**SECURITIES AND EXCHANGE COMMISSION**WASHINGTON,D.C.

**FORM 10-Q**

**Quarterly Report Pursuant to Section 13 or 15(d) oftheSecurities Exchange Act of 1934**

**For the quarterly periodended June 30, 2007**

**Commission file number 001-13843**

**DUANE READE HOLDINGS, INC.**(Exactname of registrant as specified in its charter)

| **DELAWARE**                                                     |   | **05-0599589**            |
|------------------------------------------------------------------|--------|---------------------------|
| (State or other  jurisdiction of  incorporation or organization) |   | (IRS Employer  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)

Indicateby check mark whether the registrant: (1) has filed all reports requiredto be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch 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 markwhether the registrant is a shell company as defined in Rule 12b-2of the Exchange Act (check one):

| 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 July 31, 2007,there were 2,594,977 shares of common stock issued and outstanding. None of theregistrant’s outstanding voting stock is held by non-affiliates of theregistrant.

*                    Theregistrant is not subject to the filing requirements of Section 13 or 15(d) ofthe Securities 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 and 26 Weeks Ended  June 30, 2007 and July 1, 2006                              |   | 5  |
| Consolidated Balance Sheets (Unaudited)—As of  June 30, 2007 and December 30, 2006                                                                      |   | 6  |
| Consolidated Statements of Cash Flows (Unaudited)—For  the 26 Weeks Ended June 30, 2007 and July 1, 2006        |   | 7  |
| Consolidated Statements of Comprehensive Loss  (Unaudited)—For the 13 and 26 Weeks Ended June 30, 2007 and July 1,  2006                                |   | 8  |
| Notes to Consolidated Financial Statements (Unaudited)                                                                                                                 |   | 9  |
| ITEM 2.—MANAGEMENT’S DISCUSSION AND ANALYSIS OF  FINANCIAL CONDITION AND RESULTS OF OPERATIONS                                                          |   | 29 |
| ITEM 3.—QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT  MARKET RISK                                                                                               |   | 41 |
| ITEM 4.—CONTROLS AND PROCEDURES                                                                                                                                   |   | 41 |
| PART II—OTHER  INFORMATION                                                                                                                                   |   | 44 |
| SIGNATURES                                                                                                                                                             |   | 45 |

 

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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:

·       theability to open and operate new stores on a profitable basis and the maturationof those stores and the ability to increase sales in existing stores;

·       thecompetitive environment in the drugstore industry in general and in the NewYork greater metropolitan area;

·       oursignificant indebtedness;

·       thecontinued efforts of health maintenance organizations, managed careorganizations, pharmacy benefit management companies and other third partypayers to reduce prescription reimbursement rates and pricing pressure frominternet-based and mail-order-based providers;

·       thecontinued efforts of federal, state and municipal government agencies to reduceMedicaid reimbursement rates, modify Medicare benefits and/or reduceprescription drug costs and/or coverages;

·       theimpact of the Medicare Prescription Drug, Improvement and Modernization Act of2003 (P.L. 108-179), or the Medicare Modernization Act, and theMedicare Part D benefit created thereunder;

·       changesin pharmacy prescription reimbursement rates attributable to modifications inthe definition of indexed pricing terms such as “Average Wholesale Price”;

·       thestrength of the economy in general and the economic conditions in the New Yorkgreater metropolitan area including, in particular, seasonal and weather-relatedfactors, special events, changes in consumer purchasing power and/or spendingpatterns;

·       changesin the cost of goods and services;

·       trendsin the healthcare industry, including continued conversion of variousprescription drugs to over-the-counter medications, negative publicity and therelated sales declines for certain categories of drugs including, withoutlimitation, certain pain medications and the increasing market share ofinternet-based and mail-order-based providers;

·       employmentdisputes and labor relations;

·       changesin federal and state laws and regulations, including the potential impact ofchanges in regulations surrounding the importation of pharmaceuticals fromforeign countries and changes in laws governing minimum wage requirements;

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·       ourability to successfully execute the various objectives of the “Duane Reade FullPotential” sales growth and profit enhancement program;

·       theoutcome of the arbitration proceeding that has been instituted against us by theformer Chairman, President and Chief Executive Officer;

·       theprogress and outcome of the investigation that has been commenced by the UnitedStates District Attorney’s Office for the Southern District of New York, aswell as the request from the Securities and Exchange Commission (the “SEC”) forinformation related to this matter;

·       liabilityand other claims asserted against us, including the items discussed in Note 9of the Unaudited Consolidated Interim Financial Statements contained elsewherein this report;

·       theoutcome of the legal proceedings that have been instituted against us andothers following announcement of the acquisition of Duane Reade Inc.;

·       changesin our operating strategy or development plans;

·       ourability to attract, hire and retain qualified personnel, including our abilityto attract qualified pharmacists at acceptable wage rates;

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

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

·       changesin levels of vendor rebates, allowances and related payment terms.

·       changesin timing of our acquisition of stores and prescription files and capitalexpenditure plans;

·       changesin real estate market conditions and our ability to continue to renew expiringleases or to secure suitable new store locations under acceptable lease terms;

·       ourability to successfully implement and manage new computer systems andtechnologies;

·       ourability to limit fraud and shrink;

·       demographicchanges; 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 ReadeHoldings, Inc.Consolidated  Statements of Operations(Unaudited)(In thousands)**

| ** **                                           | ** ** | **13 Weeks  Ended  June 30, 2007** | ** ** | **13 Weeks  Ended  July 1, 2006** | ** ** | **26 Weeks  Ended  June 30, 2007** | ** ** | **26 Weeks  Ended  July 1, 2006** | ** ** |
|------------------------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|
| Net sales                                            |       |                                         | $          | 431,930                                     |       |                                         |       | $                                           | 398,789    |   |   |   | $ | 846,318 |   |   |   | $ | 784,658 |   |   |
| Cost of sales                                        |       |                                         | 340,602    |                                        |       |                                         | 317,704    |                                        |       |   | 673,980 |   |   |   | 628,098 |   |   |
| Gross profit                                         |       |                                         | 91,328     |                                        |       |                                         | 81,085     |                                        |       |   | 172,338 |   |   |   | 156,560 |   |   |
| Selling, general &  administrative expenses |       |                                         | 73,325     |                                        |       |                                         | 68,146     |                                        |       |   | 146,069 |   |   |   | 137,612 |   |   |
| Labor contingency  income                            |       |                                         | —     |                                        |       |                                         | —     |                                        |       |   | — |   |   |   | (18,004 | ) |   |
| Depreciation and  amortization                       |       |                                         | 18,416     |                                        |       |                                         | 18,628     |                                        |       |   | 36,453 |   |   |   | 37,306 |   |   |
| Store pre-opening  expenses                          |       |                                         | —     |                                        |       |                                         | 102        |                                        |       |   | 150 |   |   |   | 152 |   |   |
| Other expense                                        |       |                                         | 4,223      |                                        |       |                                         | 533        |                                        |       |   | 9,241 |   |   |   | 1,635 |   |   |
| Operating loss                                       |       |                                         | (4,636     | )                                           |       |                                         | (6,324     | )                                           |       |   | (19,575 | ) |   |   | (2,141 | ) |   |
| Interest expense,  net                               |       |                                         | 14,645     |                                        |       |                                         | 14,135     |                                        |       |   | 29,080 |   |   |   | 27,873 |   |   |
| Loss before  income taxes                            |       |                                         | (19,281    | )                                           |       |                                         | (20,459    | )                                           |       |   | (48,655 | ) |   |   | (30,014 | ) |   |
| Income taxes                                         |       |                                         | 856        |                                        |       |                                         | 619        |                                        |       |   | 2,016 |   |   |   | 927 |   |   |
| Net loss                                             |       |                                         | $          | (20,137                                     | )          |                                         |       | $                                           | (21,078    | ) |   |   | $ | (50,671 | ) |   |   | $ | (30,941 | ) |   |

 

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

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

| ** **                                                                                                            | ** ** | **June 30,** | ** ** | **December 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                            | ** ** | **2007**          | ** ** | **2006**              | ** ** |
| **ASSETS**                                                                                                            | ** ** |              | ** ** | ** **            |       |   | ** ** | ** ** |   |
| Current Assets                                                                                                        |       |              |       |                  |       |   |   |   |   |
| Cash                                                                                                                  |       |              | $          | 1,382                 |       |   |   | $ | 1,395 |   |   |
| Receivables, net                                                                                                      |       |              | 55,206     |                  |       |   | 57,181 |   |   |
| Inventories                                                                                                           |       |              | 220,557    |                  |       |   | 218,924 |   |   |
| Deferred income  taxes                                                                                                |       |              | —     |                  |       |   | 2,429 |   |   |
| Prepaid expenses  and other current assets                                                                            |       |              | 25,217     |                  |       |   | 25,659 |   |   |
| TOTAL CURRENT  ASSETS                                                                                                 |       |              | 302,362    |                  |       |   | 305,588 |   |   |
| Property and  equipment, net                                                                                          |       |              | 201,594    |                  |       |   | 208,148 |   |   |
| Goodwill                                                                                                              |       |              | 70,384     |                  |       |   | 70,384 |   |   |
| Other assets, net                                                                                                     |       |              | 203,408    |                  |       |   | 214,461 |   |   |
| TOTAL ASSETS                                                                                                          |       |              | $          | 777,748               |       |   |   | $ | 798,581 |   |   |
| **LIABILITIES AND STOCKHOLDER’S EQUITY (DEFICIT)**                                                               | ** ** |              | ** ** | ** **            |       |   | ** ** | ** ** |   |
| Current Liabilities                                                                                                   |       |              |       |                  |       |   |   |   |   |
| Accounts payable                                                                                                      |       |              | $          | 80,858                |       |   |   | $ | 83,410 |   |   |
| Accrued expenses                                                                                                      |       |              | 51,335     |                  |       |   | 55,679 |   |   |
| Deferred income  taxes                                                                                                |       |              | 341        |                  |       |   | — |   |   |
| Current portion  of debt                                                                                              |       |              | 146,903    |                  |       |   | 157,122 |   |   |
| Current portion  of capital lease obligations                                                                         |       |              | 3,238      |                  |       |   | 3,173 |   |   |
| TOTAL CURRENT  LIABILITIES                                                                                            |       |              | 282,675    |                  |       |   | 299,384 |   |   |
| Long-term debt                                                                                                        |       |              | 405,032    |                  |       |   | 405,032 |   |   |
| Capital lease  obligations, less current portion                                                                      |       |              | 5,468      |                  |       |   | 7,137 |   |   |
| Deferred income  taxes                                                                                                |       |              | 28,759     |                  |       |   | 29,621 |   |   |
| Other non-current  liabilities                                                                                        |       |              | 92,256     |                  |       |   | 54,670 |   |   |
| TOTAL LIABILITIES                                                                                                     |       |              | 814,190    |                  |       |   | 795,844 |   |   |
| Commitments and  contingencies (Note 9)                                                                               |       |              |       |                  |       |   |   |   |   |
| 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                                                                                                       |       |              | 251,384    |                  |       |   | 239,807 |   |   |
| Accumulated other  comprehensive income                                                                               |       |              | 110        |                  |       |   | 193 |   |   |
| Accumulated  deficit                                                                                                  |       |              | (287,962   | )                     |       |   | (237,289 | ) |   |
| TOTAL  STOCKHOLDER’S EQUITY (DEFICIT)                                                                            |       |              | (36,442    | )                     |       |   | 2,737 |   |   |
| TOTAL LIABILITIES AND  STOCKHOLDER’S EQUITY (DEFICIT)                                                            |       |              | $          | 777,748               |       |   |   | $ | 798,581 |   |   |

 

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

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

| ** **                                                                                 | ** ** | **26 Weeks**                | ** ** | **26 Weeks**               | ** ** |
|--------------------------------------------------------------------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| ** **                                                                                 | ** ** | **Ended**                   | ** ** | **Ended**                  | ** ** |
| ** **                                                                                 | ** ** | **June 30, 2007** | ** ** | **July 1, 2006** | ** ** |
| Cash flows used in  operating activities:                                                  |       |                        |       |                       |       |
| Net loss                                                                                   |       | $                           | (50,671    | )                          | $          | (30,941 | ) |
| Adjustments to reconcile  net loss to net cash provided by (used in) operating activities: |       |                        |       |                       |       |
| Depreciation and  amortization                                                             |       | 38,281                      |       | 39,430                     |       |
| Deferred income  taxes                                                                     |       | 1,908                       |       | 861                        |       |
| Non-cash rent  expense                                                                     |       | 6,320                       |       | 5,150                      |       |
| Reversal of labor  contingency accrual                                                     |       | —                      |       | (18,004                    | )          |
| Other non-cash  expense                                                                    |       | 2,264                       |       | 104                        |       |
| Change in operating  assets and liabilities (net of the effect of acquisitions):           |       |                        |       |                       |       |
| Receivables                                                                                |       | 1,975                       |       | 2,273                      |       |
| Inventories                                                                                |       | (1,633                      | )          | 9,390                      |       |
| Accounts payable                                                                           |       | (2,552                      | )          | 5,794                      |       |
| Prepaid and  accrued expenses                                                              |       | (4,072                      | )          | 1,835                      |       |
| Other assets and  liabilities, net                                                         |       | 605                         |       | (12,023                    | )          |
| NET CASH PROVIDED  BY (USED IN) OPERATING ACTIVITIES                                       |       | (7,575                      | )          | 3,869                      |       |
| Cash flows used  in investing activities:                                                  |       |                        |       |                       |       |
| Capital  expenditures                                                                      |       | (13,406                     | )          | (12,270                    | )          |
| Lease  acquisition, customer file and other costs                                          |       | (8,811                      | )          | (4,107                     | )          |
| Proceeds from  sale of property                                                            |       | —                      |       | 1,500                      |       |
| NET CASH USED IN  INVESTING ACTIVITIES                                                     |       | (22,217                     | )          | (14,877                    | )          |
| Cash flows from  financing activities:                                                     |       |                        |       |                       |       |
| Borrowings from  revolving credit facility                                                 |       | 1,006,854                   |       | 915,368                    |       |
| Repayments of  revolving credit facility                                                   |       | (1,017,073                  | )          | (902,802                   | )          |
| Issuance of  preferred stock and warrants                                                  |       | 39,150                      |       | —                     |       |
| Capital  contribution                                                                      |       | 2,457                       |       | —                     |       |
| Deferred  financing costs                                                                  |       | (5                          | )          | (28                        | )          |
| Repayments of capital  lease obligations                                                   |       | (1,604                      | )          | (1,541                     | )          |
| NET CASH PROVIDED  BY FINANCING ACTIVITIES                                                 |       | 29,779                      |       | 10,997                     |       |
| Net decrease in cash                                                                       |       | (13                         | )          | (11                        | )          |
| Cash at beginning  of period                                                               |       | 1,395                       |       | 1,362                      |       |
| Cash at end of period                                                                      |       | $                           | 1,382      |                       | $          | 1,351 |   |

 

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

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

| ** **                                    | ** ** | **For the 13 Weeks Ended** | ** ** | **For the 26 Weeks Ended** | ** ** |
|-----------------------------------------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                    | ** ** | **June 30,**                              | ** ** | **July 1,**                               | ** ** | **June 30,** | ** ** | **July 1,** | ** ** |
| ** **                                    | ** ** | **2007**                                       | ** ** | **2006**                                       | ** ** | **2007** | ** ** | **2006** | ** ** |
| Net loss                                      |       | $                                              | (20,137    | )                                              | $          | (21,078 | ) | $ | (50,671 | ) | $ | (30,941 | ) |
| Change in fair  value of interest rate collar |       | 45                                             |       | 503                                            |       | (82 | ) | 772 |   |
| Total other  comprehensive income (loss)      |       | 45                                             |       | 503                                            |       | (82 | ) | 772 |   |
| Total comprehensive loss                      |       | $                                              | (20,092    | )                                              | $          | (20,575 | ) | $ | (50,753 | ) | $ | (30,169 | ) |

 

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

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**Notes to UnauditedConsolidated Interim Financial Statements(dollars in thousands)**

**1.   Basis ofPresentation**

Duane Reade Holdings, Inc. (“Duane Reade Holdings”or the “Company”) was formed in December 2003 by Oak Hill CapitalPartners, LP, a private equity firm (“Oak Hill”), in order to acquire DuaneReade Inc. and its subsidiaries (the “Acquisition”). Duane Reade Holdings, Inc.is a wholly-owned subsidiary of Duane Reade Shareholders, LLC (“Duane ReadeShareholders”), a parent entity also established to effectuate the Acquisition.The Acquisition was completed on July 30, 2004 through the merger of DuaneReade Acquisition Corp. (a wholly owned subsidiary of Duane Reade Holdings, Inc.)into Duane Reade Inc. with Duane Reade Inc. being the survivingentity and a wholly owned subsidiary of Duane Reade Holdings, Inc. afterthe 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 the Company’sAnnual Consolidated Financial Statements for the year ended December 30,2006. These Unaudited Consolidated Interim Financial Statements should be readin conjunction with the Company’s Consolidated Financial Statements included inits Annual Report on Form 10-K for the year ended December 30,2006. The Unaudited Consolidated Interim Financial Statements include theassets and operations of the Company and its subsidiaries. All significantintercompany transactions and balances have been eliminated. The results forthe interim periods presented are not necessarily indicative of the resultsexpected for the full year.

**2.   Recently IssuedAccounting 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 requires entities thatvoluntarily make a change in accounting principle to apply that changeretrospectively to prior periods’ financial statements, unless this would beimpracticable. SFAS No. 154 supersedes Accounting Principles BoardOpinion No. 20, “Accounting Changes” (“APB No. 20”) which previouslyrequired that most voluntary changes in accounting principle be recognized byincluding in the current period’s net earnings the cumulative effect ofchanging to the new accounting principle. SFAS No. 154 also makes adistinction between “retrospective application” of an accounting principle andthe “restatement” of financial statements to reflect the correction of anerror. Another significant change in practice under SFAS No. 154 is thatif an entity changes its method of depreciation, amortization, or depletion forlong-lived, non-financial assets, the change must be accounted for as a changein accounting estimate. Under APB No. 20, such a change would have beenreported as a change in accounting principle. SFAS No. 154 applies toaccounting changes and error corrections that are made in fiscal yearsbeginning after December 15, 2005. The Company has adopted SFAS 154, andsuch adoption has not had an effect on its consolidated financial statements.

In February 2006, the FASB issued SFAS No. 155,“Accounting for Certain Hybrid Instruments,” which amends SFAS No. 133, “Accountingfor Derivative Instruments and Hedging Activities,” and SFAS 

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No. 140, “Accountingfor Transfers and Servicing of Financial Assets and Extinguishments ofLiabilities.” SFAS No. 155 allows financial instruments that have embeddedderivatives to be accounted for as a whole (eliminating the need to bifurcatethe derivative from its host) if the holder elects to account for the wholeinstrument on a fair value basis. SFAS No. 155 also clarifies and amendscertain other provisions of SFAS No. 133 and SFAS No. 140. Thisstatement is effective for all financial instruments acquired or issued infiscal years beginning after September 15, 2006. The Company has adoptedSFAS 155, and such adoption has not had an effect on its consolidated financialstatements.

In June 2006, the FASB issued Interpretation No. 48,“Accounting for Uncertainty in Income Taxes—an interpretation of SFAS No. 109.”FIN 48 clarifies the accounting for uncertainty in income taxes by prescribinga recognition threshold for tax positions taken or expected to be taken in a taxreturn. FIN 48 is effective for fiscal years beginning after December 15,2006. The Company has adopted FIN 48 effective with the beginning of fiscal2007, and such adoption has not had a material effect on its consolidatedfinancial statements.

In September 2006, the FASB issued SFAS No. 157,“Fair Value Measurements.” This statement establishes a standard definition forfair value and a framework under generally accepted accounting principles formeasuring fair value and expands the disclosure requirements surrounding fairvalue measurements. This statement is effective for fiscal years beginningafter November 15, 2007. The Company has not yet determined the impact, ifany, of adopting SFAS No. 157.

In February 2007, theFASB issued SFAS No. 159, “The Fair Value Option for Financial Assets andFinancial Liabilities, Including an Amendment of FASB Statement No. 115.”This statement permits entities to choose to measure many financial instrumentsand certain other items at fair value that are not currently required to bemeasured at fair value. Unrealized gains and losses on items for which the fairvalue option has been elected are reported in earnings. SFAS No. 159 doesnot affect any existing accounting literature that requires certain assets andliabilities to be carried at fair value. This statement is effective for fiscalyears beginning after November 15, 2007. The Company has not yetdetermined the impact, if any, of adopting SFAS No. 159.

**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. Effective January 1,2006, the Company adopted the fair value recognition provisions of SFAS No. 123(R),using the prospective transition method. Under that transition method,compensation expense recognized for the twenty-six weeks ended June 30,2007 and July 1, 2006 reflects the vested portion of share-based paymentsgranted on or after January 1, 2006 based on the grant-date fair valueestimated in accordance with the provisions of SFAS 123(R). The Companyhas elected to recognize compensation expense on a straight-line basis over thevesting period of the respective options. During the thirteen weeks ended June 30,2007 and July 1, 2006, the Company recorded pre-tax compensation expenseof approximately $0.2 million and $0.1 million, respectively, attributable tothe vested portion of stock options granted after the adoption date. For the twenty-sixweeks ended June 30, 2007 and July 1, 2006, the corresponding expensewas $0.7 million and $0.1 million, respectively.

***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 

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March 27, 2007, theCompany amended the Stock Option Plan so that a maximum of 575,893 shares ofits common stock may be granted 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 any amendment to such agreement.

For the twenty-six weeks ended June 30, 2007, atotal of 171,000 options to acquire shares of the Company’s common stock havebeen granted, including 168,600 options granted to executive officers of theCompany on December 31, 2006.

The weighted-average grant-date fair value of optionsgranted during the twenty-six weeks ended June 30, 2007 was $5.59. Therewere no stock options exercised during the first twenty-six weeks of either2007 or 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 twenty-six weeks ended June 30, 2007. The keyassumptions used in this valuation were consistent with those used in 2006.

As of June 30, 2007, there was $2.2 million oftotal unrecognized compensation cost related to non-vested share-basedcompensation arrangements granted under the stock-based compensation plan. Thatcost is expected to be recognized on a straight-line basis over aweighted-average period of five years.

As of June 30, 2007,a total of 113,309 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.   Inventoriesand Cost of Sales**

At June 30, 2007,inventories, consisting solely of finished goods, would have been lower by $2.0million if they had been valued on a lower of first-in, first-out (“FIFO”) costor market basis instead of a last-in, first-out (“LIFO”) basis. Cost of salesincludes all store occupancy-related costs and expenses, consisting of leaseand sublease-related income and expenses, other real estate-related income andexpenses primarily resulting from the disposition of store leases, storeutility costs, warehouse expenses and distribution costs. The Company reflectspromotional allowances from vendors as a reduction of inventory or advertisingexpense, depending on the nature of the allowance, when such inventory is soldor advertising or promotions have been completed and the related allowanceshave been earned.

**5.   Exit andDisposal 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 Connectionwith Purchase 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 June 30, 2007all of the planned closings had occurred, and the Company has recorded acumulative net total of $13.4 million of primarily occupancy-related costsagainst this reserve resulting in the reserve balance of $3.6 million at June 30,2007. The balance of this reserve is expected to be utilized primarily foroccupancy-related costs in these closed stores.

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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 June 30, 2007,the balance of this reserve was $2.8 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 thetwenty-six weeks ended June 30, 2007 and July 1, 2006.

**7.   Debt**

Debtis summarized as follows (in thousands):

| ** **                                   | ** ** | **June 30,** | ** **  | **December 30,** | ** ** |
|----------------------------------------------|------------|-------------------|-------------|-----------------------|------------|
| **Description  of Instrument**          | ** ** | ** **        | ** **  | **2007**              | ** ** | **2006** | ** ** |
| Current Debt:                                |       |              |        |                  |       |   |   |
| Asset-Based  Revolving Loan Facility(1)      |       | $                 | 146,903     |                  |       | $ | 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**                               | ** ** | **$**             | **551,935** | ** **            | ** ** | **$** | **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 ShortTerm Obligations Expected to be Refinanced,” to reclassify the debt aslong-term. However, this is not an indication that this credit facility isexpected to be retired within the next year. The Company intends to continue touse this facility for its working capital needs through the date of itsmaturity in 2011.

***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,in conjunction with the issuance of $50.0 million aggregate principalamount of senior secured notes due 2010, the Company permanently reduced themaximum availability under the amended asset-based revolving loan facility by$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 tothe requirement that the Company refinance or restructure the $210.0 millionaggregate principal amount of the senior secured notes due 2010 and the $195.0million aggregate principal amount of the 9.75% senior subordinated notes due2011, in each case, on terms reasonably acceptable to the administrative agentand at least 120 days prior to each’s respective scheduled maturity date. TheCompany fully intends to refinance or restructure the outstanding principalamounts of its senior secured notes and senior subordinated notes within therequired timeframe, in accordance with the requirements of the third amendment.

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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 the ratios that the Companywould be required to maintain in this event. Borrowings under the amended asset-basedrevolving loan facility have not exceeded 90 percent of the borrowing baseand, as a result, the fixed charge covenant has not become applicable. Thereare no credit ratings related triggers in the amended asset-based revolvingloan facility that would impact the cost of borrowing, annual amortization ofprincipal 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 June 30, 2007, the amended asset-based revolving loan facility boreinterest at a weighted average annual rate of 7.01%.

At June 30, 2007, there was $146.9 millionoutstanding under the asset-based revolving loan facility, and approximately$67.5 million of remaining availability, net of $5.6 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.

***Senior SecuredFloating Rate Notes due 2010.******  ***On December 20,2004, the Company closed an offering of $160.0 million aggregate principalamount of senior secured notes due 2010. Using the net proceeds from thatoffering, together with approximately $2.2 million of borrowings under theamended asset-based revolving loan facility, the Company repaid all outstandingprincipal under its previously existing $155.0 million senior term loanfacility, along with approximately $3.6 million of early repayment premiumand accrued but unpaid interest through December 20, 2004. On August 9,2005, the Company issued a further $50.0 million of senior secured notes.These new notes were issued under the same indenture as the senior securednotes issued in December 2004, although they do not trade fungibly withthose 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 June 30, 2007, the senior secured notes bore interest at a rateof 9.86%.

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 

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in the ConsolidatedStatements of Comprehensive Loss included within the financial statements. At June 30,2007, the LIBOR rate in effect for the senior secured notes was 5.36%, whichexceeded the maximum rate under the “no cost collar.” As a result, theprotection afforded by the “no cost collar” reduced the overall effectiveinterest rate on the senior 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 thesenior secured 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 senior securednotes and the guarantees are collateralized by a first priority interest insubstantially all of Duane Reade Inc. and Duane Reade GP’s assets other thanthose assets in which the lenders under the amended asset-based revolving loanfacility have a first priority interest. The senior secured notes and theguarantees are also collateralized by a second priority interest in allcollateral pledged on a first priority basis to lenders under the amendedasset-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 June 30, 2007, the weighted average combinedinterest rate in effect on all variable rate debt outstanding, including thebenefit afforded by the “no cost collar,” was 8.67%.

***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 and August 1.The senior subordinated notes are uncollateralized obligations and subordinatedin right of payment to all of the Company’s, Duane Reade Inc.’s and Duane ReadeGP’s existing and future unsubordinated indebtedness, including borrowingsunder the amended asset-based revolving loan facility and the senior securednotes. The senior subordinated notes will rank equally with any future seniorsubordinated indebtedness and senior to any future subordinated indebtedness.The senior subordinated notes are guaranteed on an uncollateralized, seniorsubordinated basis by the Company and all of Duane Reade Inc.’s existingdirect and indirect domestic subsidiaries other than Duane Reade GP, which is aco-obligor under the senior subordinated notes. Upon the occurrence ofspecified change of control events, the Company will be required to make anoffer to repurchase all of the senior subordinated notes at 101% of theoutstanding principal amount of the senior subordinated notes plus accrued andunpaid interest to the date of repurchase. The indenture governing 

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the senior subordinatednotes contains certain affirmative and negative covenants that limit theability of Duane Reade Inc., Duane Reade GP and their restrictedsubsidiaries to incur additional indebtedness, pay dividends, make repaymentson indebtedness that is subordinated to the senior subordinated notes and tomake certain other restricted payments, incur certain liens, use proceeds fromsales of assets, enter into business combination transactions (includingmergers, consolidations and asset sales), enter into transactions withaffiliates and permit restrictions on the payment of dividends by restrictedsubsidiaries. The indenture governing the senior subordinated notes containscustomary 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. The indenture governing thesenior subordinated notes does not contain financial maintenance covenants.

***2.1478% SeniorConvertible Notes due 2022.******  ***On April 16,2002, Duane Reade Inc. completed an offering of $381.5 million aggregateprincipal amount of senior convertible notes maturing on April 16, 2022.The senior convertible notes were issued at a price of $572.76 per note(57.276% of the principal amount at maturity) and paid cash interest at therate of 2.1478% per year on the principal amount at maturity, payablesemi-annually in arrears on April 16 and October 16 of each yearbeginning on October 16, 2002, until April 16, 2007. Since that date,interest has accrued on the notes as amortization of the original issuediscount representing a yield to maturity of 3.75% per year, computed on asemi-annual bond equivalent basis. In December 2002, Duane Reade 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 theremaining $351.0 million outstanding principal value of the seniorconvertible notes. Upon the closing of the tender offer, a total of$350.9 million principal amount at maturity ($201.0 million issuancevalue) was tendered for repurchase, leaving only $55.0 thousand ofprincipal amount at maturity ($32.0 thousand of issuance value)outstanding. Duane Reade Inc. may redeem for cash all or a portion of theprincipal value of the outstanding senior convertible notes at any time after April 16,2007, at a price equal to the sum of the issue price plus accrued originalissue discount and accrued cash 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.

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At December 30, 2006, as a consequence of thesignificant losses incurred in the 2005 and 2006 fiscal years, as well as theprojected future years’ taxable losses, the Company recorded a cumulativevaluation allowance of $68.5 million. This amount represented the Company’syear-end net deferred tax asset value excluding $27.2 million of deferred taxliabilities resulting from items that are not amortized for financial statementpurposes and are therefore not expected to reverse within the loss carryforwardexpiration period. These items include post-2004 goodwill of $6.2 millionand the deferred tax liability of $21.0 million associated with the tradename.

During the three and six months ended June 30,2007, the Company incurred additional pre-tax losses of $19.3 million and $48.7million, respectively, and recorded incremental valuation allowances of $12.9million and $27.2 million, respectively. At June 30, 2007, the Company hadapproximately $156.8 million of gross deferred tax assets, approximately $90.2million of gross deferred tax liabilities and recorded a cumulative valuationallowance of $95.7 million. The tax expense reported during the three and sixmonths ended June 30, 2007 and July 1, 2006 primarily results fromthe deferred tax liabilities generated by non-amortizable goodwill.

Duane Reade Inc. is presently undergoing an examinationof its New York State Franchise Tax filings for the 2001 through 2003 taxyears. Adjustments proposed by New York state have been previously accrued and,in management’s opinion, are not considered material to the Company’sconsolidated 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 and Contingencies

The Company is party to legal actions arising in theordinary course of business. Based on information presently available to theCompany, it believes that the ultimate outcome of these actions will not have amaterial, adverse effect on its financial position, results of operations orcash flows. In addition, the Company is a party to the following legal actionsand matters:

During 2002, the Company initiated a legal actionagainst its former property insurance carrier, in an attempt to recover what itbelieves to be a fair and reasonable settlement for the business interruptionportion of its claim originating from the September 11, 2001 World TradeCenter terrorist attack, during which its single highest volume and most profitablestore was completely destroyed. After a lengthy litigation and appraisalprocess, an appraisal panel awarded the Company approximately $5.6 million (inaddition to the $9.9 million that was paid by the insurer to the Company in2002). As a result of the insurer’s refusal to pay this amount and also as aresult of the Second Circuit Court of Appeals interpretation of the Company’sinsurance policy, in January 2007, the Company commenced another action inthe U.S. District Court for the Southern District to recover both the appraisalpanel’s award and additional amounts under the policy. The U.S. District Courtrecently granted the insurance carrier’s motion to dismiss the proceeding. TheCompany is evaluating its alternatives and presently is considering an appeal.

The Company has not recognized any income related tothis matter other than $9.4 million of the original $9.9 million paid by theinsurer in 2002. It should be noted that any payment to the Company that mightbe forthcoming 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.

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In December 2005, the Company and CardinalHealth, a pharmacy inventory supplier, settled all matters relating tolitigation arising out of a dispute regarding certain former supplyarrangements and agreements. Under the terms of this settlement, the Companypaid Cardinal Health $4.5 million over a period of time to settle anoutstanding trade payable, and entered into an agreement whereby Cardinal willprovide a secondary supply of pharmaceutical products to the Company untilcertain minimum purchase levels are achieved.

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 an unspecifiedamount of unpaid wages. The Company believes this claim to be without merit,and it intends to defend itself against this claim. However, due to theuncertainty of litigation, there can be no assurance as to the ultimate outcomeof 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, the Attorney General of theState of New Jersey filed an action against the Company alleging that theCompany violated certain state regulations including regulations relating tothe presence of expired products on its shelves and certain pricingregulations. The Company has been in discussions with the Attorney General’soffice regarding settling this action; however, there can be no assurance thatthis action will be settled on terms acceptable to the Company or at all. TheCompany believes that it has valid defenses to this action and it intends tovigorously 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 

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employment agreement, anda claim for defamation. On May 17, 2007, the arbitrator issued an ordergranting leave to file Mr. Cuti’s amended demand. Mr. Cuti seeksmonetary damages, declaratory relief, rescission of his employment agreementand the payment of his legal costs and fees associated with his termination andthe 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 involving invoice credits and rebillings for theconstruction of the Company’s stores, that led to overstating the Company’spublicly reported earnings, and that caused the Company to create and maintaininaccurate records and publish financial statements containing misstatements.These counterclaims were based on information uncovered as of that date by aninvestigation conducted by independent legal counsel and forensic accountantsat the direction of the Audit 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, the respondentssought leave to file proposed amended counterclaims based on that newinformation. 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 astay of the arbitration through October 23, 2007 with respect to allmatters other than a motion to dismiss the above-mentioned patent claim (if theparties wish to proceed) and advancement of certain fees pursuant to a priororder.

***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 

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Complaint”) is pending,but has not been served on the Company. The Delaware Complaints name the formerChairman and CEO and certain other members of the Company’s board of directorsand executive officers as well as Duane Reade GP as defendants. Four of theDelaware Complaints name Oak Hill as a defendant. The New York Complaint namesthe 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. Oneof the dismissed New York complaints named Oak Hill as a defendant.

The Delaware Complaintswere consolidated on January 28, 2004, and on April 8, 2004 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.**               Issuance ofPreferred Stock and Common Stock Warrants in Connection with the Acquisition ofGristedes Store Leases

On February 20, 2007, the Company announced ithad entered into an agreement to acquire up to eight leases from the Gristedessupermarket chain for certain locations in the borough of Manhattan, New YorkCity. The acquisition of the leases is subject to the satisfaction of certainconditions, including landlord consents. As of June 30, 2007, the Companyhad received the required consents for two of these locations, which areexpected to be placed in operation during the third quarter. The Companyanticipates receiving the balance of the consents required to complete thistransaction in the near future.

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 equity commitmentof $13.0 million was funded on March 27, 2007. The balance of the $39.4million commitment, in which certain members of senior management have alsoelected to participate, was funded on June 28, 2007. The preferred stockhas a 12 year maturity date from the issuance date and provides for an annualcash dividend of 10% payable quarterly (currently prohibited by therestrictions 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 (IPO), to require holders of the preferred stock toconvert all (but not less than all) of such shares into a number of shares ofthe Company’s common stock equal to the liquidation preference for such sharesof preferred stock, divided by the price per share of the Company’s commonstock set forth in the final prospectus to be used in connection with the IPO.

In accordance with SFAS No. 150, “Accounting forCertain Financial Instruments with Characteristics of both Liabilities andEquity,” the Company has recorded the portion of the proceeds that areattributable to the preferred stock ($30.7 million) as a liability because ofthe mandatory redemption feature. Such liability is included in “Othernon-current liabilities” on the Consolidated Balance Sheet. The remainingamount of $8.4 million (net of $0.3 million of expenses) was ascribed to thewarrants, based on a relative fair value basis, and is recorded within additionalpaid-in capital.

At June 30, 2007, 600,000 shares of the Company’spreferred stock ($0.01 par value) were authorized to be issued, of which525,334 shares were outstanding, as compared to 50,000 shares authorized at December 30,2006, none of which were outstanding.

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

The senior subordinated notes and the senior securednotes were co-issued by Duane Reade Inc. and Duane Reade GP, each ofwhom is considered a “co-obligor.” The Company and each of its othersubsidiaries, composed of DRI I Inc., Duane Reade International, Inc.and Duane Reade Realty, Inc., are guarantors of such notes. Theguarantee of the Company and of each subsidiary guarantor is full andunconditional and joint 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 theCompany’s understanding and interpretation of Rule 3-10 under theSecurities and Exchange Commission’s Regulation S-X. Income tax expense(benefit) and deferred income taxes have been allocated to individual entitiesaccording to the Company’s income tax allocation methodology. Certain of theprior year information has been adjusted to conform its presentation with thecurrent year. There is no limitation on dividends or distributions between theparent and its subsidiaries. The financial information may not necessarily beindicative of results of operations or financial position had the subsidiaryguarantors operated as independent entities.

20

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**DUANE READE HOLDINGS, INC.Condensed Consolidating Statement of Operations (Unaudited)For the 13 weeks ended June 30, 2007(in thousands)**

| ** **                                           | ** ** | **Duane Reade  Holdings, Inc.** | ** ** | **Duane  Reade Inc.** | ** ** | **Duane  Reade GP** | ** ** | **Subsidiary  Guarantors** | ** ** | **Consolidating  Adjustments** | ** ** | **Duane Reade  Holdings, Inc.  Consolidated** | ** ** |
|------------------------------------------------------|------------|-------------------------------------------|------------|----------------------------|------------|--------------------------|------------|----------------------------|------------|--------------------------------|------------|---------------------------------------------------------|------------|
| Net sales                                            |       |                                      | $          | —                     |       |                     |       | $                          | —     |                           |       | $                                                       | 431,930    |   |   | $ | 10,407 |   |   |   | $ | (10,407 | ) |   |   | $ | 431,930 |   |   |
| Cost of sales                                        |       |                                      | —     |                       |       |                     | —     |                       |       | 340,602                        |       |                                                    | —     |   |   |   | — |   |   |   | 340,602 |   |   |
| Gross profit                                         |       |                                      | —     |                       |       |                     | —     |                       |       | 91,328                         |       |                                                    | 10,407     |   |   |   | (10,407 | ) |   |   | 91,328 |   |   |
| Selling,  general & administrative expenses |       |                                      | —     |                       |       |                     | —     |                       |       | 90,330                         |       |                                                    | 142        |   |   |   | (17,147 | ) |   |   | 73,325 |   |   |
| Depreciation and   amortization                      |       |                                      | —     |                       |       |                     | —     |                       |       | 18,416                         |       |                                                    | —     |   |   |   | — |   |   |   | 18,416 |   |   |
| Store pre-opening  expense                           |       |                                      | —     |                       |       |                     | —     |                       |       | —                         |       |                                                    | —     |   |   |   | — |   |   |   | — |   |   |
| Other expense                                        |       |                                      | —     |                       |       |                     | —     |                       |       | 4,223                          |       |                                                    | —     |   |   |   | — |   |   |   | 4,223 |   |   |
| Operating (loss) income                              |       |                                      | —     |                       |       |                     | —     |                       |       | (21,641                        | )          |                                                    | 10,265     |   |   |   | 6,740 |   |   |   | (4,636 | ) |   |
| Equity earnings  in affiliates                       |       |                                      | 20,137     |                       |       |                     | 20,137     |                       |       | —                         |       |                                                    | 379        |   |   |   | (40,653 | ) |   |   | — |   |   |
| Interest expense (income),  net                      |       |                                      | —     |                       |       |                     | —     |                       |       | 14,645                         |       |                                                    | (6,740     | ) |   |   | 6,740 |   |   |   | 14,645 |   |   |
| Income (loss) before income taxes               |       |                                      | (20,137    | )                          |       |                     | (20,137    | )                          |       | (36,286                        | )          |                                                    | 16,626     |   |   |   | 40,653 |   |   |   | (19,281 | ) |   |
| Income taxes  (benefit)                              |       |                                      | —     |                       |       |                     | —     |                       |       | 1,611                          |       |                                                    | (755       | ) |   |   | — |   |   |   | 856 |   |   |
| Net income (loss)                                    |       |                                      | $          | (20,137                    | )          |                     |       | $                          | (20,137    | )                              |       | $                                                       | (37,897    | ) |   | $ | 17,381 |   |   |   | $ | 40,653 |   |   |   | $ | (20,137 | ) |   |

 

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**DUANE READE HOLDINGS, INC.Condensed Consolidating Statement of Operations (Unaudited)For the 13 weeks ended July 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                                            |       |                                      | $          | —                     |       |                     |       | $                          | —     |                           |       | $                                                       | 398,789    |   |   | $ | 9,778 |   |   |   | $ | (9,778 | ) |   |   | $ | 398,789 |   |   |
| Cost of sales                                        |       |                                      | —     |                       |       |                     | —     |                       |       | 317,704                        |       |                                                    | —     |   |   |   | — |   |   |   | 317,704 |   |   |
| Gross profit                                         |       |                                      | —     |                       |       |                     | —     |                       |       | 81,085                         |       |                                                    | 9,778      |   |   |   | (9,778 | ) |   |   | 81,085 |   |   |
| Selling,  general & administrative expenses |       |                                      | —     |                       |       |                     | —     |                       |       | 77,842                         |       |                                                    | 82         |   |   |   | (9,778 | ) |   |   | 68,146 |   |   |
| Depreciation and   amortization                      |       |                                      | —     |                       |       |                     | —     |                       |       | 18,628                         |       |                                                    | —     |   |   |   | — |   |   |   | 18,628 |   |   |
| Store pre-opening  expense                           |       |                                      | —     |                       |       |                     | —     |                       |       | 102                            |       |                                                    | —     |   |   |   | — |   |   |   | 102 |   |   |
| Other expense                                        |       |                                      | —     |                       |       |                     | —     |                       |       | 533                            |       |                                                    | —     |   |   |   | — |   |   |   | 533 |   |   |
| Operating (loss) income                              |       |                                      | —     |                       |       |                     | —     |                       |       | (16,020                        | )          |                                                    | 9,696      |   |   |   | — |   |   |   | (6,324 | ) |   |
| Equity earnings  in affiliates                       |       |                                      | 21,078     |                       |       |                     | 21,078     |                       |       | —                         |       |                                                    | 363        |   |   |   | (42,519 | ) |   |   | — |   |   |
| Interest expense  (income), net                      |       |                                      | —     |                       |       |                     | —     |                       |       | 19,241                         |       |                                                    | (5,106     | ) |   |   | — |   |   |   | 14,135 |   |   |
| Income (loss) before income taxes                    |       |                                      | (21,078    | )                          |       |                     | (21,078    | )                          |       | (35,261                        | )          |                                                    | 14,439     |   |   |   | 42,519 |   |   |   | (20,459 | ) |   |
| Income taxes  (benefit)                              |       |                                      | —     |                       |       |                     | —     |                       |       | 1,066                          |       |                                                    | (447       | ) |   |   | — |   |   |   | 619 |   |   |
| Net income (loss)                                    |       |                                      | $          | (21,078                    | )          |                     |       | $                          | (21,078    | )                              |       | $                                                       | (36,327    | ) |   | $ | 14,886 |   |   |   | $ | 42,519 |   |   |   | $ | (21,078 | ) |   |

 

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**DUANEREADE HOLDINGS, INC.Condensed Consolidating Statement of Operations (Unaudited)For the 26 weeks ended June 30, 2007(in thousands)**

| ** **                                           | ** ** | **Duane Reade  Holdings, Inc.** | ** ** | **Duane  Reade Inc.** | ** ** | **Duane  Reade GP** | ** ** | **Subsidiary  Guarantors** | ** ** | **Consolidating  Adjustments** | ** ** | **Duane Reade  Holdings, Inc.  Consolidated** | ** ** |
|------------------------------------------------------|------------|-------------------------------------------|------------|----------------------------|------------|--------------------------|------------|----------------------------|------------|--------------------------------|------------|---------------------------------------------------------|------------|
| Net sales                                            |       |                                      | $          | —                     |       |                     |       | $                          | —     |                           |       | $                                                       | 846,318    |   |   | $ | 20,406 |   |   |   | $ | (20,406 | ) |   |   | $ | 846,318 |   |   |
| Cost of sales                                        |       |                                      | —     |                       |       |                     | —     |                       |       | 673,980                        |       |                                                    | —     |   |   |   | — |   |   |   | 673,980 |   |   |
| Gross profit                                         |       |                                      | —     |                       |       |                     | —     |                       |       | 172,338                        |       |                                                    | 20,406     |   |   |   | (20,406 | ) |   |   | 172,338 |   |   |
| Selling, general &  administrative expenses |       |                                      | —     |                       |       |                     | —     |                       |       | 179,382                        |       |                                                    | 227        |   |   |   | (33,540 | ) |   |   | 146,069 |   |   |
| Depreciation and   amortization                      |       |                                      | —     |                       |       |                     | —     |                       |       | 36,453                         |       |                                                    | —     |   |   |   | — |   |   |   | 36,453 |   |   |
| Store pre-opening  expense                           |       |                                      | —     |                       |       |                     | —     |                       |       | 150                            |       |                                                    | —     |   |   |   | — |   |   |   | 150 |   |   |
| Other expense                                        |       |                                      | —     |                       |       |                     | —     |                       |       | 9,241                          |       |                                                    | —     |   |   |   | — |   |   |   | 9,241 |   |   |
| Operating (loss) income                              |       |                                      | —     |                       |       |                     | —     |                       |       | (52,888                        | )          |                                                    | 20,179     |   |   |   | 13,134 |   |   |   | (19,575 | ) |   |
| Equity earnings  in affiliates                       |       |                                      | 50,671     |                       |       |                     | 50,671     |                       |       | —                         |       |                                                    | 854        |   |   |   | (102,196 | ) |   |   | — |   |   |
| Interest expense (income),  net                      |       |                                      | —     |                       |       |                     | —     |                       |       | 29,080                         |       |                                                    | (13,134    | ) |   |   | 13,134 |   |   |   | 29,080 |   |   |
| Income (loss) before income taxes               |       |                                      | (50,671    | )                          |       |                     | (50,671    | )                          |       | (81,968                        | )          |                                                    | 32,459     |   |   |   | 102,196 |   |   |   | (48,655 | ) |   |
| Income taxes  (benefit)                              |       |                                      | —     |                       |       |                     | —     |                       |       | 3,396                          |       |                                                    | (1,380     | ) |   |   | — |   |   |   | 2,016 |   |   |
| Net income (loss)                                    |       |                                      | $          | (50,671                    | )          |                     |       | $                          | (50,671    | )                              |       | $                                                       | (85,364    | ) |   | $ | 33,839 |   |   |   | $ | 102,196 |   |   |   | $ | (50,671 | ) |   |

 

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**DUANE READE HOLDINGS, INC.Condensed Consolidating Statement of Operations (Unaudited)For the 26 weeks ended July 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                                            |       |                                      | $          | —                     |       |                     |       | $                          | —     |                           |       | $                                                       | 784,658    |   |   | $ | 19,138 |   |   |   | $ | (19,138 | ) |   |   | $ | 784,658 |   |   |
| Cost of sales                                        |       |                                      | —     |                       |       |                     | —     |                       |       | 628,098                        |       |                                                    | —     |   |   |   | — |   |   |   | 628,098 |   |   |
| Gross profit                                         |       |                                      | —     |                       |       |                     | —     |                       |       | 156,560                        |       |                                                    | 19,138     |   |   |   | (19,138 | ) |   |   | 156,560 |   |   |
| Selling,  general & administrative expenses |       |                                      | —     |                       |       |                     | —     |                       |       | 156,614                        |       |                                                    | 136        |   |   |   | (19,138 | ) |   |   | 137,612 |   |   |
| Labor contingency                                    |       |                                      | —     |                       |       |                     | —     |                       |       | (18,004                        | )          |                                                    | —     |   |   |   | — |   |   |   | (18,004 | ) |   |
| Depreciation and  amortization                       |       |                                      | —     |                       |       |                     | —     |                       |       | 37,306                         |       |                                                    | —     |   |   |   | — |   |   |   | 37,306 |   |   |
| Store pre-opening  expense                           |       |                                      | —     |                       |       |                     | —     |                       |       | 152                            |       |                                                    | —     |   |   |   | — |   |   |   | 152 |   |   |
| Other expense                                        |       |                                      | —     |                       |       |                     | —     |                       |       | 1,635                          |       |                                                    | —     |   |   |   | — |   |   |   | 1,635 |   |   |
| Operating (loss) income                              |       |                                      | —     |                       |       |                     | —     |                       |       | (21,143                        | )          |                                                    | 19,002     |   |   |   | — |   |   |   | (2,141 | ) |   |
| Equity earnings  in affiliates                       |       |                                      | 30,941     |                       |       |                     | 30,941     |                       |       | —                         |       |                                                    | 605        |   |   |   | (62,487 | ) |   |   | — |   |   |
| Interest expense  (income), net                      |       |                                      | —     |                       |       |                     | —     |                       |       | 37,547                         |       |                                                    | (9,674     | ) |   |   | — |   |   |   | 27,873 |   |   |
| Income (loss) before income taxes                    |       |                                      | (30,941    | )                          |       |                     | (30,941    | )                          |       | (58,690                        | )          |                                                    | 28,071     |   |   |   | 62,487 |   |   |   | (30,014 | ) |   |
| Income taxes  (benefit)                              |       |                                      | —     |                       |       |                     | —     |                       |       | 1,813                          |       |                                                    | (886       | ) |   |   | — |   |   |   | 927 |   |   |
| Net income (loss)                                    |       |                                      | $          | (30,941                    | )          |                     |       | $                          | (30,941    | )                              |       | $                                                       | (60,503    | ) |   | $ | 28,957 |   |   |   | $ | 62,487 |   |   |   | $ | (30,941 | ) |   |

 

24

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**DUANEREADE HOLDINGS, INC.Condensed Consolidating Balance Sheet (Unaudited)As of June 30, 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                                                       |       |                                      | $          | —                     |       |                     | $          | —                     |       | $                              | 1,340      |                                                    |       | $ | 42 |   |   |   | $ | — |   |   |   | $ | 1,382 |   |   |
| Receivables                                                |       |                                      | —     |                       |       | —                   |       | 55,206                     |       |                           | —     |                                                    |       |   | — |   |   |   | 55,206 |   |   |
| Due from affiliates                                        |       |                                      | —     |                       |       | 78,866                   |       | 106,506                    |       |                           | (34        | )                                                       |       |   | (185,338 | ) |   |   | — |   |   |
| Inventories                                                |       |                                      | —     |                       |       | —                   |       | 220,557                    |       |                           | —     |                                                    |       |   | — |   |   |   | 220,557 |   |   |
| Deferred income taxes                                      |       |                                      | —     |                       |       | 1,140                    |       | 5,049                      |       |                           | (6,189     | )                                                       |       |   | — |   |   |   | — |   |   |
| Prepaid expenses and other assets                          |       |                                      | —     |                       |       | —                   |       | 25,217                     |       |                           | —     |                                                    |       |   | — |   |   |   | 25,217 |   |   |
| Total current assets                                       |       |                                      | —     |                       |       | 80,006                   |       | 413,875                    |       |                           | (6,181     | )                                                       |       |   | (185,338 | ) |   |   | 302,362 |   |   |
| Investment in affiliates                                   |       |                                      | (9,314     | )                          |       | (9,314                   | )          | —                     |       |                           | (1,942     | )                                                       |       |   | 20,570 |   |   |   | — |   |   |
| Property and equipment                                     |       |                                      | —     |                       |       | —                   |       | 201,594                    |       |                           | —     |                                                    |       |   | — |   |   |   | 201,594 |   |   |
| Goodwill, net                                              |       |                                      | —     |                       |       | —                   |       | 70,384                     |       |                           | —     |                                                    |       |   | — |   |   |   | 70,384 |   |   |
| Deferred income taxes                                      |       |                                      | —     |                       |       | 1,645                    |       | 9,032                      |       |                           | (10,677    | )                                                       |       |   | — |   |   |   | — |   |   |
| Other assets                                               |       |                                      | —     |                       |       | —                   |       | 157,176                    |       |                           | 378,557    |                                                    |       |   | (332,325 | ) |   |   | 203,408 |   |   |
| Total assets                                               |       |                                      | $          | (9,314                     | )          |                     | $          | 72,337                     |       | $                              | 852,061    |                                                    |       | $ | 359,757 |   |   |   | $ | (497,093 | ) |   |   | $ | 777,748 |   |   |
| Liabilities and  Stockholder’s Equity (Deficit)       |       |                                      |       |                       |       |                     |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |
| Current liabilities                                        |       |                                      |       |                       |       |                     |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |
| Accounts payable                                           |       |                                      | $          | —                     |       |                     | $          | —                     |       | $                              | 80,858     |                                                    |       | $ | — |   |   |   | $ | — |   |   |   | $ | 80,858 |   |   |
| Due to affiliates                                          |       |                                      | —     |                       |       | —                   |       | —                     |       |                           | 185,336    |                                                    |       |   | (185,336 | ) |   |   | — |   |   |
| Accrued interest                                           |       |                                      | —     |                       |       | —                   |       | 9,362                      |       |                           | —     |                                                    |       |   | — |   |   |   | 9,362 |   |   |
| Accrued expenses                                           |       |                                      | —     |                       |       | 86                       |       | 41,887                     |       |                           | —     |                                                    |       |   | — |   |   |   | 41,973 |   |   |
| Deferred income taxes                                      |       |                                      | —     |                       |       | 341                      |       | —                     |       |                           | —     |                                                    |       |   | — |   |   |   | 341 |   |   |
| Current portion of debt                                    |       |                                      | —     |                       |       | —                   |       | 146,903                    |       |                           | —     |                                                    |       |   | — |   |   |   | 146,903 |   |   |
| Current portion of capital lease obligation                |       |                                      | —     |                       |       | —                   |       | 3,238                      |       |                           | —     |                                                    |       |   | — |   |   |   | 3,238 |   |   |
| Total current liabilities                                  |       |                                      | —     |                       |       | 427                      |       | 282,248                    |       |                           | 185,336    |                                                    |       |   | (185,336 | ) |   |   | 282,675 |   |   |
| Long term debt                                             |       |                                      | —     |                       |       | —                   |       | 737,357                    |       |                           | —     |                                                    |       |   | (332,325 | ) |   |   | 405,032 |   |   |
| Capital lease obligation, less current portion             |       |                                      | —     |                       |       | —                   |       | 5,468                      |       |                           | —     |                                                    |       |   | — |   |   |   | 5,468 |   |   |
| Deferred income taxes                                      |       |                                      | —     |                       |       | 78,770                   |       | (79,367                    | )          |                           | 29,356     |                                                    |       |   | — |   |   |   | 28,759 |   |   |
| Other non-current liabilities                              |       |                                      | 31,113     |                       |       | 33,567                   |       | 89,802                     |       |                           | —     |                                                    |       |   | (62,226 | ) |   |   | 92,256 |   |   |
| Total liabilities                                          |       |                                      | 31,113     |                       |       | 112,764                  |       | 1,035,508                  |       |                           | 214,692    |                                                    |       |   | (579,887 | ) |   |   | 814,190 |   |   |
| Stockholder’s equity  (deficit)                       |       |                                      |       |                       |       |                     |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |
| Common stock                                               |       |                                      | 26         |                       |       | —                   |       | 26                         |       |                           | —     |                                                    |       |   | (26 | ) |   |   | 26 |   |   |
| Paid-in-capital                                            |       |                                      | 247,509    |                       |       | 247,535                  |       | 251,384                    |       |                           | 2,395      |                                                    |       |   | (497,439 | ) |   |   | 251,384 |   |   |
| Accumulated other comprehensive income                |       |                                      | —     |                       |       | —                   |       | 110                        |       |                           | —     |                                                    |       |   | — |   |   |   | 110 |   |   |
| Retained earnings (deficit)                                |       |                                      | (287,962   | )                          |       | (287,962                 | )          | (434,967                   | )          |                           | 142,670    |                                                    |       |   | 580,259 |   |   |   | (287,962 | ) |   |
| Total stockholder’s equity (deficit)                  |       |                                      | (40,427    | )                          |       | (40,427                  | )          | (183,447                   | )          |                           | 145,065    |                                                    |       |   | 82,794 |   |   |   | (36,442 | ) |   |
| Total liabilities  and stockholder’s equity (deficit) |       |                                      | $          | (9,314                     | )          |                     | $          | 72,337                     |       | $                              | 852,061    |                                                    |       | $ | 359,757 |   |   |   | $ | (497,093 | ) |   |   | $ | 777,748 |   |   |

 

25

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**DUANEREADE HOLDINGS, 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 (Deficit)            |       |                                      |       |                       |       |                     |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |
| 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 (deficit)                             |       |                                      |       |                       |       |                     |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |
| 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 (deficit)                       |       |                                      | 2,209      |                       |       | 2,209                    |       | (109,575                   | )          |                           | 111,213    |                                                    |       |   | (3,319 | ) |   |   | 2,737 |   |   |
| Total liabilities  and stockholder’s equity (deficit) |       |                                      | $          | 2,209                      |       |                     | $          | 79,665                     |       | $                              | 876,927    |                                                    |       | $ | 327,285 |   |   |   | $ | (487,505 | ) |   |   | $ | 798,581 |   |   |

 

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**DUANEREADE HOLDINGS, INC.Condensed Consolidating Statement of Cash Flows (Unaudited)For the 26 weeks ended June 30, 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                                                                                         |       |                    | $          | (50,671             | )          |              |       | $              | (50,671    | )                 |       | $                       | (85,364    | ) |   | $ | 33,839 |   |   |   | $ | 102,196 |   |   |   | $ | (50,671 | ) |   |
| Adjustments  to reconcile net (loss) income to net cash provided by (used  in) operating activities: |       |                    |       |                |       |              |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Depreciation and amortization                                                                             |       |                    | —     |                |       |              | —     |           |       | 38,281            |       |                    | —     |   |   |   | — |   |   |   | 38,281 |   |   |
| Deferred income taxes                                                                                     |       |                    | —     |                |       |              | (108       | )              |       | 3,396             |       |                    | (1,380     | ) |   |   | — |   |   |   | 1,908 |   |   |
| Non-cash rent expense                                                                                     |       |                    | —     |                |       |              | —     |           |       | 6,320             |       |                    | —     |   |   |   | — |   |   |   | 6,320 |   |   |
| Other non-cash expense                                                                                    |       |                    | —     |                |       |              | —     |           |       | 2,264             |       |                    | —     |   |   |   | — |   |   |   | 2,264 |   |   |
| Equity in income of subsidiaries                                                                          |       |                    | 50,671     |                |       |              | 50,671     |           |       | —            |       |                    | 854        |   |   |   | (102,196 | ) |   |   | — |   |   |
| Changes  in operating assets and liabilities:                                                        |       |                    |       |                |       |              |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Receivables                                                                                               |       |                    | —     |                |       |              | 154        |           |       | 1,642             |       |                    | 179        |   |   |   | — |   |   |   | 1,975 |   |   |
| Inventories                                                                                               |       |                    | —     |                |       |              | —     |           |       | (1,633            | )          |                    | —     |   |   |   | — |   |   |   | (1,633 | ) |   |
| Accounts payable                                                                                          |       |                    | —     |                |       |              | —     |           |       | (2,552            | )          |                    | —     |   |   |   | — |   |   |   | (2,552 | ) |   |
| Prepaid and accrued expenses                                                                              |       |                    | —     |                |       |              | (46        | )              |       | (4,026            | )          |                    | —     |   |   |   | — |   |   |   | (4,072 | ) |   |
| Other assets and liabilities,  net                                                                        |       |                    | —     |                |       |              | —     |           |       | 34,080            |       |                    | (33,475    | ) |   |   | — |   |   |   | 605 |   |   |
| NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES                                                       |       |                    | —     |                |       |              | —     |           |       | (7,592            | )          |                    | 17         |   |   |   | — |   |   |   | (7,575 | ) |   |
| Cash flows used in  investing activities:                                                                 |       |                    |       |                |       |              |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Capital expenditures                                                                                      |       |                    | —     |                |       |              | —     |           |       | (13,406           | )          |                    | —     |   |   |   | — |   |   |   | (13,406 | ) |   |
| Lease acquisition and other  costs                                                                        |       |                    | —     |                |       |              | —     |           |       | (8,811            | )          |                    | —     |   |   |   | — |   |   |   | (8,811 | ) |   |
| NET CASH USED IN INVESTING ACTIVITIES                                                                     |       |                    | —     |                |       |              | —     |           |       | (22,217           | )          |                    | —     |   |   |   | — |   |   |   | (22,217 | ) |   |
| Cash flows from financing  activities:                                                                    |       |                    |       |                |       |              |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Issuance of preferred stock                                                                               |       |                    | —     |                |       |              | —     |           |       | 39,150            |       |                    | —     |   |   |   | — |   |   |   | 39,150 |   |   |
| Capital contribution                                                                                      |       |                    | —     |                |       |              | —     |           |       | 2,457             |       |                    | —     |   |   |   | — |   |   |   | 2,457 |   |   |
| Borrowings from revolving credit facility                                                            |       |                    | —     |                |       |              | —     |           |       | 1,006,854         |       |                    | —     |   |   |   | — |   |   |   | 1,006,854 |   |   |
| Repayments of revolving credit facility                                                                   |       |                    | —     |                |       |              | —     |           |       | (1,017,073        | )          |                    | —     |   |   |   | — |   |   |   | (1,017,073 | ) |   |
| Repayments of capital lease obligations                                                                   |       |                    | —     |                |       |              | —     |           |       | (1,604            | )          |                    | —     |   |   |   | — |   |   |   | (1,604 | ) |   |
| Deferred financing costs                                                                                  |       |                    | —     |                |       |              | —     |           |       | (5                | )          |                    | —     |   |   |   | — |   |   |   | (5 | ) |   |
| NET CASH PROVIDED BY FINANCING ACTIVITIES                                                                 |       |                    | —     |                |       |              | —     |           |       | 29,779            |       |                    | —     |   |   |   | — |   |   |   | 29,779 |   |   |
| Net change in cash                                                                                        |       |                    | —     |                |       |              | —     |           |       | (30               | )          |                    | 17         |   |   |   | — |   |   |   | (13 | ) |   |
| Cash at beginning of period                                                                               |       |                    | —     |                |       |              | —     |           |       | 1,370             |       |                    | 25         |   |   |   | — |   |   |   | 1,395 |   |   |
| Cash at end of  period                                                                                    |       |                    | $          | —              |       |              |       | $              | —     |              |       | $                       | 1,340      |   |   | $ | 42 |   |   |   | $ | — |   |   |   | $ | 1,382 |   |   |

 

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**DUANEREADE HOLDINGS, INC.Condensed Consolidating Statement of Cash Flows (Unaudited)For the 26 weeks ended July 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)                                                                                           |       |                    | $          | (30,941             | )          |              |       | $              | (30,941    | )                 |       | $                       | (60,503    | ) |   | $ | 28,957 |   |   |   | $ | 62,487 |   |   |   | $ | (30,941 | ) |   |
| Adjustments  to reconcile net income (loss) to net cash (used in) / provided by  operating activities: |       |                    |       |                |       |              |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Depreciation and amortization                                                                               |       |                    | —     |                |       |              | —     |           |       | 39,430            |       |                    | —     |   |   |   | — |   |   |   | 39,430 |   |   |
| Deferred tax provision                                                                                      |       |                    | —     |                |       |              | (66        | )              |       | 1,813             |       |                    | (886       | ) |   |   | — |   |   |   | 861 |   |   |
| Deferred rent expense                                                                                       |       |                    | —     |                |       |              | —     |           |       | 5,150             |       |                    | —     |   |   |   | — |   |   |   | 5,150 |   |   |
| Reversal of labor contingency accrual                                                                       |       |                    | —     |                |       |              | —     |           |       | (18,004           | )          |                    | —     |   |   |   | — |   |   |   | (18,004 | ) |   |
| Other non-cash expense                                                                                      |       |                    | —     |                |       |              | —     |           |       | 104               |       |                    | —     |   |   |   | — |   |   |   | 104 |   |   |
| Equity in income of subsidiaries                                                                            |       |                    | 30,941     |                |       |              | 30,941     |           |       | —            |       |                    | 605        |   |   |   | (62,487 | ) |   |   | — |   |   |
| Changes  in operating assets and liabilities:                                                          |       |                    |       |                |       |              |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Receivables                                                                                                 |       |                    | —     |                |       |              | 81         |           |       | 1,497             |       |                    | 695        |   |   |   | — |   |   |   | 2,273 |   |   |
| Inventories                                                                                                 |       |                    | —     |                |       |              | —     |           |       | 9,390             |       |                    | —     |   |   |   | — |   |   |   | 9,390 |   |   |
| Accounts payable                                                                                            |       |                    | —     |                |       |              | —     |           |       | 5,794             |       |                    | —     |   |   |   | — |   |   |   | 5,794 |   |   |
| Prepaid and accrued expenses                                                                                |       |                    | —     |                |       |              | (15        | )              |       | 1,850             |       |                    | —     |   |   |   | — |   |   |   | 1,835 |   |   |
| Increase in other assets (liabilities), net                                                                 |       |                    | —     |                |       |              | —     |           |       | 17,352            |       |                    | (29,375    | ) |   |   | — |   |   |   | (12,023 | ) |   |
| NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES                                                         |       |                    | —     |                |       |              | —     |           |       | 3,873             |       |                    | (4         | ) |   |   | — |   |   |   | 3,869 |   |   |
| Capital expenditures                                                                                        |       |                    | —     |                |       |              | —     |           |       | (12,270           | )          |                    | —     |   |   |   | — |   |   |   | (12,270 | ) |   |
| Lease acquisition and other  costs                                                                          |       |                    | —     |                |       |              | —     |           |       | (4,107            | )          |                    | —     |   |   |   | — |   |   |   | (4,107 | ) |   |
| Proceeds from sale of property                                                                              |       |                    | —     |                |       |              | —     |           |       | 1,500             |       |                    | —     |   |   |   | — |   |   |   | 1,500 |   |   |
| NET CASH USED IN INVESTING  ACTIVITIES                                                                      |       |                    | —     |                |       |              | —     |           |       | (14,877           | )          |                    | —     |   |   |   | — |   |   |   | (14,877 | ) |   |
| Cash flows from financing  activities:                                                                      |       |                    |       |                |       |              |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Borrowings from revolving credit facility                                                                   |       |                    | —     |                |       |              | —     |           |       | 915,368           |       |                    | —     |   |   |   | — |   |   |   | 915,368 |   |   |
| Repayments of revolving credit facility                                                                |       |                    | —     |                |       |              | —     |           |       | (902,802          | )          |                    | —     |   |   |   | — |   |   |   | (902,802 | ) |   |
| Deferred financing costs                                                                                    |       |                    | —     |                |       |              | —     |           |       | (28               | )          |                    | —     |   |   |   | — |   |   |   | (28 | ) |   |
| Repayments of capital lease obligations                                                                     |       |                    | —     |                |       |              | —     |           |       | (1,541            | )          |                    | —     |   |   |   | — |   |   |   | (1,541 | ) |   |
| NET CASH PROVIDED BY FINANCING  ACTIVITIES                                                                  |       |                    | —     |                |       |              | —     |           |       | 10,997            |       |                    | —     |   |   |   | — |   |   |   | 10,997 |   |   |
| Net (decrease) increase in cash                                                                             |       |                    | —     |                |       |              | —     |           |       | (7                | )          |                    | (4         | ) |   |   | — |   |   |   | (11 | ) |   |
| Cash at beginning of period                                                                                 |       |                    | —     |                |       |              | —     |           |       | 1,338             |       |                    | 24         |   |   |   | — |   |   |   | 1,362 |   |   |
| Cash at end of  period                                                                                      |       |                    | $          | —              |       |              |       | $              | —     |              |       | $                       | 1,331      |   |   | $ | 20 |   |   |   | $ | — |   |   |   | $ | 1,351 |   |   |

 

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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 and 26weeks ended June 30, 2007 and the 13 and 26 weeks ended July 1, 2006should be read in conjunction with the more detailed financial informationcontained in our consolidated financial statements and their notes as well asthe Special Note Regarding Forward-Looking Statements that are containedelsewhere in this report.

**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 54.2% and 53.6% of our sales in the thirteen andtwenty-six weeks ended June 30, 2007, as compared to 54.1% and 53.8% inthe corresponding periods last year. Gross margins generated by our front-endbusiness are approximately twice that of our pharmacy 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. Our pharmacy sales include all items we sell by prescriptions filled atour retail locations or by our central fill/mail order facility and deliveredto our stores or mailed directly to our customers. In addition, we include inour pharmacy sales certain resales of retail pharmaceutical inventory that arerequired to be reported on a gross basis in accordance with Emerging IssuesTask Force Issue No. 99-19, “Reporting Revenue Gross as a Principalvs. Net as an Agent.” Same-store pharmacy sales do not include such resaleactivity. The pharmacy portion of our business is dominated by and dependentupon a number of third party private and government-sponsored plans thatcontract with us as an authorized provider of prescriptions. In each of thepast four years, New York State has enacted rules related to Medicaidwhich have reduced reimbursement rates and therefore our pharmacy margin. NewYork has again changed its rules effective July 1, 2007. We estimatethat these most recent changes will reduce our annual pharmacy margin byapproximately $1.8 million. Sales processed through third partyprescription plans represented approximately 93.0% of our prescription sales inthe thirteen and twenty-six weeks ended June 30, 2007 and approximately92.9% and 92.7% of our prescription sales in the thirteen and twenty-six weeksended July 1, 2006.

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 eligiblefor this 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. Prior to 

29

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January 1st 2006, state Medicaid programs that providedprescription benefits to low income households and individuals historicallyrepresented approximately 25% of our retail pharmacy sales. At June 30,2007, as a result of dual eligible individuals being automatically enrolledinto the Medicare Part D program as well as new enrollees becomingeligible by virtue of their having reached 65 years of age, state Medicaidplans had declined to approximately 14.2% of our pharmacy sales while the newMedicare Part D plan represented approximately 11.8% of our pharmacysales.

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 ofgeneric prescriptions in place of branded medications. Generic prescriptionsgenerally have lower retail sales prices but are more profitable for thepharmacy than branded prescriptions. Improved generic utilization rates as wellas a combination of direct purchases and contractual wholesaler purchasesenabled us to achieve improved gross margins on pharmacy retail sales during2005 and 2006. For the three and six months ended June 30, 2007, despitethe continued favorable impact of higher generic dispensing rates, our grossmargins on pharmacy retail sales declined in comparison to the correspondingperiods of 2006. The declines were primarily attributable to the impact ofreduced Medicaid reimbursements and the increased proportion of lower marginMedicare Part D sales.

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 in 2009. While these increases have impacted our cost of labor, we have,and believe we can continue to, offset a significant portion of these costincreases through process 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 and apart from the retail operations. In addition, Duane ReadeGP distributed some of its store leases to Duane Reade Inc. and DRII Inc., which in turn made a capital contribution of these leases to DuaneReade Realty. Duane Reade Realty is the lessee under certain store leasesentered into after its creation. Duane Reade Realty subleases to Duane Reade GPthe properties subject to those leases. The consolidated financial statementsincluded in this filing reflect the accounts of Duane Reade Holdings, Inc.and its subsidiaries for all periods shown. All significant intercompanytransactions and balances have been eliminated.

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

We operate approximately89% of our 244 stores in New York City and the remainder in the surroundingareas. As a result, our performance is substantially affected by economicconditions and other factors affecting the region such as the regulatoryenvironment, costs of energy, real estate, insurance, taxes and rent, weather,demographics, tourism levels, availability of labor and geopolitical factorssuch as terrorism. Since the second half of 2004, the New York City economy hasgenerally reflected an improving trend.

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**Results ofOperations**

***The Thirteen Weeks Ended June 30, 2007 asCompared to the Thirteen Weeks Ended July 1, 2006***

For the secondquarter of 2007, we achieved net sales of $431.9 million and incurred anet loss of $20.1 million, as compared to net sales of $398.8 millionand a net loss of $21.1 million in the second quarter of the previousyear. Pharmacy resale activity included in net sales was $15.7 million inthe second quarter of 2007, compared to $10.0 million in the previousyear. The reduced net loss is primarily attributable to the following factors:

·       An increase in gross marginof $10.2 million that was primarily attributable to higher front-end storesales and improved front-end selling margins.

·       A decrease in non-cashdepreciation and amortization expenses of $0.2 million, reflecting theimpact of the asset impairment writedown recorded in the fourth quarter of2006.

·       A decrease in storepre-opening costs of $0.1 million, as no new stores opened in the secondquarter of 2007.

The positive impactof these items was partially offset by:

·       An increase in selling,general and administrative expenses of $5.2 million, primarily reflectingincreased pharmacists’ labor costs, increases in minimum wage rates, unioncontract wage increases and payroll costs associated with additional corporatestaffing to support the continued implementation of the Duane Reade FullPotential program.

·       An increase in otherexpenses of $3.7 million, primarily due to the recently completed auditcommittee investigations, as well as the arbitration matter related to theformer Chairman and CEO.

·       An increase in interestexpense of $0.5 million resulting from higher interest rates applicable toour variable rate debt and higher borrowing levels on our amended asset-basedrevolving loan facility.

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

| ** **                                           | ** ** | **For the 13 Weeks Ended**      | ** ** |
|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                           | ** ** | **June 30, 2007**                         | ** ** | **July 1, 2006** | ** ** |
| ** **                                           | ** ** | **Dollars**                                         | ** ** | **% of Sales** | ** ** | **Dollars** | ** ** | **% of Sales** | ** ** |
| ** **                                           | ** ** | **In thousands, except percentages** | ** ** |
| Net sales                                            |       | $                                                   | 431,930    |   |   | 100.0 | % |   |   | $ | 398,789 |   |   |   | 100.0 | % |   |
| Cost of sales                                        |       | 340,602                                             |       |   | 78.9 |   |   |   | 317,704 |   |   |   | 79.7 |   |   |
| Gross profit                                         |       | 91,328                                              |       |   | 21.1 |   |   |   | 81,085 |   |   |   | 20.3 |   |   |
| Selling,  general & administrative expenses |       | 73,325                                              |       |   | 17.0 |   |   |   | 68,146 |   |   |   | 17.1 |   |   |
| Depreciation and  amortization                       |       | 18,416                                              |       |   | 4.3 |   |   |   | 18,628 |   |   |   | 4.7 |   |   |
| Store pre-opening  expenses                          |       | —                                              |       |   | 0.0 |   |   |   | 102 |   |   |   | 0.0 |   |   |
| Other expense                                        |       | 4,223                                               |       |   | 1.0 |   |   |   | 533 |   |   |   | 0.1 |   |   |
| Operating loss                                       |       | (4,636                                              | )          |   | (1.1 | ) |   |   | (6,324 | ) |   |   | (1.6 | ) |   |
| Interest expense,  net                               |       | 14,645                                              |       |   | 3.4 |   |   |   | 14,135 |   |   |   | 3.5 |   |   |
| Loss before  income taxes                            |       | (19,281                                             | )          |   | (4.5 | ) |   |   | (20,459 | ) |   |   | (5.1 | ) |   |
| Income taxes                                         |       | 856                                                 |       |   | 0.2 |   |   |   | 619 |   |   |   | 0.2 |   |   |
| Net loss                                             |       | $                                                   | (20,137    | ) |   | (4.7 | )% |   |   | $ | (21,078 | ) |   |   | (5.3 | )% |   |

 

Net sales were$431.9 million in the thirteen weeks ended June 30, 2007,representing an increase of 8.3% as compared to net sales of$398.8 million in the thirteen weeks ended July 1, 2006. Resaleactivity accounted for 1.4% of the increase, while an increase in retail storesales represented the remaining 6.9%. Total same-store sales increased by 7.9%over the second quarter of last year.

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Pharmacy sales increasedfrom $183.1 million in the second quarter of 2006 to $197.8 millionin the second quarter of 2007, an increase of 8.0%, and represented 45.8% oftotal sales, as compared with 45.9% of total sales in the second quarter of2006. Resale activity accounted for 3.1% of the sales increase, while retailsales accounted for the remaining 4.9% of the increase. Pharmacy same-storesales increased by 6.1% from last year, and third-party reimbursed pharmacysales represented 93.0% of total prescription sales, compared to 92.9% in thesecond quarter of 2006. The percentage of generic drugs dispensed increased by3.8% over the prior year, negatively impacting the pharmacy same-store salesincrease by approximately 3.1%, but contributing to an increase in gross marginper prescription dispensed. Generic drugs generally have lower retail salesprices but are more profitable than branded drugs.

Front-end sales increasedfrom $215.7 million in the second quarter of 2006 to $234.1 millionin the second quarter of 2007, an increase of 8.6%, and represented 54.2% oftotal sales, as compared to 54.1% of total sales in the second quarter of 2006.Front-end same-store sales increased by 9.4%, primarily due to a generallyimproved level of consumer demand resulting from a stronger New York Cityeconomy, increased penetration of our Dollar Rewards program, an improvedmerchandise offering and enhanced customer service reflecting the continuingimplementation of our “Full Potential” initiative introduced last year.

During the thirteen weeksended June 30, 2007, we closed one store, as compared to two stores openedand two stores closed during the thirteen weeks ended July 1, 2006. At June 30,2007, we operated 244 stores, as compared to 247 stores at July 1, 2006and 248 stores at December 30, 2006.

Cost of sales as apercentage of net sales was 78.9% and 79.7% in the second quarters of 2007 and2006, respectively, resulting in gross profit margins of 21.1% and 20.3% ineach respective period. Cost of sales also includes a $0.6 million LIFOprovision in each year’s second quarter. The gross profit margin in 2007reflects the impact of improved front-end selling margins associated with amore favorable mix of promotional and regularly-priced products, offset in partby the lower pharmacy margins resulting from increased Medicare Part Dsales as well as lower NY Medicaid reimbursement rates that were not completelyoffset by higher margins associated with an increased proportion of generic prescriptions.

Selling, general andadministrative expenses were $73.3 million, or 17.0% of net sales, and$68.1 million, or 17.1% of net sales, in the second quarter of 2007 and2006, respectively. The decrease in the 2007 expense percentage as compared to2006 was attributable to improved leveraging of costs against strong same-storesales growth in both pharmacy and front-end and increased pharmacy resaleactivity, which increased the dollar amount of sales.

Depreciation andamortization of property and equipment and intangible assets was$18.4 million in the second quarter of 2007, as compared to$18.6 million in the second quarter of 2006. The net decrease reflects a reductionin expenses that is primarily attributable to the asset impairment writedownrecorded in the fourth quarter of 2006.

We incurred no storepre-opening expenses in the second quarter of 2007, as compared to $0.1 millionin the second quarter of 2006, which was attributable to the opening of two newstores.

In the second quarter of2007, we incurred other expenses of $4.2 million, including costs associatedwith the audit committee investigations and various other matters related tothe former Chairman and CEO ($3.2 million), costs associated with the closingof various stores ($0.6 million), Oak Hill management fees ($0.3 million) andadditional severance costs associated with the termination of certainmanagement positions ($0.1 million). In the second quarter of 2006, otherexpenses of $0.5 million included Oak Hill management fees ($0.3 million) andcosts associated with our current Chairman and CEO ($0.2 million).

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Net interest expense forthe second quarter of 2007 was $14.6 million, as compared to $14.1 millionin the second quarter of 2006. This increase was primarily attributable tohigher floating interest rates and increased debt levels incurred on ourrevolving loan borrowings as compared to the prior year. At June 30, 2007,the weighted average interest rate on our variable rate outstanding debt was8.67%, as compared to a weighted average rate of 8.64% at July 1, 2006.

In the second quarter of2007, we recorded an income tax provision of $0.9 million, reflecting anestimated effective tax rate of (4.4%). This expense is the result of avaluation allowance of $12.9 million that largely offset the tax benefitgenerated by our operating loss in the quarter. In the comparable period of2006, the income tax provision of $0.6 million, resulting from a valuationallowance of $9.6 million, reflected an effective tax rate of (3.1%).

***The Twenty-Six Weeks Ended June 30, 2007 asCompared to the Twenty-Six Weeks Ended July 1, 2006***

For the first six months of 2007, we achieved netsales of $846.3 million and incurred a net loss of $50.7 million, ascompared to net sales of $784.7 million and a net loss of $30.9 million in thefirst six months of the previous year. Pharmacy resale activity included in netsales was $30.1 million in the first six months of 2007, compared to $21.4million in the previous year. The increased net loss is primarily attributableto 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 $7.6 million, primarily due to the recently completed auditcommittee investigations, as well as the arbitration matter related to theformer Chairman and CEO.

·       An increase in selling,general and administrative expenses of $8.5 million, primarily reflectingincreased pharmacists’ labor costs, increases in minimum wage rates, unioncontract wage increases and payroll costs associated with additional corporatestaffing to support the continued implementation of the Duane Reade FullPotential program.

·       An income tax provision of$2.0 million in the first six months of 2007, compared to an income taxprovision of $0.9 million in the prior year. The change in the tax provisionwas primarily attributable to the change in the pre-tax loss as compared to theprior year.

·       An increase in interestexpense of $1.2 million resulting from higher interest rates applicable toour variable rate debt and higher borrowing levels on our amended asset-basedrevolving loan facility.

Thenegative impact of these items was partially offset by:

·       An increase in gross marginof $15.8 million that was primarily attributable to higher front-end storesales and improved front-end selling margins.

·       A decrease in non-cashdepreciation and amortization expenses of $0.9 million, reflecting the impactof the asset impairment writedown recorded in the fourth quarter of 2006.

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The followingsets forth the results of operations for the periods indicated:

| ** **                                           | ** ** | **For the 26 Weeks Ended**      | ** ** |
|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                           | ** ** | **June 30, 2007**                         | ** ** | **July 1, 2006** | ** ** |
| ** **                                           | ** ** | **Dollars**                                         | ** ** | **% of Sales** | ** ** | **Dollars** | ** ** | **% of Sales** | ** ** |
| ** **                                           | ** ** | **In thousands, except percentages** | ** ** |
| Net sales                                            |       | $                                                   | 846,318    |   |   | 100.0 | % |   |   | $ | 784,658 |   |   |   | 100.0 | % |   |
| Cost of sales                                        |       | 673,980                                             |       |   | 79.6 |   |   |   | 628,098 |   |   |   | 80.0 |   |   |
| Gross profit                                         |       | 172,338                                             |       |   | 20.4 |   |   |   | 156,560 |   |   |   | 20.0 |   |   |
| Selling,  general & administrative expenses |       | 146,069                                             |       |   | 17.3 |   |   |   | 137,612 |   |   |   | 17.5 |   |   |
| Labor contingency  income                            |       | —                                              |       |   | 0.0 |   |   |   | (18,004 | ) |   |   | (2.3 | ) |   |
| Depreciation and  amortization                       |       | 36,453                                              |       |   | 4.3 |   |   |   | 37,306 |   |   |   | 4.8 |   |   |
| Store pre-opening  expenses                          |       | 150                                                 |       |   | 0.0 |   |   |   | 152 |   |   |   | 0.0 |   |   |
| Other expense                                        |       | 9,241                                               |       |   | 1.1 |   |   |   | 1,635 |   |   |   | 0.2 |   |   |
| Operating loss                                       |       | (19,575                                             | )          |   | (2.3 | ) |   |   | (2,141 | ) |   |   | (0.3 | ) |   |
| Interest expense,  net                               |       | 29,080                                              |       |   | 3.4 |   |   |   | 27,873 |   |   |   | 3.6 |   |   |
| Loss before  income taxes                            |       | (48,655                                             | )          |   | (5.7 | ) |   |   | (30,014 | ) |   |   | (3.8 | ) |   |
| Income taxes                                         |       | 2,016                                               |       |   | 0.2 |   |   |   | 927 |   |   |   | 0.1 |   |   |
| Net loss                                             |       | $                                                   | (50,671    | ) |   | (6.0 | )% |   |   | $ | (30,941 | ) |   |   | (3.9 | )% |   |

 

Net sales were $846.3 millionin the twenty-six weeks ended June 30, 2007, representing an increase of7.9% as compared to net sales of $784.7 million in the twenty-six weeksended July 1, 2006. Resale activity accounted for 1.1% of the increase,while an increase in retail store sales represented the remaining 6.8%. Totalsame-store sales increased by 8.1% over the first half of last year.

Pharmacy sales increasedfrom $362.5 million in the first half of 2006 to $392.7 million inthe first half of 2007, an increase of 8.3%, and represented 46.4% of totalsales, as compared with 46.2% of total sales in the first half of 2006. Resaleactivity accounted for 2.4% of the sales increase, while retail sales accountedfor the remaining 5.9% of the increase. Pharmacy same-store sales increased by7.5% from last year, and third-party reimbursed pharmacy sales represented93.0% of total prescription sales, compared to 92.7% in the first half of 2006.The percentage of generic drugs dispensed increased by 3.4% over the prioryear, negatively impacting the pharmacy same-store sales increase byapproximately 2.9%, but contributing to an increase in gross margin perprescription dispensed. Generic drugs generally have lower retail sales pricesbut are more profitable for us than branded drugs.

Front-end sales increasedfrom $422.2 million in the first half of 2006 to $453.6 million inthe first half of 2007, an increase of 7.5%, and represented 53.6% of totalsales, as compared to 53.8% of total sales in the first half of 2006. Front-endsame-store sales increased by 8.5%, primarily due to a generally improved levelof consumer demand resulting from a stronger New York City economy, increasedpenetration of our Dollar Rewards program, an improved merchandise offering andenhanced customer service reflecting the continuing implementation of our “FullPotential” initiative introduced last year.

During the twenty-sixweeks ended June 30, 2007, we opened two stores and closed six stores, ascompared to three stores opened and seven stores closed during the twenty-sixweeks ended July 1, 2006.

Cost of sales as apercentage of net sales was 79.6% and 80.0% in the first six months of 2007 and2006, respectively, resulting in gross profit margins of 20.4% and 20.0% ineach respective 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 in part by lower pharmacymargins resulting from increased Medicare Part D sales as well as lower NYMedicaid reimbursement rates that were not completely offset by higher marginsassociated with an increased proportion of generic prescriptions. Cost of salesalso includes a LIFO provision of $1.2 million in the first half of 2007 ascompared to a LIFO provision of $1.1 million in the first half of 2006.

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Selling, general andadministrative expenses were $146.1 million, or 17.3% of net sales, and $137.6million, or 17.5% of net sales, in the first six months of 2007 and 2006,respectively. The decrease in the 2007 expense percentage as compared to 2006was attributable to improved leveraging of costs against strong same-storesales growth in both pharmacy and front-end and increased pharmacy resaleactivity, which increased the dollar amount of sales.

Depreciation andamortization of property and equipment and intangible assets was$36.4 million in the first six months of 2007, as compared to$37.3 million in the first six months of 2006. The net decrease reflects areduction in expenses that is attributable to the asset impairment writedownrecorded in the fourth quarter of 2006.

We incurred storepre-opening expenses of $0.1 million in the first half of 2007, attributable tothe opening of two stores, as compared to $0.2 million in the first half of2006, reflecting three new stores opened during that period.

In the first six months of2007, we incurred other expenses of $9.2 million, including costs associatedwith the audit committee investigations and various other matters related tothe former Chairman and CEO ($6.0 million), costs associated with the closingof various stores ($2.3 million), Oak Hill management fees ($0.6 million) andadditional severance costs associated with the termination of certain managementpositions ($0.3 million). In the corresponding prior year period, otherexpenses of $1.6 million included Oak Hill management fees ($0.6 million),costs associated with various matters related to the former Chairman and CEO($0.4 million), severance and other costs associated with the termination ofcertain management positions ($0.3 million) and costs attributable to ourcurrent Chairman and CEO ($0.3 million).

Net interest expense for thefirst six months of 2007 was $29.1 million, as compared to $27.9 millionin the first six months of 2006. This increase was primarily attributable tohigher floating interest rates and increased debt levels incurred on ourrevolving credit borrowings as compared to the prior year.

In the first half of 2007,we recorded an income tax provision of $2.0 million, reflecting anestimated effective tax rate of (4.1%). This expense is the result of avaluation allowance of $27.2 million that largely offset the tax benefitgenerated by our operating loss in the period. In the first half of 2006, theincome tax provision of $0.9 million, resulting from a valuation allowanceof $14.1 million, reflected an effective tax rate of (3.1%).

**Liquidity and Capital Resources**

**Working Capital and Cash Flow**

Workingcapital was $19.7 million as of June 30, 2007 and $6.2 millionas of December 30, 2006. The primary factors affecting the increase inworking capital from December 30, 2006 include:

·       reduced borrowings on our amended asset-based revolving loanfacility of $10.2 million, primarily reflecting the receipt of proceeds fromthe issuance of preferred stock and warrants,

·       reducedexpense accruals of $4.3 million, primarily reflecting the second quarter 2007payment of the 2006 incentive bonus award,

·       reducedaccounts payable of $2.6 million, and

·       increasedinventory of $1.6 million.

These items were partiallyoffset by a decrease in the current portion of deferred taxes of$2.8 million, reduced receivables of $2.0 million and a reduction of $0.4million in prepaid and other current assets.

Working capital reflectsthe classification of outstanding borrowings under our amended asset-basedrevolving loan facility of $146.9 million at June 30, 2007 and$157.1 million at December 30, 2006 as 

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currentliabilities. This current classification is required because cash receiptscontrolled by the lenders are used to reduce outstanding debt and we do notmeet the criteria of SFAS No. 6 to reclassify the debt as long-term, butis not an indication that this credit facility is expected to be retired withinthe next year. This facility expires in July 2011 and we intend tocontinue to access it for our working capital needs throughout its remainingterm.

Net cash used in operatingactivities was $7.6 million in the twenty-six weeks ended June 30,2007 compared to net cash provided by operating activities of $3.9 millionin the twenty-six weeks ended July 1, 2006. The change is primarilyattributable to expenses incurred in connection with the arbitration matterrelated to the former CEO and the recently completed audit committeeinvestigations as well as a reduction in payroll related liabilities.

Net cash used in investingactivities was $22.2 million in the twenty-six weeks ended June 30,2007, compared to $14.9 million in the twenty-six weeks ended July 1,2006. In the first six months of 2007, we spent $13.4 million on capitalexpenditures, primarily related to new store openings and the remodeling ofexisting locations, and $8.8 million on lease acquisition and other costs.In the first six months of 2006, capital expenditures of $12.3 million andlease acquisition, pharmacy customer file and other costs of $4.1 million werepartially offset by $1.5 million received in connection with the termination ofa leased property.

Net cash provided byfinancing activities was $29.8 million in the twenty-six weeks ended June 30,2007, compared to $11.0 million in the twenty-six weeks ended July 1,2006. Cash provided by financing activities includes $39.1 million (net ofexpenses of $0.3 million) resulting from the issuance of preferred stock andwarrants. See Note 10 to our Unaudited Consolidated Interim Financial Statementscontained elsewhere in this report for additional information regarding thistransaction.

**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 six months of 2007, five new stores during fiscal 2006 andseven new stores during fiscal 2005. We currently plan to open a total of 17new stores and close 13 stores in 2007. The new store openings in 2007 includethe acquisition of up to eight leases in Manhattan from the Gristedessupermarket chain. This acquisition is subject to various conditions including,in some cases, the receipt of landlord consents. As of June 30, 2007, wehave received the required consents for two of these locations, which areexpected to be placed in operation during the third quarter, and we anticipatereceiving the balance of the consents required to complete this transaction inthe near future. The acquisition of the Gristedes leases and the relatedbuild-out costs and working capital commitments are being funded by the $39.4million of proceeds received from the issuance of preferred stock and warrants.Any funds in excess of the capital needed for this acquisition will be used tofund our normal capital spending, fund other new store openings or reduce ouroutstanding debt. We presently plan to open a total of 12 additional stores ineach of 2008 and 2009.

In the first six months of2007, we spent approximately $13.4 million on capital expenditures,primarily for new, renovated and replacement stores as well as a new “Pick-to-Light”flow rack merchandise distribution system in our Maspeth, New York distributioncenter. We also spent an additional $8.8 million for lease acquisition andother costs. In fiscal 2006, we spent approximately $12.3 million oncapital expenditures, and we spent an additional $4.1 million for leaseacquisition, pharmacy customer files and other costs. These amounts werepartially offset by $1.5 million received in connection with the termination ofa leased property. We also require working capital to support inventory for ourexisting and new stores. Historically, we have been able to lease almost all ofour store locations, so acquisitions of real estate are not expected to have asignificant impact on our capital requirements.

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**Other Factors Influencing our Liquidity**

Twenty-two of our stores,which generated approximately 7.3% of our net sales for fiscal 2006, haveleases scheduled to expire before the end of fiscal 2008. Six of these leaseshave renewal options. We believe that we will be able to renew most of theother expiring leases on economically favorable terms or, alternatively, findother economically attractive replacement locations to lease.

As of June 30, 2007,approximately 4,500 of our approximately 6,400 employees were represented byvarious labor unions and were covered by collective bargaining agreements.Pursuant to the terms of the collective bargaining agreements covering theseemployees, we are required, in some instances, to pay specified annualincreases in salary and benefits contributions relating to the memberemployees. We do not believe that these increases will have a material impacton our liquidity or results of operations.

Thefollowing table presents details of our significant commitments and obligationsas at June 30, 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)               |       | 146,903                                   |       | — |   | — |   | 146,903 |   | — |   |
| Capital Lease  Obligations(3)                         |       | 10,209                                    |       | 4,175 |   | 6,034 |   | — |   | — |   |
| 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) |       | 1,523                                     |       | 1,392 |   | 17 |   | 16 |   | 98 |   |
| Landlord Real  Estate Litigation Settlement(7)        |       | 607                                       |       | 560 |   | 47 |   | — |   | — |   |
| Total Contractual Cash  Obligations(8)                |       | $                                         | 1,994,114  |   | $ | 151,554 |   | $ | 295,926 |   | $ | 811,262 |   | $ | 735,372 |   |
|                                                       |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          Theseamounts include $195.0 million of outstanding senior subordinated notesdue in 2011, $210.0 million of outstanding senior secured notes due in2010 and $32,000 outstanding under the senior convertible notes due in 2022.For more information about the terms of the indebtedness described above,please see “—Debt,” below.

(2)          AtJune 30, 2007, approximately $146.9 million was outstanding and afurther $67.5 million was available for borrowing under our amended asset-basedrevolving loan facility. Obligations under this facility have been classifiedas current liabilities because cash receipts controlled by the lenders are usedto reduce outstanding debt and we do not meet the criteria of SFAS No. 6to reclassify the debt as long-term. However, this is not an indication thatthis credit facility is expected to be retired within the next year. We intendto continue to use this facility for our working capital needs through the dateof its maturity in July 2011.

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

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

(5)          Reflectsinterest payable on the $195.0 million outstanding senior subordinatednotes.

(6)          Reflectspayments specified under the employment contract with the former Chairman andCEO to be made by us in connection with his replacement on November 21,2005, as well as payments due to other executives whose employment wasterminated during 2006 and 2007. In an ongoing arbitration between Mr. Cutiand us (explained in more detail in Note 9 of the Unaudited ConsolidatedInterim 

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FinancialStatements contained elsewhere in this report), we are seeking, among otherforms of relief, rescission of employment agreements entered into between usand Mr. Cuti, the return of all compensation paid under the employmentagreements, including the benefits described in this footnote, and othermonetary damages.

(7)          Reflectscash payments due to the landlord of one of our stores in connection with thesettlement of a real estate litigation. Amounts shown are net of $0.7 millionpaid in the first six months of 2007.

(8)          Thetotals reflected in this table exclude tax-related commitments of approximately$2.4 million, which are included on the balance sheet under the category of “Othernon-current liabilities.”

Thefollowing table presents details of our other significant commercialcommitments as at June 30, 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)              |       |                                 | $          | 5,626                             |       |                                                                    | $          | 5,479 |   |   | $ | 147 |   |   |   | $ | — |   |   |   | $ | — |   |   |
| Total Commercial  Commitments              |       |                                 | $          | 5,626                             |       |                                                                    | $          | 5,479 |   |   | $ | 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 supply agreementsin the normal course of business. The largest of these agreements is withAmerisourceBergen, 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 $5.4 million of thisamount through June 30, 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, lifetimeretiree medical benefits at a cost not to exceed $50,000 annually. In an ongoing arbitration between Mr. Cutiand us (explained in detail in Note 9 to 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 paragraph, and othermonetary damages.

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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 connection with his replacement by Mr. Dreiling, we have treatedall of his equity interests as having vested. The profits interest and optionswill have no value unless the value of Duane Reade Shareholders and Duane ReadeHoldings, respectively, appreciate following the Acquisition. The formerChairman and CEO’s purchase right will be suspended at any time when theexercise of such purchase rights would result in a default under the financingarrangements of Duane Reade Shareholders, Duane Reade Holdings or DuaneReade Inc. On December 21, 2005, the former Chairman and CEO providednotice to Duane Reade Inc. that he was exercising his repurchase right tocause us to repurchase 5% of his profits interest. Pursuant to the proceduresoutlined in the new employment agreement, Duane Reade Inc. has advised him thathis profits interest as of December 21, 2005 was determined to have novalue. The benefitsdescribed in this paragraph were all granted under an employment agreementbetween Mr. Cuti and us. In an ongoing arbitration between Mr. Cutiand us (explained in detail in Note 9 to 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 paragraph, and other monetarydamages. The determination that Mr. Cuti’s profits interest as of December 21,2005 had no value is also one of several subjects specifically at issue in thearbitration.

In connection with the December 9,2005 settlement of litigation between us and Cardinal Health, we were requiredto make payments to Cardinal Health totaling $4.5 million. Such paymentsincluded $2.0 million that was paid on January 15, 2006, $1.0 million thatwas paid on June 15, 2006, $1.0 million that was paid on December 15,2006, $250,000 that was paid on March 15, 2007 and $250,000 that was paidon June 15, 2007. All such amounts had been previously accrued in thefinancial 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 DuaneReade Inc. and its subsidiaries and has no other independent assets,liabilities or operations, so, to the extent it has liquidity requirements, itwill depend on distributions of cash from Duane Reade Inc., to the extentpermitted by the various agreements to which Duane Reade Inc. is a party.Currently, we do not expect Duane Reade Holdings to have any material liquidityrequirements.

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 

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amendedasset-based revolving loan facility and the $39.4 million of additionalfunds received from the sale of preferred equity and warrants to purchase ourcommon stock, will be adequate for the next two years, to make requiredpayments on our indebtedness, to fund anticipated capital expendituresincluding the acquisition of up to eight Gristedes store leases and to satisfyour working capital requirements. We base this belief on our recent levels ofcash flow from operations of approximately $11.6 million in 2006 (whichincludes the absorption of approximately $12.2 million in non-recurring net cashpayments 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 was approximately$67.5 million at June 30, 2007. This availability increased from$53.1 million at the end of the first quarter and reflects the receipt of$26.4 million in proceeds received during the second quarter from the saleof preferred equity and warrants to purchase our capital stock. The totalproceeds of $39.4 million received in the 26 weeks ended June 30are being used to fund the acquisition of up to eight Gristedes store leases aswell as certain growth related capital expenditures. During the first half, wecompleted the acquisition of two Gristedes leases and expect to complete atleast five more before the end of the current year. Due to continued losses,our stockholder’s equity has become a deficit. However, this deficit does notimpact our liquidity as noted above and has no impact on our debt covenants.Our ability to meet our debt service obligations and reduce our total debt willdepend upon our future performance which, in turn, will be subject to generaleconomic, financial, business, competitive, legislative, regulatory and otherconditions, many of which are beyond our control. In addition, our operatingresults, cash flow and capital resources may not be sufficient for repayment ofour indebtedness in the future. Some risks that could adversely affect ourability to meet our debt service obligations include, but are not limited to,reductions in third party prescription reimbursement rates, declines in the NewYork City economy, increases in competitive activity, adverse changes in vendorcredit terms, changes in drug consumption patterns, additional adverselegislative changes or a major disruption of business in our markets from aterrorist event, natural disaster or other unexpected events. Other factorsthat may adversely affect our ability to service our debt are described aboveunder “Special Note Regarding Forward-Looking Statements.” Borrowings under theamended asset-based revolving loan facility and the aggregate$210.0 million senior secured notes bear interest at floating rates. Therefore,our financial condition will be affected by changes in prevailing interestrates. On May 25, 2005, we entered into a hedging transaction through theacquisition of a “no cost collar.” Under this arrangement, we capped ourexposure on $130 million of LIBOR-based borrowings under the senior securednotes at a maximum LIBOR rate of 5.30%. In addition, we established a minimum “floor”LIBOR rate of 3.45%, in line with then current LIBOR rates. This hedgingarrangement 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, actualfuture events can and often do result in outcomes that can be materiallydifferent from these estimates or forecasts. The accounting policies andrelated risks described in our Annual Report on Form 10-K for theyear ended December 30, 2006 are those that depend most heavily on thesejudgments and estimates. At June 30, 2007, there have been no material changesto any of the Critical Accounting Policies contained therein.

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**Off-Balance Sheet Arrangements**

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 six months ended June 30,2007.

**Recently Issued Accounting Pronouncements**

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

**ITEM3.**                QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our financial results aresubject to risk from interest rate fluctuations on that portion of our debtwhich carries variable interest rates. Variable rate debt outstanding at June 30,2007 included $146.9 million of borrowings under our amended asset-basedrevolving loan facility and $210.0 million of senior secured notes. At June 30,2007, the weighted average combined interest rate in effect on all variablerate debt outstanding was 8.67%. A 0.50% change in interest rates applied tothe $356.9 million balance of floating rate debt would affect pre-taxannual results of operations by approximately $1.8 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 June 30, 2007. The senior subordinated notes bear interest payablesemi-annually at a fixed rate of 9.75%, and are therefore not subject to riskfrom interest rate fluctuations.

On May 25, 2005, weentered into a hedging transaction through the acquisition of a “no costcollar.” Under this arrangement, we capped our exposure on $130 million ofLIBOR-based borrowings under the senior secured notes at a maximum LIBOR rateof 5.30%. In addition, we established a minimum “floor” LIBOR rate of 3.45%, inline with then current LIBOR rates. This hedging arrangement expires on June 16,2008. At June 30, 2007, the LIBOR rate in effect on the senior securednotes was 5.36%, which exceeded the maximum rate under the “no cost collar.” Asa result, on an annualized basis, the interest rate protection afforded by the “nocost collar” amounted to $78,000.

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.

**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 

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reasonableassurance that the information required to be reported in its Exchange Actfilings is recorded, processed, summarized and reported within the timeframesspecified and pursuant to the regulations of the SEC, including controls andprocedures designed to ensure that this information is accumulated andcommunicated to the Company’s management, including its Chief Executive Officerand Chief Financial Officer, as appropriate, to allow timely decisionsregarding required disclosure. It should be noted that because of inherentlimitations, the Company’s disclosure controls and procedures, however welldesigned and operated, can provide only reasonable, and not absolute, assurancethat the objectives of the disclosure controls and procedures are met.

*(a) *Evaluationof Disclosure Controls and Procedures

An evaluation was carried out under the supervisionand with the participation of the Company’s management, including the ChiefExecutive Officer and Chief Financial Officer, of the effectiveness of thedesign and operation of our “disclosure controls and procedures” (as defined inRules 13a-15(e) or 15d-15(e) under the SecuritiesExchange Act of 1934) as at the end of the period covered by this quarterlyreport.

Based on that evaluation, the Company’s ChiefExecutive Officer and Chief Financial Officer have concluded that, as of thatdate, the Company’s disclosure controls and procedures required byparagraph (b) of the Exchange Act Rules 13a-15 or 15d-15,were not effective because of the identification of a material weakness in theCompany’s internal control over financial reporting, which the Company views asan integral part of its disclosure controls and procedures.

As described in Note 2 to the financial statementscontained in the Company’s Annual Report on Form 10-K for the yearended December 30, 2006, the Audit Committee of the Company, with theassistance of independent counsel and forensic accountants, has completed aninvestigation relating to real estate transactions and related matters (the “RealEstate Related Transactions”) that occurred during the 2000 through 2004 fiscalyears. The investigation found that the Company’s accounting for a number ofthose transactions was improper. The independent counsel concluded that theReal Estate Related Transactions were orchestrated by the Company’s formerChairman and CEO, who was replaced in November 2005, and were expresslydesigned to overstate the Company’s income. According to the independent counsel’sreport, in order to accomplish this scheme, the former Chairman and CEO madecertain false representations to the Company’s Chief Financial Officer, othermembers of the management of the Company and the Company’s independentaccountants concerning the structure and economic substance of the Real EstateRelated Transactions. On May 18, 2007, the Audit Committee concluded thatthe financial statements as of and for the five months ended December 25,2004, the seven months ended July 30, 2004 and the 2000 through 2003fiscal years (collectively, the “Affected Periods”) should be restated. Theconclusion to restate was based on the conclusions of the independent counselin the investigation and the accounting impact of the misstatements arisingfrom the Real Estate Related Transactions, combined with previously-disclosedmisstatements. The previously-disclosed misstatements related to arrangementsthat the independent counsel concluded were also originated by the formerChairman and CEO for the issuance of improper credits and the subsequentrebilling of such credits related to amounts paid to construction and othercontractors at the Company’s stores and the related improper accounting, whichwere the subject of a prior Audit Committee investigation, as described in Note1 to the financial statements contained in the Company’s quarterly report on Form 10-Qfor 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 procedures, and the Audit Committee would haverecommended, as remedial action, that the Company replace its former Chairmanand CEO, had the Company not already done so, in addition to the improvementsin internal control over financial reporting discussed below.

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*(b)* Changesin Internal Control over Financial Reporting

From the discovery of these misstatements related tothe improper activities of its former Chairman and CEO, the Company recognizedthat its system of internal controls was not adequate to provide reasonableassurance that the objectives of its disclosure controls were met. In addition,the restatement of financial statements is an indicator of the existence of a “materialweakness” in the design or operation of internal control over financialreporting. A material weakness is a control deficiency, or combination ofcontrol deficiencies, that results in a more than remote likelihood that amaterial misstatement of the annual or interim financial statements will not beprevented or detected. As of June 30, 2007, the Company did not haveeffective internal control over financial reporting to preclude the intentionalfinancial reporting misstatements discovered in the investigations.

As a result of thediscovery of the internal control weaknesses uncovered by the Audit Committeeinvestigation described above, the Company is taking the following remedialactions:

·       Establishment of a ChiefCompliance Officer (reporting directly to the Company’s Chief ExecutiveOfficer) to monitor the Company’s adherence to various regulatory requirements,codes of conduct and ethics standards, including those designed to ensureaccurate and timely financial reporting.

·       Establishment of a Directorof Internal Audit that reports to the Audit Committee of the Board ofDirectors. The purpose of this new position is to design and implement a riskmanagement assessment process as well as to monitor adherence to policies andprocedures, conduct operational and financial audits designed to identifycontrol deficiencies, make recommendations to management and the AuditCommittee to strengthen internal control over financial reporting and addressopportunities to improve operations and financial reporting. The Director ofInternal Audit will also coordinate special audits as may be directed by theAudit Committee.

·       Establishment of a Directorof Financial Reporting to manage the Company’s external financial reportingrequirements and monitor compliance with authoritative accounting rules andpronouncements.

The Company has also recently established a new VicePresident of Real Estate position, which reports to the Senior Vice Presidentand General Counsel. This position has the responsibility for managing all realestate related activities under the oversight of the Company’s Real EstateCommittee, which includes all of the Company’s senior vice presidents otherthan the Senior Vice President of Human Resources and Administration. All significantreal estate related transactions are reviewed and approved through the RealEstate Committee.

These organizational changes are being made inconjunction with several improvements previously made in accounting andtransaction processing controls to reduce our exposure to errors and fraud.These previous changes included a double authorization procedure for allsignificant invoice payments within each operating department designed toreduce the Company’s exposure to fraud through any one individual acting on hisor her own accord. The Company’s Finance Department has also set up a separateinvoice review and approval process to ensure that all payments are reasonableand within normal budget parameters, and that detailed support is attached fromwhich to assess that the materials or services being purchased are reasonablefor the prices being paid.

During the second quarter of fiscal 2007, with theexception of the planned corrective measures detailed above, there were nochanges in the Company’s internal control over financial reporting thatmaterially affected or are reasonably likely to materially affect internalcontrol over financial reporting.

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**PART II**

**OTHERINFORMATION**

**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 and the Form 10-Q on July 13, 2007,thereby curing the defaults related to their delayed filings.

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

Not applicable.

**ITEM 5.**                OtherInformation

Not applicable.

**ITEM6.**                Exhibits
| Exhibit No. | ** ** | **Description** |
|------------------|------------|-----------------|
|             | 3.1        |            |   | 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). |
|             | 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: August 14, 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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