Liabilities                                                                                                       |       |               |       |                  |       |   |   |
| Accounts payable                                                                                                           |       | $                  | 86,252     |                  |       | $ | 83,410 |   |   |
| Accrued interest                                                                                                           |       | 4,683              |       |                  | 9,299      |   |   |
| Accrued expenses                                                                                                           |       | 44,294             |       |                  | 46,380     |   |   |
| Current portion  of debt                                                                                                   |       | 161,205            |       |                  | 157,122    |   |   |
| Current portion  of capital lease obligations                                                                              |       | 3,137              |       |                  | 3,173      |   |   |
| **Total Current Liabilities**                                                                                              |       | 299,571            |       |                  | 299,384    |   |   |
| Long-term debt                                                                                                             |       | 405,032            |       |                  | 405,032    |   |   |
| Capital lease  obligations, less current portion                                                                           |       | 6,316              |       |                  | 7,137      |   |   |
| Deferred income  taxes                                                                                                     |       | 29,186             |       |                  | 29,621     |   |   |
| Other non-current  liabilities                                                                                             |       | 70,529             |       |                  | 54,670     |   |   |
| **Total Liabilities**                                                                                                      |       | 810,634            |       |                  | 795,844    |   |   |
| Commitments and contingencies                                                                                              |       |               |       |                  |       |   |   |
| Stockholder’s equity (deficit)                                                                                        |       |               |       |                  |       |   |   |
| Common stock,  $0.01 par, authorized 4,205,600 shares and 3,050,000 shares; issued and  outstanding: 2,594,977 shares |       | 26                 |       |                  | 26         |   |   |
| Paid-in capital                                                                                                            |       | 244,304            |       |                  | 239,807    |   |   |
| Accumulated other  comprehensive income                                                                                    |       | 66                 |       |                  | 193        |   |   |
| Accumulated  deficit                                                                                                       |       | (267,825           | )          |                  | (237,289   | ) |   |
| **Total Stockholder’s Equity (Deficit)**                                                                              |       | (23,429            | )          |                  | 2,737      |   |   |
| **Total  Liabilities and Stockholder’s Equity or Deficit**                                                            |       | $                  | 787,205    |                  |       | $ | 798,581 |   |   |

 

The accompanying notes are an integral part of these financial statements.

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**Duane Reade Holdings, Inc.**Consolidated Statements of Cash Flows (Unaudited) (In thousands)

| ** **                                                                         | ** ** | **Three Months**        | ** ** | **Three Months**       | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                         | ** ** | **Ended**                    | ** ** | **Ended**                   | ** ** |
| ** **                                                                         | ** ** | **March 31, 2007** | ** ** | **April 1, 2006** | ** ** |
| Cash flows used in  operating activities:                                          |       |                         |       |                        |       |   |   |   |   |
| Net loss                                                                           |       |                         | $          | (30,535                     | )          |   |   | $ | (9,864 | ) |   |
| Adjustments to reconcile  net loss to net cash used in operating   activities:     |       |                         |       |                        |       |   |   |   |   |
| Depreciation and  amortization                                                     |       |                         | 18,950     |                        |       |   | 19,741 |   |   |
| Deferred income  taxes                                                             |       |                         | 1,107      |                        |       |   | 276 |   |   |
| Non-cash rent  expense                                                             |       |                         | 3,516      |                        |       |   | 2,559 |   |   |
| Other non-cash  expense                                                            |       |                         | 1,876      |                        |       |   | 25 |   |   |
| Change in operating  assets and liabilities (net of the effect of   acquisitions): |       |                         |       |                        |       |   |   |   |   |
| Receivables                                                                        |       |                         | 3,216      |                        |       |   | 5,468 |   |   |
| Inventories                                                                        |       |                         | (1,166     | )                           |       |   | 2,863 |   |   |
| Accounts payable                                                                   |       |                         | 2,842      |                        |       |   | 12,499 |   |   |
| Prepaid and  accrued expenses                                                      |       |                         | (7,735     | )                           |       |   | (6,264 | ) |   |
| Other assets and  liabilities, net                                                 |       |                         | 2,262      |                        |       |   | (27,476 | ) |   |
| NET CASH USED IN  OPERATING ACTIVITIES                                             |       |                         | (5,667     | )                           |       |   | (173 | ) |   |
| Cash flows used  in investing activities:                                          |       |                         |       |                        |       |   |   |   |   |
| Capital  expenditures                                                              |       |                         | (6,949     | )                           |       |   | (3,713 | ) |   |
| Lease  acquisition, customer file and other costs                                  |       |                         | (3,390     | )                           |       |   | (1,814 | ) |   |
| NET CASH USED IN  INVESTING ACTIVITIES                                             |       |                         | (10,339    | )                           |       |   | (5,527 | ) |   |
| Cash flows from  financing activities:                                             |       |                         |       |                        |       |   |   |   |   |
| Borrowings from  revolving credit facility                                         |       |                         | 498,423    |                        |       |   | 454,703 |   |   |
| Repayments of  revolving credit facility                                           |       |                         | (494,341   | )                           |       |   | (448,188 | ) |   |
| Issuance of  preferred stock                                                       |       |                         | 12,750     |                        |       |   | — |   |   |
| Deferred  financing costs                                                          |       |                         | (5         | )                           |       |   | (21 | ) |   |
| Repayments of  capital lease obligations                                           |       |                         | (857       | )                           |       |   | (759 | ) |   |
| NET CASH PROVIDED  BY FINANCING ACTIVITIES                                         |       |                         | 15,970     |                        |       |   | 5,735 |   |   |
| Net change in cash                                                                 |       |                         | (36        | )                           |       |   | 35 |   |   |
| Cash at beginning  of period                                                       |       |                         | 1,395      |                        |       |   | 1,362 |   |   |
| Cash at end of period                                                              |       |                         | $          | 1,359                       |       |   |   | $ | 1,397 |   |   |

 

The accompanying notes are an integral part of these financial statements.

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**Duane Reade Holdings, Inc.**Consolidated Statements of Comprehensive Loss (Unaudited)(in thousands)

| ** **                                   | ** ** | **For the 13 Weeks Ended** | ** ** |
|----------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                   | ** ** | **March 31,**                             | ** ** | **April 1,** | ** ** |
| ** **                                   | ** ** | **2007**                                       | ** ** | **2006** | ** ** |
| Net loss                                     |       | $                                              | (30,535    | ) | $ | (9,864 | ) |
| Change in fair value of interest rate collar |       | (127                                           | )          | 269 |   |
| Total Other Comprehensive Income (Loss)      |       | (127                                           | )          | 269 |   |
| Total  Comprehensive Loss                    |       | $                                              | (30,662    | ) | $ | (9,595 | ) |

 

The accompanying notes are an integral part of these financial statements

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**Notes to Unaudited Consolidated Interim FinancialStatements(dollars in thousands)**

**1.**                 Basisof Presentation

Duane Reade Holdings, Inc. (“Duane ReadeHoldings” or the “Company”) was formed in December 2003 by Oak HillCapital Partners, LP, a private equity firm (“Oak Hill”), in order to acquireDuane Reade Inc. and its subsidiaries (the “Acquisition”). Duane ReadeHoldings, Inc. is a wholly-owned subsidiary of Duane Reade Shareholders,LLC (“Duane Reade Shareholders”), a parent entity also established to effectuatethe Acquisition. The Acquisition was completed on July 30, 2004 throughthe merger of Duane Reade Acquisition Corp. (a wholly owned subsidiary of DuaneReade Holdings, Inc.) into Duane Reade Inc. with DuaneReade Inc. being the surviving entity and a wholly owned subsidiary ofDuane Reade Holdings, Inc. after the merger transaction.

The Company, along with certain of its subsidiaries,is a guarantor of the debt obligations of Duane Reade Inc. and DuaneReade, the New York general partnership that holds the operating assets andliabilities (“Duane Reade GP”). The Company has no assets or operationsother than its investment in its subsidiaries. The guarantees provided by theCompany and its other subsidiaries under the debt obligations of Duane Reade Inc.and Duane Reade GP (described in more detail in Note 7) are full andunconditional, joint and several.

The Unaudited ConsolidatedInterim Financial Statements included herein reflect all adjustments which, inthe opinion of management, are necessary to present a fair statement of theresults of operations, financial position, cash flows and comprehensive loss ofthe Company, and have been prepared, in all material respects, in accordancewith the same accounting principles followed in the preparation of theCompany’s Annual Consolidated Financial Statements for the year endedDecember 30, 2006. These Unaudited Consolidated Interim FinancialStatements should be read in conjunction with the Company’s ConsolidatedFinancial Statements included in its Annual Report on Form 10-K for theyear ended December 30, 2006. The Unaudited Consolidated Interim FinancialStatements include the assets and operations of the Company and itssubsidiaries. All significant intercompany transactions and balances have beeneliminated. The results for the interim periods presented are not necessarilyindicative of the results expected for the full year.

**2.**                 RecentlyIssued Accounting Pronouncements

In June 2005, the Financial Accounting StandardsBoard (the “FASB”) issued Statement of Financial Accounting Standards (“SFAS”)No. 154, “Accounting Changes and Error Corrections,” which requiresentities that voluntarily make a change in accounting principle to apply thatchange retrospectively to prior periods’ financial statements, unless thiswould be impracticable. SFAS No. 154 supersedes Accounting PrinciplesBoard Opinion No. 20, “Accounting Changes” (“APB No. 20”) whichpreviously required that most voluntary changes in accounting principle berecognized by including in the current period’s net earnings the cumulativeeffect of changing to the new accounting principle. SFAS No. 154 alsomakes a distinction between “retrospective application” of an accountingprinciple and the “restatement” of financial statements to reflect thecorrection of an error. Another significant change in practice under SFASNo. 154 is that if an entity changes its method of depreciation,amortization, or depletion for long-lived, non-financial assets, the changemust be accounted for as a change in accounting estimate. Under APBNo. 20, such a change would have been reported as a change in accountingprinciple. SFAS No. 154 applies to accounting changes and errorcorrections that are made in fiscal years beginning after December 15,2005. The Company has adopted SFAS 154, and such adoption has not had an effecton its consolidated financial statements.

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In February 2006, the FASB issued SFASNo. 155, “Accounting for Certain Hybrid Instruments,” which amends SFASNo. 133, “Accounting for Derivative Instruments and Hedging Activities,”and SFAS No. 140, “Accounting for Transfers and Servicing of FinancialAssets and Extinguishments of Liabilities.” SFAS No. 155 allows financialinstruments that have embedded derivatives to be accounted for as a whole(eliminating the need to bifurcate the derivative from its host) if the holderelects to account for the whole instrument on a fair value basis. SFASNo. 155 also clarifies and amends certain other provisions of SFASNo. 133 and SFAS No. 140. This statement is effective for allfinancial instruments acquired or issued in fiscal years beginning afterSeptember 15, 2006. The Company has adopted SFAS 155, and such adoptionhas not had an effect on its consolidated financial statements.

In June 2006, theFASB issued Interpretation No. 48, “Accounting for Uncertainty in IncomeTaxes—an interpretation of SFAS No. 109.” FIN 48 clarifies the accountingfor uncertainty in income taxes by prescribing a recognition threshold for taxpositions taken or expected to be taken in a tax return. FIN 48 is effectivefor fiscal years beginning after December 15, 2006. The Company hasadopted FIN 48 effective with the beginning of fiscal 2007, and such adoptionhas not had a material effect on its consolidated financial statements.

**3.**                 Stock-BasedPayment

In December 2004, theFASB issued SFAS No. 123(R), “Share-Based Payment.” This statementestablished standards for the accounting for transactions in which an entityexchanges its equity instruments for goods or services. EffectiveJanuary 1, 2006, the Company adopted the fair value recognition provisionsof SFAS No. 123(R), using the prospective transition method. Under thattransition method, compensation expense recognized for the thirteen weeks endedMarch 31, 2007 and April 1, 2006 reflects the vested portion of share-basedpayments granted on or after January 1, 2006 based on the grant-date fairvalue estimated in accordance with the provisions of SFAS 123(R). TheCompany has elected to recognize compensation expense on a straight-line basisover the vesting period of the respective options. During the three monthsended March 31, 2007 and April 1, 2006, the Company recorded pre-taxcompensation expense of approximately $0.5 million and $25 thousand,respectively, attributable to the vested portion of stock options granted afterthe adoption date.

***Management Stock Option Plan***

The Company’s Board of Directors adopted the DuaneReade Holdings, Inc. Management Stock Option Plan, referred to in thisreport as the “Stock Option Plan,” which became effective on the date theAcquisition was completed. The Stock Option Plan is administered by thecompensation committee of the Board of Directors. Any officer, employee,director or consultant of Duane Reade Holdings or any of its subsidiaries oraffiliates is eligible to be designated a participant under the Stock OptionPlan. On March 27, 2007, the Company amended the StockOption Plan so that a maximum of 575,893 shares of its common stock may begranted under the Stock Option Plan.

Under the Stock Option Plan, the compensationcommittee of Duane Reade Holdings may grant awards of nonqualified stockoptions, incentive stock options, or any combination of the foregoing. A stockoption granted under the Stock Option Plan will provide a participant with theright to purchase, within a specified period of time, a stated number of sharesof the Company’s common stock at the price specified in the award agreement.Stock options granted under the Stock Option Plan will be subject to suchterms, including the exercise price and the conditions and timing of exercise,not inconsistent with the Stock Option Plan, as may be determined by thecompensation committee and specified in the applicable stock option agreementor thereafter.

On December 31, 2006, a total of 168,600 options toacquire shares of the Company’s common stock were granted to executive officersof the Company.

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The weighted-average grant-date fair value of optionsgranted during the thirteen weeks ended March 31, 2007 was $5.59. Therewere no stock options exercised during the first thirteen weeks of either 2007or 2006.

The Company has adopted Black-Scholes option pricingand other methods of valuation, the results of which were applied to the stockoptions issued during the thirteen weeks ended March 31, 2007. The keyassumptions used in this valuation were consistent with those used in 2006.

As of March 31, 2007, there was $2.4 million of totalunrecognized compensation cost related to non-vested share-based compensationarrangements granted under the stock-based compensation plan. That cost isexpected to be recognized on a straight-line basis over a weighted-averageperiod of five years.

As of March 31, 2007, atotal of 114,359 shares of common stock of the Company were reserved for theissuance of additional stock options. The Company expects to satisfy theexercise of stock options utilizing newly-issued shares.

**4.**                 Inventoryand Cost of Sales

At March 31, 2007,inventories, consisting solely of finished goods, would have been lower by$2.6 million if they had been valued on a lower of first-in, first-out(“FIFO”) cost or market basis instead of a last-in, first-out (“LIFO”) basis.Cost of sales includes all store occupancy-related costs and expenses,consisting of lease and sublease-related income and expenses, other realestate-related income and expenses primarily resulting from the disposition ofstore leases, store utility costs, warehouse expenses and distribution costs.The Company reflects promotional allowances from vendors as a reduction ofinventory or advertising expense, depending on the nature of the allowance,when such inventory is sold or advertising or promotions have been completedand the related allowances have been earned. 

**5.**                 Exitand Disposal Activities

In connection with the July 30, 2004 acquisitionof Duane Reade Inc. and in accordance with the provisions of Emerging IssuesTask Force Issue No. 95-3, “Recognition of Liabilities in Connection withPurchase Business Combinations,” the Company established a reserve of$17.0 million for costs anticipated to be incurred as a result of theplanned closing of 11 of its stores. These costs primarily relate to rent,utilities and other on-going occupancy-related expenses. At March 31, 2007 allof the planned closings had occurred, and the Company has recorded a cumulativenet total of $13.0 million of primarily occupancy-related costs againstthis reserve resulting in the reserve balance of $4.0 million at March 31,2007. The balance of this reserve is expected to be utilized primarily foroccupancy-related costs in these closed stores.

In the normal course ofits business, the Company closes underperforming locations. In accordance withthe provisions of SFAS No. 146, “Accounting for Costs Associated with Exitor Disposal Activities,” the Company establishes reserves for costs anticipatedto be incurred in connection with such store closings. At March 31, 2007, thebalance of this reserve was $3.2 million. This balance will also be usedprimarily for occupancy-related costs in these stores.

**6.**                 Pharmacyand Customer File Acquisitions

The Company did notacquire any pharmacy customer files or pharmacy establishments in the thirteenweeks ended March 31, 2007 and April 1, 2006.

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**7.**                 Debt

Debt is summarized asfollows (in thousands):

| ** **                                   | ** ** | **March 31,** | ** **  | **December 30,** | ** ** |
|----------------------------------------------|------------|--------------------|-------------|-----------------------|------------|
| **Description of Instrument**      | ** ** | ** **         | ** **  | **2007**              | ** ** | **2006** | ** ** |
| Current Debt:                                |       |               |        |                  |       |   |   |
| Asset-Based  Revolving Loan Facility(1)      |       | $                  | 161,205     |                  |       | $ | 157,122 |   |   |
| Non-Current Debt:                            |       |               |        |                  |       |   |   |
| Senior Secured  Floating Rate Notes due 2010 |       | $                  | 210,000     |                  |       | $ | 210,000 |   |   |
| 9.75% Senior  Subordinated Notes due 2011    |       | 195,000            |        |                  | 195,000    |   |   |
| 2.1478% Senior  Convertible Notes due 2022   |       | 32                 |        |                  | 32         |   |   |
| Total                                        |       | $                  | 405,032     |                  |       | $ | 405,032 |   |   |
| **Total Debt**                               | ** ** | **$**              | **566,237** | ** **            | ** ** | **$** | **562,154** |   |   |
|                                              |            |                    |             |                       |            |  |  |  |  |  |  |

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(1)          Obligationsunder this facility have been classified as current liabilities because cashreceipts controlled by the lenders are used to reduce outstanding debt and theCompany does not meet the criteria of SFAS No. 6, “Classification of Short TermObligations Expected to be Refinanced,” to reclassify the debt as long-term.However, this is not an indication that this credit facility is expected to beretired within the next year. The Company intends to continue to use thisfacility for its working capital needs through the date of its maturity in2011.

***Asset-Based Revolving Loan Facility***

On July 22, 2004, in connection with theAcquisition, the asset-based revolving loan facility was amended toincrease the borrowing capacity to an aggregate principal amount of$250 million, subject to an adjusted borrowing base calculation based uponspecified advance rates against the value of inventory, pharmacy prescriptionfiles and accounts receivable. The original maturity date of the amendedasset-based revolving loan facility was July 21, 2008. In August 2005, inconjunction with the issuance of $50.0 million aggregate principal amountof senior secured floating rate notes due 2010, the Company permanently reducedthe maximum availability under the amended asset-based revolving loan facilityby $25.0 million to $225.0 million. On July 7, 2006, the Company enteredinto a further amendment to the amended asset-based revolving loan facility toextend its maturity from July 21, 2008 to July 21, 2011, subject to therequirement that the Company refinance or restructure the $210.0 millionaggregate principal amount of the senior secured floating rate notes due 2010and the $195.0 million aggregate principal amount of the 9.75% seniorsubordinated notes due 2011, in each case, on terms reasonably acceptable tothe administrative agent and at least 120 days prior to each’s respectivescheduled maturity date. The Company fully intends to refinance or restructurethe outstanding principal amounts of its senior secured floating rate notes andsenior subordinated notes within the required timeframe, in accordance with therequirements of the third amendment.

The amended asset-based revolving loan facilityincludes a $50 million sub-limit for the issuance of letters of credit.Obligations under the revolving loan facility are collateralized by a firstpriority interest in inventory, receivables, pharmacy prescription files,deposit accounts and certain other current assets. Under the amended asset-basedrevolving loan facility, Duane Reade GP is the sole obligor. However, theamended asset-based revolving loan facility is guaranteed on a full andunconditional basis by the Company, Duane Reade Inc. and each of the Company’sother domestic subsidiaries other than the obligor.

The amended asset-based revolving loan facilitycontains a single fixed charge coverage requirement which only becomesapplicable when borrowings exceed 90 percent of the borrowing base, asdefined in the agreement governing the amended asset-based revolving loanfacility. The July 2006 amendment reduced 

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the ratios that theCompany would be required to maintain in this event. Borrowings under the amendedasset-based revolving loan facility have not exceeded 90 percent ofthe borrowing base and, as a result, the fixed charge covenant has not becomeapplicable. There are no credit ratings related triggers in the amended asset-basedrevolving loan facility that would impact the cost of borrowing, annualamortization of principal or related indebtedness maturity. 

Revolving loansunder the amended asset-based revolving loan facility, at the Company’soption, bear interest at either:

·       arate equal to LIBOR (the London Interbank Offered Rate) plus a margin of from1.00% to 2.00%, determined based on levels of borrowing availability reset eachfiscal quarter; or

·       arate equal to the prime rate of Banc of America Retail Group Inc. plus amargin of from 0.00% to 0.50%, determined based on levels of borrowingavailability reset each fiscal quarter. Borrowings under the amendedasset-based revolving loan facility continue to be primarily LIBOR-based. At March 31, 2007, the amendedasset-based revolving loan facility bore interest at a weighted average annualrate of 6.98%.

At March 31, 2007, there was $161.2 millionoutstanding under the asset-based revolving loan facility, and approximately$53.1 million of remaining availability, net of $5.7 million reservedfor outstanding standby letters of credit. Obligations under this facility havebeen classified as current liabilities because cash receipts controlled by thelenders are used to reduce outstanding debt, and the Company does not meet thecriteria of SFAS No. 6 to reclassify the debt as long-term.

As a result of the investigation carried out by theCompany’s Audit Committee, the Company failed to file this quarterly report onForm 10-Q for the quarter ended March 31, 2007 within the time frame requiredby the SEC. Such failure is a default under the indenture governing theCompany’s senior secured floating rate notes and the indenture governing theCompany’s senior subordinated notes but will not become an event of default orresult in the acceleration of those notes until after the expiration of therelevant grace period. The lenders under the Company’s amended asset-basedrevolving loan facility have waived the default relating to that failure tofile until July 15, 2007. The filing of this Form 10-Q has cured the defaultrelated to its late filing.

***Senior SecuredFloating Rate Notes due 2010.******  ***OnDecember 20, 2004, the Company closed an offering of $160.0 millionaggregate principal amount of senior secured floating rate notes due 2010.Using the net proceeds from that offering, together with approximately$2.2 million of borrowings under the amended asset-based revolving loanfacility, the Company repaid all outstanding principal under its previouslyexisting $155.0 million senior term loan facility, along withapproximately $3.6 million of early repayment premium and accrued but unpaidinterest through December 20, 2004. On August 9, 2005, the Companyissued a further $50.0 million of senior secured floating rate notes.These new notes were issued under the same indenture as the senior securedfloating rate notes issued in December 2004, although they do not tradefungibly with those notes.

The senior secured notes bear interest at a floatingrate of LIBOR plus 4.50%, reset quarterly. Interest on the senior secured notesis payable quarterly on each March 15, June 15, September 15,and December 15. The senior secured notes mature on December 15,2010. At March 31, 2007, the senior secured notes bore interest at a rateof 9.85%.

On May 25, 2005, the Company entered into ahedging transaction through the acquisition of a “no cost collar.” Under thisarrangement, the Company capped its exposure on $130.0 million ofLIBOR-based borrowings under the senior secured notes at a maximum LIBOR rateof 5.30%. In addition, the Company established a minimum “floor” LIBOR rate of3.45% in line with then current LIBOR rates. This hedging arrangement expireson June 16, 2008. The changes in the fair value of the collar agreementare reflected in the Consolidated Statements of Comprehensive Loss includedwithin the financial statements. At 

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March 31, 2007, theLIBOR rate in effect for the senior secured notes was 5.35%, which exceeded themaximum rate under the “no cost collar.” As a result, the protection affordedby the “no cost collar” reduced the overall effective interest rate on thesenior secured notes to 9.82%.

The Company guarantees the senior secured notes on afull and unconditional, senior secured basis. Duane Reade Inc. and DuaneReade GP are co-obligors under the senior secured notes. The senior securednotes rank equally in right of payment with any of the Company’s, Duane ReadeInc.’s or Duane Reade GP’s unsubordinated indebtedness and senior in right ofpayment to any of the Company’s, Duane Reade Inc.’s or Duane Reade GP’ssubordinated or senior subordinated indebtedness. All obligations under the seniorsecured notes are guaranteed on a senior basis by each of the Company’sexisting subsidiaries, other than Duane Reade Inc. and Duane Reade GP, andwill be guaranteed by future subsidiaries of Duane Reade Inc. and Duane ReadeGP except certain foreign and certain domestic subsidiaries. The indenturegoverning the senior secured notes contains customary events of default, which,if triggered, may result in the acceleration of the indebtedness outstandingunder the indenture. The senior secured notes and the guarantees arecollateralized by a first priority interest in substantially all of Duane ReadeInc. and Duane Reade GP’s assets other than those assets in which the lendersunder the amended asset-based revolving loan facility have a first priority interest.The senior secured notes and the guarantees are also collateralized by a secondpriority interest in all collateral pledged on a first priority basis tolenders under the amended asset-based revolving loan facility.

Upon the occurrence of specified change of controlevents, Duane Reade Inc. and Duane Reade GP will be required to make an offerto repurchase all of the senior secured notes at 101% of the outstandingprincipal amount of the senior secured notes plus accrued and unpaid interestto the date of repurchase. The indenture governing the senior secured notescontains certain affirmative and negative covenants that limit the ability ofDuane Reade Inc., Duane Reade GP and their restricted subsidiaries, asdefined, to incur additional indebtedness, pay dividends, make repayments onindebtedness that is subordinated to the senior secured notes and to makecertain other restricted payments, incur certain liens, use proceeds from salesof assets, enter into business combination transactions (including mergers,consolidations and asset sales), enter into sale-leaseback transactions, enterinto transactions with affiliates and permit restrictions on the payment ofdividends by restricted subsidiaries. The indenture governing the seniorsecured notes contains customary events of default, which, if triggered, mayresult in the acceleration of the indebtedness outstanding under the indenture.There are no credit ratings related triggers in the indenture governing thesenior secured notes that would impact the cost of borrowing, annualamortization of principal or related indebtedness maturity. The indenturegoverning the senior secured notes does not contain financial maintenancecovenants.

At March 31, 2007, the weighted average combinedinterest rate in effect on all variable rate debt outstanding, including thebenefit afforded by the “no cost collar,” was 8.59%.

***Senior SubordinatedNotes due 2011.***   On July 30, 2004, uponcompletion of the Acquisition, Duane Reade Inc. and Duane Reade GPco-issued $195.0 million of 9.75% senior subordinated notes due 2011. Thesenior subordinated notes mature on August 1, 2011 and bear interest at9.75% per annum payable in semi-annual installments on February 1 andAugust 1. The senior subordinated notes are uncollateralized obligationsand subordinated in right of payment to all of the Company’s, Duane ReadeInc.’s and Duane Reade GP’s existing and future unsubordinated indebtedness,including borrowings under the amended asset-based revolving loan facility andthe senior secured notes. The senior subordinated notes will rank equally withany future senior subordinated indebtedness and senior to any future subordinatedindebtedness. The senior subordinated notes are guaranteed on anuncollateralized, senior subordinated basis by the Company and all of DuaneReade Inc.’s existing direct and indirect domestic subsidiaries other thanDuane Reade GP, which is a co-obligor under the senior subordinated notes. Uponthe occurrence of specified change of control events, the Company will berequired to make an offer to repurchase all of the senior subordinated notes at101% of the outstanding principal amount of the senior 

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subordinated notes plusaccrued and unpaid interest to the date of repurchase. The indenture governingthe senior subordinated notes contains certain affirmative and negativecovenants that limit the ability of Duane Reade Inc., Duane Reade GP andtheir restricted subsidiaries to incur additional indebtedness, pay dividends,make repayments on indebtedness that is subordinated to the senior subordinatednotes and to make certain other restricted payments, incur certain liens, useproceeds from sales of assets, enter into business combination transactions(including mergers, consolidations and asset sales), enter into transactionswith affiliates and permit restrictions on the payment of dividends byrestricted subsidiaries. The indenture governing the senior subordinated notescontains customary events of default, which, if triggered, may result in theacceleration of the indebtedness outstanding under the indenture. There are nocredit ratings related triggers in the indenture governing the seniorsubordinated notes that would impact the cost of borrowing, annual amortizationof principal or related indebtedness maturity.

***2.1478% SeniorConvertible Notes due 2022.******  ***OnApril 16, 2002, Duane Reade Inc. completed an offering of$381.5 million aggregate principal amount of senior convertible notesmaturing on April 16, 2022. The senior convertible notes were issued at aprice of $572.76 per note (57.276% of the principal amount at maturity) and paycash interest at the rate of 2.1478% per year on the principal amount atmaturity, payable semi-annually in arrears on April 16 and October 16of each year beginning on October 16, 2002, until April 16, 2007.After that date, interest will accrue on the notes as amortization of theoriginal issue discount representing a yield to maturity of 3.75% per year,computed on a semi-annual bond equivalent basis. In December 2002, DuaneReade Inc. repurchased a total of $30.5 million principal value of the seniorconvertible notes at an average purchase price of $486.99 per $1,000 note,resulting in a remaining net outstanding balance of $201.0 million.

In connection with theAcquisition, Duane Reade Inc. made a tender offer to repurchase all of the$351.0 million outstanding principal value of the senior convertible notes.Upon the closing of the tender offer, a total of $350.9 million principalamount at maturity ($201.0 million issuance value) was tendered forrepurchase, leaving only $55.0 thousand of principal amount at maturity($32.0 thousand of issuance value) outstanding. Duane Reade Inc. mayredeem for cash all or a portion of the principal value of the outstanding seniorconvertible notes at any time after April 16, 2007, at a price equal tothe sum of the issue price plus accrued original issue discount and accruedcash interest, if any, to the redemption date.

**8.**                 IncomeTaxes

Income taxes are recorded based on the estimatedcombined statutory tax rates expected to be applicable for the full fiscal yearless applicable employment related tax credits. The effective tax rate prior tothe application of deferred tax asset valuation reserves is lower than thecombined statutory rates, primarily reflecting the impact of these income taxcredits. The wage-based employment tax credits represent the economic benefitsearned by the Company for its participation in various federal and state hiringincentive programs. These benefits are based on the number of qualifyingemployees hired and retained by the Company for a specified time period.Employees qualify for these hiring programs primarily as a result of theirenrollment in various economic assistance programs.

The Company evaluates the likelihood of recognizingthe benefit of deferred tax assets, a majority of which result from theincurrence of net operating losses. This evaluation includes a review of theindividual deferred tax components and a corresponding analysis of theanticipated time period during which the “book versus tax” differences givingrise to the specific assets and liabilities would reverse. Based on thisevaluation, if the Company believes it is more likely than not that thebenefits will not be realized within the period in which the deferred taxassets are deductible, an appropriate valuation allowance would be recorded.

At December 30, 2006,as a consequence of the significant losses incurred in the 2005 and 2006 fiscalyears, as well as the projected future years’ taxable losses, the Companyrecorded a cumulative valuation 

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allowanceof $68.5 million. This amount represented the Company’s year-end net deferredtax asset value excluding $27.2 million of deferred tax liabilities resultingfrom items that are not amortized for financial statement purposes and aretherefore not expected to reverse within the loss carryforward expirationperiod. These items include post-2004 goodwill of $6.2 million and the deferredtax liability of $21.0 million associated with the tradename.

During the three monthsended March 31, 2007, the Company incurred an additional pre-tax loss of$29.4 million and recorded an incremental valuation allowance of $14.3 million.At March 31, 2007, the Company had approximately $148.6 million of grossdeferred tax assets, approximately $94.2 million of gross deferred taxliabilities and recorded a cumulative valuation allowance of $82.7 million. Thetax expense reported during the three months ended March 31, 2007 andApril 1, 2006 primarily results from the deferred tax liabilitiesgenerated by non-amortizable goodwill.

Duane Reade Inc. ispresently undergoing an examination of its New York State Franchise Tax filingsfor the 2001 through 2003 tax years. Adjustments proposed by New York statehave been previously accrued and, in management’s opinion, are not consideredmaterial to the Company’s consolidated financial statements.

The Company reflectsinterest charges incurred in connection with audit settlements as interestexpense; however, if any tax-related penalties were to be incurred, suchamounts would be recorded as a component of the income tax provision.

**9.**                 Commitments andContingencies

The Company is party tolegal actions arising in the ordinary course of business. Based on informationpresently available to the Company, it believes that the ultimate outcome ofthese actions will not have a material, adverse effect on its financialposition, results of operations or cash flows. In addition, the Company is aparty to the following legal actions and matters:

During 2002, the Companyinitiated a legal action against its former property insurance carrier, in anattempt to recover what it believes to be a fair and reasonable settlement forthe business interruption portion of its claim originating from theSeptember 11, 2001 World Trade Center terrorist attack, during which itssingle highest volume and most profitable store was completely destroyed. Aftera lengthy litigation and appraisal process, an appraisal panel awarded theCompany approximately $5.6 million (in addition to the $9.9 million that waspaid by the insurer to the Company in 2002). As a result of the insurer’srefusal to pay this amount and also as a result of the Second Circuit Court ofAppeals interpretation of the Company’s insurance policy, in January 2007,the Company commenced another action which is presently pending in the U.S. DistrictCourt for the Southern District to recover both the appraisal panel’s award andadditional amounts under the policy.

Given the risks anduncertainties inherent in litigation, there can be no definitive assurance thatthe Company will actually receive any or all of the panel’s appraised value ofthis claim, and the Company has not recognized any income related to thismatter other than $9.4 million of the original $9.9 million paid by the insurerin 2002. It should be noted that any payment to the Company that might beforthcoming as a result of this claim may also result in the incurrence ofadditional expenses that are contingent upon the amount of such insurance claimsettlement. These expenses, if incurred, are not expected to exceed$6.0 million.

In December 2005, theCompany and Cardinal Health, a former pharmacy inventory supplier, settled allmatters relating to litigation arising out of a dispute regarding certainformer supply arrangements and agreements. Under the terms of this settlement,the Company paid Cardinal Health $4.5 million over a period of time tosettle an outstanding trade payable, and entered into an agreement wherebyCardinal will provide a secondary supply of pharmaceutical products to theCompany until certain minimum purchase levels are achieved.

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In November 2004, Duane Reade Inc. wasserved with a class action complaint, Damassia v. Duane Reade Inc. Thelawsuit was filed in the United States District Court, Southern District of NewYork. The complaint alleges that, from the period beginning November 1998,the Company incorrectly gave some employees the title, “Assistant Manager,” inan attempt to avoid paying these employees overtime, in contravention of theFair Labor Standards Act and New York law. The complaint seeks twice anunspecified amount of unpaid wages. The Company believes this claim to bewithout merit, and it intends to defend itself against this claim. However, dueto the uncertainty of litigation, there can be no assurance as to the ultimateoutcome of this matter.

In April 2006, the Company was served with apurported class action complaint, Enamul Chowdhury v. Duane Reade Inc. andDuane Reade Holdings, Inc. The complaint alleges that, from a periodbeginning March 2000, the Company incorrectly classified certain employeesin an attempt to avoid paying overtime to such employees, thereby violating theFair Labor Standards Act and New York law. The complaint seeks an unspecifiedamount of damages. The Company believes this claim to be without merit, and itintends to vigorously defend itself against this claim. However, due to theinherent uncertainty of litigation, there can be no assurance as to theultimate outcome of this matter.

In January 2005, the Equal Employment OpportunityCommission filed an action against the Company in the U.S. District Court forthe Southern District of New York alleging, among other things, that theCompany created a hostile work environment for three female store employees,and potentially a class of such female employees. The Company believes that ithas reached a settlement of this litigation, which settlement will not have amaterial impact on the Company or its operating results.

In November 2006, theAttorney General of the State of New Jersey filed an action against the Companyalleging that the Company violated certain state regulations includingregulations relating to the presence of expired products on its shelves andcertain pricing regulations. The Company has been in discussions with theAttorney General’s office regarding settling this action; however, there can beno assurance that this action will be settled on terms acceptable to theCompany or at all. The Company believes that it has valid defenses to thisaction and it intends to vigorously defend itself.

***Proceedings Relating to the Former Chairman and ChiefExecutive Officer***

On September 1, 2006, Anthony J. Cuti, theCompany’s former Chairman, President and Chief Executive Officer, initiated anarbitration before the American Arbitration Association against Duane ReadeInc., Duane Reade Holdings, Inc. and Duane Reade Shareholders, LLC, whichare referred to as the “respondents.” The arbitration relates to histermination in November 2005. Mr. Cuti asserts various claimsincluding, with respect to his employment agreement, breach of contractrelating to the notice of termination provision, failure to make certainpayments toward his 1998 corporate-owned life insurance policy, relief from thenon-competition and non-solicitation covenants, failure to provide adequateinformation relating to the valuation of his profits interest and breach of thecovenant of good faith and fair dealing. Other claims relate to the patentrights for the Company’s virtual pharmacy kiosk system and payment of analleged deferred 2001 bonus based on any insurance recovery the Company mayobtain on its business interruption claim in connection with the 2001 WorldTrade Center tragedy. On March 16, 2007, Mr. Cuti sought leave tofile an amended demand asserting additional allegations in support of his claimfor breach of contract for failure to comply with the notice of terminationprovision in his employment agreement, and a claim for defamation. On May 17,2007, the arbitrator issued an order granting leave to file Mr. Cuti’samended demand. Mr. Cuti seeks monetary damages, declaratory relief,rescission of his employment agreement and the payment of his legal costs andfees associated with his termination and the arbitration.

On November 22, 2006, the respondents filedcounterclaims and affirmative defenses against Mr. Cuti in thearbitration, alleging that between 2000 and 2005, Mr. Cuti was responsiblefor improper practices 

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involving invoice creditsand rebillings for the construction of the Company’s stores, that led tooverstating the Company’s publicly reported earnings, and that caused theCompany to create and maintain inaccurate records and publish financialstatements containing misstatements. These counterclaims were based oninformation uncovered as of that date by an investigation conducted byindependent legal counsel and forensic accountants at the direction of theAudit Committee.

In a press release dated April 2, 2007, theCompany disclosed that, based on new information provided to the Company, theAudit Committee, with the assistance of independent counsel and forensicaccountants, was conducting a review and investigation concerning the proprietyof certain real estate transactions and related matters and whether theaccounting for such transactions was proper. On April 9, 2007, therespondents sought leave to file proposed amended counterclaims based on thatnew information. On May 17, 2007, the arbitrator issued an order grantingleave to file the amended counterclaims. The amended counterclaims seekrescission of employment agreements entered into between the Company and Mr. Cuti,return of all compensation paid under the employment agreements, othercompensatory and punitive damages, and legal costs and fees associated with theAudit Committee’s investigation and the arbitration.

On May 18, 2007, the independent counsel and theforensic accountants completed their review and investigation. The independentcounsel concluded that Mr. Cuti orchestrated certain real estate and othertransactions that led to overstating the Company’s publicly reported earnings,and that caused the Company to create and maintain inaccurate records andpublish financial statements containing misstatements. On May 22, 2007,the Audit Committee determined, after considering the results of the review andinvestigation, that certain of the Company’s previously-issued financialstatements would have to be restated. The restatements and the results of theinvestigation are discussed more fully in Note 2 to the financial statementscontained in the Company’s Annual Report on Form 10-K for the yearended December 30, 2006.

On May 22, 2007, the Company received a grandjury subpoena from the United States Attorney’s Office for the SouthernDistrict of New York seeking documents relating to the allegations in theamended counterclaims discussed above. The Company is cooperating fully withthe investigation. The SEC has also requested that the Company provide it withinformation related to this matter.

On May 25, 2007, theUnited States Attorney’s Office for the Southern District of New York filed anapplication requesting that the arbitrator stay further proceedings in thearbitration, including discovery, pending further developments in its criminalinvestigation of Mr. Cuti. On July 11, 2007, the arbitrator granted a stayof the arbitration through October 23, 2007 with respect to all matters otherthan a motion to dismiss the above-mentioned patent claim (if the parties wishto proceed) and advancement of certain fees pursuant to a prior order.

***Litigation Relating to the Acquisition***

The Company is aware of six purported class actioncomplaints challenging the Acquisition consummated by Duane Reade Inc. andDuane Reade Acquisition that have been filed in the Court of Chancery of theState of Delaware, referred to as the “Delaware Complaints,” and threepurported class action complaints that have been filed in the Supreme Court ofthe State of New York. Two of the New York complaints have been dismissedwithout prejudice. The other New York complaint (the “New York Complaint”) ispending, but has not been served on the Company. The Delaware Complaints namethe former Chairman and CEO and certain other members of the Company’s board ofdirectors and executive officers as well as Duane Reade GP as defendants. Fourof the Delaware Complaints name Oak Hill as a defendant. The New York Complaintnames the former Chairman and CEO and certain other members of the Company’sboard of directors and executive officers as well as Duane Reade GP asdefendants. One of the dismissed New York complaints named Oak Hill as adefendant.

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The Delaware Complaintswere consolidated on January 28, 2004, and on April 8, 2004 theplaintiffs in the Delaware actions filed a consolidated class action complaint.The Company believes these lawsuits are without merit and plans to defend theselawsuits vigorously. The plaintiffs in this litigation have been inactive forover three years.

**10.**          Issuanceof Preferred Stock and Common Stock Warrants in Connection with the Acquisitionof Gristedes Store Leases

On February 20, 2007, the Company announced ithad entered into an agreement to acquire up to eight Gristedes leasedsupermarket locations in the borough of Manhattan in New York City. Theacquisition of the leases is subject to the satisfaction of certain conditions,including landlord consents. As of June 29, 2007, the Company had receivedthe required consents for two of these locations, which are expected to beplaced in operation during the third quarter. The Company shortly expects toreceive the balance of the consents required to complete this transaction.

On March 27, 2007, certain affiliates of Oak HillCapital Partners L.P. made an equity commitment of $39.4 million in the form ofpreferred stock and warrants to acquire approximately 11% (on a fully dilutedbasis) of the Company’s common stock at an exercise price of $75.00 per share.The proceeds from this capital infusion are to be used, in part, to acquire upto eight store leases from the Gristedes supermarket chain. Any funds raisedthrough this commitment in excess of funds needed for the acquisition will beused to fund the Company’s normal capital spending, fund new store openings orreduce the Company’s outstanding debt. The first portion of this equitycommitment of $13.0 million was funded on March 27, 2007. The balance ofthe $39.4 million commitment, in which certain members of senior managementhave also elected to participate, was funded on June 28, 2007. Thepreferred stock has a 12 year maturity date from the issuance date and providesfor an annual cash dividend of 10% payable quarterly (currently prohibited bythe restrictions in the Company’s indentures and revolving credit agreement),subject to being declared by the Board of Directors. Each of the 525,334 sharesof Series A preferred stock is immediately redeemable without penalty, atthe Company’s option prior to the maturity dates, at a liquidation preferenceof $75.00 per share plus any accrued but unpaid dividends as of the redemptiondate. The Company has the right, at its option, as of immediately prior to aninitial public offering, to require holders of the preferred stock to convertall (but not less than all) of such shares into a number of shares of theCompany’s common stock equal to the liquidation preference for such shares ofpreferred stock, divided by the price per share of the Company’s common stockset forth in the final prospectus to be used in connection with the IPO.

In accordance with SFAS No. 150, “Accounting for CertainFinancial Instruments with Characteristics of both Liabilities and Equity,” theCompany has recorded the portion of the proceeds that are attributable to thepreferred stock ($10.1 million) as a liability because of the mandatoryredemption feature. The remaining amount of $2.6 million (net of $0.3 millionof expenses) was ascribed to the warrants, based on a relative fair valuebasis, and is recorded within additional paid-in capital.

At March 31, 2007,600,000 shares of the Company’s preferred stock ($0.01 par value) wereauthorized to be issued, of which 173,334 shares were outstanding, as comparedto 50,000 shares authorized at December 30, 2006, none of which wereoutstanding.

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**11.**          CondensedConsolidating Financial Information of Subsidiary Guarantors and Co-Obligors

The 9.75% senior subordinatednotes due 2011 and the senior secured floating rate notes due 2010 wereco-issued by Duane Reade Inc. and Duane Reade GP, each of whom isconsidered a “co-obligor.” The Company and each of its other subsidiaries,composed of DRI I Inc., Duane Reade International, Inc. andDuane Reade Realty, Inc., are guarantors of such notes. The guaranteeof the Company and of each subsidiary guarantor is full and unconditional andjoint and several.

The following condensed consolidating financialinformation for the Company presents the financial information of DuaneReade Holdings, Inc., the co-obligors and the subsidiary guarantors,prepared on the equity basis of accounting. Such presentation is based on the Company’sunderstanding and interpretation of Rule 3-10 under the Securitiesand Exchange Commission’s Regulation S-X. Income tax expense (benefit) anddeferred income taxes have been allocated to individual entities according tothe Company’s income tax allocation methodology. Certain of the prior yearinformation has been adjusted to conform its presentation with the currentyear. There is no limitation on dividends or distributions between the parentand its subsidiaries. The financial information may not necessarily beindicative of results of operations or financial position had the subsidiaryguarantors operated as independent entities.

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**DUANE READE HOLDINGS, INC.Condensed Consolidating Statement of Operations (Unaudited)For the 13 weeks ended March 31,2007(in thousands)**

| ** **                                           | ** ** | **Duane Reade  Holdings, Inc.** | ** ** | **Duane  Reade Inc.** | ** ** | **Duane  Reade GP** | ** ** | **Subsidiary  Guarantors** | ** ** | **Consolidating  Adjustments** | ** ** | **Duane Reade  Holdings, Inc.  Consolidated** | ** ** |
|------------------------------------------------------|------------|-------------------------------------------|------------|----------------------------|------------|--------------------------|------------|----------------------------|------------|--------------------------------|------------|---------------------------------------------------------|------------|
| Net sales                                            |       |                                      | $          | —                     |       |                     |       | $                          | —     |                           |       | $                                                       | 414,388    |   |   | $ | 9,999 |   |   |   | $ | (9,999 | ) |   |   | $ | 414,388 |   |   |
| Cost of sales                                        |       |                                      | —     |                       |       |                     | —     |                       |       | 333,379                        |       |                                                    | —     |   |   |   | — |   |   |   | 333,379 |   |   |
| Gross profit                                         |       |                                      | —     |                       |       |                     | —     |                       |       | 81,009                         |       |                                                    | 9,999      |   |   |   | (9,999 | ) |   |   | 81,009 |   |   |
| Selling,  general & administrative expenses |       |                                      | —     |                       |       |                     | —     |                       |       | 89,052                         |       |                                                    | 85         |   |   |   | (16,393 | ) |   |   | 72,744 |   |   |
| Depreciation and  amortization                       |       |                                      | —     |                       |       |                     | —     |                       |       | 18,037                         |       |                                                    | —     |   |   |   | — |   |   |   | 18,037 |   |   |
| Store pre-opening  expense                           |       |                                      | —     |                       |       |                     | —     |                       |       | 150                            |       |                                                    | —     |   |   |   | — |   |   |   | 150 |   |   |
| Other expense                                        |       |                                      | —     |                       |       |                     | —     |                       |       | 5,018                          |       |                                                    | —     |   |   |   | — |   |   |   | 5,018 |   |   |
| Operating (loss) income                              |       |                                      | —     |                       |       |                     | —     |                       |       | (31,248                        | )          |                                                    | 9,914      |   |   |   | 6,394 |   |   |   | (14,940 | ) |   |
| Equity earnings  in affiliates                       |       |                                      | 30,535     |                       |       |                     | 30,535     |                       |       | —                         |       |                                                    | 475        |   |   |   | (61,545 | ) |   |   | — |   |   |
| Interest expense,  net                               |       |                                      | —     |                       |       |                     | —     |                       |       | 14,435                         |       |                                                    | (6,394     | ) |   |   | 6,394 |   |   |   | 14,435 |   |   |
| Income (loss) before income taxes               |       |                                      | (30,535    | )                          |       |                     | (30,535    | )                          |       | (45,683                        | )          |                                                    | 15,833     |   |   |   | 61,545 |   |   |   | (29,375 | ) |   |
| Income tax  (benefit)  expense                       |       |                                      | —     |                       |       |                     | —     |                       |       | 1,804                          |       |                                                    | (644       | ) |   |   | — |   |   |   | 1,160 |   |   |
| Net income (loss)                                    |       |                                      | $          | (30,535                    | )          |                     |       | $                          | (30,535    | )                              |       | $                                                       | (47,487    | ) |   | $ | 16,477 |   |   |   | $ | 61,545 |   |   |   | $ | (30,535 | ) |   |

 

21

----

**DUANE READE HOLDINGS, INC.Condensed Consolidating Statement of Operations (Unaudited)For the 13 weeks ended April 1, 2006(in thousands)**

| ** **                                           | ** ** | **Duane Reade  Holdings, Inc.** | ** ** | **Duane  Reade Inc.** | ** ** | **Duane  Reade GP** | ** ** | **Subsidiary  Guarantors** | ** ** | **Consolidating  Adjustments** | ** ** | **Duane Reade  Holdings, Inc.  Consolidated** | ** ** |
|------------------------------------------------------|------------|-------------------------------------------|------------|----------------------------|------------|--------------------------|------------|----------------------------|------------|--------------------------------|------------|---------------------------------------------------------|------------|
| Net sales                                            |       |                                      | $          | —                     |       |                     |       | $                          | —     |                           |       | $                                                       | 385,869    |   |   | $ | 9,361 |   |   |   | $ | (9,361 | ) |   |   | $ | 385,869 |   |   |
| Cost of sales                                        |       |                                      | —     |                       |       |                     | —     |                       |       | 310,396                        |       |                                                    | —     |   |   |   | — |   |   |   | 310,396 |   |   |
| Gross profit                                         |       |                                      | —     |                       |       |                     | —     |                       |       | 75,473                         |       |                                                    | 9,361      |   |   |   | (9,361 | ) |   |   | 75,473 |   |   |
| Selling,  general & administrative expenses |       |                                      | —     |                       |       |                     | —     |                       |       | 78,771                         |       |                                                    | 54         |   |   |   | (9,361 | ) |   |   | 69,464 |   |   |
| Labor contingency                                    |       |                                      | —     |                       |       |                     | —     |                       |       | (18,004                        | )          |                                                    | —     |   |   |   | — |   |   |   | (18,004 | ) |   |
| Depreciation and amortization                   |       |                                      | —     |                       |       |                     | —     |                       |       | 18,678                         |       |                                                    | —     |   |   |   | — |   |   |   | 18,678 |   |   |
| Store pre-opening  expense                           |       |                                      | —     |                       |       |                     | —     |                       |       | 50                             |       |                                                    | —     |   |   |   | — |   |   |   | 50 |   |   |
| Other expense                                        |       |                                      | —     |                       |       |                     | —     |                       |       | 1,102                          |       |                                                    | —     |   |   |   | — |   |   |   | 1,102 |   |   |
| Operating (loss) income                              |       |                                      | —     |                       |       |                     | —     |                       |       | (5,124                         | )          |                                                    | 9,307      |   |   |   | — |   |   |   | 4,183 |   |   |
| Equity earnings  in affiliates                       |       |                                      | 9,864      |                       |       |                     | 9,864      |                       |       | —                         |       |                                                    | 242        |   |   |   | (19,970 | ) |   |   | — |   |   |
| Interest expense  (income),  net                     |       |                                      | —     |                       |       |                     | —     |                       |       | 18,305                         |       |                                                    | (4,567     | ) |   |   | — |   |   |   | 13,738 |   |   |
| Income (loss) before income taxes                    |       |                                      | (9,864     | )                          |       |                     | (9,864     | )                          |       | (23,429                        | )          |                                                    | 13,632     |   |   |   | 19,970 |   |   |   | (9,555 | ) |   |
| Income tax  (benefit) expense                        |       |                                      | —     |                       |       |                     | —     |                       |       | 758                            |       |                                                    | (449       | ) |   |   | — |   |   |   | 309 |   |   |
| Net income (loss)                                    |       |                                      | $          | (9,864                     | )          |                     |       | $                          | (9,864     | )                              |       | $                                                       | (24,187    | ) |   | $ | 14,081 |   |   |   | $ | 19,970 |   |   |   | $ | (9,864 | ) |   |

 

22

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**DUANE READEHOLDINGS, INC.Condensed Consolidating Balance Sheet (Unaudited)As of March 31, 2007(in thousands)**

| ** **                                                   | ** ** | **Duane Reade  Holdings, Inc.** | ** ** | **Duane  Reade Inc.** | ** ** | **Duane  Reade GP** | ** ** | **Subsidiary  Guarantors** | ** ** | **Consolidating  Adjustments** | ** ** | **Duane Reade  Holdings, Inc.  Consolidated** | ** ** |
|--------------------------------------------------------------|------------|-------------------------------------------|------------|----------------------------|------------|--------------------------|------------|----------------------------|------------|--------------------------------|------------|---------------------------------------------------------|------------|
| Assets                                                       |       |                                      |       |                       |       |                     |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |
| Current assets                                               |       |                                      |       |                       |       |                     |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |
| Cash                                                         |       |                                      | $          | —                     |       |                     | $          | —                     |       | $                              | 1,351      |                                                    |       | $ | 8 |   |   |   | $ | — |   |   |   | $ | 1,359 |   |   |
| Receivables                                                  |       |                                      | —     |                       |       | —                   |       | 53,965                     |       |                           | —     |                                                    |       |   | — |   |   |   | 53,965 |   |   |
| Due from affiliates                                          |       |                                      | —     |                       |       | 72,150                   |       | 113,093                    |       |                           | 95         |                                                    |       |   | (185,338 | ) |   |   | — |   |   |
| Inventories                                                  |       |                                      | —     |                       |       | —                   |       | 220,090                    |       |                           | —     |                                                    |       |   | — |   |   |   | 220,090 |   |   |
| Deferred income taxes                                        |       |                                      | —     |                       |       | 2,010                    |       | 5,067                      |       |                           | (6,189     | )                                                       |       |   | — |   |   |   | 888 |   |   |
| Prepaid expenses and other  assets                           |       |                                      | —     |                       |       | —                   |       | 26,693                     |       |                           | —     |                                                    |       |   | — |   |   |   | 26,693 |   |   |
| Total current assets                                         |       |                                      | —     |                       |       | 74,160                   |       | 420,259                    |       |                           | (6,086     | )                                                       |       |   | (185,338 | ) |   |   | 302,995 |   |   |
| Investment in affiliates                                     |       |                                      | (15,576    | )                          |       | (15,576                  | )          | —                     |       |                           | (1,576     | )                                                       |       |   | 32,728 |   |   |   | — |   |   |
| Property and equipment                                       |       |                                      | —     |                       |       | —                   |       | 206,081                    |       |                           | —     |                                                    |       |   | — |   |   |   | 206,081 |   |   |
| Goodwill, net                                                |       |                                      | —     |                       |       | —                   |       | 70,384                     |       |                           | —     |                                                    |       |   | — |   |   |   | 70,384 |   |   |
| Deferred income taxes                                        |       |                                      | —     |                       |       | 1,645                    |       | 9,032                      |       |                           | (10,677    | )                                                       |       |   | — |   |   |   | — |   |   |
| Other assets                                                 |       |                                      | —     |                       |       | —                   |       | 161,513                    |       |                           | 361,457    |                                                    |       |   | (315,225 | ) |   |   | 207,745 |   |   |
| Total assets                                                 |       |                                      | $          | (15,576                    | )          |                     | $          | 60,229                     |       | $                              | 867,269    |                                                    |       | $ | 343,118 |   |   |   | $ | (467,835 | ) |   |   | $ | 787,205 |   |   |
| Liabilities and  Stockholder’s Equity (Deficit)         |       |                                      |       |                       |       |                     |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |
| Current liabilities                                          |       |                                      |       |                       |       |                     |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |
| Accounts payable                                             |       |                                      | $          | —                     |       |                     | $          | —                     |       | $                              | 86,252     |                                                    |       | $ | — |   |   |   | $ | — |   |   |   | $ | 86,252 |   |   |
| Due to affiliates                                            |       |                                      | —     |                       |       | —                   |       | —                     |       |                           | 185,336    |                                                    |       |   | (185,336 | ) |   |   | — |   |   |
| Accrued interest                                             |       |                                      | —     |                       |       | —                   |       | 4,683                      |       |                           | —     |                                                    |       |   | — |   |   |   | 4,683 |   |   |
| Accrued expenses                                             |       |                                      | —     |                       |       | 76                       |       | 44,218                     |       |                           | —     |                                                    |       |   | — |   |   |   | 44,294 |   |   |
| Current portion of debt                                      |       |                                      | —     |                       |       | —                   |       | 161,205                    |       |                           | —     |                                                    |       |   | — |   |   |   | 161,205 |   |   |
| Current portion of capital lease obligation                  |       |                                      | —     |                       |       | —                   |       | 3,137                      |       |                           | —     |                                                    |       |   | — |   |   |   | 3,137 |   |   |
| Total current liabilities                                    |       |                                      | —     |                       |       | 76                       |       | 299,495                    |       |                           | 185,336    |                                                    |       |   | (185,336 | ) |   |   | 299,571 |   |   |
| Long term debt                                               |       |                                      | —     |                       |       | —                   |       | 720,257                    |       |                           | —     |                                                    |       |   | (315,225 | ) |   |   | 405,032 |   |   |
| Capital lease obligation, less current portion               |       |                                      | —     |                       |       | —                   |       | 6,316                      |       |                           | —     |                                                    |       |   | — |   |   |   | 6,316 |   |   |
| Deferred income taxes                                        |       |                                      | —     |                       |       | 73,276                   |       | (74,182                    | )          |                           | 30,092     |                                                    |       |   | — |   |   |   | 29,186 |   |   |
| Other non-current liabilities                                |       |                                      | 10,147     |                       |       | 12,600                   |       | 68,076                     |       |                           | —     |                                                    |       |   | (20,294 | ) |   |   | 70,529 |   |   |
| Total liabilities                                            |       |                                      | 10,147     |                       |       | 85,952                   |       | 1,019,962                  |       |                           | 215,428    |                                                    |       |   | (520,855 | ) |   |   | 810,634 |   |   |
| Stockholder’s equity  (deficit)                         |       |                                      |       |                       |       |                     |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |
| Common stock                                                 |       |                                      | 26         |                       |       | —                   |       | —                     |       |                           | —     |                                                    |       |   | — |   |   |   | 26 |   |   |
| Paid-in-capital                                              |       |                                      | 242,075    |                       |       | 242,101                  |       | 244,330                    |       |                           | 2,395      |                                                    |       |   | (486,597 | ) |   |   | 244,304 |   |   |
| Accumulated other comprehensive income                  |       |                                      | —     |                       |       | —                   |       | 66                         |       |                           | —     |                                                    |       |   | — |   |   |   | 66 |   |   |
| Retained earnings (deficit)                                  |       |                                      | (267,824   | )                          |       | (267,824                 | )          | (397,089                   | )          |                           | 125,295    |                                                    |       |   | 539,617 |   |   |   | (267,825 | ) |   |
| Total stockholder’s equity  (deficit)                   |       |                                      | (25,723    | )                          |       | (25,723                  | )          | (152,693                   | )          |                           | 127,690    |                                                    |       |   | 53,020 |   |   |   | (23,429 | ) |   |
| Total liabilities  and stockholder’s equity or  deficit |       |                                      | $          | (15,576                    | )          |                     | $          | 60,229                     |       | $                              | 867,269    |                                                    |       | $ | 343,118 |   |   |   | $ | (467,835 | ) |   |   | $ | 787,205 |   |   |

** **

23

----

**DUANE READEHOLDINGS, INC.Condensed Consolidating Balance Sheet (Unaudited)As of December 30, 2006(in thousands)**

| ** **                                            | ** ** | **Duane Reade  Holdings, Inc.** | ** ** | **Duane  Reade Inc.** | ** ** | **Duane  Reade GP** | ** ** | **Subsidiary  Guarantors** | ** ** | **Consolidating  Adjustments** | ** ** | **Duane Reade  Holdings, Inc.  Consolidated** | ** ** |
|-------------------------------------------------------|------------|-------------------------------------------|------------|----------------------------|------------|--------------------------|------------|----------------------------|------------|--------------------------------|------------|---------------------------------------------------------|------------|
| Assets                                                |       |                                      |       |                       |       |                     |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |
| Current assets                                        |       |                                      |       |                       |       |                     |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |
| Cash                                                  |       |                                      | $          | —                     |       |                     | $          | —                     |       | $                              | 1,370      |                                                    |       | $ | 25 |   |   |   | $ | — |   |   |   | $ | 1,395 |   |   |
| Receivables                                           |       |                                      | —     |                       |       | —                   |       | 57,181                     |       |                           | —     |                                                    |       |   | — |   |   |   | 57,181 |   |   |
| Due from  affiliates                                  |       |                                      | —     |                       |       | 72,259                   |       | 112,934                    |       |                           | 145        |                                                    |       |   | (185,338 | ) |   |   | — |   |   |
| Inventories                                           |       |                                      | —     |                       |       | —                   |       | 218,924                    |       |                           | —     |                                                    |       |   | — |   |   |   | 218,924 |   |   |
| Deferred income  taxes                                |       |                                      | —     |                       |       | 3,552                    |       | 5,066                      |       |                           | (6,189     | )                                                       |       |   | — |   |   |   | 2,429 |   |   |
| Prepaid expenses  and other  assets                   |       |                                      | —     |                       |       | —                   |       | 25,659                     |       |                           | —     |                                                    |       |   | — |   |   |   | 25,659 |   |   |
| Total current  assets                                 |       |                                      | —     |                       |       | 75,811                   |       | 421,134                    |       |                           | (6,019     | )                                                       |       |   | (185,338 | ) |   |   | 305,588 |   |   |
| Investment in affiliates                              |       |                                      | 2,209      |                       |       | 2,209                    |       | —                     |       |                           | (1,101     | )                                                       |       |   | (3,317 | ) |   |   | — |   |   |
| Property and  equipment                               |       |                                      | —     |                       |       | —                   |       | 208,148                    |       |                           | —     |                                                    |       |   | — |   |   |   | 208,148 |   |   |
| Goodwill, net                                         |       |                                      | —     |                       |       | —                   |       | 70,384                     |       |                           | —     |                                                    |       |   | — |   |   |   | 70,384 |   |   |
| Deferred income  taxes                                |       |                                      | —     |                       |       | 1,645                    |       | 9,032                      |       |                           | (10,677    | )                                                       |       |   | — |   |   |   | — |   |   |
| Other assets                                          |       |                                      | —     |                       |       | —                   |       | 168,229                    |       |                           | 345,082    |                                                    |       |   | (298,850 | ) |   |   | 214,461 |   |   |
| Total assets                                          |       |                                      | $          | 2,209                      |       |                     | $          | 79,665                     |       | $                              | 876,927    |                                                    |       | $ | 327,285 |   |   |   | $ | (487,505 | ) |   |   | $ | 798,581 |   |   |
| Liabilities and Stockholder’s  Equity            |       |                                      |       |                       |       |                     |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |
| Current liabilities                                   |       |                                      |       |                       |       |                     |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |
| Accounts payable                                      |       |                                      | $          | —                     |       |                     | $          | —                     |       | $                              | 83,410     |                                                    |       | $ | — |   |   |   | $ | — |   |   |   | $ | 83,410 |   |   |
| Due to affiliates                                     |       |                                      | —     |                       |       | —                   |       | —                     |       |                           | 185,336    |                                                    |       |   | (185,336 | ) |   |   | — |   |   |
| Accrued interest                                      |       |                                      | —     |                       |       | —                   |       | 9,299                      |       |                           | —     |                                                    |       |   | — |   |   |   | 9,299 |   |   |
| Accrued expenses                                      |       |                                      | —     |                       |       | 132                      |       | 46,248                     |       |                           | —     |                                                    |       |   | — |   |   |   | 46,380 |   |   |
| Current portion of  debt                              |       |                                      | —     |                       |       | —                   |       | 157,122                    |       |                           | —     |                                                    |       |   | — |   |   |   | 157,122 |   |   |
| Current portion of  capital lease obligation     |       |                                      | —     |                       |       | —                   |       | 3,173                      |       |                           | —     |                                                    |       |   | — |   |   |   | 3,173 |   |   |
| Total current  liabilities                            |       |                                      | —     |                       |       | 132                      |       | 299,252                    |       |                           | 185,336    |                                                    |       |   | (185,336 | ) |   |   | 299,384 |   |   |
| Long term debt                                        |       |                                      | —     |                       |       | —                   |       | 703,882                    |       |                           | —     |                                                    |       |   | (298,850 | ) |   |   | 405,032 |   |   |
| Capital lease  obligation, less current portion       |       |                                      | —     |                       |       | —                   |       | 7,137                      |       |                           | —     |                                                    |       |   | — |   |   |   | 7,137 |   |   |
| Deferred income  taxes                                |       |                                      | —     |                       |       | 74,871                   |       | (75,986                    | )          |                           | 30,736     |                                                    |       |   | — |   |   |   | 29,621 |   |   |
| Other non-current  liabilities                        |       |                                      | —     |                       |       | 2,453                    |       | 52,217                     |       |                           | —     |                                                    |       |   | — |   |   |   | 54,670 |   |   |
| Total liabilities                                     |       |                                      | —     |                       |       | 77,456                   |       | 986,502                    |       |                           | 216,072    |                                                    |       |   | (484,186 | ) |   |   | 795,844 |   |   |
| Stockholder’s equity                             |       |                                      |       |                       |       |                     |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |
| Common stock                                          |       |                                      | 26         |                       |       | —                   |       | —                     |       |                           | —     |                                                    |       |   | — |   |   |   | 26 |   |   |
| Paid-in-capital                                       |       |                                      | 239,472    |                       |       | 239,498                  |       | 239,833                    |       |                           | 2,395      |                                                    |       |   | (481,391 | ) |   |   | 239,807 |   |   |
| Accumulated other  comprehensive income          |       |                                      | —     |                       |       | —                   |       | 193                        |       |                           | —     |                                                    |       |   | — |   |   |   | 193 |   |   |
| Retained earnings  (deficit)                          |       |                                      | (237,289   | )                          |       | (237,289                 | )          | (349,601                   | )          |                           | 108,818    |                                                    |       |   | 478,072 |   |   |   | (237,289 | ) |   |
| Total  stockholder’s equity                      |       |                                      | 2,209      |                       |       | 2,209                    |       | (109,575                   | )          |                           | 111,213    |                                                    |       |   | (3,319 | ) |   |   | 2,737 |   |   |
| Total liabilities  and stockholder’s equity |       |                                      | $          | 2,209                      |       |                     | $          | 79,665                     |       | $                              | 876,927    |                                                    |       | $ | 327,285 |   |   |   | $ | (487,505 | ) |   |   | $ | 798,581 |   |   |

 

24

----

**DUANE READE HOLDINGS, INC.Condensed Consolidating Statement of Cash Flows (Unaudited)For the 13 weeks ended March 31, 2007(in thousands)**

| ** **                                                                                 | ** ** | ** **              | ** ** | ** **          | ** ** | ** **        | ** ** | ** **     | ** ** | ** **        | ** ** | **Duane Reade**    | ** ** |
|--------------------------------------------------------------------------------------------|------------|-------------------------|------------|---------------------|------------|-------------------|------------|----------------|------------|-------------------|------------|-------------------------|------------|
| ** **                                                                                 | ** ** | **Duane Reade**    | ** ** | **Duane**           | ** ** | **Duane**         | ** ** | **Subsidiary** | ** ** | **Consolidating** | ** ** | **Holdings, Inc.** | ** ** |
| ** **                                                                                 | ** ** | **Holdings, Inc.** | ** ** | **Reade Inc.** | ** ** | **Reade GP** | ** ** | **Guarantors** | ** ** | **Adjustments**   | ** ** | **Consolidated**        | ** ** |
| Cash flows used in operating activities:                                                   |       |                    |       |                |       |              |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Net (loss) income                                                                          |       |                    | $          | (30,535             | )          |              |       | $              | (30,535    | )                 |       | $                       | (47,487    | ) |   | $ | 16,477 |   |   |   | $ | 61,545 |   |   |   | $ | (30,535 | ) |   |
| Adjustments to reconcile net (loss) income to net  cash used in operating activities: |       |                    |       |                |       |              |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Depreciation and   amortization                                                            |       |                    | —     |                |       |              | —     |           |       | 18,950            |       |                    | —     |   |   |   | — |   |   |   | 18,950 |   |   |
| Deferred income  taxes                                                                     |       |                    | —     |                |       |              | (53        | )              |       | 1,804             |       |                    | (644       | ) |   |   | — |   |   |   | 1,107 |   |   |
| Non-cash rent  expense                                                                     |       |                    | —     |                |       |              | —     |           |       | 3,516             |       |                    | —     |   |   |   | — |   |   |   | 3,516 |   |   |
| Other non-cash  expense                                                                    |       |                    | —     |                |       |              | —     |           |       | 1,876             |       |                    | —     |   |   |   | — |   |   |   | 1,876 |   |   |
| Equity in income  of   subsidiaries                                                        |       |                    | 30,535     |                |       |              | 30,535     |           |       | —            |       |                    | 475        |   |   |   | (61,545 | ) |   |   | — |   |   |
| Changes in operating assets and liabilities:                                          |       |                    |       |                |       |              |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Receivables                                                                                |       |                    | —     |                |       |              | 109        |           |       | 3,057             |       |                    | 50         |   |   |   | — |   |   |   | 3,216 |   |   |
| Inventories                                                                                |       |                    | —     |                |       |              | —     |           |       | (1,166            | )          |                    | —     |   |   |   | — |   |   |   | (1,166 | ) |   |
| Accounts payable                                                                           |       |                    | —     |                |       |              | —     |           |       | 2,842             |       |                    | —     |   |   |   | — |   |   |   | 2,842 |   |   |
| Prepaid and accrued   expenses                                                             |       |                    | —     |                |       |              | (56        | )              |       | (7,679            | )          |                    | —     |   |   |   | — |   |   |   | (7,735 | ) |   |
| Other assets and  liabilities,   net                                                       |       |                    | —     |                |       |              | —     |           |       | 18,637            |       |                    | (16,375    | ) |   |   | — |   |   |   | 2,262 |   |   |
| NET CASH USED IN  OPERATING ACTIVITIES                                                     |       |                    | —     |                |       |              | —     |           |       | (5,650            | )          |                    | (17        | ) |   |   | — |   |   |   | (5,667 | ) |   |
| Cash flows used in investing activities:                                                   |       |                    |       |                |       |              |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Capital expenditures                                                                       |       |                    | —     |                |       |              | —     |           |       | (6,949            | )          |                    | —     |   |   |   | — |   |   |   | (6,949 | ) |   |
| Lease acquisition and  other   costs                                                       |       |                    | —     |                |       |              | —     |           |       | (3,390            | )          |                    | —     |   |   |   | — |   |   |   | (3,390 | ) |   |
| Proceeds from sale of  property                                                            |       |                    | —     |                |       |              | —     |           |       | —            |       |                    | —     |   |   |   | — |   |   |   | — |   |   |
| NET CASH USED IN  INVESTING ACTIVITIES                                                     |       |                    | —     |                |       |              | —     |           |       | (10,339           | )          |                    | —     |   |   |   | — |   |   |   | (10,339 | ) |   |
| Cash flows from financing  activities:                                                     |       |                    |       |                |       |              |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Issuance of preferred  stock                                                               |       |                    | —     |                |       |              | —     |           |       | 12,750            |       |                    | —     |   |   |   | — |   |   |   | 12,750 |   |   |
| Borrowings from revolving  credit facility                                            |       |                    | —     |                |       |              | —     |           |       | 498,423           |       |                    | —     |   |   |   | — |   |   |   | 498,423 |   |   |
| Repayments of revolving  credit facility                                                   |       |                    | —     |                |       |              | —     |           |       | (494,341          | )          |                    | —     |   |   |   | — |   |   |   | (494,341 | ) |   |
| Repayments of capital  lease obligations                                                   |       |                    | —     |                |       |              | —     |           |       | (857              | )          |                    | —     |   |   |   | — |   |   |   | (857 | ) |   |
| Deferred financing costs                                                                   |       |                    | —     |                |       |              | —     |           |       | (5                | )          |                    | —     |   |   |   | — |   |   |   | (5 | ) |   |
| NET CASH PROVIDED BY FINANCING  ACTIVITIES                                                 |       |                    | —     |                |       |              | —     |           |       | 15,970            |       |                    | —     |   |   |   | — |   |   |   | 15,970 |   |   |
| Net decrease in  cash                                                                      |       |                    | —     |                |       |              | —     |           |       | (19               | )          |                    | (17        | ) |   |   | — |   |   |   | (36 | ) |   |
| Cash at beginning  of period                                                               |       |                    | —     |                |       |              | —     |           |       | 1,370             |       |                    | 25         |   |   |   | — |   |   |   | 1,395 |   |   |
| Cash at end of  period                                                                     |       |                    | $          | —              |       |              |       | $              | —     |              |       | $                       | 1,351      |   |   | $ | 8 |   |   |   | $ | — |   |   |   | $ | 1,359 |   |   |

 

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**DUANE READE HOLDINGS, INC.Condensed Consolidating Statement of Cash Flows (Unaudited)For the 13 weeks ended April 1, 2006(in thousands)**

| ** **                                                                                                  | ** ** | ** **              | ** ** | ** **          | ** ** | ** **        | ** ** | ** **     | ** ** | ** **        | ** ** | **Duane Reade**    | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|---------------------|------------|-------------------|------------|----------------|------------|-------------------|------------|-------------------------|------------|
| ** **                                                                                                  | ** ** | **Duane Reade**    | ** ** | **Duane**           | ** ** | **Duane**         | ** ** | **Subsidiary** | ** ** | **Consolidating** | ** ** | **Holdings, Inc.** | ** ** |
| ** **                                                                                                  | ** ** | **Holdings, Inc.** | ** ** | **Reade Inc.** | ** ** | **Reade GP** | ** ** | **Guarantors** | ** ** | **Adjustments**   | ** ** | **Consolidated**        | ** ** |
| Cash flows from operating activities:                                                                       |       |                    |       |                |       |              |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Net income (loss)                                                                                           |       |                    | $          | (9,864              | )          |              |       | $              | (9,864     | )                 |       | $                       | (24,187    | ) |   | $ | 14,081 |   |   |   | $ | 19,970 |   |   |   | $ | (9,864 | ) |   |
| Adjustments to reconcile  net income (loss) to net cash (used in) / provided by operating  activities: |       |                    |       |                |       |              |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Depreciation and  amortization                                                                              |       |                    | —     |                |       |              | —     |           |       | 19,741            |       |                    | —     |   |   |   | — |   |   |   | 19,741 |   |   |
| Deferred tax  provision                                                                                     |       |                    | —     |                |       |              | (33        | )              |       | 758               |       |                    | (449       | ) |   |   | — |   |   |   | 276 |   |   |
| Deferred rent  expense                                                                                      |       |                    | —     |                |       |              | —     |           |       | 2,559             |       |                    | —     |   |   |   | — |   |   |   | 2,559 |   |   |
| Other non-cash  expense                                                                                     |       |                    | —     |                |       |              | —     |           |       | 25                |       |                    | —     |   |   |   | — |   |   |   | 25 |   |   |
| Equity in income  of subsidiaries                                                                           |       |                    | 9,864      |                |       |              | 9,864      |           |       | —            |       |                    | 242        |   |   |   | (19,970 | ) |   |   | — |   |   |
| Changes in operating  assets and liabilities:                                                          |       |                    |       |                |       |              |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Receivables                                                                                                 |       |                    | —     |                |       |              | (86        | )              |       | 3,766             |       |                    | 1,788      |   |   |   | — |   |   |   | 5,468 |   |   |
| Inventories                                                                                                 |       |                    | —     |                |       |              | —     |           |       | 2,863             |       |                    | —     |   |   |   | — |   |   |   | 2,863 |   |   |
| Accounts payable                                                                                            |       |                    | —     |                |       |              | —     |           |       | 12,499            |       |                    | —     |   |   |   | — |   |   |   | 12,499 |   |   |
| Prepaid and  accrued expenses                                                                               |       |                    | —     |                |       |              | 119        |           |       | (6,383            | )          |                    | —     |   |   |   | — |   |   |   | (6,264 | ) |   |
| Increase in other  assets (liabilities), net                                                                |       |                    | —     |                |       |              | —     |           |       | (11,851           | )          |                    | (15,625    | ) |   |   | — |   |   |   | (27,476 | ) |   |
| NET CASH PROVIDED  BY (USED IN) OPERATING ACTIVITIES                                                        |       |                    | —     |                |       |              | —     |           |       | (210              | )          |                    | 37         |   |   |   | — |   |   |   | (173 | ) |   |
| Capital  expenditures                                                                                       |       |                    | —     |                |       |              | —     |           |       | (3,713            | )          |                    | —     |   |   |   | — |   |   |   | (3,713 | ) |   |
| Lease acquisition  and other costs                                                                          |       |                    | —     |                |       |              | —     |           |       | (1,814            | )          |                    | —     |   |   |   | — |   |   |   | (1,814 | ) |   |
| Proceeds from sale  of  property                                                                            |       |                    | —     |                |       |              | —     |           |       | —            |       |                    | —     |   |   |   | — |   |   |   | — |   |   |
| NET CASH USED IN  INVESTING ACTIVITIES                                                                      |       |                    | —     |                |       |              | —     |           |       | (5,527            | )          |                    | —     |   |   |   | — |   |   |   | (5,527 | ) |   |
| Cash flows from financing activities:                                                                       |       |                    |       |                |       |              |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Borrowings from  revolving credit facility                                                                  |       |                    | —     |                |       |              | —     |           |       | 454,703           |       |                    | —     |   |   |   | — |   |   |   | 454,703 |   |   |
| Repayments of  revolving credit facility                                                               |       |                    | —     |                |       |              | —     |           |       | (448,188          | )          |                    | —     |   |   |   | — |   |   |   | (448,188 | ) |   |
| Deferred financing  costs                                                                                   |       |                    | —     |                |       |              | —     |           |       | (21               | )          |                    | —     |   |   |   | — |   |   |   | (21 | ) |   |
| Repayments of  capital lease obligations                                                                    |       |                    | —     |                |       |              | —     |           |       | (759              | )          |                    | —     |   |   |   | — |   |   |   | (759 | ) |   |
| NET CASH PROVIDED  BY FINANCING ACTIVITIES                                                                  |       |                    | —     |                |       |              | —     |           |       | 5,735             |       |                    | —     |   |   |   | — |   |   |   | 5,735 |   |   |
| Net (decrease)  increase in cash                                                                            |       |                    | —     |                |       |              | —     |           |       | (2                | )          |                    | 37         |   |   |   | — |   |   |   | 35 |   |   |
| Cash at beginning  of period                                                                                |       |                    | —     |                |       |              | —     |           |       | 1,338             |       |                    | 24         |   |   |   | — |   |   |   | 1,362 |   |   |
| Cash at end of  period                                                                                      |       |                    | $          | —              |       |              |       | $              | —     |              |       | $                       | 1,336      |   |   | $ | 61 |   |   |   | $ | — |   |   |   | $ | 1,397 |   |   |

 

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

The following discussionregarding our financial condition and results of operations for the 13 weeksended March 31, 2007 and the 13 weeks ended April 1, 2006 should beread in conjunction with the more detailed financial information contained inour consolidated financial statements and their notes as well as the SpecialNote Regarding Forward-Looking Statements that are contained elsewhere in thisreport.

**General**

Our business consists of the sale of a wide variety ofhealth and beauty care products, convenience oriented food, general merchandiseand other products and a pharmacy operation managed to supply customers withtheir prescription needs. We refer to the non-prescription portion of ourbusiness as front-end sales because most of these sales are processed throughthe front check-out sections of our stores. This portion of our businessconsists of brand name and private label health and beauty care items, food andbeverages, tobacco products, cosmetics, housewares, greeting cards,photofinishing services, photo supplies and seasonal and general merchandise.Health and beauty care products, including over-the-counter items, representour highest volume categories within front-end sales. The front-end portion ofour business represented 53.0% of our sales in the thirteen weeks ended March 31,2007, as compared to 53.5% in the corresponding period last year. Gross marginsgenerated by our front-end business are approximately twice that of ourpharmacy or back-end business.

Because of our numerous convenient locations inhigh-traffic commercial and residential areas and the lack of other convenience-orientedretailers in our core market areas, our front-end business is generally alarger proportion of our total sales than for other major conventionaldrugstore chains, whose front-end sales average between 30% and 40% of totalsales. In recent history, front-end sales have represented a decreasing shareof business year after year; however, over the last few years, pharmacy saleshave experienced a slowing rate of growth primarily due to increases in thirdparty plan co-payments, reduced sales of hormonal replacement drugs and certainarthritis medications, limitations on maximum reimbursements for certaingeneric medications by third party plans, increases in the percentage of salesrepresented by lower-priced generic medications and increased penetration bymail order and internet-based pharmacies. Our pharmacy sales include all itemswe sell by prescriptions filled at our retail locations or by our centralfill/mail order facility and delivered to our stores or mailed directly to ourcustomers. In addition, we include in our pharmacy sales certain resales of retailpharmaceutical inventory that are required to be reported on a gross basis inaccordance with Emerging Issues Task Force Issue No. 99-19, “ReportingRevenue Gross as a Principal vs. Net as an Agent.” Same-store pharmacy sales donot include such resale activity. The pharmacy portion of our business isdominated by and dependent upon a number of third party private andgovernment-sponsored plans that contract with us as an authorized provider ofprescriptions. In each of the past four years, New York State has enacted rules relatedto Medicaid which have reduced reimbursement rates and therefore our pharmacymargin. New York has again changed its rules effective July 1, 2007.We estimate that these most recent changes will reduce our annual pharmacymargin by approximately $1.8 million.

Sales processed through third party prescription plansrepresented approximately 93.1% of our prescription sales in the thirteen weeksended March 31, 2007 and approximately 92.6% of our prescription sales inthe thirteen weeks ended April 1, 2006. Historically, excluding pharmacyresale activity, our pharmacy sales experienced a faster rate of sales growththan the front-end portion of our business due to a number of favorabledemographic and industry trends such as the aging of the population, expandedpenetration of third party private and government-sponsored coverage and theincreasing utilization of prescriptions to improve quality of life and in placeof medical procedures. While these factors are still operative, our rate ofretail pharmacy sales growth has steadily declined over the last several yearsto the point where our most recent pharmacy sales results reflect a lower rateof growth than 

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the front-end portion ofour business. This slower pharmacy sales growth is the result of increased mailorder penetration (that results in losses of retail based prescription sales tomail order providers), negative publicity surrounding the adverse side effectsof certain arthritis medications and other high volume drugs, conversion ofcertain high volume prescription drugs to over-the-counter front-end productsand increased use of lower priced but more profitable generic drugs in place ofhigher priced branded medications.

During 2003, President Bush signed the MedicareModernization Act, which created a new Medicare Part D benefit thatexpanded Medicare coverage of prescription drugs for senior citizens as well asfor certain “dual eligible” individuals that were previously covered understate administered Medicaid plans. This new Medicare coverage took effect in January 2006and has resulted in decreased pharmacy margins resulting from lowerreimbursement rates than our current margins on state Medicaid prescriptions aswell as prescriptions that are not subject to third party reimbursement. Thisnew Medicare Part D program grew rapidly during 2006 and is projected tocontinue to grow in 2007 as more seniors reach age 65 and become eligible forthis coverage. While the program has had an adverse impact on our pharmacymargins, based on our experience, we expect, over time, that increasedutilization of prescription drugs by senior citizens participating in the newprograms who previously were cash paying customers will partially offset theeffect of lower margins on our revenues, although we are not certain this willbe the case. State Medicaid programs that provide prescription benefits to lowincome households and individuals have historically represented slightly lessthan 25% of our retail pharmacy sales. At March 31, 2007, as a result ofdual eligible individuals being automatically enrolled into the Medicare Part Dprogram as well as new enrollees becoming eligible by virtue of their havingreached 65 years of age, state Medicaid plans had declined to approximately14.4% of our pharmacy sales while the new Medicare Part D plan representedapproximately 11.9% of our pharmacy sales.

In an effort to offset some of the adverse pharmacygross margin impacts from the trends discussed above, there has been anintensified effort on the part of retailers to support increased utilization oflower priced but higher margin generic prescriptions in place of brandedmedications. Generic prescriptions generally have lower retail sales prices butare more profitable for the pharmacy than branded prescriptions. Improvedgeneric utilization rates as well as a combination of direct purchases andcontractual wholesaler purchases enabled us to achieve improved gross marginson pharmacy retail sales during 2005 and 2006. For the quarter ended March 31,2007, we continued to see increased generic substitution rates. The proportionof generic prescriptions dispensed was 54.3%, compared to 51.3% in the sameperiod last year.

We are impacted by recent legislation in states toincrease the minimum hourly wages. New York State increased the minimum hourlywage from $5.15 to $6.00 on January 1, 2005, to $6.75 on January 1,2006, and again to $7.15 on January 1, 2007. New Jersey increased theminimum hourly wage from $5.15 to $6.15 on October 1, 2005 and again to$7.15 on October 1, 2006. In addition, the U.S. Congress recently passedlegislation that would result in a federal minimum hourly wage increase to$7.25 two years after the effective date of the legislation, which date has yetto be determined. While these increases have impacted our cost of labor, wehave, and believe we can continue to, offset a significant portion of thesecost increases through initiatives designed to further improve our laborefficiency.

Our primary assets are ourownership of 100% of the outstanding capital stock of Duane Reade Inc.,which in turn owns 99% of the outstanding partnership interest of Duane ReadeGP and all of the outstanding common stock of DRI I Inc. DRI I Inc.owns the remaining 1% partnership interest in Duane Reade GP. Substantially allof our operations are conducted through Duane Reade GP. In August 1999, weestablished two new subsidiaries, Duane Reade International, Inc. andDuane Reade Realty, Inc. Duane Reade GP distributed to DuaneReade Inc. and DRI I Inc. all rights, title, and interest in all itstrademarks, trade names and all other intellectual property rights. In turn,Duane Reade Inc. and DRI I Inc. made a capital contribution ofthese intellectual property rights to Duane Reade International. This changecreated a controlled system to manage and exploit these intellectual propertyrights separate 

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andapart from the retail operations. In addition, Duane Reade GP distributed someof its store leases to Duane Reade Inc. and DRI I Inc., which in turnmade a capital contribution of these leases to Duane Reade Realty. Duane ReadeRealty is the lessee under certain store leases entered into after itscreation. Duane Reade Realty subleases to Duane Reade GP the properties subjectto those leases. The consolidated financial statements included in this filingreflect the accounts of Duane Reade Holdings, Inc. and its subsidiariesfor all periods shown. All significant intercompany transactions and balanceshave been eliminated.

**ConsiderationsRelated to Operating in the New York City Marketplace**

We operate approximately89% of our 245 stores in New York City and the remainder in the surroundingareas. As a result, our performance will be substantially affected by economicconditions and other factors affecting the region such as the regulatoryenvironment, cost of energy, real estate, insurance, taxes and rent, weather,demographics, availability of labor and geopolitical factors such as terrorism.Since the second half of 2004, the New York City economy has generallyreflected an improving trend. The March 2007 unemployment data for NewYork City indicated an unemployment rate of 4.3%, compared to a correspondingnational rate of 4.4%.

**Results ofOperations**

***The Thirteen Weeks Ended March 31, 2007 asCompared to the Thirteen Weeks Ended April 1, 2006***

For the firstquarter of 2007, we achieved net sales of $414.4 million and incurred a netloss of $30.5 million, as compared to net sales of $385.9 million and anet loss of $9.9 million in the first quarter of the previous year. Pharmacyresale activity included in net sales was $14.4 million in the first quarter of2007, compared to $11.4 million in the previous year. The increased loss isattributable to the following factors:

·       A non-recurring laborcontingency credit of $18.0 million recorded in the first quarter of 2006resulting from the favorable settlement of the NLRB litigation.

·       An increase in otherexpenses of $3.9 million, primarily due to the audit committee investigations,arbitration and various other costs related to the former Chairman and CEO thatwere incurred in the first quarter of 2007.

·       An increase in selling,general and administrative expenses of $3.2 million, primarily reflectingincreased pharmacists’ labor costs, increases in minimum wage rates and payrollcosts associated with additional corporate staffing to support the continuedimplementation of the Duane Reade Full Potential program.

·       An income tax provision of$1.2 million in the first quarter of 2007, compared to an income tax provisionof $0.3 million in the prior year. The change in the tax provision wasprimarily attributable to the change in the pre-tax loss as compared to theprior year.

·       An increase in interestexpense of $0.7 million resulting from higher interest rates applicable toour variable rate debt and higher borrowing levels on our amended asset-basedrevolving loan facility.

The negative impactof these items was partially offset by:

·       An increase in gross marginof $5.5 million, that was primarily attributable to higher front-end storesales.

·       A decrease in non-cashdepreciation and amortization expenses of $0.6 million, reflecting the impactof the intangible asset impairment writedown recorded in the fourth quarter of2006.

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

| ** **                                           | ** ** | **For the 13 Weeks Ended**      | ** ** |
|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                           | ** ** | **March 31, 2007**                        | ** ** | **April 1, 2006** | ** ** |
| ** **                                           | ** ** | **Dollars**                                         | ** ** | **% of Sales** | ** ** | **Dollars** | ** ** | **% of Sales** | ** ** |
| ** **                                           | ** ** | **In thousands, except percentages** | ** ** |
| Net sales                                            |       | $                                                   | 414,388    |   |   | 100.0 | % |   |   | $ | 385,869 |   |   |   | 100.0 | % |   |
| Cost of sales                                        |       | 333,379                                             |       |   | 80.4 |   |   |   | 310,396 |   |   |   | 80.4 |   |   |
| Gross profit                                         |       | 81,009                                              |       |   | 19.6 |   |   |   | 75,473 |   |   |   | 19.6 |   |   |
| Selling,  general & administrative expenses |       | 72,744                                              |       |   | 17.6 |   |   |   | 69,464 |   |   |   | 18.0 |   |   |
| Labor contingency  income                            |       | —                                              |       |   | 0.0 |   |   |   | (18,004 | ) |   |   | (4.7 | ) |   |
| Depreciation and  amortization                       |       | 18,037                                              |       |   | 4.4 |   |   |   | 18,678 |   |   |   | 4.8 |   |   |
| Store pre-opening  expenses                          |       | 150                                                 |       |   | 0.0 |   |   |   | 50 |   |   |   | 0.0 |   |   |
| Other expense                                        |       | 5,018                                               |       |   | 1.2 |   |   |   | 1,102 |   |   |   | 0.3 |   |   |
| Operating (loss)  income                             |       | (14,940                                             | )          |   | -3.6 |   |   |   | 4,183 |   |   |   | 1.1 |   |   |
| Interest expense,  net                               |       | 14,435                                              |       |   | 3.5 |   |   |   | 13,738 |   |   |   | 3.6 |   |   |
| Loss before  income taxes                            |       | (29,375                                             | )          |   | -7.1 |   |   |   | (9,555 | ) |   |   | -2.5 |   |   |
| Income tax  provision                                |       | 1,160                                               |       |   | 0.3 |   |   |   | 309 |   |   |   | 0.1 |   |   |
| Net loss                                             |       | $                                                   | (30,535    | ) |   | -7.4 | % |   |   | $ | (9,864 | ) |   |   | -2.6 | % |   |

 

Net sales were $414.4 million in the thirteenweeks ended March 31, 2007, representing an increase of 7.4% as comparedto net sales of $385.9 million in the thirteen weeks ended April 1,2006. Resale activity accounted for 0.8% of the increase, while an increase inretail store sales to customers represented the remaining 6.6%. Same-storesales increased by 8.2% over the first quarter last year.

Pharmacy sales increased from $179.4 million inthe first quarter of 2006 to $194.5 million in the first quarter of 2007,an increase of 8.6%, and represented 47.0% of total sales, as compared with46.5% of total sales in the first quarter of 2006. The overall pharmacy salesincrease includes an increase of 1.7% resulting from the increased resaleactivity, combined with an increase of 6.9% in retail pharmacy sales. Pharmacysame-store sales increased by 9.0% from last year, and third-party reimbursedpharmacy sales represented 93.1% of total prescription sales compared to 92.6%in the first quarter of 2006. The percentage of generic drugs dispensedincreased by 3.0% over the prior year, negatively impacting the pharmacysame-store sales increase by approximately 2.6%, but contributing to anincrease in gross margin per prescription dispensed. Generic drugs generallyhave lower retail sales prices but are more profitable for us than brandeddrugs.

Front-end sales increased from $206.5 million inthe first quarter of 2006 to $219.5 million in the first quarter of 2007,an increase of 6.3%, and represented 53.0% of total sales, as compared to 53.5%of total sales in the first quarter of 2006. Front-end same-store salesincreased by 7.6%, primarily due to a generally improved level of consumerdemand resulting from a stronger New York City economy, increased penetrationof our Dollar Rewards program, an improved merchandise offering and enhancedcustomer service reflecting the implementation of our “Full Potential”initiative introduced earlier this year.

During the thirteen weeks ended March 31, 2007,we opened two stores and closed five stores, as compared to one store openedand five stores closed during the thirteen weeks ended April 1, 2006. At March 31,2007, we operated 245 stores, as compared to 247 stores at April 1, 2006and 248 stores at December 30, 2006.

Cost of sales as a percentage of net sales was 80.4%in the first quarter of both 2007 and 2006, resulting in a gross profit marginof 19.6% in each period. The gross profit margin in 2007 reflects the impact ofimproved front-end selling margins associated with a more favorable mix ofpromotional and regularly-priced products, offset by the negative impact onpharmacy margins of increased Medicare 

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Part D sales as wellas lower NY Medicaid reimbursement rates that went into effect in July of2006. These factors were partially offset by the higher margins associated withan increased proportion of generic prescriptions in 2007. Cost of sales alsoincludes a $0.6 million LIFO provision in each year’s first quarter.

Selling, general and administrative expenses were$72.7 million, or 17.6% of net sales, and $69.5 million, or 18.0% of netsales, in the first quarter of 2007 and 2006, respectively. The decrease in the2007 expense percentage as compared to 2006 was attributable to improvedleverage of costs against strong rates of same-store sales growth in bothpharmacy and front-end, decreased legal and professional fees resulting fromthe settlement of certain long-running litigations, lower promotional expensesas well as various process improvement initiatives designed to reduce storeoperating costs.

Depreciation and amortization of property andequipment and intangible assets was $18.0 million in the first quarter of2007, as compared to $18.7 million in the first quarter of 2006. The netdecrease reflects a reduction in expenses that is attributable to theimpairment writedown recorded in the fourth quarter of 2006.

We incurred store pre-opening expenses of$0.1 million in the first quarter of 2007 attributable to the opening oftwo stores, as compared to $0.1 million in the first quarter of 2006 reflectingone new store opened.

In the first quarter of 2007, we incurred otherexpenses of $5.0 million, including costs associated with the audit committeeinvestigations and various other matters related to the former Chairman and CEO($2.8 million), costs associated with the closing of three stores ($1.7million), Oak Hill management fees ($0.3 million) and additional severancecosts associated with the termination of certain executive management ($0.2million). In the first quarter of 2006, other expenses of $1.1 million includedcosts associated with various matters related to the former Chairman and CEO($0.6 million), Oak Hill management fees ($0.3 million) and costs attributableto our current Chairman and CEO ($0.2 million).

Net interest expense for the first quarter of 2007 was$14.4 million, as compared to $13.7 million in the first quarter of 2006.This increase was primarily attributable to higher floating interest rates andincreased debt levels incurred on our revolving credit borrowings as comparedto the prior year. At March 31, 2007, the weighted average interest rateon our variable rate outstanding debt was 8.59%, as compared to a weightedaverage rate of 8.25% at April 1, 2006.

In the first quarter of2007, we recorded an income tax provision of $1.2 million, reflecting anestimated effective tax rate of (3.9%). This expense is the result of avaluation allowance of $14.3 million that largely offset the tax benefitgenerated by our operating loss in the quarter. In the comparable period of2006, the income tax provision of $0.3 million, resulting from a valuationallowance of $4.5 million, reflected an effective tax rate of (3.2%).

**Liquidity andCapital Resources**

**Working Capital andCash Flow**

Working capital was$3.4 million as of March 31, 2007 and $6.2 million as of December 30,2006. The primary factors affecting the reduction in working capital from December 30,2006 include:

·       increased borrowings of$4.1 million on our amended asset-based revolving loan facility,

·       increasedaccounts payable of $2.8 million,

·       receivablereductions of $3.2 million,

·       increasedinventory of $1.1 million and

·       adecrease in the current portion of deferred tax assets of $1.5 million.

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These items were partiallyoffset by reductions in other expense accruals of $7.7 million resultingprimarily from the timing of our payroll cycle and the semi-annual interestpayment on our senior subordinated notes.

Working capital reflectsthe classification of outstanding borrowings under our amended asset-basedrevolving loan facility of $161.2 million at March 31, 2007 and$157.1 million at December 30, 2006 as current liabilities. Thiscurrent classification is required because cash receipts controlled by thelenders are used to reduce outstanding debt and we do not meet the criteria ofSFAS No. 6 to reclassify the debt as long-term, but is not an indicationthat this credit facility is expected to be retired within the next year. Thisfacility expires in July 2011 and we intend to continue to access it forour working capital needs throughout its remaining term.

On July 7, 2006, weentered into a third amendment to the credit agreement governing our$225 million asset-based revolving loan facility discussed above. Thethird amendment extends the maturity date of the asset-based revolving loanfacility from July 21, 2008 to July 21, 2011. Refer to Note 7 of theUnaudited Consolidated Interim Financial Statements contained elsewhere in thisreport for further information related to this amendment.

Net cash used in operatingactivities was $5.7 million in the thirteen weeks ended March 31,2007 compared to net cash used in operating activities of $0.2 million inthe thirteen weeks ended April 1, 2006. The increase is attributable tothe timing of seasonal merchandise purchases and related disbursements in 2007compared to 2006 as well as an increase in the third party pharmacy receivablesdue to the timing of collections from certain third party pharmacy plans.

Net cash used in investingactivities was $10.3 million in the thirteen weeks ended March 31,2007, compared to $5.5 million in the thirteen weeks ended April 1,2006. In the first three months of 2007, we spent $6.9 million on capitalexpenditures, primarily related to new store openings and the remodeling ofexisting locations, and $3.4 million on lease acquisition and other costs.In the first three months of 2006, capital expenditures amounted to $3.7million and lease acquisition, pharmacy customer file and other costs were $1.8million.

Net cash provided byfinancing activities was $16.0 million in the thirteen weeks ended March 31,2007, compared to $5.7 million in the thirteen weeks ended April 1,2006. Cash provided by financing activities includes $12.7 million (net ofexpenses of $0.3 million) resulting from the issuance of preferred stock andwarrants. See Note 10 to our unaudited consolidated interim financialstatements contained elsewhere in this report for additional informationregarding this transaction.

**Operating Capital Requirements**

Our operating capitalrequirements primarily result from opening and stocking new stores, remodelingand renovating existing retail locations, purchasing pharmacy files and thecontinuing development of management information systems. We opened two newstores in the first three months of 2007, five new stores during fiscal 2006and seven new stores during fiscal 2005. We currently plan to open a total of 14 new storesand close 8 stores in 2007. The new store openings in 2007 include theacquisition of up to eight leases in Manhattan from the Gristedes supermarketchain. This acquisition is subject to various conditions including, in somecases, the receipt of landlord consents. The acquisition of the Gristedesleases and the related build-out costs and working capital commitments will befunded through a commitment by certain affiliates of Oak Hill Capital Partners,L.P. to purchase up to $39.4 million in preferred equity and warrants topurchase common stock. Any funds raised through this commitment in excess offunds needed for the acquisition will be used to fund our normal capital spending,fund new store openings or reduce our outstanding debt. On March 27, 2007,Oak Hill and its affiliates funded $13.0 million under that commitment. Thebalance of that $39.4 million commitment, in which certain members of seniormanagement also elected to participate, was funded on June 28, 2007. Wepresently plan to open a total of 12 additional stores in each of 2008 and2009.

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In the first three monthsof 2007, we spent approximately $6.9 million on capital expenditures,primarily for new, renovated and replacement stores and a new “Pick-to-Light”flow rack merchandise distribution system in our Maspeth distribution center.We also spent an additional $3.4 million for lease acquisition and othercosts. In fiscal 2006, we spent approximately $3.7 million on capitalexpenditures, and we spent an additional $1.8 million for leaseacquisition, pharmacy customer files and other costs. We also require workingcapital to support inventory for our existing and new stores. Historically, wehave been able to lease almost all of our store locations, so acquisitions ofreal estate are not expected to have a significant impact on our capitalrequirements.

**Other FactorsInfluencing our Liquidity**

Twenty-two of our stores, which generatedapproximately 7.3% of our net sales for fiscal 2006, have leases scheduled toexpire before the end of fiscal 2008. Six of these leases have renewal options.We believe that we will be able to renew most of the other expiring leases oneconomically favorable terms or, alternatively, find other economicallyattractive replacement locations to lease.

As of March 31, 2007, approximately 4,500 of ourapproximately 6,500 employees were represented by various labor unions and werecovered by collective bargaining agreements. Pursuant to the terms of thecollective bargaining agreements covering these employees, we are required, insome instances, to pay specified annual increases in salary and benefitscontributions relating to the member employees. We do not believe that theseincreases will have a material impact on our liquidity or results ofoperations.

Thefollowing table presents details of our significant commitments and obligationsas at March 31, 2007, except that the data provided with respect tooperating leases is as of December 30, 2006:

| ** **                                            | ** ** | **Payments due by Period** | ** ** |
|-------------------------------------------------------|------------|-------------------------------------------|------------|
| **Contractual Cash Obligations**            | ** ** | ** **                                | ** ** | **Total** | ** ** | **Within  1 year** | ** ** | **Within  2-3 years** | ** ** | **Within  4-5 years** | ** ** | **After  5 years** | ** ** |
| ** **                                            | ** ** | **(dollars in thousands)**      | ** ** |
| Long-Term Debt(1)                                     |       | $                                         | 405,032    |   | $ | — |   | $ | — |   | $ | 405,000 |   | $ | 32 |   |
| Asset-Based  Revolving Loan Facility(2)               |       | 161,204                                   |       | — |   | — |   | 161,204 |   | — |   |
| Capital Lease  Obligations(3)                         |       | 11,253                                    |       | 4,175 |   | 7,078 |   | — |   | — |   |
| Operating  Leases(4)                                  |       | 1,344,282                                 |       | 126,414 |   | 251,803 |   | 230,823 |   | 735,242 |   |
| Fixed Interest  Payments(5)                           |       | 85,558                                    |       | 19,013 |   | 38,025 |   | 28,520 |   | — |   |
| Former Chairman  and Other Severance Payments(6) |       | 2,386                                     |       | 2,253 |   | 17 |   | 16 |   | 100 |   |
| Former Pharmacy  Supplier Settlement(7)               |       | 250                                       |       | 250 |   | — |   | — |   | — |   |
| Landlord Real  Estate Litigation Settlement(8)        |       | 747                                       |       | 560 |   | 187 |   | — |   | — |   |
| Total Contractual Cash  Obligations(9)                |       | $                                         | 2,010,712  |   | $ | 152,665 |   | $ | 297,110 |   | $ | 825,563 |   | $ | 735,374 |   |
|                                                       |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          These amounts include$195.0 million of outstanding senior subordinated notes due in 2011,$210.0 million of outstanding senior secured notes due in 2010 and $32,000outstanding under the senior convertible notes due in 2022. For moreinformation about the terms of the indebtedness described above, please see “—Debt,”below.

(2)          At March 31, 2007,approximately $161.2 million was outstanding and a further $53.1 millionwas available for borrowing under our amended asset-based revolving loanfacility. Obligations under this facility have been classified as currentliabilities because cash receipts controlled by the lenders are used to reduceoutstanding debt and we do not meet the criteria of SFAS No. 6 toreclassify the debt as long-term. However, this is not an indication that thiscredit facility is expected to be retired within the next year. We intend tocontinue to use this facility for our working capital needs through the date ofits maturity in July 2011.

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(3)          Please refer toNote 11 to the annual consolidated financial statements on Form 10-Kfor further detail on Capital Lease obligations.

(4)          Please refer toNote 15 to the annual consolidated financial statements on Form 10-Kfor further detail on Operating Lease obligations.

(5)          Reflects interestpayable on the $195.0 million outstanding senior subordinated notes.

(6)          Reflects paymentsspecified under the employment contract with the former Chairman and CEO to bemade by us in connection with his replacement on November 21, 2005, aswell as payments due to other executives whose employment was terminated during2006 and 2007. In an ongoing arbitration between Mr. Cuti and us(explained in more detail in Note 9 of the Unaudited Consolidated InterimFinancial Statements contained elsewhere in this report), we are seeking, amongother forms of relief, rescission of employment agreements entered into betweenus and Mr. Cuti, the return of all compensation paid under the employmentagreements, including the benefits described in this footnote, and othermonetary damages.

(7)          Reflects cash paymentsdue to Cardinal Health, a former pharmacy inventory supplier, in connectionwith the settlement of an outstanding claim. Amounts shown are net of $4.0million paid during 2006 and $0.3 million paid in the first three months of2007.

(8)          Reflects cash paymentsdue to the landlord of one of our stores in connection with the settlement of areal estate litigation. Amounts shown are net of $0.6 million paid in the firstthree months of 2007.

(9)          The totals reflected inthis table exclude tax-related commitments of approximately $2.4 million, whichare included on the balance sheet under the category of “Other non-currentliabilities.”

Thefollowing table presents details of our other significant commercialcommitments as at March 31, 2007:

| ** **                                 | ** ** | ** **                           | ** ** | **Amount of Commitment Expiration per Period** | ** ** |
|--------------------------------------------|------------|--------------------------------------|------------|-------------------------------------------------------------------------|------------|
| **Other Commercial Commitments** | ** ** | ** **                           | ** ** | **Total Amounts  Committed**                                       | ** ** | **Within  1 year** | ** ** | **  2-3 years  ** | ** ** | **  4-5 years  ** | ** ** | **After   5 years** | ** ** |
| ** **                                 | ** ** | **(dollars in thousands)** | ** ** |
| Standby Letters  of Credit(1)              |       |                                 | $          | 5,749                                                                   |       |   | $ | 5,602 |   |   | $ | 147 |   |   |   | $ | — |   |   |   | $ | — |   |   |
| Total Commercial  Commitments              |       |                                 | $          | 5,749                                                                   |       |   | $ | 5,602 |   |   | $ | 147 |   |   |   | $ | — |   |   |   | $ | — |   |   |
|                                            |            |                                      |            |                                                                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          Standby letters ofcredit, primarily representing self-insured general liability claims andproperty lease security deposits, are renewed on an annual basis, unlessotherwise requested by the beneficiary.

We are party to multi-year, merchandise supplyagreements in the normal course of business. The largest of these agreements iswith AmerisourceBergen, our primary pharmaceutical supplier. Generally, theseagreements provide for certain volume commitments and may be terminated by us,subject in some cases to specified termination payments, none of which webelieve would constitute a material, adverse effect on our financial position,results of operations or cash flows. It is the opinion of management that ifany of these agreements were terminated or if any contracting party was toexperience events precluding fulfillment of its obligations, we would be ableto find a suitable alternative supplier.

In connection with the November 21, 2005replacement of Mr. Cuti by Mr. Dreiling as our Chairman and CEO, Mr. Cuti’semployment contract specifies payments to him in cash totaling up to $6.6million. We have paid a cumulative total of approximately $4.9 million of thisamount through March 31, 2007, and the remaining amount is scheduled,pursuant to the employment contract, to be paid in equal installments through December 2007.In addition, the employment contract provides for continued health insurancecoverage for Mr. Cuti during the 25-month period followingtermination and, upon expiration of that period, if Mr. Cuti is nototherwise eligible under another employer’s comparable medical plan, lifetime 

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retiree medical benefitsat a cost not to exceed $50,000 annually. In an ongoing arbitration between Mr. Cuti and us (explained indetail in Note 9 to the Unaudited Consolidated Interim Financial Statementscontained elsewhere in this report), we are seeking, among other forms ofrelief, rescission of employment agreements entered into between us and Mr. Cuti,the return of all compensation paid under the employment agreements, includingthe benefits described in this paragraph, and other monetary damages.

In connection with the appointment of Mr. Dreilingas CEO, we were required under his employment contract to make a guaranteedpayment to him of $330,000 on or before February 19, 2006, which was paidon February 17, 2006. In addition, Mr. Dreiling’s employment contractstipulated that a guaranteed 2006 bonus of not less than 100% of histhen-current $825,000 annual salary be paid on the same date as any othersenior executive bonuses related to the 2006 fiscal year are paid. This bonuswas paid on April 5, 2007.

In connection with the Acquisition, the formerChairman and CEO was granted equity interests in Duane Reade Shareholders andDuane Reade Holdings, consisting of options to purchase shares of our commonstock and a profits interest in Duane Reade Shareholders. The former Chairmanand CEO’s employment contract provides that, as a result of his replacement on November 21,2005 by Mr. Dreiling, he had the right to require us to purchase for cashto be paid over a two year period all or a portion of these equity interests ashe may designate, at a value determined in accordance with a formula. In connectionwith his replacement by Mr. Dreiling, we have treated all of his equityinterests as having vested. The profits interest and options will have no valueunless the value of Duane Reade Shareholders and Duane Reade Holdings,respectively, appreciate following the Acquisition. The former Chairman and CEO’spurchase right will be suspended at any time when the exercise of such purchaserights would result in a default under the financing arrangements of DuaneReade Shareholders, Duane Reade Holdings or Duane Reade Inc. On December 21,2005, the former Chairman and CEO provided notice to Duane Reade Inc. thathe was exercising his repurchase right to cause us to repurchase 5% of hisprofits interest. Pursuant to the procedures outlined in the new employmentagreement, Duane Reade Inc. has advised him that his profits interest as of December 21,2005 was determined to have no value. The benefits described in this paragraph were all granted under anemployment agreement between Mr. Cuti and us. In an ongoing arbitrationbetween Mr. Cuti and us (explained in detail in Note 9 to the UnauditedConsolidated Interim Financial Statements contained elsewhere in this report),we are seeking, among other forms of relief, rescission of employmentagreements entered into between us and Mr. Cuti, the return of allcompensation paid under the employment agreements, including the benefitsdescribed in this paragraph, and other monetary damages. The determination thatMr. Cuti’s profits interest as of December 21, 2005 had no value is alsoone of several subjects specifically at issue in the arbitration.

In connection with the December 9,2005 settlement of litigation between us and Cardinal Health, we are requiredto make payments to Cardinal Health totaling $4.5 million. Such payments include$2.0 million that was paid on January 15, 2006, $1.0 million that was paidon June 15, 2006, $1.0 million that was paid on December 15, 2006,$250,000 that was paid on March 15, 2007 and a remaining payment of$250,000 that was paid on June 15, 2007. All such amounts had beenpreviously accrued in the financial statements.

**Debt**

Refer to Note 7 to theUnaudited Consolidated Interim Financial Statements contained elsewhere in thisreport for adetailed description with respect to the various components of our debtstructure.

**LiquidityAssessment**

Duane Reade Holdings is a holding company formed inconnection with the Acquisition to hold 100% of the common stock of DuaneReade Inc. Duane Reade Holdings operates all of its business through 

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Duane Reade Inc. andits subsidiaries and has no other independent assets, liabilities oroperations, so, to the extent it has liquidity requirements, it will depend ondistributions of cash from Duane Reade Inc., to the extent permitted bythe various agreements to which Duane Reade Inc. is a party. Currently, wedo not expect Duane Reade Holdings to have any material liquidity requirements.

We believe that, based oncurrent levels of operations and anticipated growth, cash flow from operations,together with other available sources of funds, including revolving loanborrowings under the amended asset-based revolving loan facility and the$26.4 million of additional funds available from the sale of preferred equityand warrants to purchase our common stock, will be adequate for the next twoyears, to make required payments on our indebtedness, to fund anticipatedcapital expenditures and the acquisition of up to eight Gristedes leases and tosatisfy our working capital requirements. We base this belief on our recentlevels of cash flow from operations of approximately $11.6 million in 2006(which includes the absorption of approximately $12.2 million in non-recurringnet cash payments made in connection with litigation settlements and executiveseverance) and approximately $3.0 million in 2005 (which includes theabsorption of $9.6 million in non-recurring net cash payments made inconnection with the termination of the former Chairman and CEO’s SERP), as wellas projected improvements in working capital management, anticipated levels ofcapital expenditures and the additional borrowing capacity under the$225.0 million amended asset-based revolving loan facility, which wasapproximately $67.5 million at June 30, 2007. Due to continuedlosses, our stockholder’s equity has become a deficit. However, this deficitdoes not impact our liquidity as noted above and has no impact on our debtcovenants. Our ability to meet our debt service obligations and reduce ourtotal debt will depend upon our future performance which, in turn, will besubject to general economic, financial, business, competitive, legislative,regulatory and other conditions, many of which are beyond our control. Inaddition, our operating results, cash flow and capital resources may not besufficient for repayment of our indebtedness in the future. Some risks thatcould adversely affect our ability to meet our debt service obligationsinclude, but are not limited to, reductions in third party prescriptionreimbursement rates, declines in the New York City economy, increases incompetitive activity, adverse changes in vendor credit terms, changes in drugconsumption patterns, additional adverse legislative changes or a majordisruption of business in our markets from a terrorist event, natural disasteror other unexpected events. Other factors that may adversely affect our abilityto service our debt are described above under “Special Note RegardingForward-Looking Statements.” Borrowings under the amended asset-based revolvingloan facility and the aggregate $210.0 million senior secured notes bearinterest at floating rates. Therefore, our financial condition will be affectedby changes in prevailing interest rates. On May 25, 2005, we entered intoa hedging transaction through the acquisition of a “no cost collar.” Under thisarrangement, we capped our exposure on $130 million of LIBOR-based borrowingsunder the senior secured notes at a maximum LIBOR rate of 5.30%. In addition,we established a minimum “floor” LIBOR rate of 3.45%, in line with then currentLIBOR rates. This hedging arrangement expires on June 16, 2008.

**Critical AccountingPolicies**

Our discussion of resultsof operations and financial condition relies on our consolidated financialstatements that are prepared based on certain critical accounting policies thatrequire management to make judgments and estimates that are subject to varyingdegrees of uncertainty. We believe that investors need to be aware of thesepolicies and how they impact our financial reporting to gain a more completeunderstanding of our consolidated financial statements as a whole, as well asour related discussion and analysis presented herein. While we believe thatthese accounting policies are grounded on sound measurement criteria, actual futureevents can and often do result in outcomes that can be materially differentfrom these estimates or forecasts. The accounting policies and related risksdescribed in our Annual Report on Form 10-K for the year ended December 30,2006 are those that depend most heavily on these judgments and estimates. At March 31,2007, there have been no material changes to any of the Critical AccountingPolicies contained therein.

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**Off-Balance SheetArrangements**

We are not a party to anyagreements with, or commitments to, any special purpose entities that wouldconstitute material off-balance sheet financing other than the operating leasecommitments detailed in the Contractual Obligations and Commitments tablepresented above.

**Seasonality**

In general, sales ofdrugstore items such as prescription drugs, over-the-counter drugs and healthand beauty care products exhibit limited seasonality in the aggregate, but dovary by product category. Quarterly results are primarily affected by thetiming of certain holidays, the timing of new store openings and the sale ofseasonal products, with the Christmas holiday season normally generating ahigher proportion of sales and earnings than other periods.

**Inflation**

We believe that inflationhas not had a material impact on our results of operations during thethree years ended December 30, 2006 or the three months ended March 31,2007.

**Recently IssuedAccounting Pronouncements**

Refer to Note 2 of theUnaudited Consolidated Interim Financial Statements contained elsewhere in thisreport for adetailed description of various recently issued accounting pronouncements.

**ITEM 3.**                QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our financial results are subject to risk frominterest rate fluctuations on debt, which carries variable interest rates.Variable rate debt outstanding at March 31, 2007 included$161.2 million of borrowings under our amended asset-based revolving loanfacility and $210.0 million of senior secured notes. At March 31,2007, the weighted average combined interest rate in effect on all variablerate debt outstanding was 8.59%. A 0.50% change in interest rates applied tothe $371.2 million balance of floating rate debt would affect pre-taxannual results of operations by approximately $1.9 million, excluding thebenefit of approximately $0.1 million provided by the “no cost collar” asdetailed below. In addition, we also have $195.0 million of seniorsubordinated notes and $32.0 thousand of senior convertible notes outstandingat March 31, 2007. The senior subordinated notes and senior convertiblenotes bear interest payable semi-annually at fixed rates of 9.75% and 3.75%,respectively, and are therefore not subject to risk from interest ratefluctuations.

On May 25, 2005, we entered into a hedgingtransaction through the acquisition of a “no cost collar.” Under thisarrangement, we capped our exposure on $130 million of LIBOR-based borrowingsunder the senior secured notes at a maximum LIBOR rate of 5.30%. In addition,we established a minimum “floor” LIBOR rate of 3.45%, in line with then currentLIBOR rates. This hedging arrangement expires on June 16, 2008. At March 31,2007, the LIBOR rate in effect on the senior secured notes was 5.35%, whichexceeded the maximum rate under the “no cost collar.” As a result, on anannualized basis, the interest rate protection afforded by the “no cost collar”amounted to $65,000.

The principal objective ofour investment management activities is to maintain acceptable levels ofinterest rate and liquidity risk to facilitate our funding needs. As part ofour risk management, we may continue to use derivative financial products suchas interest rate hedges and interest rate swaps in the future.

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**ITEM4.**                CONTROLS ANDPROCEDURES

The Company maintainsdisclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) of the Securities Exchange Act of 1934, as amended (the “ExchangeAct”) designed to provide reasonable assurance that the information required tobe reported in its Exchange Act filings is recorded, processed, summarized andreported within the timeframes specified and pursuant to the regulations of theSEC, including controls and procedures designed to ensure that this informationis accumulated and communicated to the Company’s management, including its ChiefExecutive Officer and Chief Financial Officer, as appropriate, to allow timelydecisions regarding required disclosure. It should be noted that because ofinherent limitations, the Company’s disclosure controls and procedures, howeverwell designed and operated, can provide only reasonable, and not absolute,assurance that the objectives of the disclosure controls and procedures aremet.

*(a)* Evaluation of DisclosureControls and Procedures

An evaluation was carriedout under the supervision and with the participation of the Company’smanagement, including the Chief Executive Officer and Chief Financial Officer,of the effectiveness of the design and operation of our “disclosure controlsand procedures” (as defined in Rules 13a-15(e) or 15d-15(e) underthe Securities Exchange Act of 1934) as at the end of the period covered bythis quarterly report.

Based on that evaluation,the Company’s Chief Executive Officer and Chief Financial Officer haveconcluded that, as of that date, the Company’s disclosure controls andprocedures required by paragraph (b) of the Exchange Act Rules 13a-15or 15d-15, were not effective because of the identification of a materialweakness in the Company’s internal control over financial reporting, which theCompany views as an integral part of its disclosure controls and procedures.

As described in Note 2 tothe financial statements contained in the Company’s Annual Report on Form 10-Kfor the year ended December 30, 2006, the Audit Committee of the Company,with the assistance of independent counsel and forensic accountants, hascompleted an investigation relating to real estate transactions and relatedmatters (the “Real Estate Related Transactions”) that occurred during the 2000through 2004 fiscal years. The investigation found that the Company’saccounting for a number of those transactions was improper The independentcounsel concluded that the Real Estate Related Transactions were orchestratedby the Company’s former Chairman and CEO, who was replaced in November 2005,and were expressly designed to overstate the Company’s income. According to theindependent counsel’s report, in order to accomplish this scheme, the formerChairman and CEO made certain false representations to the Company’s ChiefFinancial Officer, other members of the management of the Company and theCompany’s independent accountants concerning the structure and economicsubstance of the Real Estate Related Transactions. On May 18, 2007, theAudit Committee concluded that the financial statements as of and for the fivemonths ended December 25, 2004, the seven months ended July 30, 2004and the 2000 through 2003 fiscal years (collectively, the “Affected Periods”)should be restated. The conclusion to restate was based on the conclusions ofthe independent counsel in the investigation and the accounting impact of themisstatements arising from the Real Estate Related Transactions, combined withpreviously-disclosed misstatements. The previously-disclosed misstatementsrelated to arrangements that the independent counsel concluded were alsooriginated by the former Chairman and CEO for the issuance of improper creditsand the subsequent rebilling of such credits related to amounts paid toconstruction and other contractors at the Company’s stores and the related improperaccounting, which were the subject of a prior Audit Committee investigation, asdescribed in Note 1 to the financial statements contained in the Company’squarterly report on Form 10-Q for the quarter ended September 30,2006.

In the Audit Committee’sjudgment, as a result of the actions of the former Chairman and CEO, theCompany failed to maintain effective internal control over financial reportingand disclosure controls and 

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procedures,and the Audit Committee would have recommended, as remedial action, that theCompany replace its former Chairman and CEO, had the Company not already doneso, in addition to the improvements in internal control over financialreporting discussed below.

*(b)* Changes in InternalControl over Financial Reporting

From the discovery ofthese misstatements related to the improper activities of its former Chairmanand CEO, the Company recognized that its system of internal controls was notadequate to provide reasonable assurance that the objectives of its disclosurecontrols were met. In addition, the restatement of financial statements is anindicator of the existence of a “material weakness” in the design or operationof internal control over financial reporting. A material weakness is a controldeficiency, or combination of control deficiencies, that results in a more thanremote likelihood that a material misstatement of the annual or interimfinancial statements will not be prevented or detected. As of March 31,2007, the Company did not have effective internal control over financialreporting to preclude the intentional financial reporting misstatementsdiscovered in the investigations.

As aresult of the discovery of the internal control weaknesses uncovered by theAudit Committee investigation described above, the Company is taking thefollowing remedial actions:

·       Establishment of a Chief Compliance Officer(reporting directly to the Company’s Chief Executive Officer) to monitor theCompany’s adherence to various regulatory requirements, codes of conduct and ethicsstandards, including those designed to ensure accurate and timely financialreporting.

·       Establishment of a Director of Internal Auditthat reports to the Audit Committee of the Board of Directors. The purpose ofthis new position is to design and implement a risk management assessmentprocess as well as to monitor adherence to policies and procedures, conductoperational and financial audits designed to identify control deficiencies,make recommendations to management and the Audit Committee to strengtheninternal control over financial reporting and address opportunities to improveoperations and financial reporting. The Director of Internal Audit will alsocoordinate special audits as may be directed by the Audit Committee.

·       Establishment of a Director of FinancialReporting to manage the Company’s external financial reporting requirements andmonitor compliance with authoritative accounting rules and pronouncements.

The Company has alsorecently established a new Vice President of Real Estate position, whichreports to the Senior Vice President and General Counsel. This position has theresponsibility for managing all real estate related activities under theoversight of the Company’s Real Estate Committee, which includes all of theCompany’s senior vice presidents other than the Senior Vice President of HumanResources and Administration. All significant real estate related transactionsare reviewed and approved through the Real Estate Committee.

These organizationalchanges are being made in conjunction with several improvements previously madein accounting and transaction processing controls to reduce our exposure toerrors and fraud. These previous changes included a double authorizationprocedure for all significant invoice payments within each operating departmentdesigned to reduce the Company’s exposure to fraud through any one individualacting on his or her own accord. The Company’s Finance Department has also setup a separate invoice review and approval process to ensure that all payments arereasonable and within normal budget parameters, and that detailed support isattached from which to assess that the materials or services being purchasedare reasonable for the prices being paid.

During the first quarterof fiscal 2007, with the exception of the planned corrective measures detailedabove, there were no changes in the Company’s internal control over financialreporting that materially affected or are reasonably likely to materiallyaffect internal control over financial reporting.

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**PART IIOTHER INFORMATION**

**ITEM 1.**                LegalProceedings

Refer to Note 9 of theUnaudited Consolidated Interim Financial Statements contained elsewhere in thisreport for adetailed description of the various legal proceedings in which we are involved.

**ITEM 1A.**        RiskFactors

For information regardingfactors that could affect our results of operations, financial position andliquidity, see the risk factors discussion provided in Item 1A of our AnnualReport on Form 10-K for the fiscal year ended December 30,2006. See also “Special Note Regarding Forward-Looking Statements” above.

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

Not applicable.

**ITEM 3.**                DefaultsUpon Senior Securities

As a result of theinvestigation carried out by our Audit Committee, we failed to timely file ourAnnual Report on Form 10-K for the year ended December 30, 2006and our Quarterly Report on Form 10-Q for the period ended March 31,2007, which were required to be filed with the SEC on or before March 30,2007 and May 15, 2007, respectively. Such failures constituted defaultsunder the indenture governing our senior secured notes and the indenturegoverning our senior subordinated notes, but did not become events of defaultor result in the acceleration of those notes. We filed the Form 10-Kon June 29, 2007, thereby curing the default related to its delayedfiling, and the filing of this Form 10-Q cures the default relatedto its delayed filing.

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

Not applicable.

**ITEM 5.**                OtherInformation

Not applicable.

**ITEM 6.**                Exhibits
| Exhibit No. | ** ** | ** **                                                                                                                                                                                                                                                                                                                                 | ** ** | **Description** |
|------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
| 3.1              |       | Certificate of Amendment of the Certificate of  Incorporation of Duane Reade Holdings, Inc., dated March 27, 2007  (incorporated by reference to Exhibit 5.03 of the Company’s Form 8-K  dated April 4, 2007).                                                                                               |
| 3.2              |       | Certificate of Designations, Powers, Preferences and  Rights of Series A Redeemable Preferred Stock of Duane Reade  Holdings, Inc., dated as of March 27, 2007 (incorporated by  reference to Exhibit 1.01(c) of the Company’s Form 8-K  dated April 4, 2007).                                     |
| 3.3              |       | Certificate of Corrections of the Certificate of  Designations, Powers, Preferences and Rights of Series A Redeemable  Preferred Stock of Duane Reade Holdings, Inc., dated as of  April 16, 2007 (incorporated by reference to  Exhibit 3.7(ii) of the Company’s Form 10-K dated  June 29, 2007). |
| 10.1             |       | Purchase Agreement, dated March 27, 2007,  between Duane Reade Holdings, Inc. and OHCP DR Co-Investors 2007, LLC  (incorporated by reference to Exhibit 1.01(a) of the Company’s  Form 8-K dated April 4, 2007).                                                                                        |
|                  |            |                                                                                                                                                                                                                                                                                                                                            |            |                 |  |

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| 31.1* |   | Sarbanes-Oxley Section 302 Certification of the  Company’s Chief Executive Officer (“CEO”).  |
|-------|--------|-----------------------------------------------------------------------------------------------------------------------|
| 31.2* |   | Sarbanes-Oxley  Section 302 Certification of the Company’s Chief Financial  Officer (“CFO”). |
| 32**  |   | Sarbanes-Oxley Section 906 Certifications of  the Company’s CEO and CFO.                                    |

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*                    Filed herewith

**             Furnished herewith

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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.
| Dated: July 13, 2007 | **DUANE  READE HOLDINGS, INC.**                     |
|--------------------------------|-----------------------------------------------------|
|                           | (Registrant)                                        |
|                           | /s/ RICHARD W. DREILING                             |
|                           | Richard W. Dreiling                                 |
|                           | *President and Chief Executive Officer*             |
|                           | *(Principal Executive Officer)*                     |
|                           | /s/ JOHN K. HENRY                                   |
|                           | John K. Henry                                       |
|                           | *Senior Vice President and Chief Financial Officer* |
|                           | *(Principal Accounting and Financial Officer)*      |

 

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