**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C.**

**FORM 10-Q**

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

**Forthe quarterly period ended April 1, 2006**

**Commissionfile number 001-13843**

**DUANE READE HOLDINGS, INC.**

(Exact name of registrantas specified in its charter)

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

 

**(212) 273-5700**

(Registrant’s telephonenumber, including area code)

Indicate by check markwhether the registrant: (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days.

Yes x  No o

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

Large accelerated filer o        Acceleratedfiler o        Non-acceleratedfiler 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.

None of the registrant’s outstanding voting stock isheld by non-affiliates of the registrant.

 

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**INDEX**
| PART I—FINANCIAL  INFORMATION | 5      |                                                                                                                                             |   |
|-----------------------------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                    |   | ITEM  1.—FINANCIAL STATEMENTS                                                                                                               | 5      |   |   |
|                                    |   | Consolidated  Statements of Operations (Unaudited)—For the 13 Weeks Ended April 1,  2006 and March 26, 2005                       | 5      |   |   |
|                                    |   | Consolidated  Balance Sheets (Unaudited)—As of April 1, 2006 and December 31,  2005                                               | 6      |   |   |
|                                    |   | Consolidated  Statements of Cash Flows (Unaudited)—For the 13 Weeks Ended April 1,  2006 and March 26, 2005                       | 7      |   |   |
|                                    |   | Consolidated  Statements of Comprehensive Income (Loss) (Unaudited)—For the 13 Weeks  Ended April 1, 2006 and March 26, 2005 | 8      |   |   |
|                                    |   | Notes  to Consolidated Financial Statements (Unaudited)                                                                                          | 9      |   |   |
|                                    |   | ITEM  2.—MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF  OPERATIONS                                        | 26     |   |   |
|                                    |   | ITEM  3.—QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                                                         | 36     |   |   |
|                                    |   | ITEM  4.—CONTROLS AND PROCEDURES                                                                                                            | 36     |   |   |
| PART II—OTHER  INFORMATION    | 37     |                                                                                                                                             |   |
| SIGNATURES                              | 38     |                                                                                                                                             |   |

 

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**SPECIAL NOTEREGARDING FORWARD-LOOKING STATEMENTS**

This and other of our public filings or publicstatements contain forward-looking statements within the meaning of Section 27Aof the Securities Act, Section 21E of the Securities Exchange Act and thePrivate Securities Litigation Reform Act of 1995, that involve a number ofrisks and uncertainties. These statements relate to future events or our futurefinancial performance with respect to our financial condition, results ofoperations, business plans and strategies, operating efficiencies or synergies,competitive positions, growth opportunities for existing products such asprivate label merchandise, plans and objectives of management, capitalexpenditures, growth and maturation of our stores and other matters. Thesestatements involve known and unknown risks, uncertainties and other factorsthat may cause our or our industry’s actual results, levels of activity,performance or achievements to be materially different from those expressed orimplied by any forward-looking statements. In some cases, you can identifyforward-looking statements by terminology such as “may,” “will,” “could,” “would,”“should,” “expect,” “plan,” “anticipate,” “intend,” “believe,” “estimate,” “predict,”“potential,” “pro forma,” “seek,” or “continue” or the negative of those termsor other comparable 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:

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

·       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;

·       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;

·       oursignificant indebtedness and the related impact of variable interest rates;

·       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;

·       thestrength of the economy in general and the economic conditions in the New Yorkgreater metropolitan area including, in particular, seasonal andweather-related factors, special events, changes in consumer purchasing powerand/or spending patterns;

·       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 disturbances including any resulting from the suspension ortermination of our collective bargaining agreements;

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

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·       our abilityto successfully execute the various objectives of the recently announced “DuaneReade Full Potential” sales growth and profit enhancement program;

·       liabilityand other claims asserted against us, including the items discussed under “Business—LegalProceedings”;

·       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 be taken byfederal, state or municipal authorities in response to or in anticipation ofsuch 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 Securities and Exchange Commission (the “SEC”).

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

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 might notoccur.

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**PART I—FINANCIALINFORMATION**

**ITEM 1.     FINANCIAL STATEMENTS**

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

| ** **                                           | ** ** | **For the 13 Weeks Ended** | ** ** |
|------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                           | ** ** | **April 1, 2006**                    | ** ** | **March 26, 2005** | ** ** |
| Net sales                                            |       |                                           | $          | 385,869 |   |   |   | $ | 394,767 |   |   |
| Cost of sales                                        |       |                                           | 310,396    |   |   |   | 321,958 |   |   |
| Gross profit                                         |       |                                           | 75,473     |   |   |   | 72,809 |   |   |
| Selling,  general & administrative expenses |       |                                           | 69,464     |   |   |   | 64,499 |   |   |
| Labor contingency  (income) expense                  |       |                                           | (18,004    | ) |   |   | 1,100 |   |   |
| Transaction  expense                                 |       |                                           | —     |   |   |   | 427 |   |   |
| Depreciation and  amortization                       |       |                                           | 18,678     |   |   |   | 17,646 |   |   |
| Store pre-opening  expenses                          |       |                                           | 50         |   |   |   | 100 |   |   |
| Other                                                |       |                                           | 1,102      |   |   |   | 1,148 |   |   |
|                                                 |       |                                           | 71,290     |   |   |   | 84,920 |   |   |
| Operating income  (loss)                             |       |                                           | 4,183      |   |   |   | (12,111 | ) |   |
| Interest expense,  net                               |       |                                           | 13,738     |   |   |   | 11,165 |   |   |
| Loss before  income taxes                            |       |                                           | (9,555     | ) |   |   | (23,276 | ) |   |
| Income tax provision  (benefit)                      |       |                                           | 309        |   |   |   | (10,474 | ) |   |
| Net loss                                             |       |                                           | $          | (9,864 | ) |   |   | $ | (12,802 | ) |   |

 

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

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

| ** **                                                                                      | ** ** | **April 1,  2006** | ** ** | **December 31,  2005** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                      | ** ** |                    | ** ** | ** **                  |       |   | ** ** | ** ** |   |
| Current Assets                                                                                  |       |                    |       |                        |       |   |   |   |   |
| Cash                                                                                            |       |                    | $          | 1,397                       |       |   |   | $ | 1,362 |   |   |
| Receivables, net                                                                                |       |                    | 46,852     |                        |       |   | 52,320 |   |   |
| Inventories                                                                                     |       |                    | 232,776    |                        |       |   | 235,639 |   |   |
| Deferred income taxes                                                                           |       |                    | 7,152      |                        |       |   | 7,717 |   |   |
| Prepaid expenses and other current assets                                                       |       |                    | 28,522     |                        |       |   | 26,114 |   |   |
| TOTAL CURRENT ASSETS                                                                            |       |                    | 316,699    |                        |       |   | 323,152 |   |   |
| Property and equipment,  net                                                                    |       |                    | 222,067    |                        |       |   | 229,134 |   |   |
| Goodwill                                                                                        |       |                    | 67,791     |                        |       |   | 67,791 |   |   |
| Other assets, net                                                                               |       |                    | 241,489    |                        |       |   | 251,341 |   |   |
| TOTAL ASSETS                                                                                    |       |                    | $          | 848,046                     |       |   |   | $ | 871,418 |   |   |
| **LIABILITIES AND STOCKHOLDER’S EQUITY**                                                   | ** ** |                    | ** ** | ** **                  |       |   | ** ** | ** ** |   |
| Current Liabilities                                                                             |       |                    |       |                        |       |   |   |   |   |
| Accounts payable                                                                                |       |                    | $          | 85,210                      |       |   |   | $ | 72,711 |   |   |
| Accrued interest                                                                                |       |                    | 4,691      |                        |       |   | 9,222 |   |   |
| Accrued expenses                                                                                |       |                    | 48,834     |                        |       |   | 51,959 |   |   |
| Current portion of debt                                                                         |       |                    | 142,208    |                        |       |   | 135,693 |   |   |
| Current portion of capital lease obligations                                                    |       |                    | 3,282      |                        |       |   | 3,183 |   |   |
| TOTAL CURRENT LIABILITIES                                                                       |       |                    | 284,225    |                        |       |   | 272,768 |   |   |
| Long-term debt                                                                                  |       |                    | 405,032    |                        |       |   | 405,032 |   |   |
| Capital lease  obligations, less current portion                                                |       |                    | 9,456      |                        |       |   | 10,314 |   |   |
| Deferred income  taxes                                                                          |       |                    | 31,828     |                        |       |   | 32,117 |   |   |
| Other non-current  liabilities                                                                  |       |                    | 43,152     |                        |       |   | 67,265 |   |   |
| TOTAL LIABILITIES                                                                               |       |                    | 773,693    |                        |       |   | 787,496 |   |   |
| Commitments and contingencies  (Note 9)                                                         |       |                    |       |                        |       |   |   |   |   |
| Stockholder’s equity                                                                       |       |                    |       |                        |       |   |   |   |   |
| Preferred stock, $0.01 par, authorized 50,000  shares; issued and outstanding: none             |       |                    | —     |                        |       |   | — |   |   |
| Common stock, $0.01 par, authorized 3,050,000  shares; issued and outstanding: 2,594,977 shares |       |                    | 26         |                        |       |   | 26 |   |   |
| Paid-in capital                                                                                 |       |                    | 239,472    |                        |       |   | 239,472 |   |   |
| Additional paid-in capital                                                                      |       |                    | 25         |                        |       |   | — |   |   |
| Accumulated other comprehensive income                                                          |       |                    | 531        |                        |       |   | 260 |   |   |
| Accumulated deficit                                                                             |       |                    | (165,701   | )                           |       |   | (155,836 | ) |   |
| TOTAL STOCKHOLDER’S EQUITY                                                                 |       |                    | 74,353     |                        |       |   | 83,922 |   |   |
| TOTAL LIABILITIES  AND STOCKHOLDER’S EQUITY                                                |       |                    | $          | 848,046                     |       |   |   | $ | 871,418 |   |   |

 

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

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

| ** **                                                                       | ** ** | **For the 13 Weeks Ended** | ** ** |
|----------------------------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                                       | ** ** | **April 1, 2006**                    | ** ** | **March 26, 2005** | ** ** |
| Cash flows used in  operating activities:                                        |       |                                           |       |   |   |   |   |   |   |
| Net loss                                                                         |       |                                           | $          | (9,864 | ) |   |   | $ | (12,802 | ) |   |
| Adjustments to reconcile  net loss to net cash used in operating activities:     |       |                                           |       |   |   |   |   |   |   |
| Depreciation and  amortization                                                   |       |                                           | 19,741     |   |   |   | 18,559 |   |   |
| Deferred income  taxes                                                           |       |                                           | 276        |   |   |   | (10,474 | ) |   |
| Non-cash rent  expense                                                           |       |                                           | 2,559      |   |   |   | 3,594 |   |   |
| Change in operating  assets and liabilities (net of the effect of acquisitions): |       |                                           |       |   |   |   |   |   |   |
| Receivables                                                                      |       |                                           | 5,468      |   |   |   | 897 |   |   |
| Inventories                                                                      |       |                                           | 2,863      |   |   |   | 1,409 |   |   |
| Accounts payable                                                                 |       |                                           | 12,499     |   |   |   | (1,010 | ) |   |
| Prepaid and accrued expenses                                                     |       |                                           | (6,264     | ) |   |   | (22,906 | ) |   |
| Other assets and liabilities, net                                                |       |                                           | (27,451    | ) |   |   | 6,083 |   |   |
| NET CASH USED IN  OPERATING ACTIVITIES                                           |       |                                           | (173       | ) |   |   | (16,650 | ) |   |
| Cash flows used  in investing activities:                                        |       |                                           |       |   |   |   |   |   |   |
| Capital  expenditures                                                            |       |                                           | (3,713     | ) |   |   | (7,132 | ) |   |
| Lease  acquisition, customer file and other costs                                |       |                                           | (1,814     | ) |   |   | (3,096 | ) |   |
| Proceeds from  sale of property                                                  |       |                                           | —     |   |   |   | 2,223 |   |   |
| NET CASH USED IN  INVESTING ACTIVITIES                                           |       |                                           | (5,527     | ) |   |   | (8,005 | ) |   |
| Cash flows from  financing activities:                                           |       |                                           |       |   |   |   |   |   |   |
| Borrowings from  revolving credit facility                                       |       |                                           | 454,703    |   |   |   | 475,674 |   |   |
| Repayments of  revolving credit facility                                         |       |                                           | (448,188   | ) |   |   | (449,734 | ) |   |
| Deferred  financing costs                                                        |       |                                           | (21        | ) |   |   | (607 | ) |   |
| Repayments of  capital lease obligations                                         |       |                                           | (759       | ) |   |   | (671 | ) |   |
| NET CASH PROVIDED  BY FINANCING ACTIVITIES                                       |       |                                           | 5,735      |   |   |   | 24,662 |   |   |
| Net increase in cash                                                             |       |                                           | 35         |   |   |   | 7 |   |   |
| Cash at beginning  of period                                                     |       |                                           | 1,362      |   |   |   | 1,329 |   |   |
| Cash at end of period                                                            |       |                                           | $          | 1,397 |   |   |   | $ | 1,336 |   |   |

 

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

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

| ** **                                   | ** ** | **For the 13 Weeks Ended**                                      | ** ** |
|----------------------------------------------|------------|-------------------------------------------------------------------------------------|------------|
| ** **                                   | ** ** | **April 1,       2006     ** | ** ** | **March 26,  2005** | ** ** |
| Net loss                                     |       |                                                                                | $          | (9,863 | ) |   | $ | (12,802 | ) |
| Change in fair value of interest rate collar |       |                                                                                | 269        |   |   | — |   |
| Total Other Comprehensive Income             |       |                                                                                | 269        |   |   | — |   |
| Total  Comprehensive Loss                    |       |                                                                                | $          | (9,594 | ) |   | $ | (12,802 | ) |

 

The accompanying notes are an integral part of these financial statements

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**Notesto Unaudited Consolidated Interim Financial Statements(dollars in thousands)**

**1.**                 Basisof Presentation

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 Unaudited Consolidated Interim FinancialStatements included herein reflect all adjustments which, in the opinion ofmanagement, are necessary to present a fair statement of the results ofoperations, financial position, cash flows and comprehensive income (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 31,2005. 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 31, 2005.The Unaudited Consolidated Interim Financial Statements include the accounts ofthe Company and its subsidiaries. All significant intercompany transactions andbalances have been eliminated. The results for the interim periods presentedare not necessarily indicative of the results expected for the full year.

The Company, along withcertain of its subsidiaries, is a guarantor of the debt obligations of DuaneReade Inc. and Duane Reade, the New York general partnership that holdsthe operating assets and liabilities (“Duane Reade GP”). The Company hasno assets or operations other than its investment in its subsidiaries. Theguarantees provided by the Company and its other subsidiaries under the debtobligations of Duane Reade Inc. and Duane Reade GP are full andunconditional, joint and several.

**2.**                 RecentlyIssued Accounting Pronouncements

In December 2004, Statement of FinancialAccounting Standard No. 123(R), Share-Based Payment (“SFASNo. 123(R)”) was issued. This statement established standards for theaccounting for transactions in which an entity exchanges its equity instrumentsfor goods or services. The statement focuses primarily on accounting fortransactions in which an entity obtains employee services in share-basedtransactions. The Company adopted the provisions of this statement effective January 1,2006. As a result, the interim financial statements included herein for the 13weeks ended April 1, 2006 reflect pre-tax compensation expense of approximately$25 thousand, attributable to the vested portion of stock options granted afterthe adoption date. Based on the number of options granted after the adoptiondate, the Company expects to incur stock option compensation expenses ofapproximately $0.3 million in 2006.

In June 2005, the FASB issued SFAS No. 154,Accounting Changes and Error Corrections (“SFAS No. 154”), which willrequire entities that voluntarily make a change in accounting principle toapply that change retrospectively to prior periods’ financial statements,unless this would be impracticable. SFAS No. 154 supersedes AccountingPrinciples Board Opinion No. 20, Accounting Changes (“APB No. 20”),which previously required that most voluntary changes in accounting principlebe recognized by including in the current period’s net earnings the cumulativeeffect of changing to the new accounting principle. SFAS No. 154 alsomakes a distinction between “retrospective application” of an 

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accounting principle andthe “restatement” of financial statements to reflect the correction of an error.Another significant change in practice under SFAS No. 154 will be that ifan 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.

In February 2006, theFASB issued SFAS No. 155, Accounting for Certain Hybrid Instruments (“SFASNo. 155”), which amends SFAS No. 133, Accounting for DerivativeInstruments and Hedging Activities, and SFAS No. 140, Accounting forTransfers and Servicing of Financial Assets and Extinguishments of Liabilities.SFAS No. 155 allows financial instruments that have embedded derivativesto be accounted for as a whole (eliminating the need to bifurcate thederivative 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 does notexpect that SFAS No. 155 will have a material effect on its consolidatedfinancial statements.

**3.**                 Stock-BasedPayment

Effective January 1, 2006, the Company adoptedthe fair value recognition provisions of SFAS No. 123(R), using the prospectivetransition method. Under that transition method, compensation cost recognizedfor the three months ended April 1, 2006 includes the vested portion ofshare-based payments granted on or after January 1, 2006 based on thegrant-date fair value estimated in accordance with the provisions of SFAS123(R). The Company has elected to recognize compensation expense on astraight-line basis over the vesting period of the respective options.

***Management Stock Option Plan***

The Company’s Board of Directors adopted the DuaneReade Holdings, Inc. Management Stock Option Plan, which is 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, Inc. or any of its subsidiariesor affiliates is eligible to be designated a participant under the Stock OptionPlan. On November 21, 2005, the Company amended the Stock Option Plan so that amaximum of 370,293 shares of its common stock (on a fully diluted basis) may begranted under the Stock Option Plan.

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

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Asummary of activity under the Stock Option Plan as of April 1, 2006, andchanges during the three months ended April 1, 2006 is presented below:

| **Options**                                                      | ** ** | ** ** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|------------------------------------------------------------------|------------|------------|------------|------------|------------|----------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------|------------|
| Outstanding at December 31,  2005                           |       | 367,797    |       | $          | 100.00     |                                   |       |                                                |       |                            |       |   |   |   |
| *Activity  from January 1, 2006 through April 1, 2006* |       |       |       |       |       |                                   |       |                                                |       |                            |       |   |   |
| Granted                                                          |       | 26,000     |       | $          | 100.00     |                                   |       |                                                |       |                            |       |   |   |   |
| Exercised                                                        |       | —     |       | $          | 100.00     |                                   |       |                                                |       |                            |       |   |   |   |
| Expired                                                          |       | —     |       | $          | 100.00     |                                   |       |                                                |       |                            |       |   |   |   |
| Forfeited                                                        |       | (115,277   | )          | $          | 100.00     |                                   |       |                                                |       |                            |       |   |   |   |
| Outstanding at April 1,  2006                               |       | 278,520    |       | $          | 100.00     |                                   |       | 8.9                                                 |       |                            |       | $ | — |   |   |
| Exercisable at April 1,  2006                               |       | 18,761     |       | $          | 100.00     |                                   |       | 7.4                                                 |       |                            |       | $ | — |   |   |

 

The weighted-average grant-date fair value of optionsgranted during the three months ended April 1, 2006 was $42.59. There wereno stock options granted during the three months ended March 26, 2005 andthere were no stock options exercised during the first quarter of either 2006or 2005.

The Company has adopted a Black-Scholes option pricingformula method of valuation and has engaged an external valuation consultant toprovide this analysis, the results of which were applied to the stock optionsissued during the first quarter ended April 1, 2006.

The valuation formula reflects the following keyassumptions:

Expected dividend yield: 0%—The Company hashistorically not paid any dividends, nor does it currently expect to paydividends in the foreseeable future.

Expected volatility: 32.0%—The volatility figurereflects the weighted-average 1, 5 and 10-year observed volatility ofcomparable industry participants.

Expected term (years): 6.5—The expected liferepresents the period of time for which options granted are expected to beoutstanding. This estimate was derived from historical share option exerciseexperience, which management believes provides the best estimate of theexpected term.

Risk-free interest rate: 4.38%—This reflects the rateportrayed on the Treasury Yield Curve for a period of time equivalent to theexpected term. 

As of April 1, 2006, there was $1.1 million oftotal unrecognized compensation cost related to non-vested share-basedcompensation arrangements granted under the stock-based compensation plan. Thatcost (to be reduced by forfeitures) is expected to be recognized on a straight-linebasis over a weighted-average period of 5 years.

During the quarter ended April 1, 2006, theCompany recognized approximately $25 thousand of compensation cost relatedto share-based payments.

As of April 1, 2006,91,773 shares of common stock of the Company were reserved for the issuance ofadditional stock options. The Company expects to satisfy the exercise of stockoptions utilizing newly-issued shares.

**4.**                 Inventoryand Cost of Sales

At April 1, 2006,inventories, consisting solely of finished goods, would have been lower by$5.3 million if they had been valued on a lower of first-in, first-out (“FIFO”)cost or market basis instead of 

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alast-in, first-out (“LIFO”) basis. Cost of sales includes all storeoccupancy-related costs and expenses, consisting of lease and sublease-relatedincome and expenses, other recurring real estate-related income and expensesprimarily from sales and terminations of leases related to store closings andrelocations, store utility costs, warehouse expenses and distribution costs.The Company reflects promotional allowances from vendors as a reduction of costof sales or advertising expense, depending on the nature of the allowance, whensuch advertising or promotions have been completed and the related allowanceshave been earned. Other real estate related income was $0.1 million in thethirteen weeks ended April 1, 2006 and in the comparable prior year periodas well.

**5.**                 Exitand Disposal Activities

In connection with theacquisition of Duane Reade Inc. and in accordance with the provisions ofEmerging Issues Task Force Issue No. 95-3, “Recognition of Liabilities inConnection with Purchase Business Combinations” (EITF 95-3), the Companyestablished a reserve of $19.1 million for costs anticipated to be incurred asa result of the planned closing of approximately 13 of its stores. These costsprimarily relate to rent, utilities and other on-going occupancy-relatedexpenses, as well as costs related to inventory liquidation. As at April 1,2006, all of the planned closings had occurred, and the Company has recorded acumulative net total of $7.1 million of primarily occupancy-related costsagainst this reserve resulting in the reserve balance of $12.0 million at April 1,2006.

**6.**                 Pharmacyand Customer File Acquisitions

Duringthe first quarter of 2005, the Company acquired one pharmacy customer file,which was merged into an existing store. There was no pharmacy or customer fileacquisition activity in the first quarter of 2006. The table below providesdetails of this acquisition activity for each of the periods presented (dollarsin millions).

| ** **                         | ** ** | **For the 13 Weeks Ended**  | ** ** |
|------------------------------------|------------|-------------------------------------------------|------------|
| ** **                         | ** ** | **  April 1,    2006** | ** ** | **  March 26,    2005** | ** ** |
| Customer  prescription files       |       |                                            | —     |   |   |   | 1 |   |   |
| Pharmacy  establishments           |       |                                            | —     |   |   |   | — |   |   |
| Total  acquisitions                |       |                                            | —     |   |   |   | 1 |   |   |
| Purchase price allocation:         |       |                                            |       |   |   |   |   |   |   |
| Identifiable  intangibles          |       |                                            | $          | — |   |   |   | $ | 0.8 |   |   |
| Goodwill                           |       |                                            | —     |   |   |   | — |   |   |
| Inventory                          |       |                                            | —     |   |   |   | 0.2 |   |   |
| Property and  equipment            |       |                                            | —     |   |   |   | — |   |   |
| Other assets and  liabilities, net |       |                                            | —     |   |   |   | (0.2 | ) |   |
| Total                              |       |                                            | $          | — |   |   |   | $ | 0.8 |   |   |

 

The acquired operation hasbeen included in the consolidated statement of operations from the date ofacquisition and did not have a material effect on sales or results ofoperations of the Company for the periods presented.

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**7.**                 **Debt**

Debtis summarized as follows (in thousands):

| **Description of Instrument**     | ** ** | ** ** | ** ** | **April 1,  2006** | ** ** | **December 31,  2005** | ** ** |
|---------------------------------------------|------------|------------|------------|-------------------------|------------|-----------------------------|------------|
| Asset-Based  Revolving Loan Facility        |       | $          | 142,208    |                    |       | $                           | 135,693    |   |   |
| Total Current  Debt                         |       | 142,208    |       |                    | 135,693    |                        |       |
| 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 Non-current  Debt                     |       | 405,032    |       |                    | 405,032    |                        |       |
| Total Debt                                  |       | $          | 547,240    |                    |       | $                           | 540,725    |   |   |

 

***Asset-BasedRevolving Loan Facility.******  ***On July 21,2003, Duane Reade GP entered into an asset-based revolving loan facility whichused a pre-determined percentage of the current value of inventory and selectedaccounts receivable to calculate the availability of funds eligible to beborrowed up to an aggregate principal amount of $200 million. Prior to theamendment described below, the Company’s obligations under the credit agreementand related guarantees were collateralized by substantially all of its assets.

On July 22, 2004, in connection with theAcquisition, the asset-based revolving loan facility was amended to increasethe borrowing capacity to an aggregate principal amount of $250 million,subject to an adjusted borrowing base calculation based upon specified advancerates against the value of inventory, pharmacy prescription files and accountsreceivable. The amended asset-based revolving loan facility includes a$50 million sub-limit for the issuance of letters of credit. Obligationsunder the revolving loan facility are collateralized by a first priorityinterest in inventory, receivables, pharmacy prescription files, depositaccounts and certain other current assets. Under the asset-based revolving loanfacility, Duane Reade GP is the sole obligor. However, the asset-basedrevolving loan facility is guaranteed on a full and unconditional basis by theCompany, Duane Reade Inc. and each of the Company’s other domestic subsidiariesother than the obligor.

The asset-basedrevolving loan facility contains a single fixed charge coverage requirementwhich only becomes applicable when borrowings exceed 90 percent of theborrowing base, as defined in the agreement governing the asset-based revolvingloan facility. Borrowings under the asset-based revolving loan facility havenot exceeded 90 percent of the borrowing base and, as a result, the fixedcharge covenant has not become applicable. There are no credit ratings relatedtriggers in the asset-based revolving loan facility that would impact the costof borrowing, annual amortization of principal or related indebtednessmaturity. The asset-based revolving loan facility is scheduled to mature on July 20,2008.

Revolving loansunder the asset-based revolving loan facility, at the Company’s option, bearinterest at either:

·       arate equal to LIBOR (the London Interbank Offered Rate) plus a margin of from1.50% 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 amended facilitycontinue to be primarily LIBOR-based. At April 1, 2006, the asset-basedrevolving loan facility bore interest at a weighted average annual rate of6.53%.

In August 2005, in conjunction with the issuance of$50.0 million aggregate principal amount of senior secured floating ratenotes due 2010, the Company permanently reduced the amount of availabilityunder 

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the asset-based revolvingloan facility by $25.0 million. As a result, at April 1, 2006, themaximum amount that could be borrowed under the asset-based revolving loanfacility was $225.0 million.

At April 1, 2006, there was $142.2 millionoutstanding under the asset-based revolving loan facility, and approximately$76.2 million of remaining availability, net of $6.6 million reservedfor standby letters of credit. Obligations under this facility have been classifiedas current liabilities because cash receipts controlled by the lenders are usedto reduce outstanding debt, and the Company does not meet the criteria of FAS 6to reclassify the debt as long-term. The Company intends to continue to utilizethis facility for its working capital needs through the date of its maturity inJuly 2008.

***Senior SecuredFloating Rate Notes due 2010.******  ***On December 20,2004, the Company closed an offering of $160.0 million aggregate principalamount of senior secured floating rate notes due 2010. Using the net proceedsfrom that offering, together with approximately $2.2 million of borrowingsunder the amended asset-based revolving loan facility, the Company repaid alloutstanding principal under its previously existing $155.0 million seniorterm loan facility, along with approximately $3.6 million of earlyrepayment premium and accrued but unpaid interest through December 20,2004. On August 9, 2005, theCompany issued a further $50.0 million of senior secured notes. These newnotes were issued under the same indenture as the senior secured notes issuedin December 2004, although they do not trade fungibly with those notes.

The senior secured notes bear interest at a floatingrate of LIBOR plus 4.50%, reset quarterly. Interest on the senior secured notesis payable quarterly on each March 15, June 15, September 15,and December 15, beginning on March 15, 2005. The senior securednotes mature on December 15, 2010. At April 1, 2006, the SeniorSecured Floating Rate Notes bore interest at a rate of 9.41%.

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

The Company guarantees the senior secured notes on afull and unconditional, senior secured basis. Duane Reade Inc. and Duane ReadeGP are co-obligors under the senior secured notes. The senior secured notesrank equally in right of payment with any of the Company’s, Duane Reade Inc.’sor Duane Reade GP’s unsubordinated indebtedness and senior in right of paymentto any of Duane Reade Inc.’s or Duane Reade GP’s subordinated or seniorsubordinated indebtedness. All obligations under the senior secured notes areguaranteed on a senior basis by each of the Company’s existing subsidiaries,other than Duane Reade Inc. and Duane Reade GP, and will be guaranteed byfuture subsidiaries of Duane Reade Inc. and Duane Reade GP except certainforeign and certain domestic subsidiaries. The senior secured notes and theguarantees are collateralized by a first priority interest in substantially allof Duane Reade Inc. and Duane Reade GP’s assets other than those assets inwhich the lenders under the amended asset-based revolving loan facility have afirst priority interest. The senior secured notes and the guarantees are alsocollateralized by a second priority interest in all collateral pledged on afirst priority basis to lenders under the amended asset-based revolving loanfacility.

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 

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sales of assets, enterinto business combination transactions (including mergers, consolidations andasset sales), enter into sale-leaseback transactions, enter into transactionswith affiliates and permit restrictions on the payment of dividends byrestricted subsidiaries. There are no credit ratings related triggers in theindenture governing the senior secured notes that would impact the cost ofborrowing, annual amortization of principal or related indebtedness maturity.The indenture governing the senior secured notes does not contain financialmaintenance covenants.

At April 1, 2006, the weighted average combinedinterest rate in effect on all variable rate debt outstanding was 8.25%.

***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,commencing February 1, 2005. The senior subordinated notes areuncollateralized obligations and subordinated in right of payment to all of theCompany’s, Duane Reade Inc.’s and Duane Reade GP’s existing and futureunsubordinated indebtedness, including borrowings under the amended asset-basedrevolving loan facility and the senior secured notes. The senior subordinatednotes will rank equally with any future senior subordinated indebtedness and seniorto any future subordinated indebtedness. The senior subordinated notes areguaranteed on an uncollateralized, senior subordinated basis by the Company andall of Duane Reade Inc.’s existing direct and indirect domesticsubsidiaries other than Duane Reade GP, which is a co-obligor under the seniorsubordinated notes. Upon the occurrence of specified change of control events,the Company will be required to make an offer to repurchase all of the seniorsubordinated notes at 101% of the outstanding principal amount of the seniorsubordinated notes plus accrued and unpaid interest to the date of repurchase.The indenture governing the senior subordinated notes contains certainaffirmative and negative covenants that limit the ability of Duane Reade Inc.,Duane Reade GP and their restricted subsidiaries to incur additionalindebtedness, pay dividends, make repayments on indebtedness that issubordinated to the senior subordinated notes and to make certain otherrestricted payments, incur certain liens, use proceeds from sales of assets,enter into business combination transactions (including mergers, consolidationsand asset sales), enter into transactions with affiliates and permitrestrictions on the payment of dividends by restricted subsidiaries. There areno credit ratings related triggers in the indenture governing the seniorsubordinated notes that would impact the cost of borrowing, annual amortizationof principal or related indebtedness maturity.

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

In connection with theAcquisition, Duane Reade Inc. made a tender offer to repurchase all of the$351.0 million outstanding principal value of the Convertible Notes. Uponthe closing of the tender offer, a total of $350.9 million principal value($201.0 million issuance value) was tendered for repurchase, leaving only$55.0 thousand of principal value ($32.0 thousand of issuance value)outstanding. Duane Reade Inc. may redeem for cash all or a portion of theprincipal value of the outstanding 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.

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**8.**                 IncomeTaxes

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

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

At December 31, 2005, as a consequence of thesignificant loss incurred in the fiscal quarter then ended, as well as theprojected future years’ taxable losses, this evaluation resulted in therecording of a valuation allowance of $30.4 million. This amount representedthe Company’s year-end net deferred tax asset value excluding $24.4 million ofdeferred tax liabilities resulting from items that are not amortized for bookaccounting and are therefore not expected to reverse within the loss carryforwardexpiration period.

During the quarter endedApril 1, 2006, the Company incurred an additional pre-tax loss of $9.6million and recorded an incremental valuation allowance of $4.5 million. AtApril 1, 2006, the Company had approximately $119.9 million of grossdeferred tax assets, approximately $109.7 million of gross deferred taxliabilities, and a cumulative valuation allowance of $34.9 million.

**9.**                 Commitmentsand 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 mostprofitable store was completely destroyed. The claim is pending before the UnitedStates District Court for the Southern District of New York. In September 2003,a trial on certain issues was held regarding some of the matters at issue inthe litigation, including whether the Company would have obtained a renewal ofits lease at the World Trade Center. The Company received a favorable ruling onthis and other legal issues in the case. The trial court’s decision wasappealed by the insurance carrier to the Second Circuit Court of Appeals withrespect to several aspects of the decision.

In the meantime, the matter moved into an appraisalprocess based on the trial court’s interpretation of certain legal tests, whichinterpretation was among the aspects of the decision challenged by theinsurance carrier in its appeal. The appraisal process involves a panel of twoappraisers and an arbitrator (to resolve differences between the twoappraisers) who determined the amount of insured loss the Company sustained. InJune 2005, the appraisal panel determined that the total amount of thebusiness interruption loss that the Company suffered as a result of the eventsof September 11, 2001 was 

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$50.6 million,including all interest adjustments. The panel further found that the actualamount to be paid by the insurer should be reduced by approximately$9.9 million, plus interest, which represents the amount that waspreviously paid to the Company in cash by the insurer in 2002. On June 22,2005, the Court of Appeals affirmed the decision of the trial court, withmodifications, including modifications to certain of the legal tests on whichthe appraisal panel’s decision was based. The appraisal panel has recentlyrequested additional submissions in order to assist it in making a finaldetermination as to the impact of the Second Circuit’s opinion on its originalaward. The Company believes that the panel’s decision will result in areduction of the original award, but the amount of the reduction of this claim,if any, cannot be determined at this time.

Accordingly, given the risks and uncertaintiesinherent in litigation, there can be no definitive assurance that the Companywill actually receive any or all of the panel’s appraised value of this claim,and the Company has not recognized any additional income related to thismatter. It should be noted that any payment to the Company that might beforthcoming as a result of this claim may also result in the incurrence ofadditional expenses that are contingent upon the amount of such insurance claimsettlement. These expenses, if incurred, are not expected to exceed$6.0 million.

The Company was a party to a National Labor RelationsBoard (“NLRB”) administrative proceeding regarding a dispute with the AlliedTrades Council (“ATC”) over whether a negotiating impasse was reached betweenthe Company and the union in August of 2001. The Allied Trades Councilrepresented employees in 139 of the Company’s stores in a collective bargainingagreement that expired on August 31, 2001. The Company believed that anegotiating impasse had occurred and as a result it had the right to implementits latest contract proposal which included wage increases, health and welfarebenefits, vacation and sick benefits and a 401(k) retirement program. TheCompany discontinued making additional payments into the various fundsassociated with the union as it was providing many of the benefits on a directbasis and because past contributions to these funds had caused these funds tobe in a position of excessive over funding. On February 18, 2004, anAdministrative Law Judge (“ALJ”) who had reviewed various matters related tothis proceeding issued a decision and related recommendation, which concludedthat the parties were not at impasse. The remedies recommended by the ALJincluded, among other things, a requirement for the Company to make itsemployees whole by reimbursing them for expenses ensuing from the Company’sfailure to make contributions to the union funds and to make such funds whole,plus interest. 

As a result of this decision and relatedrecommendation, the Company (after consultation with its outside counsel)determined that it was required to recognize a liability under the provisionsof Financial Accounting Standard No. 5 , Accounting for Contingencies. TheCompany, after a thorough review of the ALJ’s decision and recommendation aswell as the related litigation surrounding this matter, determined that thevalue of the contingent liability at December 27, 2003 was $12.6 million, andrecorded this amount as a labor contingency liability. The Company also determinedthat it would continue to accrue additional labor contingency expense ofapproximately $4.4 million annually, representing additional obligations forunpaid contributions and interest relative to future periods, until such timethat new information would determine a change in the factors that gave rise tothe need for the amount of such labor contingency. 

On September 15, 2004, a three-member panel of theNLRB adopted the decision of the NLRB and subsequently, the Company appealedthis decision to the *District of ColumbiaCircuit Court of Appeals.*

At December 31, 2005, the Company had recorded acumulative labor contingency liability of $20.7 million. This represented theCompany’s best estimate of the loss that would result upon application of the NLRB’sdecision. The Company believed that the actual range of loss in this mattercould be from $0, if the NLRB’s decision would not be enforced at all by theCircuit Court of Appeals, to approximately $49 million, if the NLRB’s decisionwould not be modified to provide for an offset of the amounts actually paid bythe Company on behalf of the union employees.

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On April 11, 2006, the Company announced that the NLRBhad approved a settlement agreement between the Company and the Allied TradesCouncil Division of Local 338 RWDSU/UFCW (“Local 338”) with respect to alloutstanding litigation and disputes with both the union and the NLRB. TheCompany also announced that it had reached agreement on the terms of two newthree-year collective bargaining agreements with Local 338 and Local 340A NewYork Joint Board Unite Here!, a union representing certain non-managementemployees in the balance of the Company’s stores.  The settlement agreement became effective onApril 13, 2006, when the collective bargaining agreement with Local 338was ratified by the union membership. The three-year collective bargainingagreements with both unions became effective as of April 1, 2006 and willexpire on March 31, 2009.

Under the terms of the settlement agreement, theCompany was not required to make any additional payments to the union funds,and will have only a limited contingent obligation going forward. As a resultof this settlement, the Company will cease making the annual $4.4 millionprovision toward labor litigation matters. The Company reversed $18.0 millionof the labor contingency reserve during the first quarter ended April 1, 2006.

The Company was a party to related lawsuits, IrvingKroop, et al v. Duane Reade, NY, NY et al, 00 Civ. 9841, et al.,instituted by the trustees of several union benefit funds wherein the fundsclaimed that the Company did not make certain required contributions to thesefunds from January 2000 through August 2001. The Company paid $0.7 millionin November 2005 and an additional $1.4 million in April 2006 tofully settle all of the claims in this case.

In December 2005, the Company and Cardinal Healthsettled all matters relating to litigation arising out of a dispute regardingcertain former supply arrangements and agreements. Under the terms of thissettlement, the Company will pay Cardinal Health $4.5 million over aperiod of time to settle an outstanding trade payable, and has entered into anagreement whereby Cardinal will provide a secondary supply of pharmaceuticalproducts to the Company over approximately two years. In the first quarter of2006, the Company paid $2.0 million toward the cash settlement portion of thisagreement.

A New York State Tax Appeal ruling in a matterinvolving another company may have an adverse impact upon the Company’s NewYork State Franchise Tax filings from years 1999 through 2002. This matterrelates to the required combination of affiliated subsidiaries in recognizingroyalty fee and related income for intangible property. The ruling is subjectto further legal appeal and interpretation in light of the Company’s ownspecific facts and circumstances. The outcome of this matter, and the resultingamount of additional income tax expense, if any, cannot be determined by theCompany at this time.

In November 2004, Duane Reade Inc. wasserved with a purported class action complaint, Damassia v. DuaneReade Inc. The lawsuit was filed in the United States District Court,Southern District of New York. The complaint alleges that, from the periodbeginning November 1998, the Company incorrectly gave some employees thetitle, “Assistant Manager,” in an attempt to avoid paying these employeesovertime, in contravention of the Fair Labor Standards Act and the New YorkLaw. The complaint seeks an unspecified amount of unpaid wages. The Companybelieves this claim to be without merit, and it intends to defend itselfvigorously against this claim. However, due to the inherent uncertainty oflitigation, there can be no assurance as to the ultimate outcome of thismatter.

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, andintends 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.

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In January 2005, theEqual Employment Opportunity Commission filed an action against the Company inthe U.S. District Court for the Southern District of New York alleging, amongother things, that the Company created a hostile work environment for threefemale store employees, and potentially a class of such female employees. Thisaction is in its early stages, and accordingly it is not possible to determinethe ultimate outcome, which, if adverse, could be material. However, theCompany believes that the allegations are wholly without merit and intends tovigorously defend itself in this matter.

***Litigation Relating to the Acquisition***

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

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

The 9.75% Senior Subordinated Notes due 2011 and theSenior Secured Floating Rate Notes due 2010 were co-issued by DuaneReade Inc. and Duane Reade GP, each of whom is considered a “co-obligor.”The Company and each of its’ other subsidiaries, composed of DRI I Inc.,Duane Reade International, Inc. and Duane Reade Realty, Inc.,are guarantors of such notes. The guarantee of the Company and of eachsubsidiary guarantor is full and unconditional 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. Deferred income taxes havebeen allocated to individual entities according to the Company’s income taxallocation methodology. Certain of the prior year information has been adjustedto conform its presentation with the current year. There is no limitation ondividends between the parent and its subsidiaries. The financial informationmay not necessarily be indicative of results of operations or financialposition had the subsidiary guarantors operated as independent entities.

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

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

 

20

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**DUANE READEHOLDINGS, INC.Condensed Consolidating Statement of Operations (Unaudited)For the 13 weeks ended March 26, 2005(in thousands)**

| ** **                                          | ** ** | ** **              | ** ** | ** **                     | ** ** | ** **                   | ** ** | ** **     | ** ** | ** **        | ** ** | **Duane Reade**    | ** ** |
|-----------------------------------------------------|------------|-------------------------|------------|--------------------------------|------------|------------------------------|------------|----------------|------------|-------------------|------------|-------------------------|------------|
| ** **                                          | ** ** | **Duane Reade**    | ** ** | ** **                     | ** ** | ** **                   | ** ** | **Subsidiary** | ** ** | **Consolidating** | ** ** | **Holdings, Inc.** | ** ** |
| ** **                                          | ** ** | **Holdings, Inc.** | ** ** | **Duane Reade Inc.** | ** ** | **Duane Reade GP** | ** ** | **Guarantors** | ** ** | **Adjustments**   | ** ** | **Consolidated**        | ** ** |
| Net sales                                           |       |                    | $          | —                         |       |                         |       | $              | —     |              |       |                    | $          | 394,767 |   |   |   | $ | 9,166 |   |   |   | $ | (9,166 | ) |   |   | $ | 394,767 |   |   |
| Cost of sales                                       |       |                    | —     |                           |       |                         | —     |           |       |              | 321,958    |                    |       |   | — |   |   |   | — |   |   |   | 321,958 |   |   |
| Gross profit                                        |       |                    | —     |                           |       |                         | —     |           |       |              | 72,809     |                    |       |   | 9,166 |   |   |   | (9,166 | ) |   |   | 72,809 |   |   |
| Selling, general & administrative expenses |       |                    | —     |                           |       |                         | —     |           |       |              | 73,647     |                    |       |   | 18 |   |   |   | (9,166 | ) |   |   | 64,499 |   |   |
| Labor contingency                                   |       |                    | —     |                           |       |                         | —     |           |       |              | 1,100      |                    |       |   | — |   |   |   | — |   |   |   | 1,100 |   |   |
| Transaction expense                                 |       |                    | —     |                           |       |                         | —     |           |       |              | 427        |                    |       |   | — |   |   |   | — |   |   |   | 427 |   |   |
| Depreciation and amortization                       |       |                    | —     |                           |       |                         | —     |           |       |              | 17,646     |                    |       |   | — |   |   |   | — |   |   |   | 17,646 |   |   |
| Store pre-opening expense                           |       |                    | —     |                           |       |                         | —     |           |       |              | 100        |                    |       |   | — |   |   |   | — |   |   |   | 100 |   |   |
| Other                                               |       |                    | —     |                           |       |                         | —     |           |       |              | 1,148      |                    |       |   | — |   |   |   | — |   |   |   | 1,148 |   |   |
| Operating (loss) income                             |       |                    | —     |                           |       |                         | —     |           |       |              | (21,259    | )                       |       |   | 9,148 |   |   |   | — |   |   |   | (12,111 | ) |   |
| Equity earnings in affiliates                       |       |                    | 12,802     |                           |       |                         | 12,802     |           |       |              | —     |                    |       |   | 193 |   |   |   | (25,797 | ) |   |   | — |   |   |
| Interest expense (income), net                      |       |                    | —     |                           |       |                         | —     |           |       |              | 13,776     |                    |       |   | (2,611 | ) |   |   | — |   |   |   | 11,165 |   |   |
| Income (loss) before income taxes                   |       |                    | (12,802    | )                              |       |                         | (12,802    | )              |       |              | (35,035    | )                       |       |   | 11,566 |   |   |   | 25,797 |   |   |   | (23,276 | ) |   |
| Income tax (benefit) expense                        |       |                    | —     |                           |       |                         | —     |           |       |              | (15,765    | )                       |       |   | 5,291 |   |   |   | — |   |   |   | (10,474 | ) |   |
| Net income (loss)                                   |       |                    | $          | (12,802                        | )          |                         |       | $              | (12,802    | )                 |       |                    | $          | (19,270 | ) |   |   | $ | 6,275 |   |   |   | $ | 25,797 |   |   |   | $ | (12,802 | ) |   |

 

21

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**DUANE READE HOLDINGS, INC.Condensed Consolidating Balance Sheet (Unaudited)As of April 1, 2006**

**(in thousands)**

| ** **                                        | ** ** | ** **              | ** ** | ** **                     | ** ** | ** **                   | ** ** | ** **     | ** ** | ** **        | ** ** | **Duane Reade**    | ** ** |
|---------------------------------------------------|------------|-------------------------|------------|--------------------------------|------------|------------------------------|------------|----------------|------------|-------------------|------------|-------------------------|------------|
| ** **                                        | ** ** | **Duane Reade**    | ** ** | ** **                     | ** ** | ** **                   | ** ** | **Subsidiary** | ** ** | **Consolidating** | ** ** | **Holdings, Inc.** | ** ** |
| ** **                                        | ** ** | **Holdings, Inc.** | ** ** | **Duane Reade Inc.** | ** ** | **Duane Reade GP** | ** ** | **Guarantors** | ** ** | **Adjustments**   | ** ** | **Consolidated**        | ** ** |
| Assets                                            |       |                    |       |                           |       |                         |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Current assets                                    |       |                    |       |                           |       |                         |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash                                              |       |                    | $          | —                         |       |                         |       | $              | —     |              |       |                    | $          | 1,336 |   |   |   | $ | 61 |   |   |   | $ | — |   |   |   | $ | 1,397 |   |   |
| Receivables                                       |       |                    | —     |                           |       |                         | —     |           |       |              | 46,852     |                    |       |   | — |   |   |   | — |   |   |   | 46,852 |   |   |
| Due from  affiliates                              |       |                    | —     |                           |       |                         | 72,069     |           |       |              | 114,362    |                    |       |   | — |   |   |   | (186,431 | ) |   |   | — |   |   |
| Inventories                                       |       |                    | —     |                           |       |                         | —     |           |       |              | 232,776    |                    |       |   | — |   |   |   | — |   |   |   | 232,776 |   |   |
| Deferred income  taxes                            |       |                    | —     |                           |       |                         | 8,292      |           |       |              | 5,049      |                    |       |   | (6,189 | ) |   |   | — |   |   |   | 7,152 |   |   |
| Prepaid expenses  and other  assets               |       |                    | —     |                           |       |                         | —     |           |       |              | 28,522     |                    |       |   | — |   |   |   | — |   |   |   | 28,522 |   |   |
| Total current  assets                             |       |                    | —     |                           |       |                         | 80,361     |           |       |              | 428,897    |                    |       |   | (6,128 | ) |   |   | (186,431 | ) |   |   | 316,699 |   |   |
| Investment in  affiliates                         |       |                    | 73,798     |                           |       |                         | 73,798     |           |       |              | —     |                    |       |   | 88 |   |   |   | (147,684 | ) |   |   | — |   |   |
| Property and  equipment                           |       |                    | —     |                           |       |                         | —     |           |       |              | 222,067    |                    |       |   | — |   |   |   | — |   |   |   | 222,067 |   |   |
| Goodwill net of  accumulated amortization         |       |                    | —     |                           |       |                         | —     |           |       |              | 67,791     |                    |       |   | — |   |   |   | — |   |   |   | 67,791 |   |   |
| Deferred income  taxes                            |       |                    | —     |                           |       |                         | 1,645      |           |       |              | 9,032      |                    |       |   | (10,677 | ) |   |   | — |   |   |   | — |   |   |
| Other assets                                      |       |                    | —     |                           |       |                         | —     |           |       |              | 195,257    |                    |       |   | 300,757 |   |   |   | (254,525 | ) |   |   | 241,489 |   |   |
| Total assets                                      |       |                    | $          | 73,798                         |       |                         |       | $              | 155,804    |              |       |                    | $          | 923,044 |   |   |   | $ | 284,040 |   |   |   | $ | (588,640 | ) |   |   | $ | 848,046 |   |   |
| Liabilities and  Stockholder’s Equity        |       |                    |       |                           |       |                         |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Current liabilities                               |       |                    |       |                           |       |                         |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Accounts payable                                  |       |                    | $          | —                         |       |                         |       | $              | —     |              |       |                    | $          | 85,210 |   |   |   | $ | — |   |   |   | $ | — |   |   |   | 85,210 |   |   |
| Due to affiliates                                 |       |                    | —     |                           |       |                         | —     |           |       |              | —     |                    |       |   | 186,429 |   |   |   | (186,429 | ) |   |   | — |   |   |
| Accrued interest                                  |       |                    | —     |                           |       |                         | —     |           |       |              | 4,691      |                    |       |   | — |   |   |   | — |   |   |   | 4,691 |   |   |
| Accrued expenses                                  |       |                    | —     |                           |       |                         | 12         |           |       |              | 48,822     |                    |       |   | — |   |   |   | — |   |   |   | 48,834 |   |   |
| Current portion of  long term  debt               |       |                    | —     |                           |       |                         | —     |           |       |              | 142,208    |                    |       |   | — |   |   |   | — |   |   |   | 142,208 |   |   |
| Current portion of  capital lease obligations     |       |                    | —     |                           |       |                         | —     |           |       |              | 3,282      |                    |       |   | — |   |   |   | — |   |   |   | 3,282 |   |   |
| Total current  liabilities                        |       |                    | —     |                           |       |                         | 12         |           |       |              | 284,213    |                    |       |   | 186,429 |   |   |   | (186,429 | ) |   |   | 284,225 |   |   |
| Long term debt                                    |       |                    | —     |                           |       |                         | —     |           |       |              | 659,557    |                    |       |   | — |   |   |   | (254,525 | ) |   |   | 405,032 |   |   |
| Capital lease  obligations, less current portion  |       |                    | —     |                           |       |                         | —     |           |       |              | 9,456      |                    |       |   | — |   |   |   | — |   |   |   | 9,456 |   |   |
| Deferred income  taxes                            |       |                    | —     |                           |       |                         | 80,014     |           |       |              | (80,749    | )                       |       |   | 32,563 |   |   |   | — |   |   |   | 31,828 |   |   |
| Other non-current  liabilities                    |       |                    | —     |                           |       |                         | 1,980      |           |       |              | 41,172     |                    |       |   | — |   |   |   | — |   |   |   | 43,152 |   |   |
| Total liabilities                                 |       |                    | —     |                           |       |                         | 82,006     |           |       |              | 913,649    |                    |       |   | 218,992 |   |   |   | (440,954 | ) |   |   | 773,693 |   |   |
| Stockholder’s equity                         |       |                    |       |                           |       |                         |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Common stock                                      |       |                    | 26         |                           |       |                         | —     |           |       |              | —     |                    |       |   | — |   |   |   | — |   |   |   | 26 |   |   |
| Paid-in-capital                                   |       |                    | 239,472    |                           |       |                         | 239,498    |           |       |              | 239,498    |                    |       |   | 2,395 |   |   |   | (481,391 | ) |   |   | 239,472 |   |   |
| Additional paid-in-capital                        |       |                    | —     |                           |       |                         | —     |           |       |              | 25         |                    |       |   | — |   |   |   | — |   |   |   | 25 |   |   |
| Accumulated other  comprehensive  income          |       |                    | —     |                           |       |                         | —     |           |       |              | 531        |                    |       |   | — |   |   |   | — |   |   |   | 531 |   |   |
| Retained earnings                                 |       |                    | (165,700   | )                              |       |                         | (165,700   | )              |       |              | (230,659   | )                       |       |   | 62,653 |   |   |   | 333,705 |   |   |   | (165,701 | ) |   |
| Total  stockholder’s equity                  |       |                    | 73,798     |                           |       |                         | 73,798     |           |       |              | 9,395      |                    |       |   | 65,048 |   |   |   | (147,686 | ) |   |   | 74,353 |   |   |
| Total liabilities and  stockholder’s  equity |       |                    | $          | 73,798                         |       |                         |       | $              | 155,804    |              |       |                    | $          | 923,044 |   |   |   | $ | 284,040 |   |   |   | $ | (588,640 | ) |   |   | $ | 848,046 |   |   |

 

22

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**DUANE READE HOLDINGS, INC.Condensed Consolidating Balance Sheet (Unaudited)As of December 31, 2005(in thousands)**

| ** **                                       | ** ** | ** **              | ** ** | ** **                     | ** ** | ** **                   | ** ** | ** **     | ** ** | ** **        | ** ** | **Duane Reade**    | ** ** |
|--------------------------------------------------|------------|-------------------------|------------|--------------------------------|------------|------------------------------|------------|----------------|------------|-------------------|------------|-------------------------|------------|
| ** **                                       | ** ** | **Duane Reade**    | ** ** | ** **                     | ** ** | ** **                   | ** ** | **Subsidiary** | ** ** | **Consolidating** | ** ** | **Holdings, Inc.** | ** ** |
| ** **                                       | ** ** | **Holdings, Inc.** | ** ** | **Duane Reade Inc.** | ** ** | **Duane Reade GP** | ** ** | **Guarantors** | ** ** | **Adjustments**   | ** ** | **Consolidated**        | ** ** |
| Assets                                           |       |                    |       |                           |       |                         |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Current  assets                                  |       |                    |       |                           |       |                         |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash                                             |       |                    | $          | —                         |       |                         |       | $              | —     |              |       |                    | $          | 1,338 |   |   |   | $ | 24 |   |   |   | $ | — |   |   |   | $ | 1,362 |   |   |
| Receivables                                      |       |                    | —     |                           |       |                         | —     |           |       |              | 52,320     |                    |       |   | — |   |   |   | — |   |   |   | 52,320 |   |   |
| Due from affiliates                              |       |                    | —     |                           |       |                         | 71,983     |           |       |              | 112,660    |                    |       |   | — |   |   |   | (184,643 | ) |   |   | — |   |   |
| Inventories                                      |       |                    | —     |                           |       |                         | —     |           |       |              | 235,639    |                    |       |   | — |   |   |   | — |   |   |   | 235,639 |   |   |
| Deferred income taxes                            |       |                    | —     |                           |       |                         | 8,857      |           |       |              | 5,049      |                    |       |   | (6,189 | ) |   |   | — |   |   |   | 7,717 |   |   |
| Prepaid expenses and other assets           |       |                    | —     |                           |       |                         | —     |           |       |              | 26,114     |                    |       |   | — |   |   |   | — |   |   |   | 26,114 |   |   |
| Total current assets                             |       |                    | —     |                           |       |                         | 80,840     |           |       |              | 433,120    |                    |       |   | (6,165 | ) |   |   | (184,643 | ) |   |   | 323,152 |   |   |
| Investment in affiliates                         |       |                    | 83,662     |                           |       |                         | 83,662     |           |       |              | —     |                    |       |   | 330 |   |   |   | (167,654 | ) |   |   | — |   |   |
| Property and equipment                           |       |                    | —     |                           |       |                         | —     |           |       |              | 229,134    |                    |       |   | — |   |   |   | — |   |   |   | 229,134 |   |   |
| Goodwill, net                                    |       |                    | —     |                           |       |                         | —     |           |       |              | 67,791     |                    |       |   | — |   |   |   | — |   |   |   | 67,791 |   |   |
| Deferred income taxes                            |       |                    | —     |                           |       |                         | 1,645      |           |       |              | 9,032      |                    |       |   | (10,677 | ) |   |   | — |   |   |   | — |   |   |
| Other assets                                     |       |                    | —     |                           |       |                         | —     |           |       |              | 205,109    |                    |       |   | 285,132 |   |   |   | (238,900 | ) |   |   | 251,341 |   |   |
| Total assets                                     |       |                    | $          | 83,662                         |       |                         |       | $              | 166,147    |              |       |                    | $          | 944,186 |   |   |   | $ | 268,620 |   |   |   | $ | (591,197 | ) |   |   | $ | 871,418 |   |   |
| Liabilities  and Stockholder’s Equity       |       |                    |       |                           |       |                         |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Current  liabilities                             |       |                    |       |                           |       |                         |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Accounts payable                                 |       |                    | $          | —                         |       |                         |       | $              | —     |              |       |                    | $          | 72,711 |   |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | 72,711 |   |   |
| Due to affiliates                                |       |                    | —     |                           |       |                         | —     |           |       |              | —     |                    |       |   | 184,641 |   |   |   | (184,641 | ) |   |   | — |   |   |
| Accrued interest                                 |       |                    | —     |                           |       |                         | —     |           |       |              | 9,222      |                    |       |   | — |   |   |   | — |   |   |   | 9,222 |   |   |
| Accrued expenses                                 |       |                    | —     |                           |       |                         | (107       | )              |       |              | 52,066     |                    |       |   | — |   |   |   | — |   |   |   | 51,959 |   |   |
| Current portion of debt                          |       |                    | —     |                           |       |                         | —     |           |       |              | 135,693    |                    |       |   | — |   |   |   | — |   |   |   | 135,693 |   |   |
| Current portion of capital lease obligation      |       |                    | —     |                           |       |                         | —     |           |       |              | 3,183      |                    |       |   | — |   |   |   | — |   |   |   | 3,183 |   |   |
| Total current liabilities                        |       |                    | —     |                           |       |                         | (107       | )              |       |              | 272,875    |                    |       |   | 184,641 |   |   |   | (184,641 | ) |   |   | 272,768 |   |   |
| Long term debt                                   |       |                    | —     |                           |       |                         | —     |           |       |              | 643,932    |                    |       |   | — |   |   |   | (238,900 | ) |   |   | 405,032 |   |   |
| Capital lease obligation, less current portion   |       |                    | —     |                           |       |                         | —     |           |       |              | 10,314     |                    |       |   | — |   |   |   | — |   |   |   | 10,314 |   |   |
| Deferred income taxes                            |       |                    | —     |                           |       |                         | 80,612     |           |       |              | (81,507    | )                       |       |   | 33,012 |   |   |   | — |   |   |   | 32,117 |   |   |
| Other non-current liabilities                    |       |                    | —     |                           |       |                         | 1,980      |           |       |              | 65,285     |                    |       |   | — |   |   |   | — |   |   |   | 67,265 |   |   |
| Total liabilities                                |       |                    | —     |                           |       |                         | 82,485     |           |       |              | 910,899    |                    |       |   | 217,653 |   |   |   | (423,541 | ) |   |   | 787,496 |   |   |
| Stockholder’s  equity                       |       |                    |       |                           |       |                         |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Common stock                                     |       |                    | 26         |                           |       |                         | —     |           |       |              | —     |                    |       |   | — |   |   |   | — |   |   |   | 26 |   |   |
| Paid-in-capital                                  |       |                    | 239,472    |                           |       |                         | 239,498    |           |       |              | 239,498    |                    |       |   | 2,395 |   |   |   | (481,391 | ) |   |   | 239,472 |   |   |
| Accumulated other comprehensive income           |       |                    | —     |                           |       |                         | —     |           |       |              | 260        |                    |       |   | — |   |   |   | — |   |   |   | 260 |   |   |
| Retained earnings                                |       |                    | (155,836   | )                              |       |                         | (155,836   | )              |       |              | (206,471   | )                       |       |   | 48,572 |   |   |   | 313,735 |   |   |   | (155,836 | ) |   |
| Total stockholder’s equity                  |       |                    | 83,662     |                           |       |                         | 83,662     |           |       |              | 33,287     |                    |       |   | 50,967 |   |   |   | (167,656 | ) |   |   | 83,922 |   |   |
| Total liabilities  and stockholder’s equity |       |                    | $          | 83,662                         |       |                         |       | $              | 166,147    |              |       |                    | $          | 944,186 |   |   |   | $ | 268,620 |   |   |   | $ | (591,197 | ) |   |   | $ | 871,418 |   |   |

 

23

----

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

| ** **                                                                                                  | ** ** | ** **              | ** ** | ** **                     | ** ** | ** **                   | ** ** | ** **     | ** ** | ** **        | ** ** | **Duane Reade**    | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|--------------------------------|------------|------------------------------|------------|----------------|------------|-------------------|------------|-------------------------|------------|
| ** **                                                                                                  | ** ** | **Duane Reade**    | ** ** | ** **                     | ** ** | ** **                   | ** ** | **Subsidiary** | ** ** | **Consolidating** | ** ** | **Holdings, Inc.** | ** ** |
| ** **                                                                                                  | ** ** | **Holdings, Inc.** | ** ** | **Duane Reade Inc.** | ** ** | **Duane Reade GP** | ** ** | **Guarantors** | ** ** | **Adjustments**   | ** ** | **Consolidated**        | ** ** |
| Cash flows from operating  activities:                                                                      |       |                    |       |                           |       |                         |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income (loss)                                                                                           |       |                    | $          | (9,864                         | )          |                         |       | $              | (9,864     | )                 |       |                    | $          | (24,187 | ) |   |   | $ | 14,081 |   |   |   | $ | 19,970 |   |   |   | $ | (9,864 | ) |   |
| Adjustments  to reconcile net income (loss) to net cash (used in) / provided by  operating activities: |       |                    |       |                           |       |                         |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Depreciation and amortization                                                                               |       |                    | —     |                           |       |                         | —     |           |       |              | 19,741     |                    |       |   | — |   |   |   | — |   |   |   | 19,741 |   |   |
| Deferred tax provision                                                                                      |       |                    | —     |                           |       |                         | (33        | )              |       |              | 758        |                    |       |   | (449 | ) |   |   | — |   |   |   | 276 |   |   |
| Deferred rent expense                                                                                       |       |                    | —     |                           |       |                         | —     |           |       |              | 2,559      |                    |       |   | — |   |   |   | — |   |   |   | 2,559 |   |   |
| Equity in income of subsidiaries                                                                            |       |                    | 9,864      |                           |       |                         | 9,864      |           |       |              | —     |                    |       |   | 242 |   |   |   | (19,970 | ) |   |   | — |   |   |
| Changes  in operating assets and liabilities:                                                               |       |                    |       |                           |       |                         |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Receivables                                                                                                 |       |                    | —     |                           |       |                         | (86        | )              |       |              | 3,766      |                    |       |   | 1,788 |   |   |   | — |   |   |   | 5,468 |   |   |
| Inventories                                                                                                 |       |                    | —     |                           |       |                         | —     |           |       |              | 2,863      |                    |       |   | — |   |   |   | — |   |   |   | 2,863 |   |   |
| Accounts payable                                                                                            |       |                    | —     |                           |       |                         | —     |           |       |              | 12,499     |                    |       |   | — |   |   |   | — |   |   |   | 12,499 |   |   |
| Prepaid and accrued expenses                                                                                |       |                    | —     |                           |       |                         | 119        |           |       |              | (6,383     | )                       |       |   | — |   |   |   | — |   |   |   | (6,264 | ) |   |
| Increase in other assets  (liabilities), net                                                                |       |                    | —     |                           |       |                         | —     |           |       |              | (11,826    | )                       |       |   | (15,625 | ) |   |   | — |   |   |   | (27,451 | ) |   |
| NET CASH PROVIDED BY  (USED IN) OPERATING ACTIVITIES                                                        |       |                    | —     |                           |       |                         | —     |           |       |              | (210       | )                       |       |   | 37 |   |   |   | — |   |   |   | (173 | ) |   |
| Capital expenditures                                                                                        |       |                    | —     |                           |       |                         | —     |           |       |              | (3,713     | )                       |       |   | — |   |   |   | — |   |   |   | (3,713 | ) |   |
| Lease acquisition and other costs                                                                           |       |                    | —     |                           |       |                         | —     |           |       |              | (1,814     | )                       |       |   | — |   |   |   | — |   |   |   | (1,814 | ) |   |
| Proceeds from sale of property                                                                              |       |                    | —     |                           |       |                         | —     |           |       |              | —     |                    |       |   | — |   |   |   | — |   |   |   | — |   |   |
| NET CASH USED IN INVESTING ACTIVITIES                                                                  |       |                    | —     |                           |       |                         | —     |           |       |              | (5,527     | )                       |       |   | — |   |   |   | — |   |   |   | (5,527 | ) |   |
| Cash flows from  financing activities:                                                                      |       |                    |       |                           |       |                         |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Borrowings from revolving credit  facility                                                                  |       |                    | —     |                           |       |                         | —     |           |       |              | 454,703    |                    |       |   | — |   |   |   | — |   |   |   | 454,703 |   |   |
| Repayments of revolving credit  facility                                                                    |       |                    | —     |                           |       |                         | —     |           |       |              | (448,188   | )                       |       |   | — |   |   |   | — |   |   |   | (448,188 | ) |   |
| Deferred financing costs                                                                                    |       |                    | —     |                           |       |                         | —     |           |       |              | (21        | )                       |       |   | — |   |   |   | — |   |   |   | (21 | ) |   |
| Repayments of capital lease  obligations                                                                    |       |                    | —     |                           |       |                         | —     |           |       |              | (759       | )                       |       |   | — |   |   |   | — |   |   |   | (759 | ) |   |
| NET CASH PROVIDED BY FINANCING ACTIVITIES                                                                   |       |                    | —     |                           |       |                         | —     |           |       |              | 5,735      |                    |       |   | — |   |   |   | — |   |   |   | 5,735 |   |   |
| Net (decrease) increase in cash                                                                             |       |                    | —     |                           |       |                         | —     |           |       |              | (2         | )                       |       |   | 37 |   |   |   | — |   |   |   | 35 |   |   |
| Cash at beginning of period                                                                                 |       |                    | —     |                           |       |                         | —     |           |       |              | 1,338      |                    |       |   | 24 |   |   |   | — |   |   |   | 1,362 |   |   |
| Cash at end of  period                                                                                      |       |                    | $          | —                         |       |                         |       | $              | —     |              |       |                    | $          | 1,336 |   |   |   | $ | 61 |   |   |   | $ | — |   |   |   | $ | 1,397 |   |   |

 

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**DUANE READEHOLDINGS, INC.Condensed Consolidating Statement of Cash Flows (Unaudited)For the 13 weeks ended March 26, 2005(in thousands)**

| ** **                                                                                            | ** ** | **Duane Reade  Holdings, Inc.** | ** ** | **Duane Reade Inc.** | ** ** | **Duane Reade GP** | ** ** | **Subsidiary  Guarantors** | ** ** | **Consolidating  Adjustments** | ** ** | **Duane Reade  Holdings, Inc.  Consolidated** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|----------------------------|------------|--------------------------------|------------|---------------------------------------------------------|------------|
| Cash flows from operating activities:                                                                 |       |                                      |       |                           |       |                         |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income (loss)                                                                                     |       |                                      | $          | (12,802                        | )          |                         |       | $                          | (12,802    | )                              |       |                                                    | $          | (19,270 | ) |   |   | $ | 6,275 |   |   |   | $ | 25,797 |   |   |   | $ | (12,802 | ) |   |
| Adjustments to reconcile  net income (loss) to net cash (used in) / provided by operating activities: |       |                                      |       |                           |       |                         |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Depreciation and  amortization                                                                        |       |                                      | —     |                           |       |                         | —     |                       |       |                           | 18,559     |                                                    |       |   | — |   |   |   | — |   |   |   | 18,559 |   |   |
| Deferred tax  provision                                                                               |       |                                      | —     |                           |       |                         | —     |                       |       |                           | (15,765    | )                                                       |       |   | 5,291 |   |   |   | — |   |   |   | (10,474 | ) |   |
| Deferred rent  expense                                                                                |       |                                      | —     |                           |       |                         | —     |                       |       |                           | 3,594      |                                                    |       |   | — |   |   |   | — |   |   |   | 3,594 |   |   |
| Equity in income  of  subsidiaries                                                                    |       |                                      | 12,802     |                           |       |                         | 12,802     |                       |       |                           | —     |                                                    |       |   | 193 |   |   |   | (25,797 | ) |   |   | — |   |   |
| Changes in operating  assets and liabilities:                                                         |       |                                      |       |                           |       |                         |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Receivables                                                                                           |       |                                      | —     |                           |       |                         | (70        | )                          |       |                           | 891        |                                                    |       |   | 76 |   |   |   | — |   |   |   | 897 |   |   |
| Inventories                                                                                           |       |                                      | —     |                           |       |                         | —     |                       |       |                           | 1,409      |                                                    |       |   | — |   |   |   | — |   |   |   | 1,409 |   |   |
| Accounts payable                                                                                      |       |                                      | —     |                           |       |                         | —     |                       |       |                           | (1,010     | )                                                       |       |   | — |   |   |   | — |   |   |   | (1,010 | ) |   |
| Prepaid and  accrued expenses                                                                         |       |                                      | —     |                           |       |                         | 70         |                       |       |                           | (22,976    | )                                                       |       |   | — |   |   |   | — |   |   |   | (22,906 | ) |   |
| Increase in other  assets (liabilities), net                                                     |       |                                      | —     |                           |       |                         | —     |                       |       |                           | 17,908     |                                                    |       |   | (11,825 | ) |   |   | — |   |   |   | 6,083 |   |   |
| NET CASH PROVIDED  BY (USED IN) OPERATING ACTIVITIES                                                  |       |                                      | —     |                           |       |                         | —     |                       |       |                           | (16,660    | )                                                       |       |   | 10 |   |   |   | — |   |   |   | (16,650 | ) |   |
| Capital  expenditures                                                                                 |       |                                      | —     |                           |       |                         | —     |                       |       |                           | (7,132     | )                                                       |       |   | — |   |   |   | — |   |   |   | (7,132 | ) |   |
| Lease acquisition  and other costs                                                                    |       |                                      | —     |                           |       |                         | —     |                       |       |                           | (3,096     | )                                                       |       |   | — |   |   |   | — |   |   |   | (3,096 | ) |   |
| Proceeds from sale  of property                                                                       |       |                                      | —     |                           |       |                         | —     |                       |       |                           | 2,223      |                                                    |       |   | — |   |   |   | — |   |   |   | 2,223 |   |   |
| NET CASH USED IN  INVESTING ACTIVITIES                                                                |       |                                      | —     |                           |       |                         | —     |                       |       |                           | (8,005     | )                                                       |       |   | — |   |   |   | — |   |   |   | (8,005 | ) |   |
| Cash flows from financing activities:                                                                 |       |                                      |       |                           |       |                         |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Borrowings from  revolving credit facility                                                            |       |                                      | —     |                           |       |                         | —     |                       |       |                           | 475,674    |                                                    |       |   | — |   |   |   | — |   |   |   | 475,674 |   |   |
| Repayments of  revolving  credit facility                                                             |       |                                      | —     |                           |       |                         | —     |                       |       |                           | (449,734   | )                                                       |       |   | — |   |   |   | — |   |   |   | (449,734 | ) |   |
| Deferred financing  costs                                                                             |       |                                      | —     |                           |       |                         | —     |                       |       |                           | (607       | )                                                       |       |   | — |   |   |   | — |   |   |   | (607 | ) |   |
| Repayments of  capital lease obligations                                                              |       |                                      | —     |                           |       |                         | —     |                       |       |                           | (671       | )                                                       |       |   | — |   |   |   | — |   |   |   | (671 | ) |   |
| NET CASH PROVIDED  BY FINANCING ACTIVITIES                                                            |       |                                      | —     |                           |       |                         | —     |                       |       |                           | 24,662     |                                                    |       |   | — |   |   |   | — |   |   |   | 24,662 |   |   |
| Net (decrease)  increase in cash                                                                      |       |                                      | —     |                           |       |                         | —     |                       |       |                           | (3         | )                                                       |       |   | 10 |   |   |   | — |   |   |   | 7 |   |   |
| Cash at beginning  of period                                                                          |       |                                      | —     |                           |       |                         | —     |                       |       |                           | 1,297      |                                                    |       |   | 32 |   |   |   | — |   |   |   | 1,329 |   |   |
| Cash at end of  period                                                                                |       |                                      | $          | —                         |       |                         |       | $                          | —     |                           |       |                                                    | $          | 1,294 |   |   |   | $ | 42 |   |   |   | $ | — |   |   |   | $ | 1,336 |   |   |

 

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

**General**

Our business consists of the sale of a wide variety ofhealth and beauty care products, convenience oriented food and generalmerchandise items and a pharmacy operation managed to supply customers withtheir prescription needs. We refer to the non-prescription portion of ourbusiness as front-end sales because most of these sales are processed throughthe front check-out sections of our stores. This portion of our businessconsists of brand name and private label health and beauty care items, food andbeverages, tobacco products, cosmetics, housewares, greeting cards,photofinishing services, photo supplies and seasonal and general merchandise.Health and beauty care products, including over-the-counter items, representour highest volume categories within front-end sales. The front-end portion ofour business represented 53.5% of our sales in the 13 weeks ended April 1,2006 and 50.5% of our sales in the 13 weeks ended March 26, 2005, and ischaracterized by generally higher gross margins that are approximately twicethat of our pharmacy or back-end business.

Because of our numerous convenient locations inhigh-traffic commercial and residential areas and the lack of otherconvenience-oriented retailers in our core market areas, our front-end businessis generally a larger proportion of our total sales than other majorconventional drugstore chains, which average between 30% and 40%. Historically,front-end sales have represented a decreasing share of business year afteryear; however, over the last few years, pharmacy sales have experienced adeclining rate of growth primarily due to increases in third party planco-payments, reduced sales of hormonal replacement drugs and certain arthritismedications, limitations on maximum reimbursements for certain genericmedications by third party plans, increases in the percentage of salesrepresented by lower-priced generic medications and increased penetration by mailorder and internet-based pharmacies. Our pharmacy sales include all items wesell by prescriptions filled at our retail locations or by our central fillfacility and delivered to our stores or direct to customers. In addition, weinclude in our pharmacy sales certain resales of retail pharmaceuticalinventory that are required to be reported on a gross basis in accordance withEmerging Issues Task Force Issue No. 99-19. The pharmacy portion of ourbusiness is dominated by and dependent upon a number of third party private andgovernment-sponsored plans that contract with us as an authorized provider ofprescriptions.

Sales to third party prescription plans representedapproximately 92.6% of our prescription sales in the 13 weeks ended April 1,2006 and 92.7% of our prescription sales in the 13 weeks ended March 26,2005. Historically, excluding pharmacy resale activity, our pharmacy salesexperienced a faster rate of sales growth than the front-end portion of ourbusiness due to a number of favorable demographic and industry trends such asthe aging of the population, expanded penetration of third party private andgovernment-sponsored coverage and the increasing utilization of prescriptionsto improve quality of life and in place of medical procedures. While thesefactors are still operative, our rate of non-resale pharmacy sales growth hassteadily declined over the last two and a half years to the point where ourmost recent pharmacy sales results reflect a lower rate of growth than thefront-end portion of our business. This slower pharmacy sales growth is theresult of increased mail order penetration (that results in losses of retailbased prescription sales to mail order providers), negative publicitysurrounding the adverse side effects of certain arthritis medications and otherhigh volume drugs, conversion of certain high volume prescription drugs toover-the-counter front-end products and increased use of lower priced but moreprofitable generic drugs in place of higher priced branded medications.

During 2003, President Bush signed the MedicarePrescription Drug, Improvement and Modernization Act of 2003, or, the MedicareModernization Act, which created a new Medicare Part D benefit thatexpanded Medicare coverage of prescription drugs for Medicare participants not enrolledin third party plans as well as for certain Medicare “dual eligible” participantsthat were previously covered 

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under state administeredMedicaid plans. This new Medicare coverage took effect in January 2006 andis expected to result in decreased pharmacy margins resulting from lowerreimbursement rates than our current margins on prescriptions that are notsubject to third party reimbursement. In addition, reimbursement rates forMedicare Part D are expected to be lower for these dual eligible customerstransferred into the Medicare Part D program from New York Medicaid. In June 2004,a temporary prescription drug discount program furnished under this Medicarelegislation was implemented as a means of providing limited benefits to Medicareparticipants until the full Medicare Part D program took effect in 2006.This temporary program, which expires on May 15, 2006, also resulted inlower pharmacy margins than those realized on prescriptions that were notsubject to third party plan reimbursement. Based on our experience, we expect,over time, that increased utilization of prescription drugs by Medicareparticipants enrolled in the new programs that previously were cash payingcustomers may offset the effect of lower margins on our revenues, although weare not certain this will be the case. State Medicaid programs that provideprescription benefits to low income households and individuals havehistorically represented approximately 23% of our retail pharmacy sales. As of March 2006,state Medicaid plans had declined to approximately 17.4% of our pharmacy saleswhile the new Medicare Part D plan represented approximately 7.8% of ourpharmacy sales.

In fiscal 2003 and again in fiscal 2004, New YorkState reduced Medicaid and EPIC prescription reimbursement rates, adverselyimpacting our pharmacy gross margins. New York State also increased co-paymentsby $1.00 per prescription for branded drugs and $0.50 per prescription forgenerics effective in 2005. Under the Medicaid guidelines, providers cannotrefuse to dispense prescriptions to Medicaid recipients who claim they do nothave the means to pay the required co-payments. Most Medicaid recipients do infact decline to make the co-payments resulting in the requirement for theprovider to absorb this cost. This resulted in lost reimbursements to us ofapproximately $1.4 million in fiscal 2005. For 2006, the New York Statelegislature may again consider additional reductions in Medicaid reimbursementrates to providers. In addition, legislation approved by Congress will reducefederal funding for state Medicaid programs adding additional pressure on statelegislatures to further reduce state administered Medicaid providerreimbursement rates.

In an effort to offset some of the adverse pharmacygross margin impacts from the trends discussed above, there has been anintensified effort on the part of retailers to support increased utilization oflower priced but higher margin generic prescriptions in place of brandedmedications. Improved generic utilization rates as well as a combination ofdirect purchases and contractual wholesaler purchases enabled us to achieveimproved gross margins on pharmacy retail sales during 2004 and 2005. For thequarter ended April 1, 2006, we continued to see increased genericsubstitution rates. The proportion of generic prescriptions dispensed was 50.8%,compared to 47.1% in the same period last year.

We are also impacted by recent legislation in statesto increase the minimum hourly wages. New York State increased the minimumhourly wage from $5.15 to $6.00 on January 1, 2005 and again to $6.75 on January 1,2006, and has approved a further increase to $7.15 on January 1, 2007. NewJersey increased the minimum hourly wage from $5.15 to $6.15 on October 1,2005 and has approved a further increase to $7.15 on October 1, 2006.While these increases will impact our cost of labor, we believe we can offset asignificant portion of these cost increases through initiatives designed tofurther improve our labor efficiency.

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 

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I Inc.made a capital contribution of these intellectual property rights to DuaneReade International. This change created a controlled system to manage andexploit these intellectual property rights separate and apart from the retailoperations. In addition, Duane Reade GP distributed some of its store leases toDuane Reade Inc. and DRI I Inc., which in turn made a capitalcontribution of these leases to Duane Reade Realty. Duane Reade Realty is thelessee under certain store leases entered into after its creation. Duane ReadeRealty subleases to Duane Reade GP the properties subject to those leases. Theconsolidated financial statements included in this filing reflect the accountsof Duane Reade Holdings, Inc. and its subsidiaries for all periods shown.All significant intercompany transactions and balances have been eliminated.

**New York CityEconomy**

We operate approximately 88% of our 247 stores in NewYork City and the remainder in the surrounding areas, and our financial performanceis therefore heavily influenced by the local economy. We analyze a number ofeconomic indicators specific to New York City to gauge the health of thiseconomy, including unemployment rates, job creation, gross city product andbridge and tunnel commuter traffic patterns. We also analyze market share data,same-store sales trends, average store sales and sales per square foot dataamong other key performance indicators to monitor our overall performance.During 2004, 2005 and the first quarter of 2006, the New York City economygenerally reflected an improving trend for most of these external economicindicators.

Between 2001 and 2003, theNew York City economy experienced a regional cyclical downturn and a series ofunusual events, such as the World Trade Center attacks and non-recurringincreases in real estate taxes and insurance costs. The New York greatermetropolitan area experienced above average unemployment levels, especially inthe key midtown and downtown Manhattan financial districts and lagged behindthe improving national economy throughout 2003 and the early part of 2004.However, more recently it has shown improvements in employment, tourism andoverall commerce relative to the last few years. The March 2006unemployment data for New York City indicated an unemployment rate of 4.90%,compared to a national rate of 4.70%.

**Results ofOperations**

**The Thirteen WeeksEnded April 1, 2006 as Compared to the Thirteen Weeks Ended March 26,2005**

For the firstquarter of 2006, we achieved net sales of $385.9 million and sustained a netloss of $9.9 million, as compared to net sales of $384.8 million and a net lossof $12.8 million in the first quarter of the previous year. Pharmacy resaleactivity was $11.4 million in the first quarter of 2006, compared to $28.1million in the previous year, resulting from reduced outside customer demand.The improvement in earnings is attributable to the following factors:

·       Thereversal of $18.0 million of previously accrued labor contingency expenses thatresulted from the favorable settlement of litigation with the National LaborRelations Board (NLRB) and Local 338 of the RSDWU, a union representingnon-management employees in 140 of our stores.

·       Anincrease in gross margin from 18.4% in the first quarter of 2005 to 19.6% inthe first quarter of 2006. The increase was primarily attributable to thedecline in lower margin pharmacy resale activity and improved front-end sellingmargins.

These improvementswere partially offset by:

·       Atax provision of $0.3 million in the first quarter of 2006, compared to a taxbenefit of $10.4 million in the prior year. The change in the tax provision wasprimarily attributable to a deferred tax asset valuation reserve of $4.5million recorded in the first quarter of 2006 and a reduced pre-tax lossin the same period.

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·       Anincrease in depreciation and amortization expense of $1.1 million. Thisincrease was attributable to the depreciation of capital expenditures andamortization of intangibles acquired in 2005 and the first quarter of 2006.

·       Anincrease in interest expense of $2.5 million resulting from higher interestrates applicable to our variable rate debt and higher debt levels resultingfrom the August 2005 issuance of $50 million of incremental floating ratenotes.

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

| ** **                                           | ** ** | **For the 13 Weeks Ended** | ** ** |
|------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                           | ** ** | **April 1, 2006**                    | ** ** | **March 26, 2005** | ** ** |
| ** **                                           | ** ** | **Dollars**                                    | ** ** | **% of Sales** | ** ** | **Dollars** | ** ** | **% of Sales** | ** ** |
| Net sales                                            |       | $                                              | 385,869    |   |   | 100.0 | % |   | $ | 394,767 |   |   | 100.0 | % |   |
| Cost of sales                                        |       | 310,396                                        |       |   | 80.4 |   |   | 321,958 |   |   | 81.6 |   |   |
| Gross profit                                         |       | 75,473                                         |       |   | 19.6 |   |   | 72,809 |   |   | 18.4 |   |   |
| Selling,  general & administrative expenses |       | 69,464                                         |       |   | 18.0 |   |   | 64,499 |   |   | 16.3 |   |   |
| Labor contingency                                    |       | (18,004                                        | )          |   | (4.7 | ) |   | 1,100 |   |   | 0.3 |   |   |
| Transaction  expense                                 |       | —                                         |       |   | 0.0 |   |   | 427 |   |   | 0.1 |   |   |
| Depreciation and  amortization                       |       | 18,678                                         |       |   | 4.8 |   |   | 17,646 |   |   | 4.5 |   |   |
| Store pre-opening  expenses                          |       | 50                                             |       |   | 0.0 |   |   | 100 |   |   | 0.0 |   |   |
| Other                                                |       | 1,102                                          |       |   | 0.3 |   |   | 1,148 |   |   | 0.3 |   |   |
| Operating income  (loss)                             |       | 4,183                                          |       |   | 1.1 |   |   | (12,111 | ) |   | (3.1 | ) |   |
| Interest expense,  net                               |       | 13,738                                         |       |   | 3.6 |   |   | 11,165 |   |   | 2.8 |   |   |
| Loss before  income taxes                            |       | (9,555                                         | )          |   | (2.5 | ) |   | (23,276 | ) |   | (5.9 | ) |   |
| Income tax provision  (benefit)                      |       | 309                                            |       |   | 0.1 |   |   | (10,474 | ) |   | (2.7 | ) |   |
| Net (loss)                                           |       | $                                              | (9,864     | ) |   | (2.6 | )% |   | $ | (12,802 | ) |   | (3.2 | )% |   |

 

Net sales were $385.9 million in the thirteenweeks ended April 1, 2006, representing a decrease of 2.3% as compared tonet sales of $394.8 million in the thirteen weeks ended March 26,2005. Resale activity accounted for a decrease of 4.2%, while retail sales tocustomers increased by 2.1% over this period. Same-store sales increased by1.8% over the first quarter last year.

Pharmacy sales decreased from $195.5 million inthe first quarter of 2005 to $179.4 million in the first quarter of 2006,a decrease of 8.2%, and represented 46.5% of total sales, as compared with49.5% of total sales in the first quarter of 2005. The overall pharmacy salesdecrease includes a decrease of 8.5% resulting from the reduced resaleactivity, offset by an increase of 0.3% in retail pharmacy sales. Pharmacysame-store sales decreased by 0.5% from last year, and third-party reimbursedpharmacy sales represented 92.6% of total prescription sales compared to 92.7%in the first quarter of 2005. Pharmacy same-store sales were adversely impactedby approximately 1.8% due to increased mail order penetration resulting fromconversion of certain third party plans to mandatory mail order requirementsand approximately 0.2% due to negative publicity and significantly reducedconsumer demand for arthritis medications and certain other high volume drugs.The percentage of generic prescriptions dispensed increased by 3.7% this year,resulting in a reduction of the pharmacy same-store sales increase byapproximately 2.3%, but an increase in gross margin per prescription dispensed.Generic prescriptions generally have lower retail sales prices but are moreprofitable than branded prescriptions.

Front-end sales increased from $199.3 million inthe first quarter of 2005 to $206.5 million in the first quarter of 2006,an increase of 3.6%, and represented 53.5% of total sales, as compared to 50.5%of total sales in the first quarter of 2005. Front-end same-store salesincreased by 3.9%, primarily due to a generally improved level of consumerdemand resulting from a stronger New York City economy and 

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increased penetration ofour Dollar Rewards customer loyalty card. Easter holiday sales benefited thefirst quarter of 2005, while these holiday sales will benefit the secondquarter of 2006.

During the thirteen weeks ended April 1, 2006, weopened one store and closed five stores, as compared to two stores opened andeight stores closed during the thirteen weeks ended March 26, 2005. At April 1,2006, we operated 247 stores, as compared to 249 stores at March 26, 2005and 251 stores at December 31, 2005.

Cost of sales as a percentage of net sales was 80.4%in the first quarter of 2006 and 81.6% in the first quarter of 2005, resultingin gross profit margins of 19.6% and 18.4%, respectively. This increase ingross profit margins was primarily attributable  to reduced lower margin pharmacy resaleactivity and improved front-end selling margins. Cost of sales also includes (i) a$0.6 million LIFO provision in the current year’s first quarter ascompared to a LIFO benefit of $0.2 million in the corresponding periodlast year, and (ii) real-estate related income of $0.1 million in thefirst quarters of both 2006 and 2005.

Selling, general and administrative expenses were$69.5 million, or 18.0% of net sales, and $64.5 million, or 16.3% of net sales,in the first quarter of 2006 and 2005, respectively. The increase in theseexpense ratios to sales as compared to the prior year was attributable to thereduced level of pharmacy resale activity as well as increased store sellingexpenses, primarily resulting from higher labor costs that resulted fromincreased pharmacist salaries as well as New York State minimum wage ratechanges that became effective on January 1, 2006.

Depreciation and amortization of capital expendituresand intangible assets amounted to $18.7 million in the first quarter of2006, as compared to $17.6 million in the first quarter of 2005. Thisincrease resulted from the depreciation of capital expenditures made in 2005and 2006 and amortization of identifiable intangibles acquired over the sameperiod.

We incurred store pre-opening expenses of$0.1 million in the first quarter of 2006, related to the opening of onestore. In the first quarter of last year, we incurred pre-opening costs of$0.1 million, attributable to the opening of two stores.

In the first quarter of 2006, we incurred otherexpenses of $1.1 million including (i) severance and other costs resultingfrom the termination of employment of two former executives ($0.3 million), (ii) OakHill management fees ($0.3 million), (iii) costs associated with variousmatters related to our former Chairman ($0.3 million) and (iv) expensesattributable to a retention bonus paid to our current CEO ($0.2 million). Inthe first quarter of 2005, other expenses of $1.1 million included (i) costsassociated with the planned transfer to the former Chairman of a Company-ownedsplit dollar life insurance policy ($0.6 million), (ii) Oak Hillmanagement fees ($0.3 million) and (iii) costs associated with the former Chairman’slong-term cash award ($0.2 million).

Net interest expense for the first quarter of 2006 was$13.7 million, as compared to $11.2 million in the first quarter of 2005.This increase was primarily attributable to higher interest rates and increaseddebt levels incurred on our revolving credit borrowings and floating rate notesas compared to the prior year. At April 1, 2006, the weighted averageinterest rate on our variable rate outstanding debt was 8.25%, as compared to aweighted average rate of 5.60% at March 26, 2005.

In the first quarter of2006, we recorded an income tax provision of $0.3 million, reflecting anestimated effective tax rate of (3.2)%. This expense is the result of avaluation allowance of $4.5 million that largely offset the tax benefitgenerated by our operating loss in the quarter. In the comparable period lastyear, the income tax benefit of $10.5 million reflected an estimatedeffective tax rate of 45.0%, inclusive of the anticipated benefits ofemployment tax credits. The employment tax credits represent the economicbenefits earned by us for our participation in various federal and state hiringincentive programs.

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**Liquidity andCapital Resources**

**Working Capital andCash Flow**

Working capital was $32.5 million as of April 1,2006 and $50.4 million as of December 31, 2005. Working capitalreflects the classification of outstanding borrowings under our revolving loanfacility of $142.2 million at April 1, 2006 and $135.7 millionat December 31, 2005 as current liabilities. This current classificationis required because cash receipts controlled by the lenders are used to reduceoutstanding debt and the Company does not meet the criteria of Statement ofFinancial Accounting Standard No. 6 “Classification of Short Term ObligationsExpected to be Refinanced” (FAS 6) to reclassify the debt as long-term, but isnot an indication that this credit facility is expected to be retired withinthe next year. This facility expires in July of 2008 and we intend tocontinue to access it for our working capital needs throughout its remainingterm.

Net cash used in operating activities was$0.2 million in the thirteen weeks ended April 1, 2006 compared to$16.7 million in the thirteen weeks ended March 26, 2005. The use ofcash in the prior year primarily reflects the $19.0 million paid to our former Chairmanin January 2005, in connection with the termination of our obligationsunder his SERP agreement.

Net cash used in investing activities was$5.5 million in the thirteen weeks ended April 1, 2006, compared to$8.0 million in the thirteen weeks ended March 26, 2005. In the firstquarter of 2006, capital expenditures, primarily related to new store openingsand the remodeling of existing locations, were $3.7 million, while leaseacquisition, pharmacy customer file and other costs were $1.8 million ofcash used in investing activities. In the first quarter of 2005, we spent$7.1 million on capital expenditures and $3.1 million on leaseacquisition, pharmacy customer file and other costs, which were partiallyoffset by $2.2 million of cash received in connection with the sale ofproperty.

Net cash provided byfinancing activities was $5.7 million in the thirteen weeks ended April 1,2006, compared to $24.7 million in the thirteen weeks ended March 26,2005. The decrease in cash provided by financing activities in the current yearreflects the reduction in cash used by operations as well as the lower level ofcash used in investing activities.

**Operating Capital Requirements**

Our operating capital requirementsprimarily result from opening and stocking new stores, remodeling andrenovating existing retail locations, purchasing pharmacy files and thecontinuing development of management information systems. We opened one newstore in the first quarter of 2006 and seven new stores during 2005, a declinefrom 16 stores opened in 2004 and 17 stores opened in 2003. Wecurrently plan to open five new stores in each of fiscal 2006 through fiscal2008. In 2005, we spent approximately $25.2 million on capital expenditures,primarily for new, renovated and replacement stores, and we spent an additional$8.5 million for lease acquisition, pharmacy customer files and othercosts. These amounts were partially offset by $7.1 million of proceeds wereceived resulting from the sale of two formerly owned properties in 2005. Wealso require working capital to support inventory for our existing and newstores. Historically, we have been able to lease almost all of our storelocations, so acquisitions of real estate are not expected to have asignificant impact on our capital requirements.

**Other FactorsInfluencing our Liquidity**

Seventeen of our stores, which generated approximately6.3% of our net sales for fiscal 2005, have leases scheduled to expire beforethe end of fiscal 2007. Eight of these leases have renewal options. We believethat we will be able to renew most of the other expiring leases on economicallyfavorable terms or, alternatively, find other economically attractive locationsto lease.

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As of April 1, 2006, approximately 4,300 of ourapproximately 6,000 employees were represented by various labor unions and werecovered by collective bargaining agreements. Pursuant to the terms of thecollective bargaining agreements covering these employees, we are required, insome instances, to pay specified annual increases in salary and benefitscontributions relating to the member employees. We do not believe that theseincreases will have a material impact on our liquidity or results ofoperations.

Effective April 1, 2006, the Company and Local338 have agreed to the Local 338 Collective Bargaining Agreement (the “Local338 CBA”). The Local 338 CBA covers all of the Company’s clerks, cashiers,pharmacy clerks, pharmacy technicians and photo technicians at 141 of its stores.This agreement was ratified by the union membership on April 13, 2006. TheLocal 338 CBA will expire on March 31, 2009.

Effective April 1, 2006, the Company and Local 340ANew York Joint Board UNITE HERE! have entered into the UNITE Collective BargainingAgreement (the “UNITE CBA”). The UNITE CBA covers clerks, cashiers, pharmacyclerks, pharmacy technicians and photo technicians at 110 of the Company’slocations. This agreement will expire on March 31, 2009.

Effective September 1, 2005, Duane Reade andLocal 210, International Brotherhood of Teamsters agreed on a successorcollective bargaining agreement which will expire on August 31, 2008.Local 210 represents approximately 300 employees in our Maspeth, New York andNorth Bergen, New Jersey warehouse facilities.

Thefollowing table presents details of our significant Commitments and Obligationsas at April 1, 2006, except that the data provided with respect tooperating leases is as of December 31, 2005:

| ** **                                           | ** ** | **Payments due by Period** | ** ** |
|------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                           | ** ** | **(dollars in thousands)**      | ** ** |
| **Contractual Cash Obligations**           | ** ** | ** **                                | ** ** | **Total** | ** ** | **Within  1 year** | ** ** | **Within  2-3 years** | ** ** | **Within  4-5 years** | ** ** | **After  5 years** | ** ** |
| Long-Term Debt(1)(2)                                 |       | $                                         | 547,240    |   | $ | — |   | 142,208 |   | $ | 210,000 |   | $ | 195,032 |   |
| Capital Lease Obligations(3)                         |       | 15,969                                    |       | 4,716 |   | 8,350 |   | 2,903 |   | — |   |
| Operating Leases(4)                                  |       | 1,282,765                                 |       | 122,879 |   | 242,190 |   | 220,509 |   | 697,187 |   |
| Fixed Interest Payments(5)                           |       | 104,570                                   |       | 19,013 |   | 38,025 |   | 38,025 |   | 9,507 |   |
| Former Chairman and Other Severance Payments(6) |       | 4,464                                     |       | 2,643 |   | 1,821 |   | — |   | — |   |
| Former Pharmacy Supplier Settlement(7)               |       | 2,500                                     |       | 2,250 |   | 250 |   | — |   | — |   |
| Labor Union Fund Settlement(8)                       |       | 1,400                                     |       | 1,400 |   | — |   | — |   | — |   |
| Executive Guaranteed Bonus(9)                        |       | 825                                       |       | 825 |   | — |   | — |   | — |   |
| Total Contractual  Cash Obligations                  |       | $                                         | 1,959,733  |   | $ | 153,726 |   | $ | 432,844 |   | $ | 471,437 |   | $ | 901,726 |   |
|                                                      |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          These amounts include$195.0 million of outstanding senior subordinated notes due in 2011,$210.0 million of outstanding senior secured floating rate notes due in2010, $142.2 million outstanding under the amended asset-based revolvingloan facility due in 2008, and $32,000 outstanding under the senior convertiblenotes due in 2022. At April 1, 2006, a further $76.2 million wasavailable for borrowing under the amended asset-based revolving loan facility.For more information about the terms of the indebtedness described above,please see “—Debt,” below.

(2)          At April 1, 2006,approximately $142.2 million was outstanding under our 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 FAS 6 toreclassify the debt as long-term, however this is not an indication that thiscredit facility is expected to be retired within the next year. We intend tocontinue to use this facility for our working capital needs through the date ofits maturity in July 2008.

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

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

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

(6)          Reflects payments due toour former Chairman in connection with his replacement on November 21,2005, as well as payments due to other senior executives whose employment wasterminated during the first quarter of 2006.

(7)          Reflects cash paymentsdue to Cardinal Health, a former pharmacy inventory supplier, in fullsettlement of all outstanding claims. Amounts shown are net of $2.0 millionthat was paid on January 15, 2006.

(8)          Reflectscash payments due to union benefit funds as a result of Kroop litigationsettlement. See Note 9 of the Unaudited Consolidated Interim FinancialStatements included elsewhere in this document for further information on thismatter.

(9)   Reflectsguaranteed bonus payable to our current CEO in accordance with the provisionsof his employment agreement.

The following table presents details of our othersignificant Commercial Commitments as at April 1, 2006:

| ** **                                 | ** ** | ** **                           | **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)              |       |                                 | $                                                                       | 6,626                             |   |   |   | $ | 6,355 |   |   |   | $ | 271 |   |   |   | $ | — |   |   |   | $ | — |   |   |
| Total Commercial  Commitments              |       |                                 | $                                                                       | 6,626                             |   |   |   | $ | 6,355 |   |   |   | $ | 271 |   |   |   | $ | — |   |   |   | $ | — |   |   |
|                                            |            |                                      |                                                                         |                                   |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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

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

In connection with the November 21, 2005replacement of our former Chairman, we expect to pay to him amounts in cashtotaling $6.6 million. We have paid a cumulative total of $2.5 million of thisamount through April 1, 2006, and we expect to pay the remaining amount inequal installments over the 21 months remaining through December 15, 2007. Inaddition, we expect to continue to provide health insurance coverage for ourformer Chairman during the period in which he will receive severance paymentsand, upon expiration of that period, if he is not otherwise eligible underanother employer’s comparable medical plan, to provide him with lifetimeretiree medical benefits at a cost not to exceed $50,000 annually.

In connection with the appointment of Mr. Dreiling,we were required under his employment contract to make a guaranteed payment tohim of $330,000 on or before February 19, 2006, which was paid on February 17,2006. In addition, Mr. Dreiling’s employment contract stipulates that aguaranteed 2006 bonus of not less that 100% of his current $825,000 annualsalary be paid on the same date as any other 

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senior executive bonusesrelated to the 2006 fiscal year are paid, which we expect will occur in thefirst quarter of 2007.

In connection with the Acquisition, our formerChairman was granted equity interests in Duane Reade Shareholders and DuaneReade Holdings, consisting of options to purchase shares of our common stockand a profits interest in Duane Reade Shareholders. As a result of the November 21,2005 replacement of our former Chairman, he had the right to require us topurchase for cash to be paid over a two year period all or a portion of theseequity interests as he may designate, at a value determined in accordance witha formula. Under the provisions of his employment agreement, all of his equityinterests became fully vested in December 2005. In addition, his stockoptions expired unexercised on March 21, 2006. The profits interest willhave no value unless the value of Duane Reade Shareholders appreciates followingthe Acquisition. Our former Chairman’s purchase right will be suspended at anytime when the exercise of such purchase rights would result in a default underthe financing arrangements of Duane Reade Shareholders, Duane Reade Holdings orDuane Reade Inc. On December 21, 2005, our former Chairman providednotice to Duane Reade Inc. that he was exercising his repurchase right to causeus to repurchase 5% of his profits interest. Pursuant to the proceduresoutlined in his employment agreement, Duane Reade Inc. has advised our formerChairman that the value of his profits interest as of December 21, 2005was determined to equal zero. An investment bank mutually acceptable to DuaneReade Inc. and our former Chairman will make a final determination of the valueof the profits interest as of December 21, 2005.

In connection with the December 9,2005 settlement of litigation between us and Cardinal Health, we are requiredto make payments to Cardinal Health totaling $4.5 million over the periodcommencing on January 15, 2006 through June 15, 2007, including aninitial payment of $2.0 million that was paid on January 15, 2006 andsubsequent payments of $1.0 million each on June 15, 2006 and December 15,2006 and $250,000 each on March 15, 2007 and June 15, 2007. All suchamounts had been previously accrued in the financial statements.

**Debt**

Refer to Note 7 of theUnaudited Consolidated Interim Financial Statements contained elsewhere in thisdocument for a detailed description with respect to the various components ofour debt structure.

**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 amended asset-based revolving loan facility, will beadequate for the next two years to make required payments on our indebtedness,to fund anticipated capital expenditures and to satisfy our working capitalrequirements. We base this belief on our recent levels of cash flow fromoperations of 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 our former Chairman’s SERP),$11.3 million in 2004 (which includes the absorption of $40.6 millionin Acquisition-related costs), projected improvements in working capitalmanagement, anticipated levels of capital expenditures and the additionalborrowing capacity under the $225.0 million amended asset-based revolvingloan facility, which was approximately $76.2 million at 

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April 1,2006. Our ability to meet our debt service obligations and reduce our totaldebt will depend upon our future performance which, in turn, will be subject togeneral economic, financial, business, competitive, legislative, regulatory andother conditions, many of which are beyond our control. In addition, ouroperating results, cash flow and capital resources may not be sufficient forrepayment of our indebtedness in the future. Some risks that could adverselyaffect our ability to meet our debt service obligations include, but are notlimited to, reductions in third party prescription reimbursement rates,declines in the New York City economy, increases in competitive activity,adverse changes in vendor credit terms, changes in drug consumption patterns,additional adverse legislative changes or a major disruption of business in ourmarkets from a terrorist event, natural disaster or other unexpected events.Other factors that may adversely affect our ability to service our debt aredescribed above under “Special Note Regarding Forward-Looking Statements.”Borrowings under the amended asset-based revolving loan facility and theaggregate $210.0 million senior secured floating rate notes bear interestat floating rates. Therefore, our financial condition will be affected bychanges in prevailing interest rates. On May 25, 2005, we entered into ahedging transaction through the acquisition of a “no cost collar.”  Under this arrangement, we capped ourexposure on $130 million of LIBOR-based borrowings under the floating ratenotes 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 financial statementsthat are prepared based on certain critical accounting policies that requiremanagement to make judgments and estimates that are subject to varying degreesof uncertainty. We believe that investors need to be aware of these policiesand 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 the yearended December 31, 2005 are those that depend most heavily on thesejudgments and estimates. At April 1, 2006, there have been no materialchanges to any of the Critical Accounting Policies contained therein.

**Off-Balance SheetArrangements**

We are not a party to any agreementswith, or commitments to, any special purpose entities that would constitutematerial off-balance sheet financing other than the operating lease commitmentsdetailed in the Contractual Obligations and Commitments table presented 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 the timingof certain holidays, the timing of new store openings and the sale of seasonalproducts, with the Christmas holiday season normally generating a higherproportion of sales and earnings than other periods.

**Inflation**

We believe that inflationhas not had a material impact on our results of operations during the threeyears ended December 31, 2005 or the three months ended April 1,2006.

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**Recently IssuedAccounting Pronouncements**

Refer to Note 2 of theUnaudited Consolidated Interim Financial Statements included elsewhere in thisdocument for a detailed description of various recently issued accountingpronouncements.

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

Our financial results are subject to risk frominterest rate fluctuations on debt, which carries variable interest rates.Variable rate debt outstanding at April 1, 2006 included$142.2 million of borrowings under our amended asset-based revolving loanfacility and $210.0 million of senior secured floating rate notes. At April 1,2006, the weighted average combined interest rate in effect on all variablerate debt outstanding was 8.25%. A 0.50% change in interest rates applied tothe $352.2 million balance of floating rate debt would affect pre-taxannual results of operations by approximately $1.8 million. In addition,we also have $195.0 million of Senior Subordinated Notes and $32.0thousand of Senior Convertible Notes outstanding at March 26, 2005. TheSenior Subordinated Notes and Senior Convertible Notes bear interest payablesemi-annually at fixed rates of 9.75% and 3.75%, respectively, and aretherefore not subject to risk from interest rate fluctuations.

On May 25, 2005, we entered into a hedging transactionthrough the acquisition of a “no cost collar.” Under this arrangement, wecapped our exposure on $130 million of LIBOR-based borrowings under the seniorsecured notes at a maximum LIBOR rate of 5.30%. In addition, we established aminimum “floor” LIBOR rate of 3.45%, in line with then current LIBOR rates.This hedging arrangement expires on June 16, 2008.

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.

**ITEM 4.**                CONTROLSAND PROCEDURES

(a) *Evaluationof Disclosure Controls and Procedures*.   An evaluation wascarried out under the supervision and with the participation of the Company’smanagement, including the Chief Executive Officer and Chief Financial Officer,of the effectiveness of the design and operation of our disclosure controls andprocedures (as defined in Rules 13a-15(e) or 15d-15(e) under theSecurities Exchange Act of 1934) as of the end of the period covered by thisquarterly report. Based upon that evaluation, the Company’s management,including the Chief Executive Officer and Chief Financial Officer, have eachconcluded that the design and operation of these disclosure controls andprocedures were effective as of the end of the period covered by this report.

(b) *Changes inInternal Controls over Financial Reporting*.   During the mostrecent fiscal quarter, there have not been any significant changes in ourinternal controls over financial reporting or in other factors that that havematerially affected, or are reasonably likely to materially affect, ourinternal controls over financial reporting.

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**PART II**

**OTHER INFORMATION**

**ITEM 1.**                LegalProceedings

Refer to Note 9 of theUnaudited Consolidated Interim Financial Statements included elsewhere in thisdocument for a detailed description of the various legal proceedings in whichwe 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 31, 2005. 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

Not applicable.

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

Not applicable.

**ITEM 5.**                OtherInformation

Not applicable.

**ITEM6.**                Exhibits
| Exhibit No. | ** ** | **Description**                                                                                                      |
|------------------|------------|----------------------------------------------------------------------------------------------------------------------|
| 10.23*           |       | Agreement, dated April 1, 2006, between Duane  Reade Inc. and Local 338.                                        |
| 10.24*           |       | Agreement, dated April 1, 2006, between Duane  Reade Inc. and Local 340A New York Joint Board, UNITE HERE. |
| 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:   May 16,  2006 |                                                                                               |
|--------------------------------------------|----------------------------------------------------------------------------------------------------|
| ** **                                 | **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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