**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 September 30, 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 mark whether the registrant: (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.

Yes x   No o

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer or a non-accelerated filer, asdefined in Rule 12b-2 of the Exchange Act (check one):

Large acceleratedfiler o      Acceleratedfiler o      Non-acceleratedfiler x

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

Yes o   No x

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

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

 

----

**INDEX**

| PART I—FINANCIAL  INFORMATION                                                                                                                      |   | 5  |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----|
| ITEM  1.—FINANCIAL STATEMENTS                                                                                                                           |   | 5  |
| Consolidated Statements of Operations (Unaudited)—For  the 13 and 39 Weeks Ended September 30, 2006 and September 24, 2005                    |   | 5  |
| Consolidated Balance Sheets (Unaudited)—As of  September 30, 2006 and December 31, 2005                                                       |   | 6  |
| Consolidated Statements of Cash Flows (Unaudited)—For  the 39 Weeks Ended September 30, 2006 and September 24, 2005                           |   | 7  |
| Consolidated Statements of Comprehensive Loss  (Unaudited)—For the 13 and 39 Weeks Ended September 30, 2006  and September 24, 2005 |   | 8  |
| Notes to Consolidated Financial Statements (Unaudited)                                                                                                       |   | 9  |
| ITEM 2.—MANAGEMENT’ DISCUSSION AND ANALYSIS OF  FINANCIAL CONDITION AND RESULTS OF OPERATIONS                                                 |   | 31 |
| ITEM 3.—QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT  MARKET RISK                                                                                     |   | 47 |
| ITEM 4.—CONTROLS AND PROCEDURES                                                                                                                         |   | 47 |
| PART II—OTHER  INFORMATION                                                                                                                         |   | 49 |
| SIGNATURES                                                                                                                                                   |   | 50 |

 

2

----

**SPECIAL NOTEREGARDING FORWARD-LOOKING STATEMENTS**

This and other ofour public filings or public statements contain forward-looking statementswithin the meaning of Section 27A of the Securities Act, Section 21Eof the Securities Exchange Act and the Private Securities Litigation Reform Actof 1995, that involve a number of risks and uncertainties. These statementsrelate to future events or our future financial performance with respect to ourfinancial condition, results of operations, business plans and strategies,operating efficiencies or synergies, competitive positions, growthopportunities for existing products such as private label merchandise, plansand objectives of management, capital expenditures, growth and maturation ofour stores and other matters. These statements involve known and unknown risks,uncertainties and other factors that may cause our or our industry’s actualresults, levels of activity, performance or achievements to be materiallydifferent from those expressed or implied by any forward-looking statements. Insome cases, you can identify forward-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 thenegative of those terms or other comparable terminology. These statements areonly predictions and such expectations may prove to be incorrect. Some of thethings that could cause our actual results to differ substantially from ourexpectations are:

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

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

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

·       our significantindebtedness and the related impact of variable interest rates;

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

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

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

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

·       changes in the cost ofgoods and services;

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

·       employment disputes andlabor relations;

3

----

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

·       our ability to successfullyexecute the various objectives of the recently implemented “Duane Reade FullPotential” sales growth and profit enhancement program;

·       liability and other claimsasserted against us, including the items discussed under “Business—LegalProceedings”;

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

·       changes in our operatingstrategy or development plans;

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

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

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

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

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

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

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

·       our ability to limit fraudand shrink;

·       demographic changes; and

·       other risks anduncertainties detailed elsewhere in this filing and from time to time in ourother 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.

4

----

**PART I—FINANCIALINFORMATION**

**ITEM 1. FINANCIALSTATEMENTS**

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

| ** **                                           | ** ** | **For the 13 Weeks Ended** | ** ** | **For the 39 Weeks Ended** | ** ** |
|------------------------------------------------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                           | ** ** | **Sept 30, 2006**                    | ** ** | **Sept 24, 2005**                    | ** ** | **Sept 30, 2006** | ** ** | **Sept 24, 2005** | ** ** |
| Net sales                                            |       |                                           | $          | 385,655                                        |       |   |   | $ | 378,557 |   |   |   | $ | 1,170,313 |   |   |   | $ | 1,172,824 |   |   |
| Cost of sales                                        |       |                                           | 305,016    |                                           |       |   | 305,866 |   |   |   | 933,114 |   |   |   | 948,729 |   |   |
| Gross profit                                         |       |                                           | 80,639     |                                           |       |   | 72,691 |   |   |   | 237,199 |   |   |   | 224,095 |   |   |
| Selling,  general & administrative expenses |       |                                           | 67,077     |                                           |       |   | 67,950 |   |   |   | 204,689 |   |   |   | 196,990 |   |   |
| Labor contingency  expense                           |       |                                           | —     |                                           |       |   | 1,100 |   |   |   | (18,004 | ) |   |   | 3,300 |   |   |
| Transaction  expense                                 |       |                                           | —     |                                           |       |   | 236 |   |   |   | — |   |   |   | 817 |   |   |
| Depreciation and  amortization                       |       |                                           | 16,903     |                                           |       |   | 17,816 |   |   |   | 54,209 |   |   |   | 53,313 |   |   |
| Store pre-opening  expenses                          |       |                                           | 153        |                                           |       |   | 114 |   |   |   | 305 |   |   |   | 264 |   |   |
| Other                                                |       |                                           | 148        |                                           |       |   | 1,454 |   |   |   | 1,783 |   |   |   | 4,636 |   |   |
| Operating loss                                       |       |                                           | (3,642     | )                                              |       |   | (15,979 | ) |   |   | (5,783 | ) |   |   | (35,225 | ) |   |
| Interest expense,  net                               |       |                                           | 14,356     |                                           |       |   | 12,654 |   |   |   | 42,229 |   |   |   | 35,318 |   |   |
| Loss before  income taxes                            |       |                                           | (17,998    | )                                              |       |   | (28,633 | ) |   |   | (48,012 | ) |   |   | (70,543 | ) |   |
| Income tax  provision (benefit)                      |       |                                           | 734        |                                           |       |   | (12,885 | ) |   |   | 1,661 |   |   |   | (31,704 | ) |   |
| Net loss                                             |       |                                           | $          | (18,732                                        | )          |   |   | $ | (15,748 | ) |   |   | $ | (49,673 | ) |   |   | $ | (38,839 | ) |   |

 

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

5

----

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

| ** **                                                                                       | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                       | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| **ASSETS**                                                                                       | ** ** |                   | ** ** | ** **            |       |   | ** ** | ** ** |   |
| Current Assets                                                                                   |       |                   |       |                  |       |   |   |   |   |
| Cash                                                                                             |       |                   | $          | 1,366                 |       |   |   | $ | 1,362 |   |   |
| Receivables, net                                                                                 |       |                   | 47,173     |                  |       |   | 52,320 |   |   |
| Inventories                                                                                      |       |                   | 230,754    |                  |       |   | 235,639 |   |   |
| Deferred income  taxes                                                                           |       |                   | 4,873      |                  |       |   | 7,717 |   |   |
| Prepaid expenses  and other current assets                                                       |       |                   | 26,039     |                  |       |   | 26,114 |   |   |
| TOTAL CURRENT  ASSETS                                                                            |       |                   | 310,205    |                  |       |   | 323,152 |   |   |
| Property and  equipment, net                                                                     |       |                   | 215,728    |                  |       |   | 229,134 |   |   |
| Goodwill                                                                                         |       |                   | 72,029     |                  |       |   | 67,791 |   |   |
| Other assets, net                                                                                |       |                   | 227,420    |                  |       |   | 251,341 |   |   |
| TOTAL ASSETS                                                                                     |       |                   | $          | 825,382               |       |   |   | $ | 871,418 |   |   |
| **LIABILITIES AND STOCKHOLDER’S EQUITY**                                                    | ** ** |                   | ** ** | ** **            |       |   | ** ** | ** ** |   |
| Current Liabilities                                                                              |       |                   |       |                  |       |   |   |   |   |
| Accounts payable                                                                                 |       |                   | $          | 85,569                |       |   |   | $ | 72,711 |   |   |
| Accrued interest                                                                                 |       |                   | 4,549      |                  |       |   | 9,222 |   |   |
| Accrued expenses                                                                                 |       |                   | 36,639     |                  |       |   | 51,959 |   |   |
| Current portion  of debt                                                                         |       |                   | 164,918    |                  |       |   | 135,693 |   |   |
| Current portion  of capital lease obligations                                                    |       |                   | 3,209      |                  |       |   | 3,183 |   |   |
| TOTAL CURRENT  LIABILITIES                                                                       |       |                   | 294,884    |                  |       |   | 272,768 |   |   |
| Long-term debt                                                                                   |       |                   | 405,032    |                  |       |   | 405,032 |   |   |
| Capital lease  obligations, less current portion                                                 |       |                   | 7,939      |                  |       |   | 10,314 |   |   |
| Deferred income  taxes                                                                           |       |                   | 30,682     |                  |       |   | 32,117 |   |   |
| Other non-current  liabilities                                                                   |       |                   | 52,430     |                  |       |   | 67,265 |   |   |
| TOTAL LIABILITIES                                                                                |       |                   | 790,967    |                  |       |   | 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                                                                      |       |                   | 211        |                  |       |   | — |   |   |
| Accumulated other  comprehensive income                                                          |       |                   | 216        |                  |       |   | 260 |   |   |
| Accumulated  deficit                                                                             |       |                   | (205,510   | )                     |       |   | (155,836 | ) |   |
| TOTAL STOCKHOLDER’S  EQUITY                                                                 |       |                   | 34,415     |                  |       |   | 83,922 |   |   |
| TOTAL LIABILITIES AND  STOCKHOLDER’S EQUITY                                                 |       |                   | $          | 825,382               |       |   |   | $ | 871,418 |   |   |

 

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

6

----

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

| ** **                                                                        | ** ** | **For the 39 Weeks Ended** | ** ** |
|-----------------------------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                                        | ** ** | **Sept. 30, 2006**                   | ** ** | **Sept. 24, 2005** | ** ** |
| Cash flows used in  operating activities:                                         |       |                                           |       |   |   |
| Net loss                                                                          |       | $                                              | (49,673    | ) | $ | (38,839 | ) |
| Adjustments to reconcile  net loss to net cash used in operating activities: |       |                                           |       |   |   |
| Depreciation and  amortization                                                    |       | 57,245                                         |       | 56,082 |   |
| Deferred income  taxes                                                            |       | 1,409                                          |       | (31,744 | ) |
| Non-cash rent  expense                                                            |       | 7,681                                          |       | 10,132 |   |
| Other non-cash  expense                                                           |       | 211                                            |       | (2,104 | ) |
| Change in operating  assets and liabilities (net of the effect of acquisitions):  |       |                                           |       |   |   |
| Receivables                                                                       |       | 5,147                                          |       | 3,898 |   |
| Inventories                                                                       |       | 4,885                                          |       | 4,466 |   |
| Accounts payable                                                                  |       | 12,858                                         |       | (6,589 | ) |
| Prepaid and  accrued expenses                                                     |       | (19,443                                        | )          | (12,088 | ) |
| Other assets and  liabilities, net                                                |       | (25,610                                        | )          | 6,274 |   |
| NET CASH USED IN  OPERATING ACTIVITIES                                            |       | (5,290                                         | )          | (10,512 | ) |
| Cash flows used  in investing activities:                                         |       |                                           |       |   |   |
| Capital  expenditures                                                             |       | (18,152                                        | )          | (18,386 | ) |
| Lease acquisition,  customer file and other expenditures                          |       | (5,226                                         | )          | (6,904 | ) |
| Proceeds from  sale of assets                                                     |       | 2,500                                          |       | 7,069 |   |
| NET CASH USED IN  INVESTING ACTIVITIES                                            |       | (20,878                                        | )          | (18,221 | ) |
| Cash flows from  financing activities:                                            |       |                                           |       |   |   |
| Proceeds from Senior Secured Notes                                                |       | —                                         |       | 47,860 |   |
| Borrowings from  revolving credit facility                                        |       | 1,383,370                                      |       | 1,339,509 |   |
| Repayments of  revolving credit facility                                          |       | (1,354,145                                     | )          | (1,353,619 | ) |
| Repayments of  capital lease obligations                                          |       | (2,349                                         | )          | (2,083 | ) |
| Deferred  financing costs                                                         |       | (704                                           | )          | (2,942 | ) |
| NET CASH PROVIDED  BY FINANCING ACTIVITIES                                        |       | 26,172                                         |       | 28,725 |   |
| Net increase (decrease) in cash                                                   |       | 4                                              |       | (8 | ) |
| Cash at beginning  of period                                                      |       | 1,362                                          |       | 1,329 |   |
| Cash at end of period                                                             |       | $                                              | 1,366      |   | $ | 1,321 |   |

 

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

7

----

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

| ** **                                    | ** ** | **For the 13 Weeks Ended** | ** ** | **For the 39 Weeks Ended** | ** ** |
|-----------------------------------------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                    | ** ** | **Sept. 30,**                             | ** ** | **Sept. 24,**                             | ** ** | **Sept. 30,** | ** ** | **Sept. 24,** | ** ** |
| ** **                                    | ** ** | **2006**                                       | ** ** | **2005**                                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net loss                                      |       | $                                              | (18,732    | )                                              | $          | (15,748 | ) | $ | (49,673 | ) | $ | (38,839 | ) |
| Change in fair  value of interest rate collar |       | (818                                           | )          | 81                                             |       | (46 | ) | 74 |   |
| Total other  comprehensive income (loss)      |       | (818                                           | )          | 81                                             |       | (46 | ) | 74 |   |
| Total comprehensive loss                      |       | $                                              | (19,550    | )                                              | $          | (15,667 | ) | $ | (49,719 | ) | $ | (38,765 | ) |

 

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

8

----

**Notes to Unaudited Consolidated Interim FinancialStatements(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 Company, along with certain of its subsidiaries,is a guarantor of the debt obligations of Duane Reade Inc. and DuaneReade, the New York general partnership that holds the operating assets andliabilities (“Duane Reade GP”). The Company has no assets or operationsother than its investment in its subsidiaries. The guarantees provided by theCompany and its other subsidiaries under the debt obligations of Duane Reade Inc.and Duane Reade GP are full and unconditional, joint and several.

The Unaudited ConsolidatedInterim Financial Statements included herein reflect all adjustments which, inthe opinion of management, are necessary to present a fair statement of the resultsof operations, financial position, cash flows and comprehensive loss of theCompany, and have been prepared, in all material respects, in accordance withthe 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 theaccounts of the Company and its subsidiaries. All significant intercompanytransactions and balances have been eliminated. The results for the interimperiods presented are not necessarily indicative of the results expected forthe full year.

**The Audit Committee of the Company,with the assistance of independent counsel, conducted a review andinvestigation of the fiscal periods from 2000 through September 30, 2006, relatingto arrangements originated by the former CEO for the issuance of impropercredits and the subsequent rebilling of such credits related to amounts paid toconstruction and other contractors at its stores and the related improperaccounting. The Audit Committee has completed its investigation.**

9

----

**Theinvestigation focused principally on the accounting impact of approximately$5.8 million of credits from construction contractors that were improperly takeninto the Company’s income and offsetting rebillings which were improperlyrecorded as capital expenditures in subsequent quarters by the Company.  The following table summarizes suchconstruction credits identified in the investigation, by period (dollars inthousands):**

| **Fiscal Period**                           | ** ** | ** ** | ** ** | **Amount of  Credits** | ** ** |
|--------------------------------------------------|------------|------------|------------|-----------------------------|------------|
| 2000 Fiscal Year  (Predecessor)                  |       |       | $          | 317                         |       |   |
| 2001 Fiscal Year  (Predecessor)                  |       |       | 1,386      |                        |       |
| 2002 Fiscal Year  (Predecessor)                  |       |       | 3,060      |                        |       |
| 2003 Fiscal Year  (Predecessor)                  |       |       | 752        |                        |       |
| Seven months ended July  30, 2004 (Predecessor)  |       |       | —     |                        |       |
| Five months ended  December 25, 2004 (Successor) |       |       | 297        |                        |       |
| 2005 Fiscal Year  (Successor)                    |       |       | —     |                        |       |
| 39 weeks ended September  30, 2006 (Successor)   |       |       | —     |                        |       |
| Total                                            |       |       | $          | 5,812                       |       |   |

 

**TheAudit Committee believes that all of such credits were subsequently rebilled bythe contractors and that the Company paid the contractors such rebilled amounts.**

**The credits had the effect of improperlyoffsetting SG&A expense (and improperly increasing net income) during theperiods in which they were received. Amounts subsequently rebilled by the Company were generally capitalizedas store improvements, improperly increasing the reported level of property andequipment as well as subsequent depreciation expense.  The overstated net property and equipmentthat resulted from the credit/rebilling practice was also carried through theAcquisition-related purchase accounting process on a dollar-for-dollar basis.**

**In the periods from fiscal 2000through the seven months ended July 30, 2004, increased depreciation resultedin a partial offset and understatement of operating income and income beforeincome taxes.  In the periods subsequentto July 30, 2004, increased depreciation resulted in an overstatement ofoperating loss and loss before income taxes. Income tax expense may also have been reduced as a result, based on thetax impact of such depreciation expense. Due to tax valuation reserves beingrecorded during 2006, there would not be any impact upon income tax expense forthe 2006 periods.**

Net income (loss) for all of the above periods wouldreflect the combined impact of the overstatement or understatement of income(loss) before income taxes and any related****changes inincome tax expense (benefit).

**The correction of the cumulativeeffect of the credits and re-billings on the Company’s results of operations isincluded in the results for the thirteen and thirty-nine weeks endedSeptember 30, 2006 presented in this report. These corrections resulted inthe following adjustments (dollars in thousands):**

**Depreciation and amortization wasreduced by $960**

**Operating loss decreased by $960**

**Loss before income taxes decreasedby $960**

**Net loss decreased by $960**

**The credit/rebilling practiceresulted in the overstatement of net property and equipment in all periodssince the re-billings occurred. As a result of the overstatement of netproperty and equipment and related purchase accounting adjustments made inconnection with the Acquisition, goodwill was also understated. The correctionof the cumulative effect of the credits and re-billings on the Company’sbalance sheet at September 30, 2006 is reflected in the balance sheetpresented in this report. These corrections resulted in the followingadjustments (dollars in thousands):**

10

----

**Net property, plant and equipmentwas reduced by $3,278**

**Goodwill increased by $4,238**

**Stockholder’s equity increased by$960**

**These corrections had no impact uponnet cash used in operating, investing or financing activities.**

**The credit/rebilling practice hasnot had any effect on the Company’s revenues or liquidity.  In addition, the Audit Committee hasdetermined that, as a result of the July 30, 2004 Acquisition and the relatedpurchase accounting adjustments, the credit/rebilling practice and theassociated misstatements have not had a material effect on the Company’sfinancial condition or results of operations for any periods subsequent to theAcquisition, including the 13 weeks and 39 weeks ended September 24, 2005 andSeptember 30, 2006 and that no restatements of any previously issuedpost-Acquisition financial statements will be necessary. With respect to the predecessorperiods prior to the Acquisition, the Audit Committee has concluded that, inview of the disclosure provided in this footnote and in Management’s Discussionand Analysis of Financial Condition and Results of Operations included in itsReport on Form 10-Q for the quarter and nine months endedSeptember 30, 2006 regarding the credit/rebilling practice and theassociated misstatements (including the adjustments disclosed in thisfootnote), the fact that there are no longer any public stockholders as aresult of the purchase of all the common equity of the Company’s predecessor byOak Hill in July 2004 and other factors, restatement of previously-issued predecessor financial statements wouldnot be material to the Company’s public securityholders. Therefore, the AuditCommittee has determined that restatements of previously issued predecessorfinancial statements as a result of the credit/rebilling practice will also notbe necessary.**

In addition, as a part ofits investigation, the Audit Committee also examined certain invoices fromstore maintenance and other contractors to determine whether the amounts paidto those contractors were accounted for properly. Having completed itsinvestigation with respect to those invoices, the Audit Committee has concludedthat any misstatements with respect to such invoices were inconsequential.

**2. Recently IssuedAccounting Pronouncements**

In December 2004, the Financial AccountingStandards Board (FASB) issued Statement of Financial Accounting Standard No. 123(R),Share-Based Payment (“SFAS No. 123(R)”). This statement establishedstandards for the accounting for transactions in which an entity exchanges itsequity instruments for goods or services. The statement focuses primarily onaccounting for transactions in which an entity obtains employee services inshare-based transactions. The Company adopted the provisions of this statementeffective January 1, 2006. As a result, the interim financial statementsincluded herein for the thirteen and thirty-nine weeks ended September 30,2006 reflect pre-tax compensation expense of approximately $0.1 million and$0.2 million, respectively, attributable to the vested portion of stock optionsgranted after the adoption date. Based on the number of options granted afterthe adoption date, the Company expects to incur total stock option compensationexpenses of approximately $0.3 million in 2006.

In June 2005, the FASB issued SFAS No. 154,Accounting Changes and Error Corrections (“SFAS No. 154”), whichrequires 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 supersedesAccounting Principles 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 accountingprinciple and the “restatement” of financial statements to reflect thecorrection of an error. Another significant change in practice under SFAS No. 154is that if an entity changes its method of depreciation, amortization, ordepletion for long-lived, non-financial assets, the change must be accountedfor as a change in accounting estimate. Under APB No. 20, such a changewould have been reported as a 

11

----

change in accountingprinciple. SFAS No. 154 applies to accounting changes and errorcorrections that are made in fiscal years beginning after December 15,2005.

In February 2006, the FASB issued SFAS No. 155,Accounting for Certain Hybrid Instruments (“SFAS No. 155”), which amendsSFAS No. 133, Accounting for Derivative Instruments and HedgingActivities, and SFAS No. 140, Accounting for Transfers and Servicing ofFinancial Assets and Extinguishments of Liabilities. SFAS No. 155 allowsfinancial instruments that have embedded derivatives to be accounted for as awhole (eliminating the need to bifurcate the derivative from its host) if theholder elects to account for the whole instrument on a fair value basis. SFAS No. 155also clarifies and amends certain other provisions of SFAS No. 133 andSFAS No. 140. This statement is effective for all financial instrumentsacquired or issued in fiscal years beginning after September 15, 2006. TheCompany does not expect that SFAS No. 155 will have a material effect onits consolidated financial statements.

In June 2006, the FASB issued Interpretation No. 48,Accounting for Uncertainty in Income Taxes (“FIN 48”), an interpretation ofStatement of Financial Accounting Standards No. 109, Accounting for IncomeTaxes (“FAS 109”). FIN 48 clarifies the accounting for uncertainty in incometaxes by prescribing a recognition threshold for tax positions taken orexpected to be taken in a tax return. FIN 48 is effective for fiscal yearsbeginning after December 15, 2006. The Company is currently evaluating theimpact FIN 48 will have on its financial position and results of operations.

In September 2006, the Securities and ExchangeCommission issued Staff Accounting Bulletin (“SAB”) No. 108, “Considering theEffects of Prior Year Misstatements when Quantifying Misstatements in CurrentYear Financial Statements.” SAB No. 108 requires misstatements to be quantifiedbased on their impact on each of the financial statements and relateddisclosures. SAB No. 108 is effective for fiscal years ending after November15, 2006. The Company is currently evaluating the impact that SAB No. 108 mayhave on its consolidated results of operations and financial position. 

In September 2006, theFASB issued SFAS No. 158, “Employer’s Accounting for Defined Benefit Pensionand Other Postretirement Plans-an amendment of FASB Statements No. 87, 88, 106,and 132(R).” SFAS No. 158 requires an employer to recognize in its statement offinancial position an asset for a plan’s overfunded status or a liability for aplan’s underfunded status, measure a plan’s assets and its obligations thatdetermine its funded status as of the end of the employer’s fiscal year, andrecognize changes in the funded status of a defined benefit postretirement planin the year in which the changes occur. SFAS No. 158 is effective for fiscalyears ending after December 15, 2006. The Company does not expect that SFAS No.158 will have a material effect on its consolidated results of operations andfinancial position. 

**3.**                 Stock-BasedPayment

Effective January 1,2006, the Company adopted the fair value recognition provisions of SFAS No. 123(R),using the prospective transition method. Under that transition method,compensation expense recognized for the thirty-nine weeks ended September 30,2006 includes the vested portion of share-based payments granted on or after January 1,2006 based on the grant-date fair value estimated in accordance with theprovisions of SFAS 123(R). The Company has elected to recognize compensationexpense on a straight-line basis over the vesting period of the respectiveoptions.

***Management Stock Option Plan***

The Company’s Board of Directors adopted the DuaneReade Holdings, Inc. Management Stock Option Plan, referred to in thisreport as the “Stock Option Plan,” which became effective on the date theAcquisition was completed. The Stock Option Plan is administered by thecompensation committee of the Board of Directors. Any officer, employee,director or consultant of Duane Reade Holdings, Inc. or any of itssubsidiaries or affiliates is eligible to be designated a participant under theStock Option Plan. On 

12

----

November 21, 2005,the Company amended the Stock Option Plan so that a maximum of 370,293 sharesof its common stock (on a fully diluted basis) may be granted under the StockOption Plan.

Under the Stock Option Plan, the compensationcommittee of Duane Reade Holdings, Inc. may grant awards of nonqualifiedstock options, incentive stock options, or any combination of the foregoing. Astock option granted under the Stock Option Plan will provide a participantwith the right to purchase, within a specified period of time, a stated numberof shares of the Company’s common stock at the price specified in the awardagreement. Stock options granted under the Stock Option Plan will be subject tosuch terms, including the exercise price and the conditions and timing ofexercise, not inconsistent with the Stock Option Plan, as may be determined bythe compensation committee and specified in the applicable stock optionagreement or thereafter.

Asummary of activity under the Stock Option Plan as of September 30, 2006,and changes during the thirteen and thirty-nine weeks ended September 30,2006 is presented below:

| ** **                          | ** ** | **For the 13 Weeks Ended  September 30, 2006** | ** ** | **For the 39 Weeks Ended  September 30, 2006** | ** ** |
|-------------------------------------|------------|------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|
| ** **                          | ** ** | ** **                                                                   | ** ** | **Wtd. Avg  Exercise**                                                  | ** ** | **Wtd. Avg.  Remaining  Contractual** | ** ** | **Aggregate  Intrinsic** | ** ** | ** ** | ** ** | **Wtd. Avg  Exercise** | ** ** | **Wtd. Avg.  Remaining  Contractual** | ** ** | **Aggregate  Intrinsic** | ** ** |
| **Options**                         | ** ** | ** **                                                                   | ** ** | **Shares**                                                                   | ** ** | **Price** | ** ** | **Term** | ** ** | **Value** | ** ** | **Shares** | ** ** | **Price** | ** ** | **Term** | ** ** | **Value** | ** ** |
| Outstanding at  beginning of period |       | 287,631                                                                      |       |                                                                         | $          | 100.00 |   |   |   |   |   |   |   |   |   |   | 367,797 |   |   | $ | 100.00 |   |   |   |   |   |   |   |   |   |   |
| Granted                             |       | 17,600                                                                       |       |                                                                         | $          | 100.00 |   |   |   |   |   |   |   |   |   |   | 63,211 |   |   | $ | 100.00 |   |   |   |   |   |   |   |   |   |   |
| Exercised                           |       | —                                                                       |       |                                                                         | $          | 100.00 |   |   |   |   |   |   |   |   |   |   | — |   |   | $ | 100.00 |   |   |   |   |   |   |   |   |   |   |
| Expired                             |       | —                                                                       |       |                                                                         | $          | 100.00 |   |   |   |   |   |   |   |   |   |   | — |   |   | $ | 100.00 |   |   |   |   |   |   |   |   |   |   |
| Forfeited                           |       | (1,012                                                                       | )          |                                                                         | $          | 100.00 |   |   |   |   |   |   |   |   |   |   | (126,789 | ) |   | $ | 100.00 |   |   |   |   |   |   |   |   |   |   |
| Outstanding at end  of period       |       | 304,219                                                                      |       |                                                                         | $          | 100.00 |   |   |   | 8.8 |   |   |   | $ | 0 |   |   | 304,219 |   |   | $ | 100.00 |   |   |   | 8.8 |   |   |   | $ | 0 |   |   |
| Exercisable at end of  period       |       | 36,840                                                                       |       |                                                                         | $          | 100.00 |   |   |   | 7.9 |   |   |   | $ | 0 |   |   | 36,840 |   |   | $ | 100.00 |   |   |   | 7.9 |   |   |   | $ | 0 |   |   |
|                                     |            |                                                                              |            |                                                                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The weighted-average grant-date fair value of optionsgranted during the thirteen and thirty-nine weeks ended September 30, 2006was $38.41 and $41.43, respectively. There were no stock options granted duringthe thirty-nine weeks ended September 24, 2005 and there were no stockoptions exercised during the first thirty-nine weeks of either 2006 or 2005.

The Company hasadopted a Black-Scholes option pricing formula method of valuation and hasengaged an external valuation consultant to provide this analysis, the resultsof which were applied to the stock options issued during the thirty-nine weeksended September 30, 2006.

·       Thevaluation formula reflects the following key assumptions:

·       Expected dividend yield: 0%—TheCompany has historically not paid any dividends, nor does it currently expectto pay dividends in the foreseeable future.

·       Expected volatility: 32.0%—Thevolatility figure reflects the weighted-average 1, 5 and 10-year observedvolatility of comparable industry participants.

·       Expected term (years): 6.5—Theexpected life represents the period of time for which options granted areexpected to be outstanding. This estimate was derived from historical shareoption exercise experience, which management believes provides the bestestimate of the expected term.

·       Risk-free interest rate:4.38%—This reflects the rate portrayed on the Treasury Yield Curve for a periodof time equivalent to the expected term.

13

----

As of September 30, 2006, there was $2.1 millionof total unrecognized compensation cost related to non-vested share-basedcompensation arrangements granted under the stock-based compensation plan. Thatcost is expected to be recognized on a straight-line basis over aweighted-average period of 5 years.

During the thirteen and thirty-nine weeks ended September 30,2006, the Company recognized approximately $0.1 million and $0.2 million,respectively, of compensation cost related to share-based payments.

As of September 30,2006, a total of 66,074 shares of common stock of the Company were reserved forthe issuance of additional stock options. The Company expects to satisfy theexercise of stock options utilizing newly-issued shares.

**4.**                 Inventoryand Cost of Sales

At September 30,2006, inventories, consisting solely of finished goods, would have been lowerby $4.5 million if they had been valued on a lower of first-in, first-out(“FIFO”) cost or market basis instead of a last-in, first-out (“LIFO”) basis.Cost of sales includes all store occupancy-related costs and expenses,consisting of lease and sublease-related income and expenses, other recurringreal estate-related income and expenses resulting primarily from sales andterminations of leases related to store relocations, store utility costs,warehouse expenses and distribution costs. The Company reflects promotionalallowances from vendors as a reduction of inventory or advertising expense,depending on the nature of the allowance, when such inventory is sold oradvertising or promotions have been completed and the related allowances havebeen earned. Other real estate related income was $0.2 million in thethirteen weeks ended September 30, 2006 as compared to $2.2 million in thethirteen weeks ended September 24, 2005, and $0.4 million in thethirty-nine weeks ended September 30, 2006 as compared to $2.5 million inthe thirty-nine weeks ended September 24, 2005.

**5.**                 Exitand Disposal Activities

In connection with the July 30, 2004 acquisitionof Duane Reade Inc. and in accordance with the provisions of Emerging IssuesTask Force Issue No. 95-3, “Recognition of Liabilities in Connectionwith Purchase Business Combinations” (EITF 95-3), the Company establisheda reserve of $17.0 million for costs anticipated to be incurred as aresult of the planned closing of 11 of its stores. These costs primarily relateto rent, utilities and other on-going occupancy-related expenses. At September 30,2006, all of the planned closings had occurred, and the Company has recorded acumulative net total of $8.2 million of primarily occupancy-related costsagainst this reserve resulting in the reserve balance of $8.8 million at September 30,2006. The balance of this reserve is expected to be utilized primarily foroccupancy-related costs in these closed stores.

In the normal course ofits business, the Company closes underperforming locations. In accordance withthe provisions of Statement of Financial Accounting Standards No. 146, “Accountingfor Costs Associated with Exit or Disposal Activities” (FAS 146), the Companyestablishes reserves for costs anticipated to be incurred in connection withsuch store closings. At September 30, 2006, the balance of this reservewas $2.8 million. This balance will also be used primarily foroccupancy-related costs in these stores.

14

----

**6.**                 Pharmacyand Customer File Acquisitions

Duringthe first nine months of 2005, the Company acquired four pharmacy customerfiles, which were merged with files at existing stores. There was no pharmacyor customer file acquisition activity in the first nine months of 2006. Thetable below provides details of this acquisition activity for each of theperiods presented (dollars in millions):

| ** **                         | ** ** | **For the 13 Weeks Ended** | ** ** | **For the 39 Weeks Ended** | ** ** |
|------------------------------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                         | ** ** | **  Sept. 30,  **     | ** ** | **  Sept. 24,  **     | ** ** | **  Sept. 30,  ** | ** ** | **  Sept. 24,  ** | ** ** |
| ** **                         | ** ** | **2006**                                       | ** ** | **2005**                                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| Customer  prescription files       |       |                                           | —     |                                           |       |   | — |   |   |   | — |   |   |   | 4 |   |   |
| Pharmacy  establishments           |       |                                           | —     |                                           |       |   | — |   |   |   | — |   |   |   | — |   |   |
| Total  acquisitions                |       |                                           | —     |                                           |       |   | — |   |   |   | — |   |   |   | 4 |   |   |
| Purchase price  allocation:        |       |                                           |       |                                           |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Identifiable  intangibles          |       |                                           | $          | —                                         |       |   |   | $ | 0.1 |   |   |   | $ | — |   |   |   | $ | 2.3 |   |   |
| Goodwill                           |       |                                           | —     |                                           |       |   | — |   |   |   | — |   |   |   | — |   |   |
| Inventory                          |       |                                           | —     |                                           |       |   | (0.1 | ) |   |   | — |   |   |   | 0.4 |   |   |
| Property and  equipment            |       |                                           | —     |                                           |       |   | — |   |   |   | — |   |   |   | — |   |   |
| Other assets and  liabilities, net |       |                                           | —     |                                           |       |   | — |   |   |   | — |   |   |   | (0.3 | ) |   |
| Total                              |       |                                           | $          | —                                         |       |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | 2.4 |   |   |

 

The acquired operationshave been included in the consolidated statements of operations from the dateof acquisition and did not have a material effect on sales or results ofoperations of the Company for the periods presented.

**7.**                 Debt

Debtis summarized as follows (in thousands):

| ** **                                   | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| **Description of Instrument**      | ** ** | ** **             | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Current Debt:                                |       |                   |       |                  |       |   |   |   |   |
| Asset-Based  Revolving Loan Facility(1)      |       |                   | $          | 164,918               |       |   |   | $ | 135,693 |   |   |
| Non-Current Debt:                            |       |                   |       |                  |       |   |   |   |   |
| Senior Secured  Floating Rate Notes due 2010 |       |                   | $          | 210,000               |       |   |   | $ | 210,000 |   |   |
| 9.75% Senior  Subordinated Notes due 2011    |       |                   | 195,000    |                  |       |   | 195,000 |   |   |
| 2.1478% Senior  Convertible Notes due 2022   |       |                   | 32         |                  |       |   | 32 |   |   |
| Total                                        |       |                   | $          | 405,032               |       |   |   | $ | 405,032 |   |   |
| **Total  Debt**                              | ** ** | ** **             | **$**      | **569,950**           |       | ** ** | ** ** | **$** | **540,725** |   |   |
|                                              |            |                        |            |                       |            |  |  |  |  |  |  |  |  |

----

(1)          Obligationsunder this facility have been classified as current liabilities because cashreceipts controlled by the lenders are used to reduce outstanding debt and theCompany does not meet the criteria of FAS 6 to reclassify the debt aslong-term, however this is not an indication that this credit facility isexpected to be retired within the next year. The Company intends to continue touse this facility for its working capital needs through the date of itsrecently extended maturity in 2011.

***Asset-BasedRevolving Loan Facility***

On July 22, 2004, in connection with theAcquisition, the Company entered into an amended asset-based revolvingloan facility with a maximum aggregate borrowing capacity of $250 million,subject to an adjusted borrowing base calculation based upon specified advancerates against the value of inventory, pharmacy prescription files and accounts receivable.The original maturity date of the amended asset-based revolving loanfacility was July 21, 2008. In August 2005, in conjunction with theissuance of 

15

----

$50.0 million aggregateprincipal amount of senior secured floating rate notes due 2010, the Companypermanently reduced the maximum availability under the amended asset-basedrevolving loan facility by $25.0 million to $225.0 million. On July 7,2006, the Company entered into a further amendment to the amended asset-basedrevolving loan facility to extend its maturity from July 21, 2008 to July 21,2011, subject to the requirement that the Company refinance or restructure the$210.0 million aggregate principal amount at maturity of the senior securedfloating rate notes due 2010 and the $195.0 million aggregate principal amountof the 9.75% senior subordinated notes due 2011, in each case, on termsreasonably acceptable to the administrative agent and at least 120 days priorto each’s respective scheduled maturity date. The Company fully intends to refinanceor restructure the outstanding principal amounts of its senior secured floatingrate notes and senior subordinated notes within the required timeframe, inaccordance with the requirements of the third amendment.

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

The asset-based revolving loan facility contains asingle fixed charge coverage requirement which only becomes applicable whenborrowings exceed 90 percent of the borrowing base, as defined in theagreement governing the asset-based revolving loan facility. The July 2006amendment reduced the ratios that the Company would be required to maintain inthis event. Borrowings under the asset-based revolving loan facility have notexceeded 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.

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

·       a rate equal to LIBOR (theLondon Interbank Offered Rate) plus a margin of from 1.00% to 2.00%, determinedbased on levels of borrowing availability reset each fiscal quarter; or

·       a rate equal to the primerate of Banc of America Retail Group Inc. plus a margin of from 0.00% to0.50%, determined based on levels of borrowing availability reset each fiscalquarter. Borrowings under the amended facility continue to be primarilyLIBOR-based. At September 30, 2006, the asset-based revolving loanfacility bore interest at a weighted average annual rate of 6.96%.

At December 30, 2006, there was $157.1 millionoutstanding under the asset-based revolving loan facility, and approximately $62.4 millionof remaining availability, net of $5.5 million reserved for standbyletters of credit. Obligations under this facility have been classified as currentliabilities because cash receipts controlled by the lenders are used to reduceoutstanding debt, and the Company does not meet the criteria of FAS 6 toreclassify 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 2011.

The Company has received a waiver from its lendersunder its revolving credit facility with respect to, among other things, thedelivery to the lenders of its financial statements for the quarter endedSeptember 30, 2006 and the late filing of the Company’s quarterly reporton Form 10-Q for that period.

***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 

16

----

premium and accrued butunpaid 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 September 30, 2006, the seniorsecured notes bore interest at a rate of 9.89%.

On May 25, 2005, the Company entered into ahedging transaction through the acquisition of a “no cost collar.” Under thisarrangement, the Company capped its exposure on $130.0 million ofLIBOR-based borrowings under the senior secured notes at a maximum LIBOR rateof 5.30%. In addition, the Company established a minimum “floor” LIBOR rate of3.45% in line with then current LIBOR rates. This hedging arrangement expireson June 16, 2008. The changes in the fair value of the collar agreementare reflected in the Consolidated Statements of Comprehensive Loss includedwithin the financial statements. At September 30, 2006, the LIBOR rate ineffect for the senior secured notes was 5.39%, which exceeded the maximum rateunder the “no cost collar.” As a result, the protection afforded by the “nocost collar” reduced the overall effective interest rate on the senior securednotes to 9.83%.

The Company guarantees the senior secured notes on afull and unconditional, senior secured basis. Duane Reade Inc. and DuaneReade GP are co-obligors under the senior secured notes. The senior securednotes rank equally in right of payment with any of the Company’s, Duane ReadeInc.’s or Duane Reade GP’s unsubordinated indebtedness and senior in right ofpayment to any of 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 make certainother restricted payments, incur certain liens, use proceeds from sales ofassets, enter into business combination transactions (including mergers,consolidations and asset sales), enter into sale-leaseback transactions, enterinto transactions with affiliates and permit restrictions on the payment ofdividends by restricted subsidiaries. There are no credit ratings relatedtriggers in the indenture governing the senior secured notes that would impactthe cost of borrowing, annual amortization of principal or related indebtednessmaturity. The indenture governing the senior secured notes does not containfinancial maintenance covenants.

At September 30, 2006, the weighted averagecombined interest rate in effect on all variable rate debt outstanding,including the benefit afforded by the “no cost collar,” was 8.57%.

 

17

----

***Senior Subordinated Notes due 2011.******  ***On July 30,2004, upon completion of the Acquisition, Duane Reade Inc. and DuaneReade GP co-issued $195.0 million of 9.75% senior subordinated notes due2011. The senior subordinated notes mature on August 1, 2011 and bearinterest at 9.75% per annum payable in semi-annual installments on February 1and August 1, commencing February 1, 2005. The senior subordinatednotes are uncollateralized obligations and subordinated in right of payment toall of the Company’s, Duane Reade Inc.’s and Duane Reade GP’s existing andfuture unsubordinated indebtedness, including borrowings under the amendedasset-based revolving loan facility and the senior secured notes. The seniorsubordinated notes will rank equally with any future senior subordinatedindebtedness and senior to any future subordinated indebtedness. The seniorsubordinated notes are guaranteed on an uncollateralized, senior subordinatedbasis by the Company and all of Duane Reade Inc.’s existing direct andindirect domestic subsidiaries other than Duane Reade GP, which is a co-obligorunder the senior subordinated notes. Upon the occurrence of specified change ofcontrol events, the Company will be required to make an offer to repurchase allof the senior subordinated notes at 101% of the outstanding principal amount ofthe senior subordinated notes plus accrued and unpaid interest to the date ofrepurchase. The indenture governing the senior subordinated notes containscertain affirmative and negative covenants that limit the ability of DuaneReade Inc., Duane Reade GP and their restricted subsidiaries to incuradditional indebtedness, pay dividends, make repayments on indebtedness that issubordinated to the senior subordinated notes and to make certain other restrictedpayments, incur certain liens, use proceeds from sales of assets, enter intobusiness combination transactions (including mergers, consolidations and assetsales), enter into transactions with affiliates and permit restrictions on thepayment of dividends by restricted subsidiaries. There are no credit ratingsrelated triggers in the indenture governing the senior subordinated notes thatwould impact the cost of borrowing, annual amortization of principal or relatedindebtedness maturity.

***2.1478% Senior Convertible Notes due April 16,2022.******  ***On April 16, 2002, Duane ReadeInc. completed an offering of $381.5 million aggregate principal amount ofSenior Convertible Notes maturing on April 16, 2022 (the “ConvertibleNotes”). The Convertible Notes were issued at a price of $572.76 per note(57.276% of the principal amount at maturity) and pay cash interest at the rateof 2.1478% per year on the principal amount at maturity, payable semi-annuallyin arrears on April 16 and October 16 of each year beginning on October 16,2002, until April 16, 2007. After that date, interest will accrue on thenotes as amortization of the original issue discount representing a yield tomaturity of 3.75% per year, computed on a semi-annual bond equivalent basis. InDecember 2002, Duane Reade Inc. repurchased a total of $30.5 millionprincipal value of the Convertible Notes at an average purchase price of$486.99 per $1,000 note, resulting in a remaining net outstanding balanceof $201.0 million.

In connection with the Acquisition, Duane Reade Inc.made a tender offer to repurchase all of the $351.0 million outstandingprincipal value of the Convertible Notes. Upon the closing of the tender offer,a total of $350.9 million principal amount at maturity($201.0 million issuance value) was tendered for repurchase, leaving only$55.0 thousand of principal amount at maturity ($32.0 thousand ofissuance value) outstanding. Duane Reade Inc. may redeem for cash all or aportion of the principal value of the outstanding Convertible Notes at any timeafter April 16, 2007, at a price equal to the sum of the issue price plusaccrued original issue discount and accrued cash interest, if any, to theredemption date.

**8.**                 IncomeTaxes

Incometaxes are recorded based on the estimated combined statutory tax rates expectedto be applicable for the full fiscal year less applicable employment relatedtax credits. The effective tax rate prior to the application of deferred taxasset valuation reserves is lower than the combined statutory rates, primarilyreflecting the impact of these income tax credits. The wage-based employmenttax credits represent the economic benefits earned by the Company for itsparticipation in various federal and state hiring incentive programs. Thesebenefits are based on the number of qualifying employees hired and retained bythe Company for a specified time period. Employees qualify for these hiringprograms primarily as a result of their enrollment in various economicassistance programs.

TheCompany evaluates the likelihood of recognizing the benefit of deferred taxassets, a majority of which result from the incurrence of net operating losses.This evaluation includes a review of the individual 

18

----

deferred tax components and a corresponding analysisof the anticipated time period during which the “book versus tax” differencesgiving rise 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 the significant loss incurred in the fiscal quarterthen ended, as well as the projected future years’ taxable losses, this evaluationresulted in the recording of a valuation allowance of $30.4 million. Thisamount represented the Company’s year-end net deferred tax asset valueexcluding $24.4 million of deferred tax liabilities resulting from items thatare not amortized for book accounting and are therefore not expected to reversewithin the loss carryforward expiration period.

During the three and nine months ended September 30,2006, the Company incurred additional pre-tax losses of $18.7 million and $49.7million, respectively, and recorded incremental valuation allowances of $8.5million and $22.7 million, respectively. At September 30, 2006, theCompany had approximately $131.6 million of gross deferred tax assets,approximately $104.4 million of gross deferred tax liabilities, and a valuationallowance of $53.0 million. The tax expense reported during the three and ninemonths ended September 30, 2006 primarily results from the deferred taxliabilities generated by non-amortizable goodwill.

**9.**                 Commitmentsand Contingencies

TheCompany is party to legal actions arising in the ordinary course of business.Based on information presently available to the Company, it believes that theultimate outcome of these actions will not have a material, adverse effect onits financial position, results of operations or cash flows. In addition, theCompany is a party to the following legal actions and matters:

During2002, the Company initiated a legal action against its former propertyinsurance carrier, in an attempt to recover what it believes to be a fair andreasonable settlement for the business interruption portion of its claimoriginating from the September 11, 2001 World Trade Center terroristattack, during which its single highest volume and most profitable store wascompletely destroyed. The claim is pending before the United States DistrictCourt for the Southern District of New York. In September 2003, a trial oncertain issues was held regarding some of the matters at issue in thelitigation, including whether the Company would have obtained a renewal of itslease 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.

Inthe meantime, the matter moved into an appraisal process based on the trialcourt’s interpretation of certain legal tests, which interpretation was amongthe aspects of the decision challenged by the insurance carrier in its appeal.The appraisal process involves a panel of two appraisers and an arbitrator (toresolve differences between the two appraisers) who determined the amount ofinsured loss the Company sustained. In June 2005, the appraisal paneldetermined that the total amount of the business interruption loss that theCompany suffered as a result of the events of September 11, 2001 was$50.6 million, including all interest adjustments. The panel further foundthat the actual amount to be paid by the insurer should be reduced byapproximately $9.9 million, plus interest, which represents the amountthat was previously 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. These modifications also determinedthat certain portions of the Company’s business interruption claim wererecoverable under different coverages provided under the property insurancepolicy.

In June 2006,the appraisal panel awarded Duane Reade the reduced amount of $5.6 million (inaddition to the $9.9 million previously paid by the insurer) based on its interpretationof the Second Circuit Court of Appeals’ decision regarding the nature of theinsurance coverage afforded to the Company under the business interruptionclause of the Company’s policy. In its award, the panel also stated its viewthat the Second Circuit found that the Company may be entitled to recoveradditional amounts under other provisions of its insurance policy. Based on theappraisal panel’s award and the Second Circuit’s decision, 

19

----

in July 2006 the Company demanded payment of theappraisal panel award and also filed an amended proof of loss with the insurerclaiming additional amounts. The insurer has denied the Company’s demands andtherefore the Company expects to continue to litigate in order to attempt torecover the amounts to which it believes it is entitled under the policy.

Accordingly,given the risks and uncertainties inherent in litigation, there can be nodefinitive assurance that the Company will actually receive any or all of thepanel’s appraised value of this claim, or the additional claims filed with theinsurer and the Company has not recognized any additional income related tothis matter. 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.

TheCompany was a party to a National Labor Relations Board (“NLRB”) administrativeproceeding regarding a dispute with the Allied Trades Council (“ATC”) overwhether a negotiating impasse was reached between the Company and the union in August of2001. The Allied Trades Council represented employees in 139 of the Company’sstores. In February 2004, an Administrative Law Judge (“ALJ”) concludedthat the parties were not at an impasse. The ALJ required the Company, whichhad discontinued making contributions to various union funds based on itsposition that an impasse had been reached, to (among other things) make itsemployees whole by reimbursing them for expenses ensuing from the Company’sfailure to make the contributions and to make such funds whole, plus interest. Asa result of this decision, the Company (after consultation with its outsidecounsel) determined that it was required to recognize a liability under theprovisions of Financial Accounting Standard No. 5, Accounting forContingencies.

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,and recorded this amount as a labor contingency liability. The Company alsodetermined that it would continue to accrue additional labor contingencyexpense of approximately $4.4 million annually, representing additionalobligations for unpaid contributions and interest relative to future periods,until such time that new information would determine a change in the factors thatgave rise to the need for the amount of such labor contingency.

Asof April 1, 2006, the aggregate amount of the labor contingency liabilitythat the Company had recorded was $21.4 million. On April 13, 2006, asettlement agreement between the Company and the Allied Trades Council Divisionof Local 338 RWDSU/UFCW (“Local 338”) became effective with respect to alloutstanding litigation and disputes with both the union and the NLRB. TheCompany also entered into two new three-year collective bargaining agreementswith Local 338 and Local 340A New York Joint Board UNITE HERE!, a unionrepresenting certain non-management employees in the balance of the Company’sstores. The three-year collective bargaining agreements with both unions becameeffective as of April 1, 2006 and will expire on March 31, 2009.

Underthe terms of the settlement agreement, the Company was not required to make anyadditional payments to the union funds and had only a limited contingentobligation going forward. As a result of this settlement, the Company hasceased making the annual $4.4 million provision toward labor litigationmatters. The Company reversed $18.0 million of the labor contingency reserveduring the first quarter ended April 1, 2006.

TheCompany was a party to related lawsuits, Irving Kroop, et al v. Duane Reade,NY, NY et al, 00 Civ. 9841, et al., instituted by the trustees ofseveral union benefit funds wherein the funds claimed that the Company did notmake certain required contributions to these funds from January 2000through August 2001. The Company paid $0.7 million in November 2005and an additional $1.4 million in April 2006 to fully settle all ofthe claims in this case.

In December 2005,the Company and Cardinal Health settled all matters relating to litigationarising out of a dispute regarding certain former supply arrangements andagreements. Under the terms of this settlement, the Company will pay CardinalHealth $4.5 million over a period of time to settle an 

20

----

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 nine monthsof 2006, the Company paid $3.0 million toward the cash settlement portion ofthis agreement.

A NewYork State Tax Appeal ruling in a matter involving another company may have anadverse impact upon the Company’s New York State Franchise Tax filings fromyears 1999 through 2002. This matter relates to the required combination ofaffiliated subsidiaries in recognizing royalty fee and related income forintangible property. The ruling is subject to further legal appeal andinterpretation in light of the Company’s own specific facts and circumstances.The outcome of this matter, and the resulting amount of additional income taxexpense, if any, cannot be determined by the Company at this time.

In November 2004,Duane Reade Inc. was served with a purported class action complaint,Damassia v. Duane Reade Inc. The lawsuit was filed in the UnitedStates District Court, Southern District of New York. The complaintalleges that, from the period beginning November 1998, the Companyincorrectly gave some employees the title, “Assistant Manager,” in an attemptto avoid paying these employees overtime, in contravention of the Fair LaborStandards Act and New York law. The complaint seeks an unspecified amount ofunpaid wages. The Company believes this claim to be without merit, and itintends to defend itself vigorously against this claim. However, due to theinherent uncertainty of litigation, there can be no assurance as to theultimate outcome of this matter.

In April 2006,the Company was served with a purported class action complaint, EnamulChowdhury v. Duane Reade Inc. and Duane Reade Holdings, Inc. Thecomplaint alleges that, from a period beginning March 2000, the Companyincorrectly classified certain employees in an attempt to avoid paying overtimeto such employees, thereby violating the Fair Labor Standards Act and New Yorklaw. The complaint seeks an unspecified amount of damages. The Company believesthis claim to be without merit, and it intends to vigorously defend itselfagainst this claim. However, due to the inherent uncertainty of litigation,there can be no assurance as to the ultimate outcome of this matter.

In January 2005, the Equal Employment OpportunityCommission filed an action against the Company in the U.S. District Court forthe Southern District of New York alleging, among other things, that theCompany created a hostile work environment for three female store employees,and potentially a class of such female employees. At the present time, it isnot possible to determine the ultimate outcome of this action, which, ifadverse, could be material. However, the Company believes that the allegationsare wholly without merit and intends to vigorously defend itself in thismatter.

On September 1, 2006, Anthony J. Cuti, theCompany’s former Chairman, President and Chief Executive Officer, initiated anarbitration before the American Arbitration Association against Duane ReadeInc., Duane Reade Holdings, Inc. and Duane Reade Shareholders, LLC. Thearbitration relates to his termination. Mr. Cuti asserts various claimsincluding, with respect to his employment agreement, breach of contractrelating to the notice of termination provision, failure to make certainpayments towards his 1998 corporate-owned life insurance policy, relief fromthe non-competition and non-solicitation covenants, failure to provide adequateinformation relating to the valuation of his profits interest and breach of thecovenant of good faith and fair dealing. Other claims relate to the patentrights for the Company’s virtual pharmacy kiosk system and payment of analleged deferred 2001 bonus based on any insurance recovery the Company mayobtain on its business interruption claim in connection with the 2001 WorldTrade Center tragedy. Mr. Cuti seeks monetary damages, declaratory relief,rescission of his employment agreement, and the payment of his legal costs andfees associated with his termination and the arbitration.

On November 22, 2006, Duane Reade Inc., DuaneReade Holdings, Inc. and Duane Reade Shareholders, LLC filed counterclaimsagainst Mr. Cuti in the arbitration. The counterclaims were based on informationuncovered as of that date by an investigation conducted by independent legalcounsel at the direction of the Audit Committee, the final results of which arediscussed more fully in Note 1. The counterclaims allege that between 2000and 2005, he was responsible for improper practices involving invoice creditsand rebillings for the construction of the Company’s stores, that led to overstatingpublicly 

21

----

reported earnings of theCompany, and that caused the Company to create and maintain inaccurate recordsand publish financial statements containing misstatements. The counterclaimsseek rescission of employment agreements entered into between the Company and Mr.Cuti, return of all compensation paid under the employment agreement, othercompensatory and punitive damages, and legal costs and fees associated with theinvestigation and arbitration.

The Company believes ithas strong defenses to Mr. Cuti’s claims and strong counterclaims and intendsto pursue them vigorously.

***Litigation Relating to the Acquisition***

TheCompany is aware of six purported class action complaints challenging theAcquisition consummated by Duane Reade Inc. and Duane Reade Acquisitionthat have been filed in the Court of Chancery of the State of Delaware,referred to as the “Delaware Complaints,” and three purported class actioncomplaints that have been filed in the Supreme Court of the State of New York.Two of the New York complaints have been dismissed without prejudice. Theother New York complaint (the “New York Complaint”) is pending but has notbeen served on the Company. The Delaware Complaints name the former Chairmanand certain other members of the Company’s board of directors and executiveofficers as well as Duane Reade as defendants. Four of the Delaware Complaintsname Oak Hill as a defendant. The New York Complaint names the former Chairmanand certain other members of the Company’s board of directors and executiveofficers as well as Duane Reade as defendants. One of the dismissed New Yorkcomplaints named Oak Hill as a defendant.

The Delaware Complaints were consolidated on January 28,2004, and on April 8, 2004 the plaintiffs in the Delaware actions filed aconsolidated class action complaint. The Company believes these lawsuits arewithout merit and plans to defend these lawsuits vigorously. However, due tothe inherent uncertainty of litigation, there can be no assurance as to theultimate outcome of this matter.

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

The9.75% Senior Subordinated Notes due 2011 and the Senior Secured Floating RateNotes due 2010 were co-issued by Duane Reade 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. Theguarantee of the Company and of each subsidiary guarantor is full andunconditional and joint and several.

Thefollowing condensed consolidating financial information for the Companypresents the financial information of Duane Reade Holdings, Inc., theco-obligors and the subsidiary guarantors, prepared on the equity basis ofaccounting. Such presentation is based on the Company’s understanding andinterpretation of Rule 3-10 under the Securities and ExchangeCommission’s Regulation S-X. Income tax expense (benefit) and deferred incometaxes have been allocated to individual entities according to the Company’sincome tax allocation methodology. Certain of the prior year information hasbeen adjusted to conform its presentation with the current year. There is nolimitation on dividends or distributions between the parent and itssubsidiaries. The financial information may not necessarily be indicative ofresults of operations or financial position had the subsidiary guarantorsoperated as independent entities.

22

----

**DUANE READE HOLDINGS, INC.Condensed Consolidating Statement of Operations (Unaudited)For the 13 weeks ended September 30, 2006(in thousands)**

| ** **                                           | ** ** | **Duane Reade  Holdings, Inc.** | ** ** | **Duane  Reade Inc.** | ** ** | **Duane  Reade GP** | ** ** | **Subsidiary  Guarantors** | ** ** | **Consolidating  Adjustments** | ** ** | **Duane Reade  Holdings, Inc.  Consolidated** | ** ** |
|------------------------------------------------------|------------|--------------------------------------|------------|----------------------------|------------|--------------------------|------------|----------------------------|------------|--------------------------------|------------|---------------------------------------------------------|------------|
| Net sales                                            |       |                                 | $          | —                     |       |                     |       | $                          | —     |                           |       | $                                                       | 385,655    |   |   | $ | 9,247 |   |   |   | $ | (9,247 | ) |   |   | $ | 385,655 |   |   |
| Cost of sales                                        |       |                                 | —     |                       |       |                     | —     |                       |       | 305,016                        |       |                                                    | —     |   |   |   | — |   |   |   | 305,016 |   |   |
| Gross profit                                         |       |                                 | —     |                       |       |                     | —     |                       |       | 80,639                         |       |                                                    | 9,247      |   |   |   | (9,247 | ) |   |   | 80,639 |   |   |
| Selling, general &  administrative expenses |       |                                 | —     |                       |       |                     | —     |                       |       | 81,934                         |       |                                                    | 136        |   |   |   | (14,993 | ) |   |   | 67,077 |   |   |
| Labor contingency                                    |       |                                 | —     |                       |       |                     | —     |                       |       | —                         |       |                                                    | —     |   |   |   | — |   |   |   | — |   |   |
| Transaction  expense                                 |       |                                 | —     |                       |       |                     | —     |                       |       | —                         |       |                                                    | —     |   |   |   | — |   |   |   | — |   |   |
| Depreciation and  amortization                       |       |                                 | —     |                       |       |                     | —     |                       |       | 16,903                         |       |                                                    | —     |   |   |   | — |   |   |   | 16,903 |   |   |
| Store pre-opening  expense                           |       |                                 | —     |                       |       |                     | —     |                       |       | 153                            |       |                                                    | —     |   |   |   | — |   |   |   | 153 |   |   |
| Other                                                |       |                                 | —     |                       |       |                     | —     |                       |       | 148                            |       |                                                    | —     |   |   |   | — |   |   |   | 148 |   |   |
| Operating (loss) income                              |       |                                 | —     |                       |       |                     | —     |                       |       | (18,499                        | )          |                                                    | 9,111      |   |   |   | 5,746 |   |   |   | (3,642 | ) |   |
| Equity earnings  in affiliates                       |       |                                 | 19,692     |                       |       |                     | 19,692     |                       |       | —                         |       |                                                    | 351        |   |   |   | (39,735 | ) |   |   | — |   |   |
| Interest expense,  net                               |       |                                 | —     |                       |       |                     | —     |                       |       | 14,356                         |       |                                                    | (5,746     | ) |   |   | 5,746 |   |   |   | 14,356 |   |   |
| Income (loss) before income taxes                    |       |                                 | (19,692    | )                          |       |                     | (19,692    | )                          |       | (32,855                        | )          |                                                    | 14,506     |   |   |   | 39,735 |   |   |   | (17,998 | ) |   |
| Income tax  (benefit)  expense                       |       |                                 | —     |                       |       |                     | —     |                       |       | 1,308                          |       |                                                    | (574       | ) |   |   | — |   |   |   | 734 |   |   |
| Net income (loss)                                    |       |                                 | $          | (19,692                    | )          |                     |       | $                          | (19,692    | )                              |       | $                                                       | (34,163    | ) |   | $ | 15,080 |   |   |   | $ | 39,735 |   |   |   | $ | (18,732 | ) |   |

 

23

----

**DUANE READE HOLDINGS, INC.Condensed Consolidating Statement of Operations (Unaudited)For the 13 weeks ended September 24, 2005(in thousands)**

| ** **                                           | ** ** | **Duane Reade  Holdings, Inc.** | ** ** | **Duane  Reade Inc.** | ** ** | **Duane  Reade GP** | ** ** | **Subsidiary  Guarantors** | ** ** | **Consolidating  Adjustments** | ** ** | **Duane Reade  Holdings, Inc.  Consolidated** | ** ** |
|------------------------------------------------------|------------|-------------------------------------------|------------|----------------------------|------------|--------------------------|------------|----------------------------|------------|--------------------------------|------------|----------------------------------------------------|------------|
| Net sales                                            |       |                                      | $          | —                     |       |                     |       | $                          | —     |                           |       | $                                                  | 378,557    |   |   | $ | 8,981 |   |   |   | $ | (8,981 | ) |   |   | $ | 378,557 |   |   |
| Cost of sales                                        |       |                                      | —     |                       |       |                     | —     |                       |       | 305,866                        |       |                                               | —     |   |   |   | — |   |   |   | 305,866 |   |   |
| Gross profit                                         |       |                                      | —     |                       |       |                     | —     |                       |       | 72,691                         |       |                                               | 8,981      |   |   |   | (8,981 | ) |   |   | 72,691 |   |   |
| Selling, general &  administrative expenses |       |                                      | —     |                       |       |                     | —     |                       |       | 76,885                         |       |                                               | 46         |   |   |   | (8,981 | ) |   |   | 67,950 |   |   |
| Labor contingency                                    |       |                                      | —     |                       |       |                     | —     |                       |       | 1,100                          |       |                                               | —     |   |   |   | — |   |   |   | 1,100 |   |   |
| Transaction  expense                                 |       |                                      | —     |                       |       |                     | —     |                       |       | 236                            |       |                                               | —     |   |   |   | — |   |   |   | 236 |   |   |
| Depreciation and  amortization                       |       |                                      | —     |                       |       |                     | —     |                       |       | 17,816                         |       |                                               | —     |   |   |   | — |   |   |   | 17,816 |   |   |
| Store pre-opening  expense                           |       |                                      | —     |                       |       |                     | —     |                       |       | 114                            |       |                                               | —     |   |   |   | — |   |   |   | 114 |   |   |
| Other                                                |       |                                      | —     |                       |       |                     | —     |                       |       | 1,454                          |       |                                               | —     |   |   |   | — |   |   |   | 1,454 |   |   |
| Operating (loss) income                              |       |                                      | —     |                       |       |                     | —     |                       |       | (24,914                        | )          |                                               | 8,935      |   |   |   | — |   |   |   | (15,979 | ) |   |
| Equity earnings  in affiliates                       |       |                                      | 15,748     |                       |       |                     | 15,748     |                       |       | —                         |       |                                               | 224        |   |   |   | (31,720 | ) |   |   | — |   |   |
| Interest expense,  net                               |       |                                      | —     |                       |       |                     | —     |                       |       | 15,733                         |       |                                               | (3,079     | ) |   |   | — |   |   |   | 12,654 |   |   |
| Income (loss) before income taxes               |       |                                      | (15,748    | )                          |       |                     | (15,748    | )                          |       | (40,647                        | )          |                                               | 11,790     |   |   |   | 31,720 |   |   |   | (28,633 | ) |   |
| Income tax  (benefit) expense                        |       |                                      | —     |                       |       |                     | —     |                       |       | (18,291                        | )          |                                               | 5,406      |   |   |   | — |   |   |   | (12,885 | ) |   |
| Net income (loss)                                    |       |                                      | $          | (15,748                    | )          |                     |       | $                          | (15,748    | )                              |       | $                                                  | (22,356    | ) |   | $ | 6,384 |   |   |   | $ | 31,720 |   |   |   | $ | (15,748 | ) |   |

 

24

----

**DUANE READE HOLDINGS, INC.Condensed Consolidating Statement of Operations (Unaudited)For the 39 weeks ended September 30, 2006(in thousands)**

| ** **                                           | ** ** | **Duane Reade  Holdings, Inc.** | ** ** | **Duane  Reade Inc.** | ** ** | **Duane  Reade GP** | ** ** | **Subsidiary  Guarantors** | ** ** | **Consolidating  Adjustments** | ** ** | **Duane Reade  Holdings, Inc.  Consolidated** | ** ** |
|------------------------------------------------------|------------|-------------------------------------------|------------|----------------------------|------------|--------------------------|------------|----------------------------|------------|--------------------------------|------------|----------------------------------------------------|------------|
| Net sales                                            |       |                                      | $          | —                     |       |                     |       | $                          | —     |                           |       | $                                                  | 1,170,313  |   |   | $ | 28,386 |   |   |   | $ | (28,386 | ) |   |   | $ | 1,170,313 |   |   |
| Cost of sales                                        |       |                                      | —     |                       |       |                     | —     |                       |       | 933,114                        |       |                                               | —     |   |   |   | — |   |   |   | 933,114 |   |   |
| Gross profit                                         |       |                                      | —     |                       |       |                     | —     |                       |       | 237,199                        |       |                                               | 28,386     |   |   |   | (28,386 | ) |   |   | 237,199 |   |   |
| Selling,  general & administrative expenses |       |                                      | —     |                       |       |                     | —     |                       |       | 248,222                        |       |                                               | 272        |   |   |   | (43,805 | ) |   |   | 204,689 |   |   |
| Labor contingency                                    |       |                                      | —     |                       |       |                     | —     |                       |       | (18,004                        | )          |                                               | —     |   |   |   | — |   |   |   | (18,004 | ) |   |
| Transaction expense                                  |       |                                      | —     |                       |       |                     | —     |                       |       | —                         |       |                                               | —     |   |   |   | — |   |   |   | — |   |   |
| Depreciation and  amortization                       |       |                                      | —     |                       |       |                     | —     |                       |       | 54,209                         |       |                                               | —     |   |   |   | — |   |   |   | 54,209 |   |   |
| Store pre-opening  expense                           |       |                                      | —     |                       |       |                     | —     |                       |       | 305                            |       |                                               | —     |   |   |   | — |   |   |   | 305 |   |   |
| Other                                                |       |                                      |       |                       |       |                     | —     |                       |       | 1,783                          |       |                                               | —     |   |   |   | — |   |   |   | 1,783 |   |   |
| Operating (loss)  income                             |       |                                      | —     |                       |       |                     | —     |                       |       | (49,316                        | )          |                                               | 28,114     |   |   |   | 15,419 |   |   |   | (5,783 | ) |   |
| Equity earnings in  affiliates                       |       |                                      | 50,633     |                       |       |                     | 50,633     |                       |       | —                         |       |                                               | 956        |   |   |   | (102,222 | ) |   |   | — |   |   |
| Interest expense, net                                |       |                                      | —     |                       |       |                     | —     |                       |       | 42,229                         |       |                                               | (15,419    | ) |   |   | 15,419 |   |   |   | 42,229 |   |   |
| Income (loss)  before income taxes              |       |                                      | (50,633    | )                          |       |                     | (50,633    | )                          |       | (91,545                        | )          |                                               | 42,577     |   |   |   | 102,222 |   |   |   | (48,012 | ) |   |
| Income tax (benefit)  expense                        |       |                                      | —     |                       |       |                     | —     |                       |       | 3,138                          |       |                                               | (1,477     | ) |   |   | — |   |   |   | 1,661 |   |   |
| Net income (loss)                                    |       |                                      | $          | (50,633                    | )          |                     |       | $                          | (50,633    | )                              |       | $                                                  | (94,683    | ) |   | $ | 44,054 |   |   |   | $ | 102,222 |   |   |   | $ | (49,673 | ) |   |

 

25

----

**DUANE READE HOLDINGS, INC.Condensed Consolidating Statement of Operations (Unaudited)For the 39 weeks ended September 24, 2005(in thousands)**

|                                                 |   | **Duane Reade  Holdings, Inc.** | ** ** | **Duane  Reade Inc.** | ** ** | **Duane  Reade GP** | ** ** | **Subsidiary  Guarantors** |    | **Consolidating  Adjustments** | ** ** | **Duane Reade  Holdings, Inc.  Consolidated** |      |
|------------------------------------------------------|--------|-------------------------------------------|------------|----------------------------|------------|--------------------------|------------|----------------------------|---------|--------------------------------|------------|---------------------------------------------------------|-----------|
| Net sales                                            |   |                                      | $          | —                     |       |                     |       | $                          | —  |                           |       | $                                                       | 1,172,824 |   |   | $ | 27,514 |   |   |   | $ | (27,514 | ) |   |   | $ | 1,172,824 |   |   |
| Cost of sales                                        |   |                                      | —     |                       |       |                     | —     |                       |    | 948,729                        |       |                                                    | —    |   |   |   | — |   |   |   | 948,729 |   |   |
| Gross profit                                         |   |                                      | —     |                       |       |                     | —     |                       |    | 224,095                        |       |                                                    | 27,514    |   |   |   | (27,514 | ) |   |   | 224,095 |   |   |
| Selling,  general & administrative expenses |   |                                      | —     |                       |       |                     | —     |                       |    | 224,348                        |       |                                                    | 156       |   |   |   | (27,514 | ) |   |   | 196,990 |   |   |
| Labor contingency                                    |   |                                      | —     |                       |       |                     | —     |                       |    | 3,300                          |       |                                                    | —    |   |   |   | — |   |   |   | 3,300 |   |   |
| Transaction  expense                                 |   |                                      | —     |                       |       |                     | —     |                       |    | 817                            |       |                                                    | —    |   |   |   | — |   |   |   | 817 |   |   |
| Depreciation and  amortization                       |   |                                      | —     |                       |       |                     | —     |                       |    | 53,313                         |       |                                                    | —    |   |   |   | — |   |   |   | 53,313 |   |   |
| Store pre-opening  expense                           |   |                                      | —     |                       |       |                     | —     |                       |    | 264                            |       |                                                    | —    |   |   |   | — |   |   |   | 264 |   |   |
| Other                                                |   |                                      | —     |                       |       |                     | —     |                       |    | 4,636                          |       |                                                    | —    |   |   |   | — |   |   |   | 4,636 |   |   |
| Operating (loss) income                              |   |                                      | —     |                       |       |                     | —     |                       |    | (62,583                        | )          |                                                    | 27,358    |   |   |   | — |   |   |   | (35,225 | ) |   |
| Equity earnings  in affiliates                       |   |                                      | 38,839     |                       |       |                     | 38,839     |                       |    | —                         |       |                                                    | 586       |   |   |   | (78,264 | ) |   |   | — |   |   |
| Interest expense,  net                               |   |                                      | —     |                       |       |                     | —     |                       |    | 43,840                         |       |                                                    | (8,522    | ) |   |   | — |   |   |   | 35,318 |   |   |
| Income (loss) before income taxes                    |   |                                      | (38,839    | )                          |       |                     | (38,839    | )                          |    | (106,423                       | )          |                                                    | 35,294    |   |   |   | 78,264 |   |   |   | (70,543 | ) |   |
| Income tax  (benefit) expense                        |   |                                      | —     |                       |       |                     | —     |                       |    | (47,829                        | )          |                                                    | 16,125    |   |   |   | — |   |   |   | (31,704 | ) |   |
| Net income (loss)                                    |   |                                      | $          | (38,839                    | )          |                     |       | $                          | (38,839 | )                              |       | $                                                       | (58,594   | ) |   | $ | 19,169 |   |   |   | $ | 78,264 |   |   |   | $ | (38,839 | ) |   |

 

26

----

**DUANE READE HOLDINGS, INC.Condensed Consolidating Balance Sheet (Unaudited)As of September 30, 2006(in thousands)**

| ** **                                       | ** ** | **Duane Reade  Holdings, Inc.** | ** ** | **Duane  Reade Inc.** | ** ** | **Duane  Reade GP** | ** ** | **Subsidiary  Guarantors** | ** ** | **Consolidating  Adjustments** | ** ** | **Duane Reade  Holdings, Inc.  Consolidated** | ** ** |
|--------------------------------------------------|------------|-------------------------------------------|------------|----------------------------|------------|--------------------------|------------|----------------------------|------------|--------------------------------|------------|---------------------------------------------------------|------------|
| Assets                                           |       |                                      |       |                       |       |                     |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |
| Current assets                                   |       |                                      |       |                       |       |                     |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |
| Cash                                             |       |                                      | $          | —                     |       |                     | $          | —                     |       | $                              | 1,350      |                                                    |       | $ | 16 |   |   |   | $ | — |   |   |   | $ | 1,366 |   |   |
| Receivables                                      |       |                                      | —     |                       |       | —                   |       | 47,173                     |       |                           | —     |                                                    |       |   | — |   |   |   | 47,173 |   |   |
| Due from affiliates                              |       |                                      | —     |                       |       | 71,825                   |       | 113,702                    |       |                           | (189       | )                                                       |       |   | (185,338 | ) |   |   | — |   |   |
| Inventories                                      |       |                                      | —     |                       |       | —                   |       | 230,754                    |       |                           | —     |                                                    |       |   | — |   |   |   | 230,754 |   |   |
| Deferred income taxes                            |       |                                      | —     |                       |       | 6,013                    |       | 5,049                      |       |                           | (6,189     | )                                                       |       |   | — |   |   |   | 4,873 |   |   |
| Prepaid expenses and other assets                |       |                                      | —     |                       |       | —                   |       | 26,039                     |       |                           | —     |                                                    |       |   | — |   |   |   | 26,039 |   |   |
| Total current assets                             |       |                                      | —     |                       |       | 77,838                   |       | 424,067                    |       |                           | (6,362     | )                                                       |       |   | (185,338 | ) |   |   | 310,205 |   |   |
| Investment in affiliates                         |       |                                      | 33,028     |                       |       | 33,028                   |       | —                     |       |                           | (626       | )                                                       |       |   | (65,430 | ) |   |   | — |   |   |
| Property and equipment                           |       |                                      | —     |                       |       | —                   |       | 215,728                    |       |                           | —     |                                                    |       |   | — |   |   |   | 215,728 |   |   |
| Goodwill, net                                    |       |                                      | —     |                       |       | —                   |       | 72,029                     |       |                           | —     |                                                    |       |   | — |   |   |   | 72,029 |   |   |
| Deferred income taxes                            |       |                                      | —     |                       |       | 1,645                    |       | 9,032                      |       |                           | (10,677    | )                                                       |       |   | — |   |   |   | — |   |   |
| Other assets                                     |       |                                      | —     |                       |       | —                   |       | 181,188                    |       |                           | 329,557    |                                                    |       |   | (283,325 | ) |   |   | 227,420 |   |   |
| Total assets                                     |       |                                      | $          | 33,028                     |       |                     | $          | 112,511                    |       | $                              | 902,044    |                                                    |       | $ | 311,892 |   |   |   | $ | (534,093 | ) |   |   | $ | 825,382 |   |   |
| Liabilities and  Stockholder’s Equity       |       |                                      |       |                       |       |                     |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |
| Current liabilities                              |       |                                      |       |                       |       |                     |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |
| Accounts payable                                 |       |                                      | $          | —                     |       |                     | $          | —                     |       | $                              | 85,569     |                                                    |       | $ | — |   |   |   | $ | — |   |   |   | $ | 85,569 |   |   |
| Due to affiliates                                |       |                                      | —     |                       |       | —                   |       | —                     |       |                           | 185,336    |                                                    |       |   | (185,336 | ) |   |   | — |   |   |
| Accrued interest                                 |       |                                      | —     |                       |       | —                   |       | 4,549                      |       |                           | —     |                                                    |       |   | — |   |   |   | 4,549 |   |   |
| Accrued expenses                                 |       |                                      | —     |                       |       | (13                      | )          | 36,652                     |       |                           | —     |                                                    |       |   | — |   |   |   | 36,639 |   |   |
| Current portion of debt                          |       |                                      | —     |                       |       | —                   |       | 164,918                    |       |                           | —     |                                                    |       |   | — |   |   |   | 164,918 |   |   |
| Current portion of capital lease obligation      |       |                                      | —     |                       |       | —                   |       | 3,209                      |       |                           | —     |                                                    |       |   | — |   |   |   | 3,209 |   |   |
| Total current liabilities                        |       |                                      | —     |                       |       | (13                      | )          | 294,897                    |       |                           | 185,336    |                                                    |       |   | (185,336 | ) |   |   | 294,884 |   |   |
| Long term debt                                   |       |                                      | —     |                       |       | —                   |       | 688,357                    |       |                           | —     |                                                    |       |   | (283,325 | ) |   |   | 405,032 |   |   |
| Capital lease obligation, less current portion   |       |                                      | —     |                       |       | —                   |       | 7,939                      |       |                           | —     |                                                    |       |   | — |   |   |   | 7,939 |   |   |
| Deferred income taxes                            |       |                                      | —     |                       |       | 77,516                   |       | (78,369                    | )          |                           | 31,535     |                                                    |       |   | — |   |   |   | 30,682 |   |   |
| Other non-current liabilities                    |       |                                      | —     |                       |       | 1,980                    |       | 50,450                     |       |                           | —     |                                                    |       |   | — |   |   |   | 52,430 |   |   |
| Total liabilities                                |       |                                      | —     |                       |       | 79,483                   |       | 963,274                    |       |                           | 216,871    |                                                    |       |   | (468,661 | ) |   |   | 790,967 |   |   |
| Stockholder’s equity                        |       |                                      |       |                       |       |                     |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |
| Common stock                                     |       |                                      | 26         |                       |       | —                   |       | 26                         |       |                           | —     |                                                    |       |   | (26 | ) |   |   | 26 |   |   |
| Paid-in-capital                                  |       |                                      | 239,472    |                       |       | 239,498                  |       | 239,472                    |       |                           | 2,395      |                                                    |       |   | (481,365 | ) |   |   | 239,472 |   |   |
| Additional paid-in capital                       |       |                                      | —     |                       |       | —                   |       | 211                        |       |                           | —     |                                                    |       |   | — |   |   |   | 211 |   |   |
| Accumulated other comprehensive income           |       |                                      | —     |                       |       | —                   |       | 216                        |       |                           | —     |                                                    |       |   | — |   |   |   | 216 |   |   |
| Retained earnings                                |       |                                      | (206,470   | )                          |       | (206,470                 | )          | (301,155                   | )          |                           | 92,626     |                                                    |       |   | 415,959 |   |   |   | (205,510 | ) |   |
| Total stockholder’s equity                  |       |                                      | 33,028     |                       |       | 33,028                   |       | (61,230                    | )          |                           | 95,021     |                                                    |       |   | (65,432 | ) |   |   | 34,415 |   |   |
| Total liabilities  and stockholder’s equity |       |                                      | $          | 33,028                     |       |                     | $          | 112,511                    |       | $                              | 902,044    |                                                    |       | $ | 311,892 |   |   |   | $ | (534,093 | ) |   |   | $ | 825,382 |   |   |

 

27

----

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

| ** **                                        | ** ** | **Duane Reade  Holdings, Inc.** | ** ** | **Duane  Reade Inc.** | ** ** | **Duane  Reade GP** | ** ** | **Subsidiary  Guarantors** | ** ** | **Consolidating  Adjustments** | ** ** | **Duane Reade  Holdings, Inc.  Consolidated** | ** ** |
|---------------------------------------------------|------------|-------------------------------------------|------------|----------------------------|------------|--------------------------|------------|----------------------------|------------|--------------------------------|------------|---------------------------------------------------------|------------|
| Assets                                            |       |                                      |       |                       |       |                     |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |
| Current assets                                    |       |                                      |       |                       |       |                     |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |
| Cash                                              |       |                                      | $          | —                     |       |                     | $          | —                     |       | $                              | 1,338      |                                                    |       | $ | 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 |   |   |

 

28

----

**DUANE READEHOLDINGS, INC.Condensed Consolidating Statement of Cash Flows (Unaudited)For the 39 weeks ended September 30, 2006(in thousands)**

| ** **                                                                                       | ** ** | **Duane Reade  Holdings, Inc.** | ** ** | **Duane  Reade Inc.** | ** ** | **Duane  Reade GP** | ** ** | **Subsidiary  Guarantors** | ** ** | **Consolidating  Adjustments** | ** ** | **Duane Reade  Holdings, Inc.  Consolidated** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|----------------------------|------------|--------------------------|------------|----------------------------|------------|--------------------------------|------------|---------------------------------------------------------|------------|
| Cash flows used in  operating  activities:                                                       |       |                                      |       |                       |       |                     |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Net (loss) income                                                                                |       |                                      | $          | (50,633                    | )          |                     |       | $                          | (50,633    | )                              |       | $                                                       | (94,683    | ) |   | $ | 44,054 |   |   |   | $ | 102,222 |   |   |   | $ | (49,673 | ) |   |
| Adjustments  to reconcile net (loss) income to net cash used in operating  activities: |       |                                      |       |                       |       |                     |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Depreciation and  amortization                                                                   |       |                                      | —     |                       |       |                     | —     |                       |       | 57,245                         |       |                                                    | —     |   |   |   | — |   |   |   | 57,245 |   |   |
| Deferred income taxes                                                                            |       |                                      | —     |                       |       |                     | (252       | )                          |       | 3,138                          |       |                                                    | (1,477     | ) |   |   | — |   |   |   | 1,409 |   |   |
| Non-cash rent expense                                                                            |       |                                      | —     |                       |       |                     | —     |                       |       | 7,681                          |       |                                                    | —     |   |   |   | — |   |   |   | 7,681 |   |   |
| Other non-cash expense                                                                           |       |                                      | —     |                       |       |                     | —     |                       |       | 211                            |       |                                                    | —     |   |   |   | — |   |   |   | 211 |   |   |
| Equity in income of subsidiaries                                                                 |       |                                      | 50,633     |                       |       |                     | 50,633     |                       |       | —                         |       |                                                    | 956        |   |   |   | (102,222 | ) |   |   | — |   |   |
| Changes  in operating assets and liabilities:                                                    |       |                                      |       |                       |       |                     |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Receivables                                                                                      |       |                                      | —     |                       |       |                     | 158        |                       |       | 4,105                          |       |                                                    | 884        |   |   |   | — |   |   |   | 5,147 |   |   |
| Inventories                                                                                      |       |                                      | —     |                       |       |                     | —     |                       |       | 4,885                          |       |                                                    | —     |   |   |   | — |   |   |   | 4,885 |   |   |
| Accounts payable                                                                                 |       |                                      | —     |                       |       |                     | —     |                       |       | 12,858                         |       |                                                    | —     |   |   |   | — |   |   |   | 12,858 |   |   |
| Prepaid and accrued expenses                                                                     |       |                                      | —     |                       |       |                     | 94         |                       |       | (19,537                        | )          |                                                    | —     |   |   |   | — |   |   |   | (19,443 | ) |   |
| Other assets and liabilities, net                                                                |       |                                      | —     |                       |       |                     | —     |                       |       | 18,815                         |       |                                                    | (44,425    | ) |   |   | — |   |   |   | (25,610 | ) |   |
| NET CASH USED IN OPERATING ACTIVITIES                                                            |       |                                      | —     |                       |       |                     | —     |                       |       | (5,282                         | )          |                                                    | (8         | ) |   |   | — |   |   |   | (5,290 | ) |   |
| Cash  flows used in investing  activities:                                                       |       |                                      |       |                       |       |                     |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Capital expenditures                                                                             |       |                                      | —     |                       |       |                     | —     |                       |       | (18,152                        | )          |                                                    | —     |   |   |   | — |   |   |   | (18,152 | ) |   |
| Lease acquisition and other costs                                                                |       |                                      | —     |                       |       |                     | —     |                       |       | (5,226                         | )          |                                                    | —     |   |   |   | — |   |   |   | (5,226 | ) |   |
| Proceeds from sale of property                                                                   |       |                                      | —     |                       |       |                     | —     |                       |       | 2,500                          |       |                                                    | —     |   |   |   | — |   |   |   | 2,500 |   |   |
| NET CASH USED IN INVESTING ACTIVITIES                                                       |       |                                      | —     |                       |       |                     | —     |                       |       | (20,878                        | )          |                                                    | —     |   |   |   | — |   |   |   | (20,878 | ) |   |
| Cash flows from  financing activities:                                                           |       |                                      |       |                       |       |                     |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Borrowings from revolving credit facility                                                        |       |                                      | —     |                       |       |                     | —     |                       |       | 1,383,370                      |       |                                                    | —     |   |   |   | — |   |   |   | 1,383,370 |   |   |
| Repayments of revolving credit facility                                                          |       |                                      | —     |                       |       |                     | —     |                       |       | (1,354,145                     | )          |                                                    | —     |   |   |   | — |   |   |   | (1,354,145 | ) |   |
| Repayments of capital lease obligations                                                          |       |                                      | —     |                       |       |                     | —     |                       |       | (2,349                         | )          |                                                    | —     |   |   |   | — |   |   |   | (2,349 | ) |   |
| Deferred financing costs                                                                         |       |                                      | —     |                       |       |                     | —     |                       |       | (704                           | )          |                                                    | —     |   |   |   | — |   |   |   | (704 | ) |   |
| NET CASH PROVIDED BY FINANCING ACTIVITIES                                                   |       |                                      | —     |                       |       |                     | —     |                       |       | 26,172                         |       |                                                    | —     |   |   |   | — |   |   |   | 26,172 |   |   |
| Net increase (decrease) in cash                                                                  |       |                                      | —     |                       |       |                     | —     |                       |       | 12                             |       |                                                    | (8         | ) |   |   | — |   |   |   | 4 |   |   |
| Cash at beginning of period                                                                      |       |                                      | —     |                       |       |                     | —     |                       |       | 1,338                          |       |                                                    | 24         |   |   |   | — |   |   |   | 1,362 |   |   |
| Cash at end of  period                                                                           |       |                                      | $          | —                     |       |                     |       | $                          | —     |                           |       | $                                                       | 1,350      |   |   | $ | 16 |   |   |   | $ | — |   |   |   | $ | 1,366 |   |   |

 

29

----

**DUANE READEHOLDINGS, INC.Condensed Consolidating Statement of Cash Flows (Unaudited)For the 39 weeks ended September 24, 2005(in thousands)**

| ** **                                                                                       | ** ** | **Duane Reade  Holdings, Inc.** | ** ** | **Duane  Reade Inc.** | ** ** | **Duane  Reade GP** | ** ** | **Subsidiary  Guarantors** | ** ** | **Consolidating  Adjustments** | ** ** | **Duane Reade  Holdings, Inc.  Consolidated** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|----------------------------|------------|--------------------------|------------|----------------------------|------------|--------------------------------|------------|---------------------------------------------------------|------------|
| Cash flows used in  operating  activities:                                                       |       |                                      |       |                       |       |                     |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Net (loss) income                                                                                |       |                                      | $          | (38,839                    | )          |                     |       | $                          | (38,839    | )                              |       | $                                                       | (58,594    | ) |   | $ | 19,169 |   |   |   | $ | 78,264 |   |   |   | $ | (38,839 | ) |   |
| Adjustments  to reconcile net (loss) income to net cash used in operating  activities: |       |                                      |       |                       |       |                     |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Depreciation and  amortization                                                                   |       |                                      | —     |                       |       |                     | —     |                       |       | 56,082                         |       |                                                    | —     |   |   |   | — |   |   |   | 56,082 |   |   |
| Deferred income taxes                                                                            |       |                                      | —     |                       |       |                     | —     |                       |       | (47,829                        | )          |                                                    | 16,125     |   |   |   | (40 | ) |   |   | (31,744 | ) |   |
| Non-cash rent expense                                                                            |       |                                      | —     |                       |       |                     | —     |                       |       | 10,132                         |       |                                                    | —     |   |   |   | — |   |   |   | 10,132 |   |   |
| Other non-cash expense                                                                           |       |                                      | —     |                       |       |                     | —     |                       |       | (2,104                         | )          |                                                    | —     |   |   |   | — |   |   |   | (2,104 | ) |   |
| Equity in income of  subsidiaries                                                                |       |                                      | 38,839     |                       |       |                     | 38,839     |                       |       | —                         |       |                                                    | 586        |   |   |   | (78,264 | ) |   |   | — |   |   |
| Changes  in operating assets and liabilities:                                                    |       |                                      |       |                       |       |                     |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Receivables                                                                                      |       |                                      | —     |                       |       |                     | 137        |                       |       | 31,601                         |       |                                                    | (27,880    | ) |   |   | 40 |   |   |   | 3,898 |   |   |
| Inventories                                                                                      |       |                                      | —     |                       |       |                     | —     |                       |       | 4,466                          |       |                                                    | —     |   |   |   | — |   |   |   | 4,466 |   |   |
| Accounts payable                                                                                 |       |                                      | —     |                       |       |                     | —     |                       |       | (6,589                         | )          |                                                    | —     |   |   |   | — |   |   |   | (6,589 | ) |   |
| Prepaid and accrued expenses                                                                     |       |                                      | —     |                       |       |                     | (137       | )                          |       | (11,951                        | )          |                                                    | —     |   |   |   | — |   |   |   | (12,088 | ) |   |
| Other assets and liabilities, net                                                                |       |                                      | —     |                       |       |                     | —     |                       |       | 14,299                         |       |                                                    | (8,025     | ) |   |   | — |   |   |   | 6,274 |   |   |
| NET CASH USED IN OPERATING ACTIVITIES                                                       |       |                                      | —     |                       |       |                     | —     |                       |       | (10,487                        | )          |                                                    | (25        | ) |   |   | — |   |   |   | (10,512 | ) |   |
| Cash flows used in  investing  activities:                                                       |       |                                      |       |                       |       |                     |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Capital expenditures                                                                             |       |                                      | —     |                       |       |                     | —     |                       |       | (18,386                        | )          |                                                    | —     |   |   |   | — |   |   |   | (18,386 | ) |   |
| Lease acquisition and other costs                                                                |       |                                      | —     |                       |       |                     | —     |                       |       | (6,904                         | )          |                                                    | —     |   |   |   | — |   |   |   | (6,904 | ) |   |
| Proceeds from sale of property                                                                   |       |                                      | —     |                       |       |                     | —     |                       |       | 7,069                          |       |                                                    | —     |   |   |   | — |   |   |   | 7,069 |   |   |
| NET CASH USED IN INVESTING ACTIVITIES                                                       |       |                                      | —     |                       |       |                     | —     |                       |       | (18,221                        | )          |                                                    | —     |   |   |   | — |   |   |   | (18,221 | ) |   |
| Cash flows from  financing activities:                                                           |       |                                      |       |                       |       |                     |       |                       |       |                           |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Proceeds from senior  secured notes                                                              |       |                                      | —     |                       |       |                     | —     |                       |       | 47,860                         |       |                                                    | —     |   |   |   | — |   |   |   | 47,860 |   |   |
| Borrowings from revolving credit facility                                                        |       |                                      | —     |                       |       |                     | —     |                       |       | 1,339,509                      |       |                                                    | —     |   |   |   | — |   |   |   | 1,339,509 |   |   |
| Repayments of revolving credit facility                                                          |       |                                      | —     |                       |       |                     | —     |                       |       | (1,353,619                     | )          |                                                    | —     |   |   |   | — |   |   |   | (1,353,619 | ) |   |
| Repayments of capital lease obligations                                                          |       |                                      | —     |                       |       |                     | —     |                       |       | (2,083                         | )          |                                                    | —     |   |   |   | — |   |   |   | (2,083 | ) |   |
| Deferred financing costs                                                                         |       |                                      | —     |                       |       |                     | —     |                       |       | (2,942                         | )          |                                                    | —     |   |   |   | — |   |   |   | (2,942 | ) |   |
| NET CASH PROVIDED BY FINANCING ACTIVITIES                                                   |       |                                      | —     |                       |       |                     | —     |                       |       | 28,725                         |       |                                                    | —     |   |   |   | — |   |   |   | 28,725 |   |   |
| Net increase (decrease) in cash                                                                  |       |                                      | —     |                       |       |                     | —     |                       |       | 17                             |       |                                                    | (25        | ) |   |   | — |   |   |   | (8 | ) |   |
| Cash at beginning of period                                                                      |       |                                      | —     |                       |       |                     | —     |                       |       | 1,297                          |       |                                                    | 32         |   |   |   | — |   |   |   | 1,329 |   |   |
| Cash at end of  period                                                                           |       |                                      | $          | —                     |       |                     |       | $                          | —     |                           |       | $                                                       | 1,314      |   |   | $ | 7 |   |   |   | $ | — |   |   |   | $ | 1,321 |   |   |

 

30

----

**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 52.9% and 53.5% of our sales in the thirteen andthirty-nine weeks ended September 30, 2006, respectively, as compared to51.9% and 51.2% in the corresponding periods last year. Gross margins generatedby our front-end business are approximately twice that of our pharmacy orback-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%. In recenthistory, front-end sales have represented a decreasing share of business yearafter year; 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 sales representedby lower-priced generic medications and increased penetration by mail order andinternet-based pharmacies. Our pharmacy sales include all items we sell byprescriptions filled at our retail locations or by our central fill facilityand delivered to our stores or direct to customers. In addition, we include inour pharmacy sales certain resales of retail pharmaceutical inventory that arerequired to be reported on a gross basis in accordance with Emerging IssuesTask Force Issue No. 99-19, “Reporting Revenue Gross as a Principalvs. Net as an Agent.” Same-store pharmacy sales do not include such resaleactivity. The pharmacy portion of our business is dominated by and dependentupon a number of third party private and government-sponsored plans that contractwith us as an authorized provider of prescriptions.

Sales processed through third party prescription plansrepresented approximately 92.9% and 92.8% of our prescription sales in the thirteenand thirty-nine weeks ended September 30, 2006, respectively, andapproximately 92.6% and 92.7% of our prescription sales in the thirteen andthirty-nine weeks ended September 24, 2005, respectively. Historically,excluding pharmacy resale activity, our pharmacy sales experienced a fasterrate of sales growth than the front-end portion of our business due to a numberof favorable demographic and industry trends such as the aging of thepopulation, 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 retail 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 

31

----

benefit that expandedMedicare coverage of prescription drugs for Medicare participants not enrolledin third party plans as well as for certain Medicare “dual eligible”participants that were previously covered under state administered Medicaidplans. This new Medicare coverage took effect in January 2006 and hasresulted in decreased pharmacy margins due to its lower reimbursement rates comparedto our current margins on prescriptions that are not subject to third partyreimbursement, as well as for customers transferred into the Medicare Part Dprogram from New York Medicaid. Based on our experience, we expect, over time,that increased utilization of prescription drugs by Medicare participantsenrolled in the new programs that previously were cash paying customers mayoffset the adverse effect of lower margins on our revenues, although we are notcertain this will be the case. State Medicaid programs that provideprescription benefits to low income households and individuals havehistorically represented slightly less than 25% of our retail pharmacy sales.As of September 2006, state Medicaid plans had declined to approximately15.0% of our pharmacy sales while the new Medicare Part D plan representedapproximately 11.7% of our pharmacy sales.

In each of the past three years, New York State hasenacted rules related to Medicaid which have reduced reimbursement ratesand therefore our pharmacy margin. New York has again changed its rules effectiveJuly 1, 2006. We estimate that these most recent changes will reduce ourannual pharmacy margin by approximately $1.6 million.

In an effort to offset some of the adverse pharmacygross margin impacts from the trends discussed above, there has been anintensified effort on the part of retailers to support increased utilization oflower priced but higher margin generic prescriptions in place of brandedmedications. Generic prescriptions generally have lower retail sales prices butare more profitable for the pharmacy than branded prescriptions. Improvedgeneric utilization rates as well as a combination of direct purchases andcontractual wholesaler purchases enabled us to achieve improved gross marginson pharmacy retail sales during 2004 and 2005. For the quarter ended September 30,2006, we continued to see increased generic substitution rates. The proportionof generic prescriptions dispensed was 52.6%, compared to 49.2% in the sameperiod last year.

We are also impacted by legislation to increase stateminimum hourly wages. New York State increased the minimum hourly 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 again to $7.15 on October 1, 2006. While these increases willimpact our cost of labor, we believe we can offset a significant portion ofthese cost increases through initiatives designed to further improve our laborefficiency.

Our primary assets are ourownership of 100% of the outstanding capital stock of Duane Reade Inc.,which in turn owns 99% of the outstanding partnership interest of Duane ReadeGP and all of the outstanding common stock of DRI I Inc. DRI I Inc.owns the remaining 1% partnership interest in Duane Reade GP. Substantially allof our operations are conducted through Duane Reade GP. In August 1999, weestablished two new subsidiaries, Duane Reade International, Inc. andDuane Reade Realty, Inc. Duane Reade GP distributed to DuaneReade Inc. and DRI I Inc. all rights, title, and interest in all itstrademarks, trade names and all other intellectual property rights. In turn,Duane Reade Inc. and DRI I Inc. made a capital contribution of theseintellectual property rights to Duane Reade International. This change createda controlled system to manage and exploit these intellectual property rightsseparate and apart from the retail operations. In addition, Duane Reade GPdistributed some of its store leases to Duane Reade Inc. and DRII Inc., which in turn made a capital contribution of these leases to DuaneReade Realty. Duane Reade Realty is the lessee under certain store leasesentered into after its creation. Duane Reade Realty subleases to Duane Reade GPthe properties subject to those leases. The consolidated financial statementsincluded in this filing reflect the accounts of Duane Reade Holdings, Inc.and its subsidiaries for all periods shown. All significant intercompanytransactions and balances have been eliminated.

32

----

**New York CityEconomy**

We operate approximately88% of our 249 stores in New York City and the remainder in the surroundingareas, and our financial performance is therefore heavily influenced by thelocal economy. We analyze a number of economic indicators specific to New YorkCity to gauge the health of this economy, including unemployment rates, jobcreation, gross city product and bridge and tunnel commuter traffic patterns.We also analyze market share data, same-store sales trends, average store salesand sales per square foot data among other key performance indicators tomonitor our overall performance. During 2004, 2005 and the first nine months of2006, the New York City economy generally reflected an improving trend for mostof these external economic indicators. The September 2006 unemploymentdata for New York City indicated an unemployment rate of 4.5%, compared to acorresponding national rate of 4.6%.

**Audit CommitteeInvestigation**

The Audit Committee, with the assistance ofindependent counsel, conducted a review and investigation of the fiscal periodsfrom 2000 through September 30, 2006, relating to arrangements originated bythe former CEO for the issuance of improper credits and the subsequent rebillingof such credits related to amounts paid to construction and other contractorsat its stores and the related improper accounting. The Audit Committee has completedits investigation.

Theinvestigation focused principally on the accounting impact of approximately$5.8 million of credits from construction contractors that were improperlytaken into our income and offsetting rebillings which were improperly recordedas capital expenditures in subsequent quarters by us.  The following table summarizes suchconstruction credits identified in the investigation, by period (dollars inthousands): 

| **Fiscal Period**                           | ** ** | ** ** | ** ** | **Amount of  Credits** | ** ** |
|--------------------------------------------------|------------|------------|------------|-----------------------------|------------|
| 2000 Fiscal Year  (Predecessor)                  |       |       | $          | 317                         |       |   |
| 2001 Fiscal Year  (Predecessor)                  |       |       | 1,386      |                        |       |
| 2002 Fiscal Year  (Predecessor)                  |       |       | 3,060      |                        |       |
| 2003 Fiscal Year  (Predecessor)                  |       |       | 752        |                        |       |
| Seven months ended July  30, 2004 (Predecessor)  |       |       | —     |                        |       |
| Five months ended  December 25, 2004 (Successor) |       |       | 297        |                        |       |
| 2005 Fiscal Year  (Successor)                    |       |       | —     |                        |       |
| 39 weeks ended September  30, 2006 (Successor)   |       |       | —     |                        |       |
| Total                                            |       |       | $          | 5,812                       |       |   |

 

**The Audit Committee believes thatall of such credits were subsequently rebilled by the contractors and that wepaid the contractors such rebilled amounts.**

**The credits had the effect of improperlyoffsetting SG&A expense (and improperly increasing net income) during theperiods in which they were received. Amounts subsequently rebilled by us were generally capitalized as storeimprovements, improperly increasing the reported level of property andequipment as well as subsequent depreciation expense.  The overstated net property and equipmentthat resulted from the credit/rebilling practice was also carried through theAcquisition-related purchase accounting process on a dollar-for-dollar basis.**

In the periods from fiscal 2000 through the sevenmonths ended July 30, 2004, increased depreciation resulted in a partial offsetand understatement of operating income and income before income taxes.  In the periods subsequent to July 30, 2004,increased depreciation resulted in an overstatement of operating loss and lossbefore income taxes.  Income tax expensemay also have been reduced as a result, based on the tax impact of suchdepreciation expense. Due to tax valuation reserves being recorded during 2006,there would not be any impact upon income tax expense for the 2006 periods.

33

----

Net income (loss) for all of the above periods wouldreflect the combined impact of the overstatement or understatement of income(loss) before income taxes and any related changes in income tax expense(benefit).

The correction of the cumulative effect of the creditsand re-billings on our results of operations is included in the results for thethirteen and thirty-nine weeks ended September 30, 2006 presented in thisreport. These corrections resulted in the following adjustments (dollars inthousands):

Depreciation and amortization was reduced by $960

Operating loss decreased by $960

Loss before income taxes decreased by $960

Net loss decreased by $960

The credit/rebilling practice resulted in theoverstatement of net property and equipment in all periods since there-billings occurred. As a result of the overstatement of net property andequipment and related purchase accounting adjustments made in connection withthe acquisition by Oak Hill Capital Partners, L.P. on July 30, 2004 (the“Acquisition”), goodwill was also understated. The correction of the cumulative effect of the credits and re-billingson our balance sheet at September 30, 2006 is reflected in the balance sheetpresented in this report. These corrections resulted in the followingadjustments (dollars in thousands):

Net property, plant and equipment was reduced by$3,278

Goodwill increased by $4,238

Stockholder’s equity increased by $960

These corrections had no impact upon net cash used inoperating, investing or financing activities.

While we have reflected the correction of thecumulative effect of the credits and re-billings in the financial statements presentedherein, the effect of these credits and re-billings on SG&A expense,depreciation expense and net income (loss) for previously reported periods issummarized below as follows (dollars in thousands): 

| **Fiscal Period**                           | ** ** | ** ** | ** ** | **Increase  (Decrease) in  SG&A Expense** | ** ** | **Increase  (Decrease) in  Depreciation  Expense** | ** ** | **Increase  (Decrease) in  Net Income  (Loss)** | ** ** |
|--------------------------------------------------|------------|------------|------------|---------------------------------------------------------|------------|---------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| 2000 Fiscal Year  (Predecessor)                  |       |       | $          | (317                                                    | )          |                                                    |       | $                                                         | 16         |   |   |   | $ | 180 |   |   |
| 2001 Fiscal Year  (Predecessor)                  |       |       | $          | (1,386                                                  | )          |                                                    |       | $                                                         | 101        |   |   |   | $ | 781 |   |   |
| 2002 Fiscal Year  (Predecessor)                  |       |       | $          | (3,060                                                  | )          |                                                    |       | $                                                         | 323        |   |   |   | $ | 1,763 |   |   |
| 2003 Fiscal Year  (Predecessor)                  |       |       | $          | (752                                                    | )          |                                                    |       | $                                                         | 514        |   |   |   | $ | 173 |   |   |
| Seven months  ended July 30, 2004 (Predecessor)  |       |       | $          | —                                                  |       |                                                    |       | $                                                         | 323        |   |   |   | $ | (241 | ) |   |
| Five months ended  December 25, 2004 (Successor) |       |       | $          | —                                                  |       |                                                    |       | $                                                         | (60        | ) |   |   | $ | 60 |   |   |
| 2005 Fiscal Year  (Successor)                    |       |       | $          | —                                                  |       |                                                    |       | $                                                         | 582        |   |   |   | $ | (582 | ) |   |

 

34

----

The effect of thesecredits and re-billings on our net property and equipment for previouslyreported periods is summarized below (dollars in thousands):

| **Period Ended**            | ** ** | ** ** | ** ** | **Overstatement  in Property and  Equipment, Net** | ** ** |
|----------------------------------|------------|------------|------------|-------------------------------------------------------------------|------------|
| December 30, 2000  (Predecessor) |       |       | $          | 301                                                               |       |   |
| December 29, 2001  (Predecessor) |       |       | $          | 1,586                                                             |       |   |
| December 28, 2002  (Predecessor) |       |       | $          | 4,323                                                             |       |   |
| December 27, 2003  (Predecessor) |       |       | $          | 4,561                                                             |       |   |
| July 30, 2004  (Predecessor)     |       |       | $          | 4,238                                                             |       |   |
| December 25, 2004  (Successor)   |       |       | $          | 4,298                                                             |       |   |
| December 31, 2005  (Successor)   |       |       | $          | 3,716                                                             |       |   |

 

All of the credit/rebilling activity uncovered by theinvestigation occurred during the tenure of our former Chairman and ChiefExecutive Officer, who was replaced in November 2005. Information gatheredin the course of the investigation has led the Audit Committee to conclude thatthe former Chairman and Chief Executive Officer authored, approved and directedthe improper credit/rebilling activity. The Audit Committee also determinedthat Mr. John Henry, our Chief Financial Officer, was not involved in theorigination or approval of any of the misstatements and was unaware of the credit/rebillingpractice.

The credit/rebilling practice has not had any effect onour revenues or liquidity.  In addition,the Audit Committee has determined that, as a result of the July 30, 2004Acquisition and the related purchase accounting adjustments, thecredit/rebilling practice and the associated misstatements have not had amaterial effect on our financial condition or results of operations for anyperiods subsequent to the Acquisition, including the 13 weeks and 39 weeksended September 24, 2005 and September 30, 2006 and that no restatements of anypreviously issued post-Acquisition financial statements will be necessary.  With respect to the predecessor periods priorto the Acquisition, the Audit Committee has concluded that, in view of thedisclosure provided in this report regarding the credit/rebilling practice andthe associated misstatements (including the adjustments disclosed in thisreport), the fact that there are no longer any public stockholders as a resultof the purchase of all of the common equity of our predecessor by Oak Hill inJuly 2004 and other factors, restatements of previously-issued predecessorfinancial statements would not be material to our public securityholders.Therefore, the Audit Committee has determined that restatements ofpreviously-issued predecessor financial statements as a result of thecredit/rebilling practice will also not be necessary.

In addition, as a part of its investigation, the AuditCommittee also examined certain invoices from store maintenance and othercontractors to determine whether the amounts paid to those contractors wereaccounted for properly. Having completed its investigation with respect to thoseinvoices, the Audit Committee believes that any misstatements with respect tosuch invoices were inconsequential.

The financial informationfor the three and nine month periods ended September 30, 2006 that is discussedin this Management’s Discussion and Analysis of Financial Condition and Resultsof Operations has been adjusted to eliminate the effects of the credits andrebillings.

35

----

**Results ofOperations**

***The Thirteen Weeks Ended September 30, 2006 asCompared to the Thirteen Weeks Ended September 24, 2005***

For the thirdquarter of 2006, we achieved net sales of $385.6 million and incurred a netloss of $18.7 million, as compared to net sales of $378.6 million and anet loss of $15.7 million in the third quarter of the previous year. Pharmacyresale activity was $15.8 million in the third quarter of 2006, compared to$19.3 million in the previous year, resulting from reduced outside customerdemand. The increased loss is attributable to the following factors:

·       A tax provision of $0.7 million in the third quarter of 2006, comparedto a tax benefit of $12.9 million in the prior year. The change in the taxprovision was primarily attributable to the fact that the current year’s incometax benefit was fully reserved for by a $8.5 million deferred tax valuationreserve.

·       An increase in interestexpense of $1.7 million resulting from higher interest rates applicable toour variable rate debt and higher debt levels resulting from the August 2005issuance of $50 million of senior secured notes.

The negative impactof these items was partially offset by:

·       An increase in gross marginof $7.9 million, that was primarily attributable to higher front-end storesales.

·       A decrease in selling,general and administrative expenses of $0.9 million, primarily reflectingdecreased legal and professional fees resulting from the settlement of certainlong-running litigations, partially offset by the impact of increased payrollcosts resulting from general merit increases and increases in the New YorkState minimum wage rate as well as increased supervisory hirings.

·       A reduction in laborcontingency expenses of $1.1 million resulting from the favorable settlement ofthe NLRB litigation in April 2006.

·       A reduction in otherexpenses of $1.3 million, primarily due to employment costs related to ourformer Chairman and CEO incurred in the third quarter of 2005 that did notrecur in 2006.

36

----

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

| ** **                                           | ** ** | **For the 13 Weeks Ended**      | ** ** |
|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                           | ** ** | **September 30, 2006**                    | ** ** | **September 24, 2005** | ** ** |
| ** **                                           | ** ** | **Dollars**                                         | ** ** | **% of Sales** | ** ** | **Dollars** | ** ** | **% of Sales** | ** ** |
| ** **                                           | ** ** | **In thousands, except percentages** | ** ** |
| Net sales                                            |       | $                                                   | 385,655    |   |   | 100.0 | % |   |   | $ | 378,557 |   |   |   | 100.0 | % |   |
| Cost of sales                                        |       | 305,016                                             |       |   | 79.1 |   |   |   | 305,866 |   |   |   | 80.8 |   |   |
| Gross profit                                         |       | 80,639                                              |       |   | 20.9 |   |   |   | 72,691 |   |   |   | 19.2 |   |   |
| Selling,  general & administrative expenses |       | 67,077                                              |       |   | 17.4 |   |   |   | 67,950 |   |   |   | 17.9 |   |   |
| Labor contingency  expense                           |       | —                                              |       |   | 0.0 |   |   |   | 1,100 |   |   |   | 0.3 |   |   |
| Transaction  expenses                                |       | —                                              |       |   | 0.0 |   |   |   | 236 |   |   |   | 0.1 |   |   |
| Depreciation and  amortization                       |       | 16,903                                              |       |   | 4.4 |   |   |   | 17,816 |   |   |   | 4.7 |   |   |
| Store pre-opening  expenses                          |       | 153                                                 |       |   | 0.0 |   |   |   | 114 |   |   |   | 0.0 |   |   |
| Other                                                |       | 148                                                 |       |   | 0.0 |   |   |   | 1,454 |   |   |   | 0.4 |   |   |
| Operating loss                                       |       | (3,642                                              | )          |   | -0.9 |   |   |   | (15,979 | ) |   |   | -4.2 |   |   |
| Interest expense,  net                               |       | 14,356                                              |       |   | 3.7 |   |   |   | 12,654 |   |   |   | 3.3 |   |   |
| Loss before  income taxes                            |       | (17,998                                             | )          |   | -4.7 |   |   |   | (28,633 | ) |   |   | -7.6 |   |   |
| Income tax  provision (benefit)                      |       | 734                                                 |       |   | 0.2 |   |   |   | (12,885 | ) |   |   | -3.4 |   |   |
| Net loss                                             |       | $                                                   | (18,732    | ) |   | -4.9 | % |   |   | $ | (15,748 | ) |   |   | -4.2 | % |   |

 

Net sales were $385.6 million in the thirteenweeks ended September 30, 2006, representing an increase of 1.9% ascompared to net sales of $378.6 million in the thirteen weeks ended September 24,2005. Resale activity accounted for a decrease of 0.9%, while retail storesales to customers increased by 2.8% over this period. Same-store salesincreased by 4.4% over the third quarter last year.

Pharmacy sales decreased from $181.9 million inthe third quarter of 2005 to $181.4 million in the third quarter of 2006,a decrease of 0.2%, and represented 47.1% of total sales, as compared with48.1% of total sales in the third quarter of 2005. The overall pharmacy salesdecrease includes a decrease of 2.0% resulting from the reduced resaleactivity, partially offset by an increase of 1.8% in retail pharmacy sales.Pharmacy same-store sales increased by 2.9% from last year, and third-partyreimbursed pharmacy sales represented 92.9% of total prescription sales comparedto 92.6% in the third quarter of 2005. Pharmacy same-store sales were adverselyimpacted by approximately 0.2% due to negative publicity and reduced consumerdemand for arthritis medications and certain other high volume drugs. Thepercentage of generic drugs dispensed increased by 3.4% over the prior year,negatively impacting the pharmacy same-store sales increase by approximately2.7%, but contributing to an increase in gross margin per prescriptiondispensed. Generic drugs generally have lower retail sales prices but are moreprofitable for the pharmacy than branded drugs.

Front-end sales increased from $196.6 million inthe third quarter of 2005 to $204.2 million in the third quarter of 2006,an increase of 3.8%, and represented 52.9% of total sales, as compared to 51.9%of total sales in the third quarter of 2005. Front-end same-store salesincreased by 5.7%, primarily due to a generally improved level of consumerdemand resulting from a stronger New York City economy, increased penetrationof our Dollar Rewards program, an improved merchandise offering and enhancedcustomer service reflecting the implementation of our “Full Potential”initiative introduced earlier this year.

During the thirteen weeks ended September 30,2006, we opened two stores, as compared to two stores opened and three storesclosed during the thirteen weeks ended September 24, 2005. At September 30,2006, we operated 249 stores, as compared to 249 stores at September 24,2005 and 251 stores at December 31, 2005.

37

----

Cost of sales as a percentage of net sales was 79.1%in the third quarter of 2006 and 80.8% in the third quarter of 2005, resultingin gross profit margins of 20.9% and 19.2%, respectively. This increase ingross profit margins was primarily attributable to improved front-end sellingmargins associated with a more favorable mix of promotional andregularly-priced product margins, as well as reduced shrink losses. Cost ofsales also includes a $0.6 million LIFO provision in the current year’sthird quarter as compared to a LIFO provision of $0.3 million in thecorresponding period last year, and real-estate related income of$0.2 million in the third quarter of 2006 as compared to $2.2 million inthe corresponding period of 2005.

Selling, general and administrative expenses were $67.1million, or 17.4% of net sales, and $68.0 million, or 17.9% of net sales,in the third quarter of 2006 and 2005, respectively. The decrease in theseexpense ratios to sales as compared to the prior year was attributable todecreased legal and professional fees resulting from the settlement of certainlong-running litigations, as well as various process improvement initiativesdesigned to reduce store operating costs.

Depreciation and amortization of property andequipment and intangible assets was $16.9 million in the third quarter of2006, as compared to $17.8 million in the third quarter of 2005. The netdecrease reflects the impact of the adjustments described in Note 1 to thefinancial statements included in this report, partially offset by additionalexpenses resulting 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$0.2 million in the third quarter of 2006, related to the opening of twostores. In the third quarter of 2005, we incurred pre-opening costs of $0.1million, attributable to the opening of two stores.

In the third quarter of 2006,we incurred other expenses of $0.1 million, including Oak Hill management fees($0.3 million), additional severance costs associated with the termination ofcertain executive management positions ($0.2 million) and costs associated withvarious matters related to our current CEO and our former Chairman ($0.1million). These costs were partially offset by the reversal of the excessliability for the Company’s Phantom Shares ($0.5 million). In the third quarterof 2005, other expenses of $1.5 million included costs associated with theplanned transfer to our former Chairman of a Company-owned split dollar lifeinsurance policy ($0.7 million), Oak Hill management fees ($0.3 million), costsassociated with our former Chairman’s long-term cash award ($0.2 million) and expensesassociated with the implementation of a tax indemnity insurance policy relatedto the deductibility of certain payments made to our former Chairman inconnection with the Acquisition ($0.2 million).

Net interest expense forthe third quarter of 2006 was $14.4 million, as compared to $12.7 millionin the third quarter of 2005. This increase was primarily attributable tohigher floating interest rates and increased debt levels incurred on ourrevolving credit borrowings and senior secured notes as compared to the prioryear. At September 30, 2006, the weighted average interest rate on ourvariable rate outstanding debt was 8.57%, as compared to a weighted averagerate of 7.13% at September 24, 2005.

In the third quarter of2006, we recorded an income tax provision of $0.7 million, reflecting anestimated effective tax rate of (3.1)%. This expense is the result of avaluation allowance of $8.5 million that largely offset the tax benefitgenerated by our operating loss in the quarter. In the comparable period of2005, the income tax benefit of $12.9 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.

***The Thirty-Nine Weeks Ended September 30, 2006 asCompared to the Thirty-Nine Weeks Ended September 24, 2005***

Forthe first nine months of 2006, we achieved net sales of $1.2 billion andsustained a net loss of $49.7 million, as compared to net sales of $1.2billion and a net loss of $38.8 million in the first nine months of 2005.Pharmacy resale activity declined to $37.2 million in the first nine months of2006, compared to 

38

----

$72.3 million in the comparable period of the previousyear, resulting from reduced outside customer demand. The increased loss isattributable to the following factors:

·  A tax provision of $1.7 million in the firstnine months of 2006, compared to a tax benefit of $31.7 million in the prioryear. The change in the tax provision was primarily attributable to the factthat the current year’s income tax benefit was fully reserved for by a $22.7million deferred tax valuation reserve.

·       Anincrease in interest expense of $6.9 million resulting from higherinterest rates applicable to our variable rate debt and higher debt levels inthe first nine months of 2006 primarily resulting from the August 2005issuance of $50 million of senior secured notes.

·       Anincrease in selling, general and administrative costs of $7.7 million, primarilydue to higher labor costs that resulted from increased pharmacist salaries aswell as New York State minimum wage rate increases that became effective on January 1,2006.

·       Anincrease in depreciation and amortization expense of $0.9 million that wasattributable to the depreciation of capital expenditures and amortization ofintangibles acquired in 2005 and the first nine months of 2006.

Thenegative impact of these items was partially offset by:

·       Thereversal of $18.0 million of previously accrued labor contingency expenses thatresulted from the favorable settlement of litigation with the NLRB.

·       Anincrease in gross margin of $13.1 million, primarily attributable to higherfront-end store sales.

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

| ** **                                           | ** ** | **For the 39 Weeks Ended**      | ** ** |
|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                           | ** ** | **September 30, 2006**                    | ** ** | **September 24, 2005** | ** ** |
| ** **                                           | ** ** | **Dollars**                                         | ** ** | **% of Sales** | ** ** | **Dollars** | ** ** | **% of Sales** | ** ** |
| ** **                                           | ** ** | **In thousands, except percentages** | ** ** |
| Net sales                                            |       | $                                                   | 1,170,313  |   |   | 100.0 | % |   |   | $ | 1,172,824 |   |   |   | 100.0 | % |   |
| Cost of sales                                        |       | 933,114                                             |       |   | 79.7 |   |   |   | 948,729 |   |   |   | 80.9 |   |   |
| Gross profit                                         |       | 237,199                                             |       |   | 20.3 |   |   |   | 224,095 |   |   |   | 19.1 |   |   |
| Selling,  general & administrative expenses |       | 204,689                                             |       |   | 17.5 |   |   |   | 196,990 |   |   |   | 16.8 |   |   |
| Labor contingency  expense                           |       | (18,004                                             | )          |   | -1.5 |   |   |   | 3,300 |   |   |   | 0.3 |   |   |
| Transaction  expenses                                |       | —                                              |       |   | 0.0 |   |   |   | 817 |   |   |   | 0.1 |   |   |
| Depreciation and  amortization                       |       | 54,209                                              |       |   | 4.6 |   |   |   | 53,313 |   |   |   | 4.5 |   |   |
| Store pre-opening  expenses                          |       | 305                                                 |       |   | 0.0 |   |   |   | 264 |   |   |   | 0.0 |   |   |
| Other                                                |       | 1,783                                               |       |   | 0.2 |   |   |   | 4,636 |   |   |   | 0.4 |   |   |
| Operating loss                                       |       | (5,783                                              | )          |   | -0.5 |   |   |   | (35,225 | ) |   |   | -3.0 |   |   |
| Interest expense,  net                               |       | 42,229                                              |       |   | 3.6 |   |   |   | 35,318 |   |   |   | 3.0 |   |   |
| Loss before  income taxes                            |       | (48,012                                             | )          |   | -4.1 |   |   |   | (70,543 | ) |   |   | -6.0 |   |   |
| Income tax  provision (benefit)                      |       | 1,661                                               |       |   | 0.1 |   |   |   | (31,704 | ) |   |   | -2.7 |   |   |
| Net loss                                             |       | $                                                   | (49,673    | ) |   | -4.2 | % |   |   | $ | (38,839 | ) |   |   | -3.3 | % |   |

 

Net sales were $1.2 billion in the thirty-nineweeks ended September 30, 2006, representing a decrease of 0.2% ascompared to net sales of $1.2 billion in the thirty-nine weeks ended September 24,2005. Resale activity accounted for a decrease of 3.0%, while retail storesales to customers increased by 2.8% over this period. Same-store salesincreased by 3.7% over the same period in 2005.

Pharmacy sales decreased from $572.4 million inthe first nine months of 2005 to $544.0 million in the first nine monthsof 2006, a decrease of 5.0%, and represented 46.5% of total sales, as comparedwith 

39

----

48.8% of total sales inthe first nine months of 2005. The overall pharmacy sales decrease includes adecrease of 6.1% resulting from the reduced resale activity, partially offsetby an increase of 1.1% in retail pharmacy sales. Pharmacy same-store salesincreased by 1.4% from last year, and third-party reimbursed pharmacy sales represented92.8% of total prescription sales compared to 92.7% in the comparable period of2005.

Front-end sales increased from $600.4 million inthe first nine months of 2005 to $626.3 million in the first nine monthsof 2006, an increase of 4.3%, and represented 53.5% of total sales, as comparedto 51.2% of total sales in the first nine months of 2005. Front-end same-storesales increased by 5.6%, primarily due to a generally improved level ofconsumer demand resulting from a stronger New York City economy, increasedpenetration of our Dollar Rewards loyalty card program, an improved merchandiseoffering and enhanced customer service reflecting the implementation of our“Full Potential” initiative introduced earlier this year.

During the thirty-nine weeks ended September 30,2006, we opened five stores and closed seven stores, as compared to five storesopened and eleven stores closed during the thirty-nine weeks ended September 24,2005.

Cost of sales as a percentage of net sales was 79.7%in the first nine months of 2006 and 80.9% in the first nine months of 2005,resulting in gross profit margins of 20.3% and 19.1%, respectively. Thisincrease in gross profit margins was primarily attributable to reduced lowermargin pharmacy resale activity, an improved mix of higher-margin front-endsales and reduced shrink losses. Cost of sales also includes a$1.7 million LIFO provision in the current year’s first nine months ascompared to a LIFO provision of $0.4 million in the corresponding period lastyear, and real-estate related income of $0.4 million in the first nine monthsof 2006 as compared to $2.5 million in the first nine months of 2005.

Selling, general and administrative expenses were $204.7 million,or 17.5% of net sales, and $197.0 million, or 16.8% of net sales, in thefirst nine months of 2006 and 2005, respectively. The increase in these expenseratios to sales as compared to the prior year was attributable to the reducedlevel of pharmacy resale activity as well as increased store selling expenses.The increase in store selling expenses was primarily due to higher labor coststhat resulted from increased pharmacist salaries as well as New York State minimumwage rate increases that became effective on January 1, 2006. Theseincreased costs were partially offset by reduced legal and professional feesresulting from the settlement of certain long-running litigations.

Depreciation and amortization of property andequipment and intangible assets was $54.2 million in the first nine monthsof 2006, as compared to $53.3 million in the first nine months of 2005.This increase resulted from the depreciation of capital expenditures made in2005 and 2006 and amortization of identifiable intangibles acquired over thesame period.

We incurred store pre-opening expenses of $0.3 millionin the first nine months of both 2006 and 2005, related to the opening of fivestores in each period.

In the first nine months of 2006, we incurred otherexpenses of $1.8 million including Oak Hill management fees ($0.9 million), costsassociated with various matters related to our current CEO and former Chairman($0.7 million), severance and other costs resulting from the termination ofemployment of three former executives ($0.5 million) and expenses attributableto a retention bonus paid to our current CEO ($0.2 million). These costs werepartially offset by the reversal of the excess liability for the Company’sPhantom Shares ($0.5 million). In the corresponding period in 2005, otherexpenses of $4.6 million included costs associated with the planned transfer toour former Chairman of a Company-owned split dollar life insurance policy ($2.0million), expenses associated with the implementation of a tax indemnityinsurance policy related to the deductibility of certain payments made to ourformer Chairman in connection with the Acquisition ($1.0 million), Oak Hillmanagement fees ($0.9 million) and costs associated with our former Chairman’slong-term cash award ($0.7 million).

40

----

Net interest expense for the first nine months of 2006was $42.2 million, as compared to $35.3 million in the first nine monthsof 2005. This increase was primarily attributable to higher floating interestrates and increased debt levels incurred on our revolving credit borrowings andsenior secured notes as compared to the prior year.

In the first nine monthsof 2006, we recorded an income tax provision of $1.7 million, reflectingan estimated effective tax rate of (3.1)%. This expense is the result of avaluation allowance of $22.7 million that largely offset the tax benefitgenerated by our operating loss in the first nine months. In the comparableperiod last year, the income tax benefit of $31.7 million reflected anestimated effective 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.

**Liquidity andCapital Resources**

**Working Capital andCash Flow**

Working capital was$15.3 million as of September 30, 2006 and $50.4 million as of December 31,2005. The primary factors affecting the reduction in working capital from December 31,2005 include: 

·          increased borrowings of $29.2 million on ourasset-based revolving loan,

·     increased accounts payable of $12.9million,

·     receivable reductions of $5.1 million,

·     inventory reductions of $4.9million and

·     a decrease in the current portion ofdeferred tax assets of $2.8 million. 

These items were partially offset by reductionsin other expense accruals of $19.9 million resulting primarily from reducedlegal and professional fees, the payment of certain previously accrued legalsettlements and the timing of the Company’s payroll cycle and the semi-annualinterest payment on the Company’s senior subordinated notes. Working capitalreflects the classification of outstanding borrowings under our revolving loanfacility of $164.9 million at September 30, 2006 and$135.7 million at December 31, 2005 as current liabilities. Thiscurrent classification is required because cash receipts controlled by thelenders are used to reduce outstanding debt and we do not meet the criteria ofStatement of Financial Accounting Standard No. 6 “Classification of ShortTerm Obligations Expected to be Refinanced” (FAS 6) to reclassify the debt aslong-term, but is not, an indication that this credit facility is expected tobe retired within the next year. This facility expires in July 2011 and weintend to continue to access it for our working capital needs throughout itsremaining term.

On July 7, 2006, we entered into a thirdamendment to the credit agreement governing our $225 million asset-basedrevolving loan facility discussed above. The third amendment extends thematurity date of the asset-based revolving loan facility from July 21,2008 to July 21, 2011. Refer to Note 7 of the Unaudited ConsolidatedInterim Financial Statements contained elsewhere in this document for furtherinformation related to this amendment.

Net cash used in operating activities was $5.3 millionin the thirty-nine weeks ended September 30, 2006 compared to net cashused in operating activities of $10.5 million in the thirty-nine weeksended September 24, 2005. The use of cash in the current year includesapproximately $7.5 million of payments made in connection with the settlementof certain long-running litigations, as well as approximately $2.5 millionof severance and other compensation-related payments made to certain formeremployees, including approximately $1.9 million to our former Chairman. The useof cash in the prior year primarily reflects the net $8.7 million paid to ourformer Chairman in connection with the termination of our 

41

----

obligations under his SERPagreement, as well as approximately $2.5 million of other expenditures relatedto our former Chairman’s compensation.

Net cash used in investing activities was $20.9 millionin the thirty-nine weeks ended September 30, 2006, compared to$18.2 million in the thirty-nine weeks ended September 24, 2005. Inthe first nine months of 2006, we spent $18.2 million on capitalexpenditures, primarily related to new store openings and the remodeling ofexisting locations, and $5.2 million on lease acquisition and other costs,which were partially offset by $2.5 million of cash received in connection withthe termination of a leased property. In the first nine months of 2005, capitalexpenditures of $18.4 million and lease acquisition, pharmacy customer file andother costs of $6.9 million were partially offset by $7.1 million of cashreceived in connection with the sale of property.

Net cash provided byfinancing activities was $26.2 million in the thirty-nine weeks ended September 30,2006, compared to $28.7 million in the thirty-nine weeks ended September 24,2005. The decrease in cash provided by financing activities in the current yearreflects the reduction in cash used by operations.

**Operating CapitalRequirements**

Our operating capitalrequirements primarily result from opening and stocking new stores, remodelingand renovating existing retail locations, purchasing pharmacy files and thecontinuing development of management information systems. We opened five newstores in the first nine months of 2006 and seven new stores during fiscal2005, a decline from 16 stores opened in 2004 and 17 stores opened in2003. We currently plan to open a total of six new stores in fiscal 2006 and sixnew stores in each of fiscal 2007 and fiscal 2008. In the first nine months of2006, we spent approximately $18.2 million on capital expenditures,primarily for new, renovated and replacement stores, and we spent an additional$5.2 million for lease acquisition and other costs. These amounts werepartially offset by $2.5 million of proceeds we received resulting from thetermination of a leased property. In fiscal 2005, we spent approximately$25.2 million on capital expenditures, 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 former properties. We also requireworking capital to support inventory for our existing and new stores.Historically, we have been able to lease almost all of our store locations, soacquisitions of real estate are not expected to have a significant impact onour 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 attractivereplacement locations to lease.

As of September 30, 2006, approximately 4,100 ofour approximately 6,400 employees were represented by various labor unions andwere covered 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.

42

----

Thefollowing table presents details of our significant commitments and obligationsas at September 30, 2006, except that the data provided with respect tooperating leases is as of December 31, 2005:

| ** **                                            | ** ** | **Payments due by Period** | ** ** |
|-------------------------------------------------------|------------|-------------------------------------------|------------|
| **Contractual Cash Obligations**            | ** ** | ** **                                | ** ** | **Total** | ** ** | **Within  1 year** | ** ** | **Within  2-3 years** | ** ** | **Within  4-5 years** | ** ** | **After   5 years** | ** ** |
| ** **                                            | ** ** | **(dollars in thousands)**      | ** ** |
| Long-Term Debt(1)                                     |       | $                                         | 405,032    |   | $ | — |   | $ | — |   | $ | 405,000 |   | $ | 32 |   |
| Asset-Based  Revolving Loan Facility(2)               |       | 164,918                                   |       | — |   | — |   | 164,918 |   | — |   |
| Capital Lease  Obligations(3)                         |       | 13,612                                    |       | 4,446 |   | 8,236 |   | 930 |   | — |   |
| Operating  Leases(4)                                  |       | 1,282,765                                 |       | 122,879 |   | 242,190 |   | 220,509 |   | 697,187 |   |
| Fixed Interest  Payments(5)                           |       | 95,063                                    |       | 19,013 |   | 38,025 |   | 38,025 |   | — |   |
| Former Chairman  and Other Severance Payments(6) |       | 3,223                                     |       | 2,530 |   | 693 |   | — |   | — |   |
| Former Pharmacy  Supplier Settlement(7)               |       | 1,500                                     |       | 1,500 |   | — |   | — |   | — |   |
| Landlord Real  Estate Litigation Settlement(8)        |       | 1,250                                     |       | 833 |   | 417 |   | — |   | — |   |
| Executive  Guaranteed Bonus(9)                        |       | 825                                       |       | 825 |   | — |   | — |   | — |   |
| Total Contractual Cash  Obligations                   |       | $                                         | 1,968,188  |   | $ | 152,026 |   | $ | 289,561 |   | $ | 829,382 |   | $ | 697,219 |   |
|                                                       |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

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

(2)          AtSeptember 30, 2006, approximately $164.9 million was outstanding anda further $54.6 million was available for borrowing 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 2011.

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

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

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

(6)          Reflectspayments due to our former Chairman in connection with his replacement on November 21,2005, as well as payments due to other executives whose employment wasterminated during 2006.

(7)          Reflectscash payments due to Cardinal Health, a former pharmacy inventory supplier, in connectionwith the settlement of an outstanding claim. Amounts shown are net of $3.0million paid during the first nine months of 2006.

(8)          Reflectscash payments due to the landlord of one of the Company’s stores in connectionwith the settlement of a real estate litigation.

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

43

----

Thefollowing table presents details of our other significant commercial commitmentsas atSeptember 30, 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)              |       |                                 | $          | 5,500                                                                   |       |   |   | $ | 4,477 |   |   |   | $ | 1,023 |   |   |   | $ | — |   |   |   | $ | — |   |   |
| Total Commercial Commitments               |       |                                 | $          | 5,500                                                                   |       |   |   | $ | 4,477 |   |   |   | $ | 1,023 |   |   |   | $ | — |   |   |   | $ | — |   |   |
|                                            |            |                                      |            |                                                                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)          Standbyletters of credit, primarily representing self-insured general liability claimsand property lease security deposits, are renewed on an annual basis, unlessotherwise requested by the beneficiary.

We are party tomulti-year, merchandise supply agreements in the normal course of business. Thelargest of these agreements is with AmerisourceBergen, our primarypharmaceutical supplier. Generally, these agreements provide for certain volumecommitments and may be terminated by us, subject in some cases to specifiedtermination payments, none of which we believe would constitute a material,adverse effect on our financial position, results of operations or cash flows.It is the opinion of management that if any of these agreements were terminatedor if any contracting party was to experience events precluding fulfillment ofits obligations, we would be able to find a suitable alternative supplier.

In connection with theNovember 21, 2005 replacement of our former Chairman, we are required topay to him amounts in cash totaling $6.6 million. We have paid a cumulativetotal of $3.7 million of this amount through September 30, 2006, and weexpect to pay the remaining amount in equal installments over the 15 monthsremaining through December 15, 2007. In addition, we expect to continue toprovide health insurance coverage for our former Chairman during the period inwhich he will receive severance payments and, upon expiration of that period,if he is not otherwise eligible under another employer’s comparable medicalplan, to provide him with lifetime retiree medical benefits at a cost not toexceed $50,000 annually.

In connection with theappointment of Mr. Dreiling as CEO, we made a guaranteed payment to him of$330,000 on February 17, 2006. Mr. Dreiling’s employment contract alsostipulates that a guaranteed 2006 bonus of $825,000 be paid on the same date asany other senior executive bonuses related to the 2006 fiscal year are paid,which we expect will occur in the first quarter of 2007.

In connection with theAcquisition, our former Chairman was granted equity interests in Duane ReadeShareholders and Duane Reade Holdings, consisting of options to purchase sharesof our common stock and a profits interest in Duane Reade Shareholders. As aresult of the November 21, 2005 replacement of our former Chairman, he hadthe right to require us to purchase for cash to be paid over a two year periodall or a portion of these equity interests as he may designate, at a valuedetermined in accordance with a formula. Under the provisions of his employmentagreement, all of his equity interests became fully vested in December 2005.In addition, his stock options expired unexercised on March 21, 2006. Theprofits interest will have no value unless the value of Duane ReadeShareholders appreciates following the Acquisition. Our former Chairman’spurchase right will be suspended at any time when the exercise of such purchaserights would result in a default under the financing arrangements of DuaneReade Shareholders, Duane Reade Holdings or Duane Reade Inc. On December 21,2005, our former Chairman provided notice to Duane Reade Inc. that he wasexercising his repurchase right to cause us to repurchase 5% of his profitsinterest. Pursuant to the procedures outlined in his employment agreement,Duane Reade Inc. has advised our former Chairman that the value of his profitsinterest as of December 21, 2005 was determined to equal zero. Aninvestment bank mutually acceptable to Duane Reade Inc. and our formerChairman will make a final determination of the value of the profits interestas 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 

44

----

January 15,2006, a second payment of $1.0 million that was paid on June 15, 2006, andremaining payments of $1.0 million due on December 15, 2006 and $250,000each on March 15, 2007 and June 15, 2007. All such amounts had beenpreviously 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.

**Liquidity Assessment**

Duane Reade Holdings is aholding company formed in connection with the Acquisition to hold 100% of thecommon stock of Duane Reade Inc. Duane Reade Holdings operates all of itsbusiness through Duane Reade Inc. and its subsidiaries and has no otherindependent assets, liabilities or operations, so, to the extent it hasliquidity requirements, it will depend on distributions of cash from DuaneReade Inc., to the extent permitted by the various agreements to whichDuane Reade Inc. is a party. Currently, we do not expect Duane Reade Holdingsto have any material liquidity requirements.

We believe that, based oncurrent levels of operations and anticipated growth, cash flow from operations,together with other available sources of funds, including revolving loanborrowings under the amended asset-based revolving loan facility, 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 in the nine months ended September 30, 2006 which, afteradjusting for approximately $10.0 million of unusual and non-recurring items,amounted to approximately $4.8 million, approximately $3.0 million in 2005(which includes the absorption of $9.6 million in non-recurring net cashpayments made in connection with the termination of our former Chairman’s SERP)and approximately $11.3 million in 2004 (which includes the absorption of$40.6 million in Acquisition-related costs), as well as projectedimprovements in working capital management, anticipated levels of capitalexpenditures and the additional borrowing capacity under the$225.0 million amended asset-based revolving loan facility, which wasapproximately $62.4 million at December 30, 2006. Our ability to meetour debt service obligations and reduce our total debt will depend upon ourfuture performance which, in turn, will be subject to general economic,financial, business, competitive, legislative, regulatory and other conditions,many of which are beyond our control. In addition, our operating results, cashflow and capital resources may not be sufficient for repayment of ourindebtedness in the future. Some risks that could adversely affect our abilityto meet our debt service obligations include, but are not limited to,reductions in third party prescription reimbursement rates, declines in the NewYork City economy, increases in competitive activity, adverse changes in vendorcredit terms, changes in drug consumption patterns, additional adverselegislative changes or a major disruption of business in our markets from aterrorist event, natural disaster or other unexpected events. Other factorsthat may adversely affect our ability to service our debt are described aboveunder “Special Note Regarding Forward-Looking Statements.” Borrowings under theamended asset-based revolving loan facility and the aggregate$210.0 million senior secured notes bear interest at floating rates.Therefore, our financial condition will be affected by changes in prevailinginterest rates. 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.

**Critical Accounting Policies**

Our discussion of resultsof operations and financial condition relies on our consolidated financialstatements that are prepared based on certain critical accounting policies thatrequire management to make judgments and estimates that are subject to varyingdegrees of uncertainty. We believe that investors need to be aware of thesepolicies and how they impact our financial reporting to gain a more complete 

45

----

understandingof our consolidated financial statements as a whole, as well as our relateddiscussion and analysis presented herein. While we believe that theseaccounting policies are grounded on sound measurement criteria, actual futureevents can and often do result in outcomes that can be materially differentfrom these estimates or forecasts. The accounting policies and related risksdescribed in our Annual Report on Form 10-K for the year ended December 31,2005 are those that depend most heavily on these judgments and estimates. At September 30,2006, there have been no material changes to any of the Critical AccountingPolicies contained therein.

**Off-Balance Sheet Arrangements**

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

**Seasonality**

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

**Inflation**

We believe that inflationhas not had a material impact on our results of operations during the three yearsended December 31, 2005 or the nine months ended September 30, 2006.

**Recently Issued Accounting Pronouncements**

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

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

Our financial results aresubject to risk from interest rate fluctuations on debt, which carries variableinterest rates. Variable rate debt outstanding at September 30, 2006included $164.9 million of borrowings under our amended asset-basedrevolving loan facility and $210.0 million of senior secured notes. At September 30,2006, the weighted average combined interest rate in effect on all variablerate debt outstanding was 8.57%. A 0.50% change in interest rates applied tothe $374.9 million balance of floating rate debt would affect pre-taxannual results of operations by approximately $1.9 million, excluding thebenefit of approximately $0.1 million provided by the “no cost collar” asdetailed below. In addition, we also have $195.0 million of seniorsubordinated notes and $32.0 thousand of senior convertible notes outstandingat September 30, 2006. The senior subordinated notes and seniorconvertible notes bear interest payable semi-annually at fixed rates of 9.75%and 3.75%, respectively, and are therefore not subject to risk from interestrate fluctuations.

On May 25, 2005, weentered into a hedging transaction through the acquisition of a “no costcollar.” Under this arrangement, we capped our exposure on $130 million ofLIBOR-based borrowings under the senior secured notes at a maximum LIBOR rateof 5.30%. In addition, we established a minimum “floor” LIBOR rate of 3.45%, inline with then current LIBOR rates. This hedging arrangement expires on June 16,2008. At September 30, 2006, the LIBOR rate in effect on the seniorsecured notes was 5.39%, which exceeded the maximum rate under the “no costcollar.” As a result, on an annualized basis, the interest rate protectionafforded by the “no cost collar” amounted to $117,000.

The principal objective ofour investment management activities is to maintain acceptable levels ofinterest rate and liquidity risk to facilitate our funding needs. As part ofour risk management, we may 

46

----

continueto use derivative financial products such as interest rate hedges and interestrate swaps in the future.

**ITEM4.**                CONTROLS ANDPROCEDURES

(a)  *Evaluation of DisclosureControls 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 the SecuritiesExchange Act of 1934) as of the end of the period covered by this quarterlyreport.

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

This material weaknessrelates to the lack of procedures to monitor the proper billing of constructionand other contractors and the proper accounting treatment for the amountsbilled.  As was previously disclosed, theAudit Committee of the Company, with the assistance of independent counsel, hasconducted a review and investigation of the fiscal periods from 2000 throughSeptember 30, 2006, relating to billing and accounting practices relating toamounts paid to construction and other contractors at its stores.  In the investigation, the Company identified$5.8 million of credits from construction contractors that were taken into theCompany’s income and offsetting rebillings in subsequent quarters by theCompany, as described in Note 1 to the financial statements included in thisreport and in “Item 2: Management’s Discussion and Analysis of FinancialCondition and Results of Operations—Audit Committee Investigation.”

All of the credit/rebilling activity uncovered by theinvestigation occurred during the tenure of the Company's former Chairman andChief Executive Officer, who was replaced in November 2005. Informationgathered in the course of the investigation has led the Audit Committee toconclude that the former Chairman and Chief Executive Officer authored,approved and directed the improper credit/rebilling activity. The Audit Committeealso determined that Mr. John Henry, the Company's Chief FinancialOfficer, was not involved in the origination or approval of any of themisstatements and was unaware of the credit/rebilling practice. In the AuditCommittee's judgment, as a result of the actions of the former Chairman andChief Executive Officer, the Company failed to maintain effective internalcontrol over financial reporting and disclosure controls and procedures, andthe Audit Committee would have recommended, as remedial action, that theCompany replace its former Chairman and Chief Executive Officer, had theCompany not already done so, in addition to the improvements in internalcontrol over financial reporting discussed below.

(b) *Changes in Internal Control overFinancial Reporting*.   From the discoveryof the misstatements, the Company recognized that its system of internalcontrol over capital expenditures did not provide for sufficient documentarysupport or independent invoice review and authorization that might haveprevented them from occurring. In response to this, the Company’s FinanceDepartment is installing a double authorization procedure for all significantinvoice payments within each operating department. These dual sign-offs aredesigned to reduce the Company’s exposure to fraud through any one individualacting on his or her own accord. Additionally, the Company’s Finance Departmentwill set up a separate invoice review and approval process to ensure that allpayments are reasonable and in line with normal budget parameters, and thatmore detailed support is attached from which to assess that the materials orservices being purchased are reasonable for the prices being paid.

Other than as discussed above, there were no changesin the Company’s internal control over financial reporting that occurred duringthe last fiscal quarter that have materially affected, or are reasonably likelyto materially affect, the Company’s internal control over financial reporting.

47

----

**PART IIOTHER 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**                                                                                                      |
|------------------|------------|----------------------------------------------------------------------------------------------------------------------|
| 10.35*           |       | Employment Letter, dated as of August 29, 2006,  between the Company and Vincent A. Scarfone.                   |
| 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.                                   |

----

*                    Filed herewith

**             Furnished herewith

48

----

**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:   January 10, 2007 |                                                                                              |
|-----------------------------------------------|---------------------------------------------------------------------------------------------------|
| ** **                                    | **DUANE READE HOLDINGS, INC.**                                                                    |
|                                          | (Registrant)                                                                                      |
|                                          | /s/ RICHARD W. DREILING                                                                           |
|                                          | Richard W. Dreiling                                                                               |
|                                          | *President and Chief Executive Officer  (Principal Executive Officer)*                            |
|                                          | /s/ JOHN K. HENRY                                                                                 |
|                                          | John K. Henry                                                                                     |
|                                          | *Senior Vice President and Chief Financial Officer  (Principal Accounting and Financial Officer)* |

 

49

----