**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 July 1, 2006**

**Commissionfile number 001-13843**

**DUANE READE HOLDINGS, INC.**

(Exact name of registrantas specified in its charter)

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

 

**(212) 273-5700**

(Registrant’s telephonenumber, including area code)

Indicate by check 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-accelerated filer x

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

Yes o   No x

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

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

 

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**INDEX**

| PART I—FINANCIAL  INFORMATION                                                                                                     |   | 5  |   |
|---------------------------------------------------------------------------------------------------------------------------------------------|--------|----|--------|
| ITEM  1.—FINANCIAL STATEMENTS                                                                                                          |   | 5  |   |
| Consolidated Statements of Operations (Unaudited)—For  the 13 and 26 Weeks Ended July 1, 2006 and June 25, 2005              |   | 5  |   |
| Consolidated  Balance Sheets (Unaudited)—As of July 1, 2006 and December 31, 2005                                            |   | 6  |   |
| Consolidated Statements of Cash Flows (Unaudited)—For  the 26 Weeks Ended July 1, 2006 and June 25, 2005                     |   | 7  |   |
| Consolidated Statements of Comprehensive Loss (Unaudited)—For  the 13 and 26 Weeks Ended July 1, 2006 and June 25, 2005 |   | 8  |   |
| Notes to Consolidated Financial Statements (Unaudited)                                                                                      |   | 9  |   |
| ITEM 2.—MANAGEMENT’ DISCUSSION AND ANALYSIS OF  FINANCIAL CONDITION AND RESULTS OF OPERATIONS                                     |   | 26 |   |
| ITEM 3.—QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT  MARKET RISK                                                                    |   | 38 |   |
| ITEM 4.—CONTROLS AND PROCEDURES                                                                                                        |   | 38 |   |
| PART II—OTHER INFORMATION                                                                                                         |   | 39 |   |
| SIGNATURES                                                                                                                                  |   | 40 |   |

 

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**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:

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

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

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

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

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

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

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

·       changesin the cost of goods and services;

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

·       employmentdisputes and labor relations;

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

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·       ourability to successfully execute the various objectives of the recentlyannounced “Duane Reade Full Potential” sales growth and profit enhancementprogram;

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

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

·       changesin our operating strategy or development plans;

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

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

·       naturaldisasters and the continued impact of, or new occurrences of, terrorist attacksin the New York greater metropolitan area and any actions that may be taken byfederal, state or municipal authorities in response to or in anticipation ofsuch events and occurrences;

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

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

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

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

·       ourability to limit fraud and shrink;

·       demographicchanges; and

·       otherrisks and uncertainties detailed elsewhere in this filing and from time to timein our other filings with the Securities and Exchange Commission (the “SEC”).

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

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

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**PART I -FINANCIAL INFORMATION**

**ITEM 1. FINANCIALSTATEMENTS**

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

| ** **                                           | ** ** | **For the 13 Weeks Ended** | ** ** | **For the 26 Weeks Ended**  | ** ** |
|------------------------------------------------------|------------|----------------------------|------------|-----------------------------|------------|
| ** **                                           | ** ** | **July 1, 2006** | ** ** | **June 25, 2005** | ** ** | **July 1, 2006** | ** ** | **June 25, 2005** | ** ** |
| Net sales                                            |       |                       | $          | 398,789                     |       |   |   | $ | 399,500 |   |   |   | $ | 784,658 |   |   |   | $ | 794,267 |   |   |
| Cost of sales                                        |       |                       | 317,704    |                        |       |   | 320,905 |   |   |   | 628,098 |   |   |   | 642,863 |   |   |
| Gross profit                                         |       |                       | 81,085     |                        |       |   | 78,595 |   |   |   | 156,560 |   |   |   | 151,404 |   |   |
| Selling,  general & administrative expenses |       |                       | 68,146     |                        |       |   | 64,541 |   |   |   | 137,612 |   |   |   | 129,040 |   |   |
| Labor contingency  expense                           |       |                       | —     |                        |       |   | 1,100 |   |   |   | (18,004 | ) |   |   | 2,200 |   |   |
| Transaction  expense                                 |       |                       | —     |                        |       |   | 154 |   |   |   | — |   |   |   | 581 |   |   |
| Depreciation and  amortization                       |       |                       | 18,628     |                        |       |   | 17,851 |   |   |   | 37,306 |   |   |   | 35,497 |   |   |
| Store pre-opening  expenses                          |       |                       | 102        |                        |       |   | 50 |   |   |   | 152 |   |   |   | 150 |   |   |
| Other                                                |       |                       | 533        |                        |       |   | 2,033 |   |   |   | 1,635 |   |   |   | 3,182 |   |   |
|                                                 |       |                       | 87,409     |                        |       |   | 85,729 |   |   |   | 158,701 |   |   |   | 170,650 |   |   |
| Operating loss                                       |       |                       | (6,324     | )                           |       |   | (7,134 | ) |   |   | (2,141 | ) |   |   | (19,246 | ) |   |
| Interest expense,  net                               |       |                       | 14,135     |                        |       |   | 11,499 |   |   |   | 27,873 |   |   |   | 22,664 |   |   |
| Loss before  income taxes                            |       |                       | (20,459    | )                           |       |   | (18,633 | ) |   |   | (30,014 | ) |   |   | (41,910 | ) |   |
| Income tax  provision (benefit)                      |       |                       | 619        |                        |       |   | (8,345 | ) |   |   | 927 |   |   |   | (18,819 | ) |   |
| Net loss                                             |       |                       | $          | (21,078                     | )          |   |   | $ | (10,288 | ) |   |   | $ | (30,941 | ) |   |   | $ | (23,091 | ) |   |

 

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

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

| ** **                                                                                       | ** ** | **July 1,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|------------------|------------|-----------------------|------------|
| ** **                                                                                       | ** ** | **2006**         | ** ** | **2005**              | ** ** |
| **ASSETS**                                                                                       | ** ** |             | ** ** | ** **            |       |   | ** ** | ** ** |   |
| Current Assets                                                                                   |       |             |       |                  |       |   |   |   |   |
| Cash                                                                                             |       |             | $          | 1,351                 |       |   |   | $ | 1,362 |   |   |
| Receivables, net                                                                                 |       |             | 50,047     |                  |       |   | 52,320 |   |   |
| Inventories                                                                                      |       |             | 226,249    |                  |       |   | 235,639 |   |   |
| Deferred income  taxes                                                                           |       |             | 5,980      |                  |       |   | 7,717 |   |   |
| Prepaid expenses  and other current assets                                                       |       |             | 27,093     |                  |       |   | 26,114 |   |   |
| TOTAL CURRENT  ASSETS                                                                            |       |             | 310,720    |                  |       |   | 323,152 |   |   |
| Property and equipment,  net                                                                     |       |             | 221,624    |                  |       |   | 229,134 |   |   |
| Goodwill                                                                                         |       |             | 67,791     |                  |       |   | 67,791 |   |   |
| Other assets, net                                                                                |       |             | 236,738    |                  |       |   | 251,341 |   |   |
| TOTAL ASSETS                                                                                     |       |             | $          | 836,873               |       |   |   | $ | 871,418 |   |   |
| **LIABILITIES AND STOCKHOLDER’S EQUITY**                                                    | ** ** |             | ** ** | ** **            |       |   | ** ** | ** ** |   |
| Current Liabilities                                                                              |       |             |       |                  |       |   |   |   |   |
| Accounts payable                                                                                 |       |             | $          | 78,505                |       |   |   | $ | 72,711 |   |   |
| Accrued interest                                                                                 |       |             | 9,354      |                  |       |   | 9,222 |   |   |
| Accrued expenses                                                                                 |       |             | 54,169     |                  |       |   | 51,959 |   |   |
| Current portion  of debt                                                                         |       |             | 148,259    |                  |       |   | 135,693 |   |   |
| Current portion  of capital lease obligations                                                    |       |             | 3,246      |                  |       |   | 3,183 |   |   |
| TOTAL CURRENT  LIABILITIES                                                                       |       |             | 293,533    |                  |       |   | 272,768 |   |   |
| Long-term debt                                                                                   |       |             | 405,032    |                  |       |   | 405,032 |   |   |
| Capital lease  obligations, less current portion                                                 |       |             | 8,710      |                  |       |   | 10,314 |   |   |
| Deferred income  taxes                                                                           |       |             | 31,241     |                  |       |   | 32,117 |   |   |
| Other non-current  liabilities                                                                   |       |             | 44,500     |                  |       |   | 67,265 |   |   |
| TOTAL LIABILITIES                                                                                |       |             | 783,016    |                  |       |   | 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                                                                      |       |             | 104        |                  |       |   | — |   |   |
| Accumulated other  comprehensive income                                                          |       |             | 1,034      |                  |       |   | 260 |   |   |
| Accumulated  deficit                                                                             |       |             | (186,779   | )                     |       |   | (155,836 | ) |   |
| TOTAL  STOCKHOLDER’S EQUITY                                                                 |       |             | 53,857     |                  |       |   | 83,922 |   |   |
| TOTAL LIABILITIES AND  STOCKHOLDER’S EQUITY                                                 |       |             | $          | 836,873               |       |   |   | $ | 871,418 |   |   |

 

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

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

| ** **                                                                                      | ** ** | **For the 26 Weeks Ended** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                                      | ** ** | **July 1, 2006** | ** ** | **June 25, 2005** | ** ** |
| Cash flows provided by  (used in) operating activities:                                         |       |                       |       |   |   |   |   |
| Net loss                                                                                        |       | $                          | (30,941    | ) |   | $ | (23,091 | ) |   |
| Adjustments to reconcile  net loss to net cash provided by (used in) operating activities: |       |                       |       |   |   |   |   |
| Depreciation and  amortization                                                                  |       | 39,430                     |       |   | 37,238 |   |   |
| Deferred income  taxes                                                                          |       | 861                        |       |   | (18,858 | ) |   |
| Non-cash rent  expense                                                                          |       | 5,150                      |       |   | 6,901 |   |   |
| Other non-cash  expense                                                                         |       | 104                        |       |   | — |   |   |
| Change in operating  assets and liabilities (net of the effect of acquisitions):                |       |                       |       |   |   |   |   |
| Receivables                                                                                     |       | 2,273                      |       |   | 5,600 |   |   |
| Inventories                                                                                     |       | 9,390                      |       |   | (15,187 | ) |   |
| Accounts payable                                                                                |       | 5,794                      |       |   | 8,288 |   |   |
| Prepaid and  accrued expenses                                                                   |       | 1,835                      |       |   | (15,891 | ) |   |
| Other assets and  liabilities, net                                                              |       | (30,027                    | )          |   | 6,331 |   |   |
| NET CASH PROVIDED  BY (USED IN) OPERATING ACTIVITIES                                            |       | 3,869                      |       |   | (8,669 | ) |   |
| Cash flows used  in investing activities:                                                       |       |                       |       |   |   |   |   |
| Capital  expenditures                                                                           |       | (12,270                    | )          |   | (14,310 | ) |   |
| Lease  acquisition, customer file and other costs                                               |       | (4,107                     | )          |   | (5,764 | ) |   |
| Proceeds from  sale of property                                                                 |       | 1,500                      |       |   | 2,223 |   |   |
| NET CASH USED IN  INVESTING ACTIVITIES                                                          |       | (14,877                    | )          |   | (17,851 | ) |   |
| Cash flows from  financing activities:                                                          |       |                       |       |   |   |   |   |
| Borrowings from  revolving credit facility                                                      |       | 915,368                    |       |   | 901,942 |   |   |
| Repayments of  revolving credit facility                                                        |       | (902,802                   | )          |   | (873,440 | ) |   |
| Repayments of  capital lease obligations                                                        |       | (1,541                     | )          |   | (1,368 | ) |   |
| Deferred  financing costs                                                                       |       | (28                        | )          |   | (622 | ) |   |
| NET CASH PROVIDED  BY FINANCING ACTIVITIES                                                      |       | 10,997                     |       |   | 26,512 |   |   |
| Net decrease in cash                                                                            |       | (11                        | )          |   | (8 | ) |   |
| Cash at beginning  of period                                                                    |       | 1,362                      |       |   | 1,329 |   |   |
| Cash at end of period                                                                           |       | $                          | 1,351      |   |   | $ | 1,321 |   |   |

 

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

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

| ** **                                    | ** ** | **For the 13 Weeks Ended** | ** ** | **For the 26 Weeks Ended** | ** ** |
|-----------------------------------------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                    | ** ** | **July 1,**                               | ** ** | **June 25,**                              | ** ** | **July 1,** | ** ** | **June 25,** | ** ** |
| ** **                                    | ** ** | **2006**                                       | ** ** | **2005**                                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net loss                                      |       | $                                              | (21,078    | )                                              | $          | (10,288 | ) | $ | (30,941 | ) | $ | (23,091 | ) |
| Change in fair  value of interest rate collar |       | 503                                            |       | (7                                             | )          | 772 |   | (7 | ) |
| Total other  comprehensive income (loss)      |       | 503                                            |       | (7                                             | )          | 772 |   | (7 | ) |
| Total comprehensive loss                      |       | $                                              | (20,575    | )                                              | $          | (10,295 | ) | $ | (30,169 | ) | $ | (23,098 | ) |

 

The accompanying notes are an integral part of these financial statements

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

**1.   Basis ofPresentation**

Duane Reade Holdings, Inc. (“Duane Reade Holdings”or the “Company”) was formed in December 2003 by Oak Hill CapitalPartners, LP, a private equity firm (“Oak Hill”) in order to acquire DuaneReade Inc. and its subsidiaries (the “Acquisition”). Duane Reade Holdings, Inc.is a wholly-owned subsidiary of Duane Reade Shareholders, LLC (“Duane ReadeShareholders”), a parent entity also established to effectuate the Acquisition.The Acquisition was completed on July 30, 2004 through the merger of DuaneReade Acquisition Corp. (a wholly owned subsidiary of Duane Reade Holdings, Inc.)into Duane Reade Inc. with Duane Reade Inc. being the survivingentity and a wholly owned subsidiary of Duane Reade Holdings, Inc. afterthe merger transaction.

The Unaudited Consolidated Interim FinancialStatements included herein reflect all adjustments which, in the opinion ofmanagement, are necessary to present a fair statement of the results ofoperations, financial position, cash flows and comprehensive 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 Company, along withcertain of its subsidiaries, is a guarantor of the debt obligations of DuaneReade Inc. and Duane Reade, the New York general partnership that holdsthe operating assets and liabilities (“Duane Reade GP”). The Company hasno assets or operations other than its investment in its subsidiaries. Theguarantees provided by the Company and its other subsidiaries under the debtobligations of Duane Reade Inc. and Duane Reade GP are full andunconditional, joint and several.

**2.   RecentlyIssued Accounting Pronouncements**

In December 2004, Statement of FinancialAccounting Standard No. 123(R), Share-Based Payment (“SFAS No. 123(R)”)was issued. This statement established standards for the accounting fortransactions in which an entity exchanges its equity instruments for goods orservices. The statement focuses primarily on accounting for transactions inwhich an entity obtains employee services in share-based transactions. TheCompany adopted the provisions of this statement effective January 1,2006. As a result, the interim financial statements included herein for the 13and 26 weeks ended July 1, 2006 reflect pre-tax compensation expense ofapproximately $80 thousand and $0.1 million, respectively, attributable to thevested portion of stock options granted after the adoption date. Based on thenumber of options granted after the adoption date, the Company expects to incurtotal stock option compensation expenses of approximately $0.3 million in2006.

In June 2005, the FASB issued SFAS No. 154,Accounting Changes and Error Corrections (“SFAS No. 154”), which requiresentities that voluntarily make a change in accounting principle to apply thatchange retrospectively to prior periods’ financial statements, unless thiswould be impracticable. SFAS No. 154 supersedes Accounting PrinciplesBoard Opinion No. 20, Accounting Changes (“APB No. 20”), whichpreviously required that most voluntary changes in accounting principle berecognized by including in the current period’s net earnings the cumulativeeffect of changing to the new accounting principle. 

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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 change in accounting principle. SFAS No. 154applies to accounting changes and error corrections that are made in fiscalyears beginning after December 15, 2005.

In February 2006, theFASB issued SFAS No. 155, Accounting for Certain Hybrid Instruments (“SFASNo. 155”), which amends SFAS No. 133, Accounting for DerivativeInstruments and Hedging Activities, and SFAS No. 140, Accounting forTransfers and Servicing of Financial Assets and Extinguishments of Liabilities.SFAS No. 155 allows financial instruments that have embedded derivativesto be accounted for as a whole (eliminating the need to bifurcate the derivativefrom its host) if the holder elects to account for the whole instrument on afair value basis. SFAS No. 155 also clarifies and amends certain otherprovisions of SFAS No. 133 and SFAS No. 140. This statement iseffective for all financial instruments acquired or issued in fiscal yearsbeginning after September 15, 2006. The Company does not expect that SFAS No. 155will have a material effect on its consolidated financial statements.

In June 2006, theFinancial Accounting Standards Board (FASB) issued FASB InterpretationNo. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48), aninterpretation of Statement of Financial Accounting Standards No. 109,“Accounting for Income Taxes” (FAS 109). FIN 48 clarifies the accounting foruncertainty in income taxes by prescribing a recognition threshold for taxpositions taken or expected to be taken in a tax return. FIN 48 is effectivefor fiscal years beginning after December 15, 2006. We are currentlyevaluating the impact FIN 48 will have on our financial position or results ofoperations.

**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 cost recognized for the six months ended July 1, 2006includes 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, which is referred to inthis report 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 November 21, 2005, the Company amended the StockOption Plan so that a maximum of 370,293 shares of its common stock (on a fullydiluted basis) may be granted under the Stock Option 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 

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Option Plan, as may bedetermined by the compensation committee and specified in the applicable stockoption agreement or thereafter.

Asummary of activity under the Stock Option Plan as of July 1, 2006, andchanges during the three and six months ended July 1, 2006 ispresented below:

| ** **                         | ** ** | **For the 13 Weeks  Ended July 1, 2006** | ** ** | **For the 26 Weeks  Ended July 1, 2006** | ** ** |
|------------------------------------|------------|------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                         | ** ** | ** **                                                             | ** ** | ** **                                                             | ** ** | **Wtd. Avg.** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Wtd. Avg.** | ** ** | ** ** | ** ** |
| ** **                         | ** ** | ** **                                                             | ** ** | **Wtd. Avg.**                                                     | ** ** | **Remaining** | ** ** | **Aggregate** | ** ** | ** ** | ** ** | **Wtd. Avg.** | ** ** | **Remaining** | ** ** | **Aggregate** | ** ** |
| ** **                         | ** ** | ** **                                                             | ** ** | **Exercise**                                                           | ** ** | **Contractual** | ** ** | **Intrinsic** | ** ** | ** ** | ** ** | **Exercise** | ** ** | **Contractual** | ** ** | **Intrinsic** | ** ** |
| **Options**                        | ** ** | ** **                                                             | ** ** | **Shares**                                                             | ** ** | **Price** | ** ** | **Term** | ** ** | **Value** | ** ** | **Shares** | ** ** | **Price** | ** ** | **Term** | ** ** | **Value** | ** ** |
| Outstanding at beginning of period |       | 278,520                                                                |       |                                                                   | $          | 100.00 |   |   |   |   |   |   |   |   |   |   | 367,797 |   |   | $ | 100.00 |   |   |   |   |   |   |   |   |   |   |
| Granted                            |       | 19,611                                                                 |       |                                                                   | $          | 100.00 |   |   |   |   |   |   |   |   |   |   | 45,611 |   |   | $ | 100.00 |   |   |   |   |   |   |   |   |   |   |
| Exercised                          |       | —                                                                 |       |                                                                   | $          | 100.00 |   |   |   |   |   |   |   |   |   |   | — |   |   | $ | 100.00 |   |   |   |   |   |   |   |   |   |   |
| Expired                            |       | —                                                                 |       |                                                                   | $          | 100.00 |   |   |   |   |   |   |   |   |   |   | — |   |   | $ | 100.00 |   |   |   |   |   |   |   |   |   |   |
| Forfeited                          |       | (10,500                                                                | )          |                                                                   | $          | 100.00 |   |   |   |   |   |   |   |   |   |   | (125,777 | ) |   | $ | 100.00 |   |   |   |   |   |   |   |   |   |   |
| Outstanding at end of period       |       | 287,631                                                                |       |                                                                   | $          | 100.00 |   |   |   | 8.4 |   |   |   | $ | 0 |   |   | 287,631 |   |   | $ | 100.00 |   |   |   | 8.4 |   |   |   | $ | 0 |   |   |
| Exerciseable at  end of period     |       | 20,584                                                                 |       |                                                                   | $          | 100.00 |   |   |   | 6.5 |   |   |   | $ | 0 |   |   | 20,584 |   |   | $ | 100.00 |   |   |   | 6.5 |   |   |   | $ | 0 |   |   |
|                                    |            |                                                                        |            |                                                                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The weighted-average grant-date fair value of optionsgranted during the three months ended July 1, 2006 was $42.59. There wereno stock options granted during the six months ended June 25, 2005 andthere were no stock options exercised during the first half of either 2006 or2005.

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

The valuationformula reflects the following key assumptions:

·       Expecteddividend yield: 0%—The Company has historically not paid any dividends, nordoes it currently expect to pay dividends in the foreseeable future.

·       Expectedvolatility: 32.0%—The volatility figure reflects the weighted-average 1, 5 and10-year observed volatility of comparable industry participants.

·       Expectedterm (years): 6.5—The expected life represents the period of time for whichoptions granted are expected to be outstanding. This estimate was derived fromhistorical share option exercise experience, which management believes providesthe best estimate of the expected term.

·       Risk-freeinterest rate: 4.38%—This reflects the rate portrayed on the Treasury YieldCurve for a period of time equivalent to the expected term.

As of July 1, 2006, there was $1.8 million oftotal unrecognized compensation cost related to non-vested share-basedcompensation arrangements granted under the stock-based compensation plan. Thatcost (to be reduced by forfeitures) is expected to be recognized on astraight-line basis over a weighted-average period of 5 years.

During the three and six months ended July 1,2006, the Company recognized approximately $80 thousand and $0.1 million,respectively, of compensation cost related to share-based payments.

As of July 1, 2006,82,662 shares of common stock of the Company were reserved for the issuance ofadditional stock options. The Company expects to satisfy the exercise of stockoptions utilizing newly-issued shares.

**4.   Inventoryand Cost of Sales**

At July 1, 2006,inventories, consisting solely of finished goods, would have been lower by $4.8 millionif they had been valued on a lower of first-in, first-out (“FIFO”) cost ormarket basis instead of a last-in, 

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first-out(“LIFO”) basis. Cost of sales includes all store occupancy-related costs andexpenses, consisting of lease and sublease-related income and expenses, otherrecurring real estate-related income and expenses resulting primarily fromsales and terminations of leases related to store relocations, store utilitycosts, warehouse expenses and distribution costs. The Company reflectspromotional allowances from vendors as a reduction of inventory or advertisingexpense, depending on the nature of the allowance, when such inventory is soldor advertising or promotions have been completed and the related allowanceshave been earned. Other real estate related income was $0.1 million in thethirteen weeks ended July 1, 2006 and June 25, 2005, and $0.2 millionin the twenty-six weeks ended July 1, 2006 and June 25, 2005.

**5.   Exit andDisposal Activities**

In connection with theacquisition of Duane Reade Inc. and in accordance with the provisions ofEmerging Issues Task Force Issue No. 95-3, “Recognition ofLiabilities in Connection with Purchase Business Combinations” (EITF 95-3),the Company established a reserve of $17.0 million for costs anticipatedto be incurred as a result of the planned closing of approximately 11 of itsstores. These costs primarily relate to rent, utilities and other on-goingoccupancy-related expenses, as well as costs related to inventory liquidation.At July 1, 2006, all of the planned closings had occurred, and the Companyhas recorded a cumulative net total of $6.8 million of primarilyoccupancy-related costs against this reserve resulting in the reserve balanceof $10.2 million at July 1, 2006. The balance of this reserve isexpected to be utilized primarily for occupancy related costs in these closedstores.

In the normal course of its business, the Companyoccasionally decides to close one or more of its underperforminglocations.  In accordance with theprovisions 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 July 1, 2006,the balance of this reserve was $3.3 million. This balance will also be used primarilyfor occupancy related costs in these stores.

**6.   Pharmacyand Customer File Acquisitions**

Duringthe first six 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 six 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 26 Weeks Ended**           | ** ** |
|------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                         | ** ** | **July 1,**                                         | ** ** | **June 25,**                                        | ** ** | **July 1,** | ** ** | **June 25,** | ** ** |
| ** **                         | ** ** | **    2006    ** | ** ** | **    2005    ** | ** ** | **    2006    ** | ** ** | **    2005    ** | ** ** |
| Customer  prescription files       |       |                                                     | —     |                                                     |       |   | 3 |   |   |   | — |   |   |   | 4 |   |   |
| Pharmacy  establishments           |       |                                                     | —     |                                                     |       |   | — |   |   |   | — |   |   |   | — |   |   |
| Total  acquisitions                |       |                                                     | —     |                                                     |       |   | 3 |   |   |   | — |   |   |   | 4 |   |   |
| Purchase price  allocation:        |       |                                                     |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Identifiable  intangibles          |       |                                                     | $          | —                                                   |       |   |   | $ | 1.4 |   |   |   | $ | — |   |   |   | $ | 2.2 |   |   |
| Goodwill                           |       |                                                     | —     |                                                     |       |   | — |   |   |   | — |   |   |   | — |   |   |
| Inventory                          |       |                                                     | —     |                                                     |       |   | 0.3 |   |   |   | — |   |   |   | 0.5 |   |   |
| Property and  equipment            |       |                                                     | —     |                                                     |       |   | — |   |   |   | — |   |   |   | — |   |   |
| Other assets and  liabilities, net |       |                                                     | —     |                                                     |       |   | (0.1 | ) |   |   | — |   |   |   | (0.3 | ) |   |
| Total                              |       |                                                     | $          | —                                                   |       |   |   | $ | 1.6 |   |   |   | $ | — |   |   |   | $ | 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.

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**7.   Debt**

Debtis summarized as follows (in thousands):

| ** **                                   | ** ** | **July 1,** | ** **  | **December 31,** | ** ** |
|----------------------------------------------|------------|------------------|-------------|-----------------------|------------|
| **Description of Instrument**      | ** ** | ** **       | ** **  | **2006**              | ** ** | **2005** | ** ** |
| Current Debt:                                |       |             |        |                  |       |   |   |
| Asset-Based  Revolving Loan Facility(1)      |       | $                | 148,259     |                  |       | $ | 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**                              | ** ** | **$**            | **553,291** | ** **            | ** ** | **$** | **540,725** |   |   |
|                                              |            |                  |             |                       |            |  |  |  |  |  |  |

 

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(1)          Obligations under thisfacility have been classified as current liabilities because cash receipts controlledby the lenders are used to reduce outstanding debt and the Company does not meetthe criteria of FAS 6 to reclassify the debt as long-term, however this is notan indication that this credit facility is expected to be retired within thenext year. The Company intends to continue to use this facility for its workingcapital needs through the date of its recently extended maturity in 2011.

 

***Asset-BasedRevolving Loan Facility***

On July 22, 2004, in connection with theAcquisition, the Company entered into an amended asset-based revolving loanfacility 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 accountsreceivable. The original maturity date of the amended asset-based revolvingloan facility was July 21, 2008. In August 2005, in conjunction withthe issuance of $50.0 million aggregate principal amount of senior securedfloating rate notes due 2010, the Company permanently reduced the maximumavailability under the amended asset-based revolving loan facility by $25.0million to $225.0 million. On July 7, 2006, the Company entered into afurther amendment to the amended asset-based revolving loan facility to extendits maturity from July 21, 2008 to July 21, 2011, subject to therequirement that the Company refinance or restructure the $210.0 millionaggregate principal amount at maturity of the senior secured floating ratenotes due 2010 and the $195.0 million aggregate principal amount of the 9.75%senior subordinated notes due 2011, in each case, on terms reasonably acceptableto the administrative agent and at least 120 days prior to each’s respectivescheduled maturity date. The Company fully intends to refinance or restructurethe outstanding principal amounts of its senior secured floating rate notes andsenior subordinated notes within the required timeframe, in accordance with therequirements of the third amendment.

The amended asset-based revolving loan facilityincludes a $50 million sub-limit for the issuance of letters of credit.Obligations under the revolving loan facility are collateralized by a firstpriority interest in inventory, receivables, pharmacy prescription files,deposit accounts and certain other current assets. Under the 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 

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facility have not exceeded90 percent of the borrowing base and, as a result, the fixed chargecovenant 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:

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

·       arate equal to the prime rate of Banc of America Retail Group Inc. plus amargin of from 0.00% to 0.50%, determined based on levels of borrowingavailability reset each fiscal quarter. Borrowings under the amended facilitycontinue to be primarily LIBOR-based. At July 1, 2006, the asset-basedrevolving loan facility bore interest at a weighted average annual rate of6.97%.

At July 1, 2006, there was $148.3 millionoutstanding under the asset-based revolving loan facility, and approximately$69.6 million of remaining availability, net of $7.1 million reservedfor standby letters of credit. Obligations under this facility have beenclassified as current liabilities because cash receipts controlled by thelenders are used to reduce outstanding debt, and the Company does not meet thecriteria of FAS 6 to reclassify the debt as long-term. The Company intends tocontinue to utilize this facility for its working capital needs through the dateof its maturity in July 2011.

***Senior SecuredFloating Rate Notes due 2010.******  ***On December 20,2004, the Company closed an offering of $160.0 million aggregate principalamount of senior secured floating rate notes due 2010. Using the net proceedsfrom that offering, together with approximately $2.2 million of borrowingsunder the amended asset-based revolving loan facility, the Company repaid alloutstanding principal under its previously existing $155.0 million seniorterm loan facility, along with approximately $3.6 million of earlyrepayment premium and accrued but unpaid interest through December 20,2004. On August 9, 2005, the Company issued a further $50.0 millionof senior secured notes. These new notes were issued under the same indentureas the senior secured notes issued in December 2004, although they do nottrade 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 July 1, 2006, the senior securednotes bore interest at a rate of 9.83%.

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 July 1, 2006, the LIBOR rate in effectfor the senior secured notes was 5.33%, which exceeded the maximum rate underthe “no cost collar.” As a result, the protection afforded by the “no costcollar” reduced the overall effective interest rate on the senior secured notesto 9.81%.

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 

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Duane Reade Inc. andDuane Reade GP, and will be guaranteed by future subsidiaries of Duane ReadeInc. and Duane Reade GP except certain foreign and certain domesticsubsidiaries. The senior secured notes and the guarantees are collateralized bya first priority interest in substantially all of Duane Reade Inc. and DuaneReade GP’s assets other than those assets in which the lenders under theamended asset-based revolving loan facility have a first priority interest. Thesenior secured notes and the guarantees are also collateralized by a secondpriority interest in all collateral pledged on a first priority basis tolenders under the amended asset-based revolving loan facility.

Upon the occurrence of specified change of controlevents, Duane Reade Inc. and Duane Reade GP will be required to make an offerto repurchase all of the senior secured notes at 101% of the outstandingprincipal amount of the senior secured notes plus accrued and unpaid interestto the date of repurchase. The indenture governing the senior secured notescontains certain affirmative and negative covenants that limit the ability ofDuane Reade Inc., Duane Reade GP and their restricted subsidiaries, asdefined, to incur additional indebtedness, pay dividends, make repayments onindebtedness that is subordinated to the senior secured notes and to makecertain other restricted payments, incur certain liens, use proceeds from salesof assets, enter into business combination transactions (including mergers,consolidations and asset sales), enter into sale-leaseback transactions, enterinto transactions with affiliates and permit restrictions on the payment ofdividends by restricted subsidiaries. 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 July 1, 2006, the weighted average combinedinterest rate in effect on all variable rate debt outstanding, including thebenefit afforded by the “no cost collar,” was 8.64%.

***Senior SubordinatedNotes due 2011.******  ***On July 30, 2004, uponcompletion of the Acquisition, Duane Reade Inc. and Duane Reade GPco-issued $195.0 million of 9.75% senior subordinated notes due 2011. Thesenior subordinated notes mature on August 1, 2011 and bear interest at9.75% per annum payable in semi-annual installments on February 1 and August 1,commencing February 1, 2005. The senior subordinated notes areuncollateralized obligations and subordinated in right of payment to all of theCompany’s, Duane Reade Inc.’s and Duane Reade GP’s existing and futureunsubordinated indebtedness, including borrowings under the amended asset-basedrevolving loan facility and the senior secured notes. The senior subordinatednotes will rank equally with any future senior subordinated indebtedness and seniorto any future subordinated indebtedness. The senior subordinated notes areguaranteed on an uncollateralized, senior subordinated basis by the Company andall of Duane Reade Inc.’s existing direct and indirect domesticsubsidiaries other than Duane Reade GP, which is a co-obligor under the seniorsubordinated notes. Upon the occurrence of specified change of control events,the Company will be required to make an offer to repurchase all of the seniorsubordinated notes at 101% of the outstanding principal amount of the seniorsubordinated notes plus accrued and unpaid interest to the date of repurchase.The indenture governing the senior subordinated notes contains certainaffirmative and negative covenants that limit the ability of Duane Reade Inc.,Duane Reade GP and their restricted subsidiaries to incur additionalindebtedness, pay dividends, make repayments on indebtedness that issubordinated to the senior subordinated notes and to make certain otherrestricted payments, incur certain liens, use proceeds from sales of assets,enter into business combination transactions (including mergers, consolidationsand asset sales), enter into transactions with affiliates and permitrestrictions on the payment of dividends by restricted subsidiaries. There areno credit ratings related triggers in the indenture governing the seniorsubordinated notes that would impact the cost of borrowing, annual amortizationof principal or related indebtedness maturity.

 

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***2.1478% SeniorConvertible Notes due April 16, 2022.******  ***OnApril 16, 2002, Duane Reade Inc. completed an offering of$381.5 million aggregate principal amount of Senior Convertible Notesmaturing on April 16, 2022 (the “Convertible Notes”). The Convertible Noteswere issued at a price of $572.76 per note (57.276% of the principal amount atmaturity) and pay cash interest at the rate of 2.1478% per year on theprincipal amount at maturity, payable semi-annually in arrears on April 16and October 16 of each year beginning on October 16, 2002, untilApril 16, 2007. After that date, interest will accrue on the notes asamortization of the original issue discount representing a yield to maturity of3.75% per year, computed on a semi-annual bond equivalent basis. In December 2002,Duane Reade Inc. repurchased a total of $30.5 million principal value ofthe Convertible Notes at an average purchase price of $486.99 per $1,000 note,resulting in a remaining net outstanding balance of $201.0 million.

In connection with theAcquisition, Duane Reade Inc. made a tender offer to repurchase all of the$351.0 million outstanding principal value of the Convertible Notes. Uponthe closing of the tender offer, a total of $350.9 million principal amountat maturity ($201.0 million issuance value) was tendered for repurchase,leaving only $55.0 thousand of principal amount at maturity ($32.0 thousandof issuance 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**

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

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

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

During the three and sixmonths ended July 1, 2006, the Company incurred additional pre-tax lossesof $20.5 million and $30.0 million, respectively, and recorded incrementalvaluation allowances of $9.6 million and $14.1 million, respectively. At July 1,2006, the Company had approximately $126.2 million of gross deferred taxassets, approximately $106.9 million of gross deferred tax liabilities, and a valuationallowance of $44.5 million. The tax expense reported during the three and six months ended July 1,2006 primarily results from the deferred tax liabilities generated bynon-amortizable goodwill.

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**9.   Commitmentsand Contingencies**

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

During 2002, the Company initiated a legal actionagainst its former property insurance carrier, in an attempt to recover what itbelieves to be a fair and reasonable settlement for the business interruptionportion of its claim originating from the September 11, 2001 World TradeCenter terrorist attack, during which its single highest volume and most profitablestore was completely destroyed. The claim is pending before the United StatesDistrict Court for the Southern District of New York. In September 2003, atrial on certain 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.

In the meantime, the matter moved into an appraisalprocess based on the trial court’s interpretation of certain legal tests, whichinterpretation was among the aspects of the decision challenged by theinsurance carrier in its appeal. The appraisal process involves a panel of twoappraisers and an arbitrator (to resolve differences between the twoappraisers) who determined the amount of insured loss the Company sustained. InJune 2005, the appraisal panel determined that the total amount of thebusiness interruption loss that the Company suffered as a result of the eventsof September 11, 2001 was $50.6 million, including all interestadjustments. The panel further found that the actual amount to be paid by theinsurer should be reduced by approximately $9.9 million, plus interest,which represents the amount that was previously paid to the Company in cash bythe insurer in 2002. On June 22, 2005, the Court of Appeals affirmed the decisionof the trial court, with modifications, including modifications to certain ofthe legal tests on which the appraisal panel’s decision was based. Thesemodifications also determined that certain portions of the Company’s businessinterruption claim were recoverable under different coverages provided underthe property insurance policy.

In June 2006, the appraisal panel awarded Duane Readethe reduced amount of $5.6 million based on its interpretation of the Second CircuitCourt of Appeals’ decision regarding the nature of the insurance coverageafforded to the Company under the business interruption clause of the Company’spolicy. In its award, the panel also stated its view that the Second Circuitfound that the Company may be entitled to recover additional amounts under otherprovisions of its insurance policy. Based on the appraisal panel’s award and the Second Circuit’s decision,in July 2006 the Company demanded payment of the appraisal panel award and alsofiled an amended proof of loss with the insurer claiming additionalamounts.  The insurer has denied theCompany’s demands and therefore the Company expects to continue to litigate inorder to attempt to recover the amounts to which it believes it is entitledunder the policy.

Accordingly, given the risks and uncertaintiesinherent in litigation, there can be no definitive assurance that the Companywill actually receive any or all of the panel’s appraised value of this claim, orthe additional claims filed with the insurer and the Company has not recognizedany additional income related to this matter. It should be noted that anypayment to the Company that might be forthcoming as a result of this claim mayalso result in the incurrence of additional expenses that are contingent uponthe amount of such insurance claim settlement. These expenses, if incurred, arenot expected to exceed $6.0 million.

The Company was a party to a National Labor RelationsBoard (“NLRB”) administrative proceeding regarding a dispute with the AlliedTrades Council (“ATC”) over whether a negotiating impasse was reached betweenthe Company and the union in August of 2001. The Allied Trades Councilrepresented employees in 139 of the Company’s stores.  In February 2004, an Administrative Law Judge(“ALJ”) 

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concluded that the partieswere not at an impasse.  The ALJ requiredthe Company, which had discontinued making contributions to various union fundsbased on its position that an impasse had been reached, to (among other things)make its employees whole by reimbursing them for expenses ensuing from theCompany’s failure to make the contributions and to make such funds whole, plusinterest.  As a result of this decision,the Company (after consultation with its outside counsel) determined that itwas required to recognize a liability under the provisions of FinancialAccounting Standard No. 5, Accounting for Contingencies.

The Company, after a thorough review of the ALJ’sdecision and recommendation as well as the related litigation surrounding thismatter, determined that the value of the contingent liability at December 27,2003 was $12.6 million, and recorded this amount as a labor contingencyliability. The Company also determined that it would continue to accrueadditional labor contingency expense of approximately $4.4 million annually,representing additional obligations for unpaid contributions and interestrelative to future periods, until such time that new information woulddetermine a change in the factors that gave rise to the need for the amount of suchlabor contingency.

As of April 1, 2006, the aggregate amount of the laborcontingency liability that the Company had recorded was $21.4 million.  On April 13, 2006, a settlement agreementbetween the Company and the Allied Trades Council Division of Local 338RWDSU/UFCW (“Local 338”) became effective with respect to all outstandinglitigation and disputes with both the union and the NLRB. The Company alsoentered into two new three-year collective bargaining agreements with Local 338and Local 340A New York Joint Board UNITE HERE!, a union representing certainnon-management employees in the balance of the Company’s stores.  The three-year collective bargainingagreements with both unions became effective as of April 1, 2006 and willexpire on March 31, 2009.

Under the terms of the settlement agreement, theCompany was not required to make any additional payments to the union funds andhad only a limited contingent obligation going forward. As a result of thissettlement, the Company has ceased making the annual $4.4 million provisiontoward labor litigation matters. The Company reversed $18.0 million of thelabor contingency reserve during the first quarter ended April 1, 2006.

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

In December 2005, the Company and Cardinal Healthsettled all matters relating to litigation arising out of a dispute regardingcertain former supply arrangements and agreements. Under the terms of thissettlement, the Company will pay Cardinal Health $4.5 million over aperiod of time to settle an outstanding trade payable, and has entered into anagreement whereby Cardinal will provide a secondary supply of pharmaceuticalproducts to the Company over approximately two years. In the first six monthsof 2006, the Company paid $3.0 million toward the cash settlement portion ofthis agreement.

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

In November 2004, Duane Reade Inc. wasserved with a purported class action complaint, Damassia v. DuaneReade Inc. The lawsuit was filed in the United States District Court,Southern District 

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of New York. Thecomplaint alleges that, from the period beginning November 1998, theCompany incorrectly gave some employees the title, “Assistant Manager,” in anattempt to avoid paying these employees overtime, in contravention of the FairLabor Standards Act and New York law. The complaint seeks an unspecified amountof unpaid 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 apurported class action complaint, Enamul Chowdhury v. Duane Reade Inc. andDuane Reade Holdings, Inc. The complaint alleges that, from a periodbeginning March 2000, the Company incorrectly classified certain employeesin an attempt to avoid paying overtime to such employees, thereby violating theFair Labor Standards Act and New York law. The complaint seeks an unspecifiedamount of damages. The Company believes this claim to be without merit, and itintends to vigorously defend itself against this claim. However, due to theinherent uncertainty of litigation, there can be no assurance as to theultimate outcome of this matter.

In January 2005, theEqual Employment Opportunity Commission filed an action against the Company inthe U.S. District Court for the Southern District of New York alleging, amongother things, that the Company created a hostile work environment for threefemale store employees, and potentially a class of such female employees. Atthe present time, it is not possible to determine the ultimate outcome of thisaction, which, if adverse, could be material. However, the Company believesthat the allegations are wholly without merit and intends to vigorously defenditself in this matter.

***Litigation Relating to the Acquisition***

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

The Delaware Complaintswere consolidated on January 28, 2004, and on April 8, 2004 theplaintiffs in the Delaware actions filed a consolidated class action complaint.The Company believes these lawsuits are without merit and plans to defend theselawsuits vigorously. However, due to the inherent uncertainty of litigation,there can be no assurance as to the ultimate outcome of this matter.

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

The 9.75% Senior Subordinated Notes due 2011 and theSenior Secured Floating Rate Notes due 2010 were co-issued by DuaneReade Inc. and Duane Reade GP, each of whom is considered a “co-obligor.”The Company and each of its’ other subsidiaries, composed of DRI I Inc.,Duane Reade International, Inc. and Duane Reade Realty, Inc.,are guarantors of such notes. The guarantee of the Company and of eachsubsidiary guarantor is full and unconditional and joint and several.

The following condensed consolidating financialinformation for the Company presents the financial information of DuaneReade Holdings, Inc., the co-obligors and the subsidiary guarantors,prepared on the equity basis of accounting. Such presentation is based on theCompany’s understanding and interpretation of Rule 3-10 under theSecurities and Exchange Commission’s Regulation S-X. Income tax 

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expense (benefit) anddeferred income taxes have been allocated to individual entities according tothe Company’s income tax allocation methodology. Certain of the prior yearinformation has been adjusted to conform its presentation with the currentyear. There is no limitation on dividends or distributions between the parentand its subsidiaries. The financial information may not necessarily beindicative of results of operations or financial position had the subsidiaryguarantors operated as independent entities.

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

| ** **                                           | ** ** | ** **              | ** ** | ** **                     | ** ** | ** **                   | ** ** | ** **     | ** ** | ** **        | ** ** | **Duane Reade**    | ** ** |
|------------------------------------------------------|------------|-------------------------|------------|--------------------------------|------------|------------------------------|------------|----------------|------------|-------------------|------------|-------------------------|------------|
| ** **                                           | ** ** | **Duane Reade**    | ** ** | ** **                     | ** ** | ** **                   | ** ** | **Subsidiary** | ** ** | **Consolidating** | ** ** | **Holdings, Inc.** | ** ** |
| ** **                                           | ** ** | **Holdings, Inc.** | ** ** | **Duane Reade Inc.** | ** ** | **Duane Reade GP** | ** ** | **Guarantors** | ** ** | **Adjustments**   | ** ** | **Consolidated**        | ** ** |
| Net sales                                            |       |                    | $          | —                         |       |                         |       | $              | —     |              |       |                    | $          | 398,789 |   |   |   | $ | 9,778 |   |   |   | $ | (9,778 | ) |   |   | $ | 398,789 |   |   |
| Cost of sales                                        |       |                    | —     |                           |       |                         | —     |           |       |              | 317,704    |                    |       |   | — |   |   |   | — |   |   |   | 317,704 |   |   |
| Gross profit                                         |       |                    | —     |                           |       |                         | —     |           |       |              | 81,085     |                    |       |   | 9,778 |   |   |   | (9,778 | ) |   |   | 81,085 |   |   |
| Selling,  general & administrative expenses |       |                    | —     |                           |       |                         | —     |           |       |              | 77,842     |                    |       |   | 82 |   |   |   | (9,778 | ) |   |   | 68,146 |   |   |
| Labor contingency                                    |       |                    | —     |                           |       |                         | —     |           |       |              | —     |                    |       |   | — |   |   |   | — |   |   |   | — |   |   |
| Transaction expense                                  |       |                    | —     |                           |       |                         | —     |           |       |              | —     |                    |       |   | — |   |   |   | — |   |   |   | — |   |   |
| Depreciation and  amortization                       |       |                    | —     |                           |       |                         | —     |           |       |              | 18,628     |                    |       |   | — |   |   |   | — |   |   |   | 18,628 |   |   |
| Store pre-opening expense                            |       |                    | —     |                           |       |                         | —     |           |       |              | 102        |                    |       |   | — |   |   |   | — |   |   |   | 102 |   |   |
| Other                                                |       |                    | —     |                           |       |                         | —     |           |       |              | 533        |                    |       |   | — |   |   |   | — |   |   |   | 533 |   |   |
| Operating (loss) income                              |       |                    | —     |                           |       |                         | —     |           |       |              | (16,020    | )                       |       |   | 9,696 |   |   |   | — |   |   |   | (6,324 | ) |   |
| Equity earnings in  affiliates                       |       |                    | 21,078     |                           |       |                         | 21,078     |           |       |              | —     |                    |       |   | 363 |   |   |   | (42,519 | ) |   |   | — |   |   |
| Interest expense, net                                |       |                    | —     |                           |       |                         | —     |           |       |              | 19,241     |                    |       |   | (5,106 | ) |   |   | — |   |   |   | 14,135 |   |   |
| Income (loss) before income taxes               |       |                    | (21,078    | )                              |       |                         | (21,078    | )              |       |              | (35,261    | )                       |       |   | 14,439 |   |   |   | 42,519 |   |   |   | (20,459 | ) |   |
| Income tax (benefit)  expense                        |       |                    | —     |                           |       |                         | —     |           |       |              | 1,066      |                    |       |   | (447 | ) |   |   | — |   |   |   | 619 |   |   |
| Net income (loss)                                    |       |                    | $          | (21,078                        | )          |                         |       | $              | (21,078    | )                 |       |                    | $          | (36,327 | ) |   |   | $ | 14,886 |   |   |   | $ | 42,519 |   |   |   | $ | (21,078 | ) |   |

 

**DUANE READE HOLDINGS, INC.Condensed Consolidating Statement of Operations (Unaudited)For the 13 weeks ended June 25, 2005(in thousands)**

| ** **                                           | ** ** | ** **              | ** ** | ** **                     | ** ** | ** **                   | ** ** | ** **     | ** ** | ** **        | ** ** | **Duane Reade**    | ** ** |
|------------------------------------------------------|------------|-------------------------|------------|--------------------------------|------------|------------------------------|------------|----------------|------------|-------------------|------------|-------------------------|------------|
| ** **                                           | ** ** | **Duane Reade**    | ** ** | ** **                     | ** ** | ** **                   | ** ** | **Subsidiary** | ** ** | **Consolidating** | ** ** | **Holdings, Inc.** | ** ** |
| ** **                                           | ** ** | **Holdings, Inc.** | ** ** | **Duane Reade Inc.** | ** ** | **Duane Reade GP** | ** ** | **Guarantors** | ** ** | **Adjustments**   | ** ** | **Consolidated**        | ** ** |
| Net sales                                            |       |                    | $          | —                         |       |                         |       | $              | —     |              |       |                    | $          | 399,500 |   |   |   | $ | 9,367 |   |   |   | $ | (9,367 | ) |   |   | $ | 399,500 |   |   |
| Cost of sales                                        |       |                    | —     |                           |       |                         | —     |           |       |              | 320,905    |                    |       |   | — |   |   |   | — |   |   |   | 320,905 |   |   |
| Gross profit                                         |       |                    | —     |                           |       |                         | —     |           |       |              | 78,595     |                    |       |   | 9,367 |   |   |   | (9,367 | ) |   |   | 78,595 |   |   |
| Selling,  general & administrative expenses |       |                    | —     |                           |       |                         | —     |           |       |              | 73,816     |                    |       |   | 92 |   |   |   | (9,367 | ) |   |   | 64,541 |   |   |
| Labor contingency                                    |       |                    | —     |                           |       |                         | —     |           |       |              | 1,100      |                    |       |   | — |   |   |   | — |   |   |   | 1,100 |   |   |
| Transaction expense                                  |       |                    | —     |                           |       |                         | —     |           |       |              | 154        |                    |       |   | — |   |   |   | — |   |   |   | 154 |   |   |
| Depreciation and  amortization                       |       |                    | —     |                           |       |                         | —     |           |       |              | 17,851     |                    |       |   | — |   |   |   | — |   |   |   | 17,851 |   |   |
| Store pre-opening expense                            |       |                    | —     |                           |       |                         | —     |           |       |              | 50         |                    |       |   | — |   |   |   | — |   |   |   | 50 |   |   |
| Other                                                |       |                    | —     |                           |       |                         | —     |           |       |              | 2,033      |                    |       |   | — |   |   |   | — |   |   |   | 2,033 |   |   |
| Operating (loss) income                              |       |                    | —     |                           |       |                         | —     |           |       |              | (16,409    | )                       |       |   | 9,275 |   |   |   | — |   |   |   | (7,134 | ) |   |
| Equity earnings in  affiliates                       |       |                    | 10,288     |                           |       |                         | 10,288     |           |       |              | —     |                    |       |   | 170 |   |   |   | (20,746 | ) |   |   | — |   |   |
| Interest expense, net                                |       |                    | —     |                           |       |                         | —     |           |       |              | 14,331     |                    |       |   | (2,832 | ) |   |   | — |   |   |   | 11,499 |   |   |
| Income (loss) before  income taxes                   |       |                    | (10,288    | )                              |       |                         | (10,288    | )              |       |              | (30,740    | )                       |       |   | 11,937 |   |   |   | 20,746 |   |   |   | (18,633 | ) |   |
| Income tax (benefit)  expense                        |       |                    | —     |                           |       |                         | —     |           |       |              | (13,767    | )                       |       |   | 5,422 |   |   |   | — |   |   |   | (8,345 | ) |   |
| Net income (loss)                                    |       |                    | $          | (10,288                        | )          |                         |       | $              | (10,288    | )                 |       |                    | $          | (16,973 | ) |   |   | $ | 6,515 |   |   |   | $ | 20,746 |   |   |   | $ | (10,288 | ) |   |

 

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**DUANE READE HOLDINGS, INC.Condensed Consolidating Statement of Operations (Unaudited)For the 26 weeks ended July 1, 2006(in thousands)**

| ** **                                          | ** ** | ** **              | ** ** | ** **                     | ** ** | ** **                   | ** ** | ** **     | ** ** | ** **        | ** ** | **Duane Reade**    | ** ** |
|-----------------------------------------------------|------------|-------------------------|------------|--------------------------------|------------|------------------------------|------------|----------------|------------|-------------------|------------|-------------------------|------------|
| ** **                                          | ** ** | **Duane Reade**    | ** ** | ** **                     | ** ** | ** **                   | ** ** | **Subsidiary** | ** ** | **Consolidating** | ** ** | **Holdings, Inc.** | ** ** |
| ** **                                          | ** ** | **Holdings, Inc.** | ** ** | **Duane Reade Inc.** | ** ** | **Duane Reade GP** | ** ** | **Guarantors** | ** ** | **Adjustments**   | ** ** | **Consolidated**        | ** ** |
| Net sales                                           |       |                    | $          | —                         |       |                         |       | $              | —     |              |       |                    | $          | 784,658 |   |   |   | $ | 19,138 |   |   |   | $ | (19,138 | ) |   |   | $ | 784,658 |   |   |
| Cost of sales                                       |       |                    | —     |                           |       |                         | —     |           |       |              | 628,098    |                    |       |   | — |   |   |   | — |   |   |   | 628,098 |   |   |
| Gross profit                                        |       |                    | —     |                           |       |                         | —     |           |       |              | 156,560    |                    |       |   | 19,138 |   |   |   | (19,138 | ) |   |   | 156,560 |   |   |
| Selling, general & administrative expenses |       |                    | —     |                           |       |                         | —     |           |       |              | 156,614    |                    |       |   | 136 |   |   |   | (19,138 | ) |   |   | 137,612 |   |   |
| Labor contingency                                   |       |                    | —     |                           |       |                         | —     |           |       |              | (18,004    | )                       |       |   | — |   |   |   | — |   |   |   | (18,004 | ) |   |
| Transaction expense                                 |       |                    | —     |                           |       |                         | —     |           |       |              | —     |                    |       |   | — |   |   |   | — |   |   |   | — |   |   |
| Depreciation and amortization                       |       |                    | —     |                           |       |                         | —     |           |       |              | 37,306     |                    |       |   | — |   |   |   | — |   |   |   | 37,306 |   |   |
| Store pre-opening expense                           |       |                    | —     |                           |       |                         | —     |           |       |              | 152        |                    |       |   | — |   |   |   | — |   |   |   | 152 |   |   |
| Other                                               |       |                    | —     |                           |       |                         | —     |           |       |              | 1,635      |                    |       |   | — |   |   |   | — |   |   |   | 1,635 |   |   |
| Operating (loss) income                             |       |                    | —     |                           |       |                         | —     |           |       |              | (21,143    | )                       |       |   | 19,002 |   |   |   | — |   |   |   | (2,141 | ) |   |
| Equity earnings in affiliates                       |       |                    | 30,941     |                           |       |                         | 30,941     |           |       |              | —     |                    |       |   | 605 |   |   |   | (62,487 | ) |   |   | — |   |   |
| Interest expense, net                               |       |                    | —     |                           |       |                         | —     |           |       |              | 37,547     |                    |       |   | (9,674 | ) |   |   | — |   |   |   | 27,873 |   |   |
| Income (loss) before income taxes              |       |                    | (30,941    | )                              |       |                         | (30,941    | )              |       |              | (58,690    | )                       |       |   | 28,071 |   |   |   | 62,487 |   |   |   | (30,014 | ) |   |
| Income tax (benefit) expense                        |       |                    | —     |                           |       |                         | —     |           |       |              | 1,813      |                    |       |   | (886 | ) |   |   | — |   |   |   | 927 |   |   |
| Net income (loss)                                   |       |                    | $          | (30,941                        | )          |                         |       | $              | (30,941    | )                 |       |                    | $          | (60,503 | ) |   |   | $ | 28,957 |   |   |   | $ | 62,487 |   |   |   | $ | (30,941 | ) |   |

**DUANE READE HOLDINGS, INC.Condensed Consolidating Statement of Operations (Unaudited)For the 26 weeks ended June 25, 2005(in thousands)**

| ** **                                          | ** ** | ** **              | ** ** | ** **                     | ** ** | ** **                   | ** ** | ** **     | ** ** | ** **        | ** ** | **Duane Reade**    | ** ** |
|-----------------------------------------------------|------------|-------------------------|------------|--------------------------------|------------|------------------------------|------------|----------------|------------|-------------------|------------|-------------------------|------------|
| ** **                                          | ** ** | **Duane Reade**    | ** ** | ** **                     | ** ** | ** **                   | ** ** | **Subsidiary** | ** ** | **Consolidating** | ** ** | **Holdings, Inc.** | ** ** |
| ** **                                          | ** ** | **Holdings, Inc.** | ** ** | **Duane Reade Inc.** | ** ** | **Duane Reade GP** | ** ** | **Guarantors** | ** ** | **Adjustments**   | ** ** | **Consolidated**        | ** ** |
| Net sales                                           |       |                    | $          | —                         |       |                         |       | $              | —     |              |       |                    | $          | 794,267 |   |   |   | $ | 18,533 |   |   |   | $ | (18,533 | ) |   |   | $ | 794,267 |   |   |
| Cost of sales                                       |       |                    | —     |                           |       |                         | —     |           |       |              | 642,863    |                    |       |   | — |   |   |   | — |   |   |   | 642,863 |   |   |
| Gross profit                                        |       |                    | —     |                           |       |                         | —     |           |       |              | 151,404    |                    |       |   | 18,533 |   |   |   | (18,533 | ) |   |   | 151,404 |   |   |
| Selling, general & administrative expenses |       |                    | —     |                           |       |                         | —     |           |       |              | 147,462    |                    |       |   | 111 |   |   |   | (18,533 | ) |   |   | 129,040 |   |   |
| Labor contingency                                   |       |                    | —     |                           |       |                         | —     |           |       |              | 2,200      |                    |       |   | — |   |   |   | — |   |   |   | 2,200 |   |   |
| Transaction expense                                 |       |                    | —     |                           |       |                         | —     |           |       |              | 581        |                    |       |   | — |   |   |   | — |   |   |   | 581 |   |   |
| Depreciation and amortization                       |       |                    | —     |                           |       |                         | —     |           |       |              | 35,497     |                    |       |   | — |   |   |   | — |   |   |   | 35,497 |   |   |
| Store pre-opening expense                           |       |                    | —     |                           |       |                         | —     |           |       |              | 150        |                    |       |   | — |   |   |   | — |   |   |   | 150 |   |   |
| Other                                               |       |                    | —     |                           |       |                         | —     |           |       |              | 3,182      |                    |       |   | — |   |   |   | — |   |   |   | 3,182 |   |   |
| Operating (loss) income                             |       |                    | —     |                           |       |                         | —     |           |       |              | (37,668    | )                       |       |   | 18,422 |   |   |   | — |   |   |   | (19,246 | ) |   |
| Equity earnings in affiliates                       |       |                    | 23,091     |                           |       |                         | 23,091     |           |       |              | —     |                    |       |   | 362 |   |   |   | (46,544 | ) |   |   | — |   |   |
| Interest expense, net                               |       |                    | —     |                           |       |                         | —     |           |       |              | 28,108     |                    |       |   | (5,444 | ) |   |   | — |   |   |   | 22,664 |   |   |
| Income (loss) before income taxes              |       |                    | (23,091    | )                              |       |                         | (23,091    | )              |       |              | (65,776    | )                       |       |   | 23,504 |   |   |   | 46,544 |   |   |   | (41,910 | ) |   |
| Income tax (benefit) expense                        |       |                    | —     |                           |       |                         | —     |           |       |              | (29,536    | )                       |       |   | 10,717 |   |   |   | — |   |   |   | (18,819 | ) |   |
| Net income (loss)                                   |       |                    | $          | (23,091                        | )          |                         |       | $              | (23,091    | )                 |       |                    | $          | (36,240 | ) |   |   | $ | 12,787 |   |   |   | $ | 46,544 |   |   |   | $ | (23,091 | ) |   |

 

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

| ** **                                     | ** ** | ** **              | ** ** | ** **                     | ** ** | ** **                   | ** ** | ** **     | ** ** | ** **        | ** ** | **Duane Reade**    | ** ** |
|------------------------------------------------|------------|-------------------------|------------|--------------------------------|------------|------------------------------|------------|----------------|------------|-------------------|------------|-------------------------|------------|
| ** **                                     | ** ** | **Duane Reade**    | ** ** | ** **                     | ** ** | ** **                   | ** ** | **Subsidiary** | ** ** | **Consolidating** | ** ** | **Holdings, Inc.** | ** ** |
| ** **                                     | ** ** | **Holdings, Inc.** | ** ** | **Duane Reade Inc.** | ** ** | **Duane Reade GP** | ** ** | **Guarantors** | ** ** | **Adjustments**   | ** ** | **Consolidated**        | ** ** |
| Assets                                         |       |                    |       |                           |       |                         |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Current assets                                 |       |                    |       |                           |       |                         |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash                                           |       |                    | $          | —                         |       |                         |       | $              | —     |              |       |                    | $          | 1,331 |   |   |   | $ | 20 |   |   |   | $ | — |   |   |   | $ | 1,351 |   |   |
| Receivables                                    |       |                    | —     |                           |       |                         | —     |           |       |              | 50,047     |                    |       |   | — |   |   |   | — |   |   |   | 50,047 |   |   |
| Due from affiliates                            |       |                    | —     |                           |       |                         | 71,902     |           |       |              | 113,436    |                    |       |   | — |   |   |   | (185,338 | ) |   |   | — |   |   |
| Inventories                                    |       |                    | —     |                           |       |                         | —     |           |       |              | 226,249    |                    |       |   | — |   |   |   | — |   |   |   | 226,249 |   |   |
| Deferred income taxes                          |       |                    | —     |                           |       |                         | 7,120      |           |       |              | 5,049      |                    |       |   | (6,189 | ) |   |   | — |   |   |   | 5,980 |   |   |
| Prepaid expenses and other assets         |       |                    | —     |                           |       |                         | —     |           |       |              | 27,093     |                    |       |   | — |   |   |   | — |   |   |   | 27,093 |   |   |
| Total current assets                           |       |                    | —     |                           |       |                         | 79,022     |           |       |              | 423,205    |                    |       |   | (6,169 | ) |   |   | (185,338 | ) |   |   | 310,720 |   |   |
| Investment in affiliates                       |       |                    | 52,720     |                           |       |                         | 52,720     |           |       |              | —     |                    |       |   | (275 | ) |   |   | (105,165 | ) |   |   | — |   |   |
| Property and equipment                         |       |                    | —     |                           |       |                         | —     |           |       |              | 221,624    |                    |       |   | — |   |   |   | — |   |   |   | 221,624 |   |   |
| Goodwill, net                                  |       |                    | —     |                           |       |                         | —     |           |       |              | 67,791     |                    |       |   | — |   |   |   | — |   |   |   | 67,791 |   |   |
| Deferred income taxes                          |       |                    | —     |                           |       |                         | 1,645      |           |       |              | 9,032      |                    |       |   | (10,677 | ) |   |   | — |   |   |   | — |   |   |
| Other assets                                   |       |                    | —     |                           |       |                         | —     |           |       |              | 190,506    |                    |       |   | 314,507 |   |   |   | (268,275 | ) |   |   | 236,738 |   |   |
| Total assets                                   |       |                    | $          | 52,720                         |       |                         |       | $              | 133,387    |              |       |                    | $          | 912,158 |   |   |   | $ | 297,386 |   |   |   | $ | (558,778 | ) |   |   | $ | 836,873 |   |   |
| Liabilities and  Stockholders Equity           |       |                    |       |                           |       |                         |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Current liabilities                            |       |                    |       |                           |       |                         |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Accounts payable                               |       |                    | $          | —                         |       |                         |       | $              | —     |              |       |                    | $          | 78,505 |   |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | 78,505 |   |   |
| Due to affiliates                              |       |                    | —     |                           |       |                         | —     |           |       |              | —     |                    |       |   | 185,336 |   |   |   | (185,336 | ) |   |   | — |   |   |
| Accrued interest                               |       |                    | —     |                           |       |                         | —     |           |       |              | 9,354      |                    |       |   | — |   |   |   | — |   |   |   | 9,354 |   |   |
| Accrued expenses                               |       |                    | —     |                           |       |                         | (122       | )              |       |              | 54,291     |                    |       |   | — |   |   |   | — |   |   |   | 54,169 |   |   |
| Current portion of debt                        |       |                    | —     |                           |       |                         | —     |           |       |              | 148,259    |                    |       |   | — |   |   |   | — |   |   |   | 148,259 |   |   |
| Current portion of capital lease obligation    |       |                    | —     |                           |       |                         | —     |           |       |              | 3,246      |                    |       |   | — |   |   |   | — |   |   |   | 3,246 |   |   |
| Total current liabilities                      |       |                    | —     |                           |       |                         | (122       | )              |       |              | 293,655    |                    |       |   | 185,336 |   |   |   | (185,336 | ) |   |   | 293,533 |   |   |
| Long term debt                                 |       |                    | —     |                           |       |                         | —     |           |       |              | 673,307    |                    |       |   | — |   |   |   | (268,275 | ) |   |   | 405,032 |   |   |
| Capital lease obligation, less current portion |       |                    | —     |                           |       |                         | —     |           |       |              | 8,710      |                    |       |   | — |   |   |   | — |   |   |   | 8,710 |   |   |
| Deferred income taxes                          |       |                    | —     |                           |       |                         | 78,809     |           |       |              | (79,694    | )                       |       |   | 32,126 |   |   |   | — |   |   |   | 31,241 |   |   |
| Other non-current liabilities                  |       |                    | —     |                           |       |                         | 1,980      |           |       |              | 42,520     |                    |       |   | — |   |   |   | — |   |   |   | 44,500 |   |   |
| Total liabilities                              |       |                    | —     |                           |       |                         | 80,667     |           |       |              | 938,498    |                    |       |   | 217,462 |   |   |   | (453,611 | ) |   |   | 783,016 |   |   |
| Stockholders equity                            |       |                    |       |                           |       |                         |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Common stock                                   |       |                    | 26         |                           |       |                         | —     |           |       |              | —     |                    |       |   | — |   |   |   | — |   |   |   | 26 |   |   |
| Paid-in-capital                                |       |                    | 239,472    |                           |       |                         | 239,498    |           |       |              | 239,498    |                    |       |   | 2,395 |   |   |   | (481,391 | ) |   |   | 239,472 |   |   |
| Additional paid-in capital                     |       |                    | —     |                           |       |                         | —     |           |       |              | 104        |                    |       |   | — |   |   |   | — |   |   |   | 104 |   |   |
| Accumulated other comprehensive income         |       |                    | —     |                           |       |                         | —     |           |       |              | 1,034      |                    |       |   | — |   |   |   | — |   |   |   | 1,034 |   |   |
| Retained earnings                              |       |                    | (186,778   | )                              |       |                         | (186,778   | )              |       |              | (266,976   | )                       |       |   | 77,529 |   |   |   | 376,224 |   |   |   | (186,779 | ) |   |
| Total stockholders equity                      |       |                    | 52,720     |                           |       |                         | 52,720     |           |       |              | (26,340    | )                       |       |   | 79,924 |   |   |   | (105,167 | ) |   |   | 53,857 |   |   |
| Total liabilities  and stockholders equity     |       |                    | $          | 52,720                         |       |                         |       | $              | 133,387    |              |       |                    | $          | 912,158 |   |   |   | $ | 297,386 |   |   |   | $ | (558,778 | ) |   |   | $ | 836,873 |   |   |

 

22

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

| ** **                                     | ** ** | ** **              | ** ** | ** **                     | ** ** | ** **                   | ** ** | ** **     | ** ** | ** **        | ** ** | **Duane Reade**    | ** ** |
|------------------------------------------------|------------|-------------------------|------------|--------------------------------|------------|------------------------------|------------|----------------|------------|-------------------|------------|-------------------------|------------|
| ** **                                     | ** ** | **Duane Reade**    | ** ** | ** **                     | ** ** | ** **                   | ** ** | **Subsidiary** | ** ** | **Consolidating** | ** ** | **Holdings, Inc.** | ** ** |
| ** **                                     | ** ** | **Holdings, Inc.** | ** ** | **Duane Reade Inc.** | ** ** | **Duane Reade GP** | ** ** | **Guarantors** | ** ** | **Adjustments**   | ** ** | **Consolidated**        | ** ** |
| Assets                                         |       |                    |       |                           |       |                         |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Current assets                                 |       |                    |       |                           |       |                         |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash                                           |       |                    | $          | —                         |       |                         |       | $              | —     |              |       |                    | $          | 1,338 |   |   |   | $ | 24 |   |   |   | $ | — |   |   |   | $ | 1,362 |   |   |
| Receivables                                    |       |                    | —     |                           |       |                         | —     |           |       |              | 52,320     |                    |       |   | — |   |   |   | — |   |   |   | 52,320 |   |   |
| Due from affiliates                            |       |                    | —     |                           |       |                         | 71,983     |           |       |              | 112,660    |                    |       |   | — |   |   |   | (184,643 | ) |   |   | — |   |   |
| Inventories                                    |       |                    | —     |                           |       |                         | —     |           |       |              | 235,639    |                    |       |   | — |   |   |   | — |   |   |   | 235,639 |   |   |
| Deferred income taxes                          |       |                    | —     |                           |       |                         | 8,857      |           |       |              | 5,049      |                    |       |   | (6,189 | ) |   |   | — |   |   |   | 7,717 |   |   |
| Prepaid expenses and other assets         |       |                    | —     |                           |       |                         | —     |           |       |              | 26,114     |                    |       |   | — |   |   |   | — |   |   |   | 26,114 |   |   |
| Total current assets                           |       |                    | —     |                           |       |                         | 80,840     |           |       |              | 433,120    |                    |       |   | (6,165 | ) |   |   | (184,643 | ) |   |   | 323,152 |   |   |
| Investment in affiliates                       |       |                    | 83,662     |                           |       |                         | 83,662     |           |       |              | —     |                    |       |   | 330 |   |   |   | (167,654 | ) |   |   | — |   |   |
| Property and equipment                         |       |                    | —     |                           |       |                         | —     |           |       |              | 229,134    |                    |       |   | — |   |   |   | — |   |   |   | 229,134 |   |   |
| Goodwill, net                                  |       |                    | —     |                           |       |                         | —     |           |       |              | 67,791     |                    |       |   | — |   |   |   | — |   |   |   | 67,791 |   |   |
| Deferred income taxes                          |       |                    | —     |                           |       |                         | 1,645      |           |       |              | 9,032      |                    |       |   | (10,677 | ) |   |   | — |   |   |   | — |   |   |
| Other assets                                   |       |                    | —     |                           |       |                         | —     |           |       |              | 205,109    |                    |       |   | 285,132 |   |   |   | (238,900 | ) |   |   | 251,341 |   |   |
| Total assets                                   |       |                    | $          | 83,662                         |       |                         |       | $              | 166,147    |              |       |                    | $          | 944,186 |   |   |   | $ | 268,620 |   |   |   | $ | (591,197 | ) |   |   | $ | 871,418 |   |   |
| Liabilities and  Stockholders 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 |   |   |
| Stockholders  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 stockholders equity                      |       |                    | 83,662     |                           |       |                         | 83,662     |           |       |              | 33,287     |                    |       |   | 50,967 |   |   |   | (167,656 | ) |   |   | 83,922 |   |   |
| Total liabilities  and stockholders equity     |       |                    | $          | 83,662                         |       |                         |       | $              | 166,147    |              |       |                    | $          | 944,186 |   |   |   | $ | 268,620 |   |   |   | $ | (591,197 | ) |   |   | $ | 871,418 |   |   |

 

23

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**DUANE READEHOLDINGS, INC.Condensed Consolidating Statement of Cash Flows (Unaudited)For the 26 weeks ended July 1, 2006(in thousands)**

| ** **                                                                                           | ** ** | ** **              | ** ** | ** **                     | ** ** | ** **                   | ** ** | ** **     | ** ** | ** **        | ** ** | **Duane Reade**    | ** ** |
|------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|--------------------------------|------------|------------------------------|------------|----------------|------------|-------------------|------------|-------------------------|------------|
| ** **                                                                                           | ** ** | **Duane Reade**    | ** ** | ** **                     | ** ** | ** **                   | ** ** | **Subsidiary** | ** ** | **Consolidating** | ** ** | **Holdings, Inc.** | ** ** |
| ** **                                                                                           | ** ** | **Holdings, Inc.** | ** ** | **Duane Reade Inc.** | ** ** | **Duane Reade GP** | ** ** | **Guarantors** | ** ** | **Adjustments**   | ** ** | **Consolidated**        | ** ** |
| Cash flows provided by (used in) operating  activities:                                              |       |                    |       |                           |       |                         |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net (loss) income                                                                                    |       |                    | $          | (30,941                        | )          |                         |       | $              | (30,941    | )                 |       |                    | $          | (60,503 | ) |   |   | $ | 28,957 |   |   |   | $ | 62,487 |   |   |   | $ | (30,941 | ) |   |
| Adjustments to  reconcile net (loss) income to net cash provided by (used in) operating  activities: |       |                    |       |                           |       |                         |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Depreciation and  amortization                                                                       |       |                    | —     |                           |       |                         | —     |           |       |              | 39,430     |                    |       |   | — |   |   |   | — |   |   |   | 39,430 |   |   |
| Deferred income  taxes                                                                               |       |                    | —     |                           |       |                         | (66        | )              |       |              | 1,813      |                    |       |   | (886 | ) |   |   | — |   |   |   | 861 |   |   |
| Non-cash rent  expense                                                                               |       |                    | —     |                           |       |                         | —     |           |       |              | 5,150      |                    |       |   | — |   |   |   | — |   |   |   | 5,150 |   |   |
| Other non-cash  expense                                                                              |       |                    | —     |                           |       |                         | —     |           |       |              | 104        |                    |       |   | — |   |   |   | — |   |   |   | 104 |   |   |
| Equity in income  of subsidiaries                                                                    |       |                    | 30,941     |                           |       |                         | 30,941     |           |       |              | —     |                    |       |   | 605 |   |   |   | (62,487 | ) |   |   | — |   |   |
| Changes in  operating assets and liabilities:                                                        |       |                    |       |                           |       |                         |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Receivables                                                                                          |       |                    | —     |                           |       |                         | 81         |           |       |              | 1,497      |                    |       |   | 695 |   |   |   | — |   |   |   | 2,273 |   |   |
| Inventories                                                                                          |       |                    | —     |                           |       |                         | —     |           |       |              | 9,390      |                    |       |   | — |   |   |   | — |   |   |   | 9,390 |   |   |
| Accounts payable                                                                                     |       |                    | —     |                           |       |                         | —     |           |       |              | 5,794      |                    |       |   | — |   |   |   | — |   |   |   | 5,794 |   |   |
| Prepaid and  accrued expenses                                                                        |       |                    | —     |                           |       |                         | (15        | )              |       |              | 1,850      |                    |       |   | — |   |   |   | — |   |   |   | 1,835 |   |   |
| Other assets and  liabilities, net                                                                   |       |                    | —     |                           |       |                         | —     |           |       |              | (652       | )                       |       |   | (29,375 | ) |   |   | — |   |   |   | (30,027 | ) |   |
| NET CASH PROVIDED  BY (USED IN) OPERATING ACTIVITIES                                                 |       |                    | —     |                           |       |                         | —     |           |       |              | 3,873      |                    |       |   | (4 | ) |   |   | — |   |   |   | 3,869 |   |   |
| Cash flows used in investing activities:                                                             |       |                    |       |                           |       |                         |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Capital  expenditures                                                                                |       |                    | —     |                           |       |                         | —     |           |       |              | (12,270    | )                       |       |   | — |   |   |   | — |   |   |   | (12,270 | ) |   |
| Lease acquisition  and other costs                                                                   |       |                    | —     |                           |       |                         | —     |           |       |              | (4,107     | )                       |       |   | — |   |   |   | — |   |   |   | (4,107 | ) |   |
| Proceeds from sale  of property                                                                      |       |                    | —     |                           |       |                         | —     |           |       |              | 1,500      |                    |       |   | — |   |   |   | — |   |   |   | 1,500 |   |   |
| NET CASH USED IN  INVESTING ACTIVITIES                                                               |       |                    | —     |                           |       |                         | —     |           |       |              | (14,877    | )                       |       |   | — |   |   |   | — |   |   |   | (14,877 | ) |   |
| Cash flows from financing activities:                                                                |       |                    |       |                           |       |                         |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Borrowings from  revolving credit facility                                                           |       |                    | —     |                           |       |                         | —     |           |       |              | 915,368    |                    |       |   | — |   |   |   | — |   |   |   | 915,368 |   |   |
| Repayments of  revolving credit facility                                                             |       |                    | —     |                           |       |                         | —     |           |       |              | (902,802   | )                       |       |   | — |   |   |   | — |   |   |   | (902,802 | ) |   |
| Repayments of  capital lease obligations                                                             |       |                    | —     |                           |       |                         | —     |           |       |              | (1,541     | )                       |       |   | — |   |   |   | — |   |   |   | (1,541 | ) |   |
| Deferred financing  costs                                                                            |       |                    | —     |                           |       |                         | —     |           |       |              | (28        | )                       |       |   | — |   |   |   | — |   |   |   | (28 | ) |   |
| NET CASH PROVIDED  BY FINANCING ACTIVITIES                                                           |       |                    | —     |                           |       |                         | —     |           |       |              | 10,997     |                    |       |   | — |   |   |   | — |   |   |   | 10,997 |   |   |
| Net decrease in  cash                                                                                |       |                    | —     |                           |       |                         | —     |           |       |              | (7         | )                       |       |   | (4 | ) |   |   | — |   |   |   | (11 | ) |   |
| Cash at beginning  of period                                                                         |       |                    | —     |                           |       |                         | —     |           |       |              | 1,338      |                    |       |   | 24 |   |   |   | — |   |   |   | 1,362 |   |   |
| Cash at end of  period                                                                               |       |                    | $          | —                         |       |                         |       | $              | —     |              |       |                    | $          | 1,331 |   |   |   | $ | 20 |   |   |   | $ | — |   |   |   | $ | 1,351 |   |   |

 

24

----

**DUANE READE HOLDINGS, INC.Condensed Consolidating Statement of Cash Flows (Unaudited)For the 26 weeks ended June 25, 2005(in thousands)**

| ** **                                                                            | ** ** | ** **              | ** ** | ** **                     | ** ** | ** **                   | ** ** | ** **     | ** ** | ** **        | ** ** | **Duane Reade**    | ** ** |
|---------------------------------------------------------------------------------------|------------|-------------------------|------------|--------------------------------|------------|------------------------------|------------|----------------|------------|-------------------|------------|-------------------------|------------|
| ** **                                                                            | ** ** | **Duane Reade**    | ** ** | ** **                     | ** ** | ** **                   | ** ** | **Subsidiary** | ** ** | **Consolidating** | ** ** | **Holdings, Inc.** | ** ** |
| ** **                                                                            | ** ** | **Holdings, Inc.** | ** ** | **Duane Reade Inc.** | ** ** | **Duane Reade GP** | ** ** | **Guarantors** | ** ** | **Adjustments**   | ** ** | **Consolidated**        | ** ** |
| Cash flows used in  operating activities:                                             |       |                    |       |                           |       |                         |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net (loss) income                                                                     |       |                    | $          | (23,091                        | )          |                         |       | $              | (23,091    | )                 |       |                    | $          | (36,240 | ) |   |   | $ | 12,787 |   |   |   | $ | 46,544 |   |   |   | $ | (23,091 | ) |   |
| Adjustments to  reconcile net (loss) income to net cash used in operating activities: |       |                    |       |                           |       |                         |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Depreciation and  amortization                                                        |       |                    | —     |                           |       |                         | —     |           |       |              | 37,238     |                    |       |   | — |   |   |   | — |   |   |   | 37,238 |   |   |
| Deferred income  taxes                                                                |       |                    | —     |                           |       |                         | (39        | )              |       |              | (29,536    | )                       |       |   | 10,717 |   |   |   | — |   |   |   | (18,858 | ) |   |
| Non-cash rent  expense                                                                |       |                    | —     |                           |       |                         | —     |           |       |              | 6,901      |                    |       |   | — |   |   |   | — |   |   |   | 6,901 |   |   |
| Equity in income  of subsidiaries                                                     |       |                    | 23,091     |                           |       |                         | 23,091     |           |       |              | —     |                    |       |   | 362 |   |   |   | (46,544 | ) |   |   | — |   |   |
| Changes in operating  assets and liabilities:                                         |       |                    |       |                           |       |                         |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Receivables                                                                           |       |                    | —     |                           |       |                         | 163        |           |       |              | 21,293     |                    |       |   | (15,856 | ) |   |   | — |   |   |   | 5,600 |   |   |
| Inventories                                                                           |       |                    | —     |                           |       |                         | —     |           |       |              | (15,187    | )                       |       |   | — |   |   |   | — |   |   |   | (15,187 | ) |   |
| Accounts payable                                                                      |       |                    | —     |                           |       |                         | —     |           |       |              | 8,288      |                    |       |   | — |   |   |   | — |   |   |   | 8,288 |   |   |
| Prepaid and  accrued expenses                                                         |       |                    | —     |                           |       |                         | (124       | )              |       |              | (15,767    | )                       |       |   | — |   |   |   | — |   |   |   | (15,891 | ) |   |
| Other assets and  liabilities, net                                                    |       |                    | —     |                           |       |                         | —     |           |       |              | 14,356     |                    |       |   | (8,025 | ) |   |   | — |   |   |   | 6,331 |   |   |
| NET CASH USED IN  OPERATING ACTIVITIES                                                |       |                    | —     |                           |       |                         | —     |           |       |              | (8,654     | )                       |       |   | (15 | ) |   |   | — |   |   |   | (8,669 | ) |   |
| Cash flows used in  investing activities:                                             |       |                    |       |                           |       |                         |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Capital  expenditures                                                                 |       |                    | —     |                           |       |                         | —     |           |       |              | (14,310    | )                       |       |   | — |   |   |   | — |   |   |   | (14,310 | ) |   |
| Lease acquisition  and other costs                                                    |       |                    | —     |                           |       |                         | —     |           |       |              | (5,764     | )                       |       |   | — |   |   |   | — |   |   |   | (5,764 | ) |   |
| Proceeds from sale  of property                                                       |       |                    | —     |                           |       |                         | —     |           |       |              | 2,223      |                    |       |   | — |   |   |   | — |   |   |   | 2,223 |   |   |
| NET CASH USED IN  INVESTING ACTIVITIES                                                |       |                    | —     |                           |       |                         | —     |           |       |              | (17,851    | )                       |       |   | — |   |   |   | — |   |   |   | (17,851 | ) |   |
| Cash flows from financing  activities:                                                |       |                    |       |                           |       |                         |       |           |       |              |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Borrowings from  revolving credit facility                                            |       |                    | —     |                           |       |                         | —     |           |       |              | 901,942    |                    |       |   | — |   |   |   | — |   |   |   | 901,942 |   |   |
| Repayments of  revolving credit facility                                              |       |                    | —     |                           |       |                         | —     |           |       |              | (873,440   | )                       |       |   | — |   |   |   | — |   |   |   | (873,440 | ) |   |
| Repayments of  capital lease obligations                                              |       |                    | —     |                           |       |                         | —     |           |       |              | (1,368     | )                       |       |   | — |   |   |   | — |   |   |   | (1,368 | ) |   |
| Deferred financing  costs                                                             |       |                    | —     |                           |       |                         | —     |           |       |              | (622       | )                       |       |   | — |   |   |   | — |   |   |   | (622 | ) |   |
| NET CASH PROVIDED  BY FINANCING ACTIVITIES                                            |       |                    | —     |                           |       |                         | —     |           |       |              | 26,512     |                    |       |   | — |   |   |   | — |   |   |   | 26,512 |   |   |
| Net increase (decrease)  in cash                                                      |       |                    | —     |                           |       |                         | —     |           |       |              | 7          |                    |       |   | (15 | ) |   |   | — |   |   |   | (8 | ) |   |
| Cash at beginning of  period                                                          |       |                    | —     |                           |       |                         | —     |           |       |              | 1,297      |                    |       |   | 32 |   |   |   | — |   |   |   | 1,329 |   |   |
| Cash at end of period                                                                 |       |                    | $          | —                         |       |                         |       | $              | —     |              |       |                    | $          | 1,304 |   |   |   | $ | 17 |   |   |   | $ | — |   |   |   | $ | 1,321 |   |   |

 

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

**General**

Our business consists of the sale of a wide variety ofhealth and beauty care products, convenience oriented food and generalmerchandise items and a pharmacy operation managed to supply customers withtheir prescription needs. We refer to the non-prescription portion of ourbusiness as front-end sales because most of these sales are processed throughthe front check-out sections of our stores. This portion of our businessconsists of brand name and private label health and beauty care items, food andbeverages, tobacco products, cosmetics, housewares, greeting cards,photofinishing services, photo supplies and seasonal and general merchandise.Health and beauty care products, including over-the-counter items, representour highest volume categories within front-end sales. The front-end portion ofour business represented 54.1% and 53.8% of our sales in the 13 and 26 weeksended July 1, 2006, respectively, as compared to 51.2% and 50.8% in thecorresponding periods last year. Gross margins generated by our front-endbusiness are approximately twice that of our pharmacy or back-end business.

Because of our numerous convenient locations inhigh-traffic commercial and residential areas and the lack of otherconvenience-oriented retailers in our core market areas, our front-end businessis generally a larger proportion of our total sales than other majorconventional drugstore chains, which average between 30% and 40%. Historically,front-end sales have represented a decreasing share of business year afteryear; however, over the last few years, pharmacy sales have experienced adeclining rate of growth primarily due to increases in third party planco-payments, reduced sales of hormonal replacement drugs and certain arthritismedications, limitations on maximum reimbursements for certain genericmedications by third party plans, increases in the percentage of salesrepresented by lower-priced generic medications and increased penetration bymail order and internet-based pharmacies. Our pharmacy sales include all itemswe sell by prescriptions filled at our retail locations or by our central fillfacility and delivered to our stores or direct to customers. In addition, weinclude in our pharmacy sales certain resales of retail pharmaceuticalinventory that are required to be reported on a gross basis in accordance withEmerging Issues Task Force Issue No. 99-19. Same-store pharmacysales do not include such resale activity. The pharmacy portion of our businessis dominated by and dependent upon a number of third party private andgovernment-sponsored plans that contract with us as an authorized provider ofprescriptions.

Sales processed through third party prescription plansrepresented approximately 92.9% and 92.7% of our prescription sales in the 13and 26 weeks ended July 1, 2006 and approximately 92.8% of ourprescription sales in both the 13 and 26 weeks ended June 25, 2005.Historically, excluding pharmacy resale activity, our pharmacy salesexperienced a faster rate of sales growth than the front-end portion of ourbusiness due to a number of favorable demographic and industry trends such asthe aging of the population, expanded penetration of third party private andgovernment-sponsored coverage and the increasing utilization of prescriptionsto improve quality of life and in place of medical procedures. While thesefactors are still operative, our rate of non-resale pharmacy sales growth hassteadily declined over the last two and a half years to the point where ourmost recent pharmacy sales results reflect a lower rate of growth than thefront-end portion of our business. This slower pharmacy sales growth is theresult of increased mail order penetration (that results in losses of retailbased prescription sales to mail order providers), negative publicitysurrounding the adverse side effects of certain arthritis medications and otherhigh volume drugs, conversion of certain high volume prescription drugs to over-the-counterfront-end products and increased use of lower priced but more profitablegeneric 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 

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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 ratesthan our current margins on prescriptions that are not subject to third partyreimbursement, as well as for these dual eligible customers transferred intothe Medicare Part D program from New York Medicaid. Based on ourexperience, we expect, over time, that increased utilization of prescriptiondrugs by Medicare participants enrolled in the new programs that previouslywere cash paying customers may offset the adverse effect of lower margins onour revenues, although we are not certain this will be the case. State Medicaidprograms that provide prescription benefits to low income households andindividuals have historically represented approximately 23% of our retailpharmacy sales. As of June 2006, state Medicaid plans had declined toapproximately 15.3% of our pharmacy sales while the new Medicare Part Dplan represented approximately 10.5% of our pharmacy sales.

In each of the past three years, New York State hasenacted rules related to Medicaid which have reduced our pharmacy margin. NewYork has again changed its rules effective July 1, 2006. We estimate that thesemost recent changes will reduce our annual 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 than branded prescriptions. Improved generic utilizationrates as well as a combination of direct purchases and contractual wholesalerpurchases enabled us to achieve improved gross margins on pharmacy retail salesduring 2004 and 2005. For the quarter ended July 1, 2006, we continued tosee increased generic substitution rates. The proportion of genericprescriptions dispensed was 51.0%, compared to 47.9% in the same period lastyear.

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

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

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**New York CityEconomy**

We operate approximately 88% of our 247 stores in NewYork City and the remainder in the surrounding areas, and our financialperformance is therefore heavily influenced by the local economy. We analyze anumber of economic indicators specific to New York City to gauge the health ofthis economy, including unemployment rates, job creation, gross city productand bridge and tunnel commuter traffic patterns. We also analyze market sharedata, same-store sales trends, average store sales and sales per square footdata among other key performance indicators to monitor our overall performance.During 2004, 2005 and the first half of 2006, the New York City economy generallyreflected an improving trend for most of these external economic indicators.

Between 2001 and 2003, theNew York City economy experienced a regional cyclical downturn and a series ofunusual events, such as the World Trade Center attacks and non-recurringincreases in real estate taxes and insurance costs. The New York greatermetropolitan area experienced above average unemployment levels, especially inthe key midtown and downtown Manhattan financial districts and lagged behindthe improving national economy throughout 2003 and the early part of 2004. Sincethe first half of 2004 it has shown significant growth in employment, tourismand overall commerce resulting in a more favorable retail environment. The June 2006unemployment data for New York City indicated an unemployment rate of 5.1%,compared to a national rate of 4.6%.

**Results ofOperations**

**The Thirteen WeeksEnded July 1, 2006 as Compared to the Thirteen Weeks Ended June 25,2005**

For the secondquarter of 2006, we achieved net sales of $398.8 million and sustained a netloss of $21.1 million, as compared to net sales of $399.5 million and a netloss of $10.3 million in the second quarter of the previous year. Pharmacyresale activity was $10.0 million in the second quarter of 2006, compared to$24.9 million in the previous year, resulting from reduced outside customerdemand. The reduction in earnings is attributable to the following factors:

·       A tax provision of $0.6 million in the secondquarter of 2006, compared to a tax benefit of $8.3 million in the prior year.The change in the tax provision was primarily attributable to a deferred taxasset valuation reserve of $9.6 million recorded in the second quarter of 2006.

·       Anincrease in interest expense of $2.6 million resulting from higherinterest rates applicable to our variable rate debt and higher debt levelsresulting from the August 2005 issuance of $50 million of senior securednotes.

·       Anincrease in selling, general and administrative expenses of $3.6 million,primarily resulting from higher labor costs that resulted from increasedpharmacist salaries, as well as New York State minimum wage rate increases thatbecame effective on January 1, 2006.

The negative impactof these items was partially offset by:

·       Anincrease in gross margin of $2.5 million, that was primarily attributable tohigher front-end store sales.

·       Areduction in labor contingency expenses of $1.1 millon resulting from thefavorable settlement of the NLRB litigation in April 2006.

·       Areduction in other expenses of $1.5 millon, primarily due to costs related toour former Chairman and CEO incurred in the second quarter of 2005 that did notrecur in 2006.

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

| ** **                                           | ** ** | **For the 13 Weeks Ended**                | ** ** |
|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                           | ** ** | **July 1, 2006**                          | ** ** | **June 25, 2005** | ** ** |
| ** **                                           | ** ** | **Dollars**                                         | ** ** | **% of Sales** | ** ** | **Dollars** | ** ** | **% of Sales** | ** ** |
| ** **                                           | ** ** | **In thousands, except percentages** | ** ** |
| Net sales                                            |       | $                                                   | 398,789    |   |   | 100.0 | % |   | $ | 399,500 |   |   | 100.0 | % |   |
| Cost of sales                                        |       | 317,704                                             |       |   | 79.7 |   |   | 320,905 |   |   | 80.3 |   |   |
| Gross profit                                         |       | 81,085                                              |       |   | 20.3 |   |   | 78,595 |   |   | 19.7 |   |   |
| Selling,  general & administrative expenses |       | 68,146                                              |       |   | 17.1 |   |   | 64,541 |   |   | 16.2 |   |   |
| Labor contingency  expense                           |       | —                                              |       |   | 0.0 |   |   | 1,100 |   |   | 0.3 |   |   |
| Transaction  expenses                                |       | —                                              |       |   | 0.0 |   |   | 154 |   |   | 0.0 |   |   |
| Depreciation and  amortization                       |       | 18,628                                              |       |   | 4.7 |   |   | 17,851 |   |   | 4.5 |   |   |
| Store pre-opening  expenses                          |       | 102                                                 |       |   | 0.0 |   |   | 50 |   |   | 0.0 |   |   |
| Other                                                |       | 533                                                 |       |   | 0.1 |   |   | 2,033 |   |   | 0.5 |   |   |
| Operating loss                                       |       | (6,324                                              | )          |   | -1.6 |   |   | (7,134 | ) |   | -1.8 |   |   |
| Interest expense,  net                               |       | 14,135                                              |       |   | 3.5 |   |   | 11,499 |   |   | 2.9 |   |   |
| Loss before  income taxes                            |       | (20,459                                             | )          |   | -5.1 |   |   | (18,633 | ) |   | -4.7 |   |   |
| Income tax  provision (benefit)                      |       | 619                                                 |       |   | 0.2 |   |   | (8,345 | ) |   | -2.1 |   |   |
| Net loss                                             |       | $                                                   | (21,078    | ) |   | -5.3 | % |   | $ | (10,288 | ) |   | -2.6 | % |   |

 

Net sales were $398.8 million in the thirteenweeks ended July 1, 2006, representing a decrease of 0.2% as compared tonet sales of $399.5 million in the thirteen weeks ended June 25,2005. Resale activity accounted for a decrease of 3.7%, while retail store salesto customers increased by 3.5% over this period. Same-store sales increased by 4.8%over the second quarter last year.

Pharmacy sales decreased from $195.1 million inthe second quarter of 2005 to $183.1 million in the second quarter of2006, a decrease of 6.1%, and represented 45.9% of total sales, as comparedwith 48.8% of total sales in the second quarter of 2005. The overall pharmacysales decrease includes a decrease of 7.6% resulting from the reduced resale activity,partially offset by an increase of 1.5% in retail pharmacy sales. Pharmacysame-store sales increased by 1.9% from last year, and third-party reimbursedpharmacy sales represented 92.9% of total prescription sales compared to 92.8%in the second quarter of 2005. Pharmacy same-store sales were adverselyimpacted by approximately 1.0% due to increased mail order penetrationresulting from conversion of certain third party plans to mandatory mail orderrequirements and approximately 0.2% due to negative publicity and reducedconsumer demand for arthritis medications and certain other high volume drugs.The percentage of generic prescriptions dispensed increased by 3.1% over theprior year, negatively impacting the pharmacy same-store sales increase byapproximately 2.0%, but contributing to an increase in gross margin perprescription dispensed. Generic prescriptions generally have lower retail salesprices but are more profitable than branded prescriptions.

Front-end sales increased from $204.4 million inthe second quarter of 2005 to $215.7 million in the second quarter of2006, an increase of 5.5%, and represented 54.1% of total sales, as compared to51.2% of total sales in the first quarter of 2005. Front-end same-store salesincreased by 7.3%, primarily due to a generally improved level of consumerdemand resulting from a stronger New York City economy and increasedpenetration of our Dollar Rewards program. In 2006, the second quarterbenefited by approximately 0.5% from Easter holiday sales, while in 2005, theseholiday sales benefited the first quarter.

During the thirteen weeks ended July 1, 2006, weopened two stores and closed two stores, as compared to one store opened and nostore closures during the thirteen weeks ended June 25, 2005. At July 1,2006, we operated 247 stores, as compared to 250 stores at June 25, 2005and 251 stores at December 31, 2005.

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Cost of sales as a percentage of net sales was 79.7%in the second quarter of 2006 and 80.3% in the second quarter of 2005,resulting in gross profit margins of 20.3% and 19.7%, respectively. Thisincrease in gross profit margins was primarily attributable to reduced lowermargin pharmacy resale activity and a reduction in store occupancy costs as apercentage of sales. Cost of sales also includes a $0.6 million LIFOprovision in the current year’s second quarter as compared to a LIFO provisionof $0.3 million in the corresponding period last year, and real-estaterelated income of $0.1 million in the second quarters of both 2006 and2005.

Selling, general and administrative expenses were$68.1 million, or 17.1% of net sales, and $64.5 million, or 16.2% of net sales,in the second quarter of 2006 and 2005, respectively. The increase in theseexpense ratios to sales as compared to the prior year was attributable to thereduced level of pharmacy resale activity (which reduces the aggregate amountof net sales) as well as increased store selling expenses. The increase instore selling expenses resulted primarily from higher labor costs that resultedfrom increased pharmacist salaries as well as New York State minimum wage rate increasesthat became effective on January 1, 2006.

Depreciation and amortization of property andequipment and intangible assets was $18.6 million in the second quarter of2006, as compared to $17.9 million in the second quarter of 2005. Thisincrease resulted from the depreciation of capital expenditures made in 2005and 2006 and amortization of identifiable intangibles acquired over the sameperiod.

We incurred store pre-opening expenses of$0.1 million in the second quarter of 2006, related to the opening of twostores. In the second quarter of last year, we incurred pre-opening costs of$0.1 million, attributable to the opening of one store.

In the second quarter of 2006, we incurred otherexpenses of $0.5 million, including (i) Oak Hill management fees ($0.3million) and (ii) costs associated with various matters related to ourcurrent CEO and our former Chairman ($0.2 million). In the second quarter of2005, other expenses of $2.0 million included (i) expenses associated withthe implementation of a tax indemnity insurance policy related to thedeductibility of certain payments made to our former Chairman in connectionwith the Acquisition ($0.9 million), (ii) costs associated with theplanned transfer to our former Chairman of a Company-owned split dollar lifeinsurance policy ($0.6 million), (iii) Oak Hill management fees ($0.3million) and (iv) costs associated with our former Chairman’s long-termcash award ($0.2 million).

Net interest expense for the second quarter of 2006was $14.1 million, as compared to $11.5 million in the second quarter of2005. 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. At July 1, 2006, theweighted average interest rate on our variable rate outstanding debt was 8.64%,as compared to a weighted average rate of 6.22% at June 25, 2005.

In the second quarter of2006, we recorded an income tax provision of $0.6 million, reflecting anestimated effective tax rate of (3.1)%. This expense is the result of avaluation allowance of $9.6 million that largely offset the tax benefitgenerated by our operating loss in the quarter. In the comparable period of2005, the income tax benefit of $8.3 million reflected an estimatedeffective tax rate of 44.8%, 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 Twenty-SixWeeks Ended July 1, 2006 as Compared to the Twenty-Six Weeks Ended June 25,2005**

For the first halfof 2006, we achieved net sales of $784.7 million and sustained a net loss of$30.9 million, as compared to net sales of $794.3 million and a net loss of$23.1 million in the first half of 2005. Pharmacy resale activity was $21.4million in the first half of 2006, compared to $53.0 million in the 

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previousyear, resulting from reduced outside customer demand. The reduction in earningsis attributable to the following factors:

·       Atax provision of $0.9 million in the first half of 2006, compared to a taxbenefit of $18.8 million in the prior year. The change in the tax provision wasprimarily attributable to a deferred tax asset valuation reserve of $14.1million recorded in the first half of 2006 and a reduced pre-tax loss in thesame period.

·       Anincrease in interest expense of $5.2 million resulting from higher interestrates applicable to our variable rate debt and higher debt levels in the firsthalf of 2006 resulting from the August 2005 issuance of $50 million of seniorsecured notes.

·       Anincrease in selling, general and administrative costs of $8.6 million,primarily resulting from higher labor costs that resulted from increasedpharmacist salaries as well as New York State minimum wage rate increases thatbecame effective on January 1, 2006.

·       Anincrease in depreciation and amortization expense of $1.8 million that wasattributable to the depreciation of capital expenditures and amortization ofintangibles acquired in 2005 and the first half of 2006.

The negative impactof 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 $5.2 million, primarily attributable to higherfront-end store sales.

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

| ** **                                           | ** ** | **For the 26 Weeks Ended**                | ** ** |
|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                           | ** ** | **July 1, 2006**                          | ** ** | **June 25, 2005** | ** ** |
| ** **                                           | ** ** | **Dollars**                                         | ** ** | **% of Sales** | ** ** | **Dollars** | ** ** | **% of Sales** | ** ** |
| ** **                                           | ** ** | **In thousands, except percentages** | ** ** |
| Net sales                                            |       | $                                                   | 784,658    |   |   | 100.0 | % |   | $ | 794,267 |   |   | 100.0 | % |   |
| Cost of sales                                        |       | 628,098                                             |       |   | 80.0 |   |   | 642,863 |   |   | 80.9 |   |   |
| Gross profit                                         |       | 156,560                                             |       |   | 20.0 |   |   | 151,404 |   |   | 19.1 |   |   |
| Selling,  general & administrative expenses |       | 137,612                                             |       |   | 17.5 |   |   | 129,040 |   |   | 16.2 |   |   |
| Labor contingency  expense                           |       | (18,004                                             | )          |   | -2.3 |   |   | 2,200 |   |   | 0.3 |   |   |
| Transaction  expenses                                |       | —                                              |       |   | 0.0 |   |   | 581 |   |   | 0.1 |   |   |
| Depreciation and  amortization                       |       | 37,306                                              |       |   | 4.8 |   |   | 35,497 |   |   | 4.5 |   |   |
| Store pre-opening  expenses                          |       | 152                                                 |       |   | 0.0 |   |   | 150 |   |   | 0.0 |   |   |
| Other                                                |       | 1,635                                               |       |   | 0.2 |   |   | 3,182 |   |   | 0.4 |   |   |
| Operating loss                                       |       | (2,141                                              | )          |   | -0.3 |   |   | (19,246 | ) |   | -2.4 |   |   |
| Interest expense,  net                               |       | 27,873                                              |       |   | 3.6 |   |   | 22,664 |   |   | 2.9 |   |   |
| Loss before  income taxes                            |       | (30,014                                             | )          |   | -3.8 |   |   | (41,910 | ) |   | -5.3 |   |   |
| Income tax  provision (benefit)                      |       | 927                                                 |       |   | 0.1 |   |   | (18,819 | ) |   | -2.4 |   |   |
| Net loss                                             |       | $                                                   | (30,941    | ) |   | -3.9 | % |   | $ | (23,091 | ) |   | -2.9 | % |   |

 

Net sales were $784.7 million in the twenty-sixweeks ended July 1, 2006, representing a decrease of 1.2% as compared tonet sales of $794.3 million in the twenty-six weeks ended June 25,2005. Resale activity accounted for a decrease of 4.0%, while retail store salesto customers increased by 2.8% over this period. Same-store sales increased by 3.3%over the same period in 2005.

Pharmacy sales decreased from $390.5 million inthe first half of 2005 to $362.5 million in the first half of 2006, adecrease of 7.2%, and represented 46.2% of total sales, as compared with 49.2%of total sales in 

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the first half of 2005.The overall pharmacy sales decrease includes a decrease of 8.1% resulting fromthe reduced resale activity, partially offset by an increase of 0.9% in retailpharmacy sales. Pharmacy same-store sales increased by 0.7% from last year, andthird-party reimbursed pharmacy sales represented 92.7% of total prescriptionsales compared to 92.8% in the comparable period of 2005.

Front-end sales increased from $403.8 million inthe first half of 2005 to $422.2 million in the first half of 2006, anincrease of 4.6%, and represented 53.8% of total sales, as compared to 50.8% oftotal sales in the first half of 2005. Front-end same-store sales increased by 5.6%,primarily due to a generally improved level of consumer demand resulting from astronger New York City economy and increased penetration of our Dollar Rewards program.

During the twenty-six weeks ended July 1, 2006,we opened three stores and closed seven stores, as compared to three storesopened and eight stores closed during the twenty-six weeks ended June 25,2005.

Cost of sales as a percentage of net sales was 80.0%in the first half of 2006 and 80.9% in the first half of 2005, resulting ingross profit margins of 20.0% and 19.1%, respectively. This increase in grossprofit margins was primarily attributable to reduced lower margin pharmacyresale activity and improved front-end sales. Cost of sales also includes a$1.1 million LIFO provision in the current year’s first six months ascompared to a LIFO provision of $0.1 million in the corresponding period lastyear, and real-estate related income of $0.2 million in the first half of both2006 and 2005.

Selling, general and administrative expenses were$137.6 million, or 17.5% of net sales, and $129.0 million, or 16.2% of netsales, in the first six months of 2006 and 2005, respectively. The increase inthese expense ratios to sales as compared to the prior year was attributable tothe reduced level of pharmacy resale activity (which reduces the aggregateamount of net sales) as well as increased store selling expenses. The increasein store selling expenses resulted primarily from higher labor costs thatresulted from increased pharmacist salaries as well as New York State minimumwage rate increases that became effective on January 1, 2006.

Depreciation and amortization of property andequipment and intangible assets was $37.3 million in the first half of2006, as compared to $35.5 million in the first half of 2005. Thisincrease resulted from the depreciation of capital expenditures made in 2005and 2006 and amortization of identifiable intangibles acquired over the sameperiod.

We incurred store pre-opening expenses of$0.2 million, related to the opening of three stores, in the first half ofboth 2006 and 2005.

In the first half of 2006, we incurred other expensesof $1.6 million including (i) Oak Hill management fees ($0.6 million), (ii) costsassociated with various matters related to our current CEO and former Chairman($0.5 million), (iii) severance and other costs resulting from thetermination of employment of two former executives ($0.3 million) and (iv) expensesattributable to a retention bonus paid to our current CEO ($0.2 million). Inthe corresponding period in 2005, other expenses of $3.2 million included (i) costsassociated with the planned transfer to our former Chairman of a Company-ownedsplit dollar life insurance policy ($1.2 million), (ii) 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 ($0.9 million), (iii) Oak Hill managementfees ($0.6 million) and (iv) costs associated with our former Chairman’slong-term cash award ($0.5 million).

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Net interest expense for the first half of 2006 was$27.8 million, as compared to $22.7 million in the first half of 2005.This increase was primarily attributable to higher floating interest rates andincreased debt levels incurred on our revolving credit borrowings and seniorsecured notes as compared to the prior year.

In the first half of 2006,we recorded an income tax provision of $0.9 million, reflecting anestimated effective tax rate of (3.1)%. This expense is the result of avaluation allowance of $14.1 million that largely offset the tax benefitgenerated by our operating loss in the first six months. In the comparableperiod last year, the income tax benefit of $18.8 million reflected anestimated effective tax rate of 44.9%, 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 $17.2 million as ofJuly 1, 2006 and $50.4 million as of December 31, 2005. Theprimary factors affecting the reduction in working capital fromDecember 31, 2005 include: (i) increased borrowings of $12.6 millionon our asset-based revolving loan, (ii) inventory reductions of $9.4million, (iii) increased accounts payable of $5.8 million and(iv) changes in other accruals of $6.6 million. Working capital reflectsthe classification of outstanding borrowings under our revolving loan facilityof $148.3 million at July 1, 2006 and $135.7 million atDecember 31, 2005 as current liabilities. This current classification isrequired because cash receipts controlled by the lenders are used to reduceoutstanding debt and we do not meet the criteria of Statement of FinancialAccounting Standard No. 6 “Classification of Short Term ObligationsExpected to be Refinanced” (FAS 6) to reclassify the debt as long-term, but isnot, an indication that this credit facility is expected to be retired withinthe next year. This facility expires in July 2011 and we intend tocontinue to access it for our working capital needs throughout its remainingterm.

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 provided by operating activities was$3.9 million in the twenty-six weeks ended July 1, 2006 compared tonet cash used in operating activities of $8.7 million in the twenty-sixweeks ended June 25, 2005. The use of cash in the prior year primarilyreflects the $19.0 million paid to our former Chairman in January 2005, inconnection with the termination of our obligations under his SERP agreement.

Net cash used in investing activities was$14.9 million in the twenty-six weeks ended July 1, 2006, compared to$17.9 million in the twenty-six weeks ended June 25, 2005. In thefirst six months of 2006, we spent $12.3 million on capital expenditures,primarily related to new store openings and the remodeling of existinglocations, and $4.1 million on lease acquisition and other costs, whichwere partially offset by $1.5 million of cash received in connection with the terminationof a leased property. In the first six months of 2005, capital expenditures of$14.3 million and lease acquisition, pharmacy customer file and other costs of$5.8 million were partially offset by $2.2 million of cash received inconnection with the sale of property.

Net cash provided byfinancing activities was $11.0 million in the twenty-six weeks ended July 1,2006, compared to $26.5 million in the twenty-six weeks ended June 25,2005. The decrease in cash provided by financing activities in the current yearreflects the reduction in cash used by operations as well as the lower level ofcash used to fund investing activities.

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**Operating CapitalRequirements**

Our operating capitalrequirements primarily result from opening and stocking new stores, remodeling andrenovating existing retail locations, purchasing pharmacy files and thecontinuing development of management information systems. We opened three newstores in the first half of 2006 and seven new stores during fiscal 2005, adecline from 16 stores opened in 2004 and 17 stores opened in 2003.We currently plan to open a total of six new stores in fiscal 2006 and five newstores in each of fiscal 2007 and fiscal 2008. In the first half of 2006, wespent approximately $12.3 million on capital expenditures, primarily for new,renovated and replacement stores, and we spent an additional $4.1 million forlease acquisition and other costs. These amounts were partially offset by $1.5million of proceeds we received resulting from the termination of a leasedproperty. In fiscal 2005, we spent approximately $25.2 million on capitalexpenditures, and we spent an additional $8.5 million for leaseacquisition, pharmacy customer files and other costs. These amounts werepartially offset by $7.1 million of proceeds we received resulting fromthe sale of two formerly owned properties in 2005. We also require workingcapital to support inventory for our existing and new stores. Historically, wehave been able to lease almost all of our store locations, so acquisitions ofreal estate are not expected to have a significant impact on our capitalrequirements.

**Other FactorsInfluencing our Liquidity**

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

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

The following table presents details of oursignificant Commitments and Obligations as at July 1, 2006, except thatthe data provided with respect to operating 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)(2)                                 |       | $                                         | 553,291    |   | $ | — |   | $ | — |   | $ | 210,000 |   | $ | 343,291 |   |
| Capital Lease  Obligations (3)                         |       | 14,790                                    |       | 4,581 |   | 8,350 |   | 1,859 |   | — |   |
| Operating Leases  (4)                                  |       | 1,282,765                                 |       | 122,879 |   | 242,190 |   | 220,509 |   | 697,187 |   |
| Fixed Interest  Payments (5)                           |       | 104,570                                   |       | 19,013 |   | 38,025 |   | 38,025 |   | 9,507 |   |
| Former Chairman  and Other Severance Payments (6) |       | 3,692                                     |       | 2,441 |   | 1,251 |   | — |   | — |   |
| Former Pharmacy  Supplier Settlement (7)               |       | 1,500                                     |       | 1,500 |   | — |   | — |   | — |   |
| Executive  Guaranteed Bonus (8)                        |       | 825                                       |       | 825 |   | — |   | — |   | — |   |
| Total Contractual Cash  Obligations                    |       | $                                         | 1,961,433  |   | $ | 151,239 |   | $ | 289,816 |   | $ | 470,393 |   | $ | 1,049,985 |   |
|                                                        |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)         These amountsinclude $195.0 million of outstanding senior subordinated notes due in2011, $210.0 million of outstanding senior secured notes due in 2010,$148.3 million outstanding under the amended asset-based revolving loanfacility due in 2011, and $32,000 outstanding under the senior convertiblenotes due in 2022. At July 1, 2006, a further $69.6 million wasavailable for borrowing under the amended asset-based revolving loan facility.For more information about the terms of the indebtedness described above,please see “—Debt,” below.

(2)         At July 1,2006, approximately $148.3 million was outstanding under our asset-basedrevolving loan facility. Obligations under this facility have been classifiedas current liabilities because cash receipts controlled by the lenders are usedto reduce outstanding debt and we do not meet the criteria of FAS 6 toreclassify the debt as long-term, however this is not an indication that thiscredit facility is expected to be retired within the next year. 

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We intend to continue touse this facility for our working capital needs through the date of itsrecently extended maturity in July 2011.

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

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

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

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

(7)         Reflects cashpayments due to Cardinal Health, a former pharmacy inventory supplier, in fullsettlement of all outstanding claims. Amounts shown are net of $3.0 millionpaid during the first half of 2006.

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

Thefollowing table presents details of our other significant CommercialCommitments as atJuly 1, 2006:

| ** **                                 | ** ** | ** **                           | ** ** | **Amount of Commitment Expiration per Period** | ** ** |
|--------------------------------------------|------------|--------------------------------------|------------|-------------------------------------------------------------------------|------------|
| **Other Commercial Commitments** | ** ** | ** **                           | ** ** | **Total Amounts   Committed**                                 | ** ** | **Within  1 year** | ** ** | **2-3 years** | ** ** | **4-5 years** | ** ** | **After  5 years** | ** ** |
| ** **                                 | ** ** | **(dollars in thousands)** | ** ** |
| Standby Letters  of Credit (1)             |       |                                 | $          | 7,166                                                                   |       |   | $ | 7,019 |   |   | $ | 147 |   |   |   | $ | — |   |   |   | $ | — |   |   |
| Total Commercial  Commitments              |       |                                 | $          | 7,166                                                                   |       |   | $ | 7,019 |   |   | $ | 147 |   |   |   | $ | — |   |   |   | $ | — |   |   |
|                                            |            |                                      |            |                                                                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)        Standby letters of credit, primarily representing self-insuredgeneral liability claims and property lease security deposits, are renewed onan annual basis, unless otherwise requested by the beneficiary.

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

In connection with the November 21, 2005replacement of our former Chairman, we expect to pay to him amounts in cashtotaling $6.6 million. We have paid a cumulative total of $3.1 million of thisamount through July 1, 2006, and we expect to pay the remaining amount inequal installments over the 18 months remaining through December 15, 2007.In addition, we expect to continue to provide health insurance coverage for ourformer Chairman during the period in which he will receive severance paymentsand, upon expiration of that period, if he is not otherwise eligible underanother employer’s comparable medical plan, to provide him with lifetimeretiree medical benefits at a cost not to exceed $50,000 annually.

In connection with the appointment of Mr. Dreilingas CEO, we were required under his employment contract to make a guaranteedpayment to him of $330,000 on or before February 19, 2006, which was paidon February 17, 2006. In addition, Mr. Dreiling’s employment contractstipulates that a guaranteed 2006 bonus of not less that 100% of his current$825,000 annual salary be paid on the same date as any other senior executivebonuses related to the 2006 fiscal year are paid, which we expect will occur inthe first quarter of 2007.

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

In connection with the December 9,2005 settlement of litigation between us and Cardinal Health, we are requiredto make payments to Cardinal Health totaling $4.5 million over the periodcommencing on January 15, 2006 through June 15, 2007, including aninitial payment of $2.0 million that was paid on January 15, 2006, asecond 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 a holding company formed inconnection with the Acquisition to hold 100% of the common stock of DuaneReade Inc. Duane Reade Holdings operates all of its business through DuaneReade Inc. and its subsidiaries and has no other independent assets,liabilities or operations, so, to the extent it has liquidity requirements, itwill depend on distributions of cash from Duane Reade Inc., to the extentpermitted by the various agreements to which Duane Reade Inc. is a party.Currently, we do not expect Duane Reade Holdings to have any material liquidityrequirements.

We believe that, based oncurrent levels of operations and anticipated growth, cash flow from operations,together with other available sources of funds, including revolving loanborrowings under the amended asset-based revolving loan facility, will beadequate for the next two years to make required payments on our indebtedness,to fund anticipated capital expenditures and to satisfy our working capitalrequirements. We base this belief on our recent levels of cash flow fromoperations of approximately $3.0 million in 2005 (which includes theabsorption of $9.6 million in non-recurring net cash payments made inconnection with the termination of our former Chairman’s SERP), $11.3 millionin 2004 (which includes the absorption of $40.6 million inAcquisition-related costs), projected improvements in working capitalmanagement, anticipated levels of capital expenditures and the additionalborrowing capacity under the $225.0 million amended asset-based revolvingloan facility, which was approximately $69.6 million at July 1, 2006.Our ability to meet our debt service obligations and reduce our total debt willdepend upon our future performance which, in turn, will be subject to generaleconomic, financial, business, competitive, legislative, regulatory and otherconditions, many of which are beyond our control. In addition, our 

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operatingresults, cash flow and capital resources may not be sufficient for repayment ofour indebtedness in the future. Some risks that could adversely affect ourability to meet our debt service obligations include, but are not limited to,reductions in third party prescription reimbursement rates, declines in the NewYork City economy, increases in competitive activity, adverse changes in vendorcredit terms, changes in drug consumption patterns, additional adverselegislative changes or a major disruption of business in our markets from aterrorist event, natural disaster or other unexpected events. Other factorsthat may adversely affect our ability to service our debt are described aboveunder “Special Note Regarding Forward-Looking Statements.” Borrowings under theamended asset-based revolving loan facility and the aggregate$210.0 million senior secured notes bear interest at floating rates.Therefore, our financial condition will be affected by changes in 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 AccountingPolicies**

Our discussion of resultsof operations and financial condition relies on our consolidated financialstatements that are prepared based on certain critical accounting policies thatrequire management to make judgments and estimates that are subject to varyingdegrees of uncertainty. We believe that investors need to be aware of thesepolicies and how they impact our financial reporting to gain a more completeunderstanding of our consolidated financial statements as a whole, as well asour related discussion and analysis presented herein. While we believe thatthese accounting policies are grounded on sound measurement criteria, actualfuture events can and often do result in outcomes that can be materiallydifferent from these estimates or forecasts. The accounting policies andrelated risks described in our Annual Report on Form 10-K for theyear ended December 31, 2005 are those that depend most heavily on thesejudgments and estimates. At July 1, 2006, there have been no materialchanges to any of the Critical Accounting Policies contained therein.

**Off-Balance SheetArrangements**

We are not a party to 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 threeyears ended December 31, 2005 or the six months ended July 1, 2006.

**Recently IssuedAccounting Pronouncements**

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

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

Our financial results are subject to risk frominterest rate fluctuations on debt, which carries variable interest rates.Variable rate debt outstanding at July 1, 2006 included$148.3 million of borrowings under our amended asset-based revolving loanfacility and $210.0 million of senior secured notes. At July 1, 2006,the weighted average combined interest rate in effect on all variable rate debtoutstanding was 8.64%. A 0.50% change in interest rates applied to the$358.3 million balance of floating rate debt would affect pre-tax annualresults of operations by approximately $1.8 million, excluding the benefitof approximately $0.7 million provided by the  “no cost collar” as detailed below. Inaddition, we also have $195.0 million of senior subordinated notes and$32.0 thousand of senior convertible notes outstanding at July 1, 2006.The senior subordinated notes and senior convertible notes bear interestpayable semi-annually at fixed rates of 9.75% and 3.75%, respectively, and aretherefore not subject to risk from interest rate fluctuations.

On May 25, 2005, we entered into a hedgingtransaction through the acquisition of a “no cost collar.” Under thisarrangement, we capped our exposure on $130 million of LIBOR-based borrowingsunder the senior secured notes at a maximum LIBOR rate of 5.30%. In addition,we established a minimum “floor” LIBOR rate of 3.45%, in line with then currentLIBOR rates. This hedging arrangement expires on June 16, 2008. At July 1,2006, the LIBOR rate in effect on the senior secured notes was 5.33%, whichexceeded the maximum rate under the “no cost collar.” As a result, on anannualized basis, the interest rate protection afforded by the “no cost collar”amounted to $39,000.

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

**ITEM 4.**                CONTROLSAND PROCEDURES

(a)   *Evaluation of Disclosure Controls and Procedures*.   Anevaluation was carried out under the supervision and with the participation ofthe Company’s management, including the Chief Executive Officer and ChiefFinancial Officer, of the effectiveness of the design and operation of ourdisclosure controls and procedures (as defined in Rules 13a-15(e) or15d-15(e) under the Securities Exchange Act of 1934) as of the endof the period covered by this quarterly report. Based upon that evaluation, theCompany’s management, including the Chief Executive Officer and Chief FinancialOfficer, have each concluded that the design and operation of these disclosurecontrols and procedures were effective as of the end of the period covered bythis report.

(b)   *Changes in Internal Controls over Financial Reporting*.   Duringthe most recent fiscal quarter, there have not been any significant changes inour internal controls over financial reporting or in other factors that thathave materially affected, or are reasonably likely to materially affect, ourinternal controls over financial reporting.

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**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**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.34*           | ** ** | Third Amendment to Credit Agreement, dated as of  July 7, 2006, among Duane Reade, Duane Reade Inc., DRI I Inc.,  Duane Reade International, Inc., Duane Reade Realty, Inc., Duane  Reade Holdings, Inc., Bank of America, as Issuing Bank and Administrative  Agent, Fleet Retail Group, LLC, as Collateral Agent, Wachovia Bank  National Association, as Documentation Agent, General Electric Capital  Corporation, as Syndication Agent and Wells Fargo Retail Finance, LLC, as  Syndication Agent and Co-Lead Arranger. |
| 31.1*            |       | Sarbanes-Oxley Section 302 Certification of the  Company’s Chief Executive Officer (“CEO”).                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 31.2*            |       | Sarbanes-Oxley Section 302 Certification of the  Company’s Chief Financial Officer (“CFO”).                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 32**             |       | Sarbanes-Oxley Section 906 Certifications of  the Company’s CEO and CFO.                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |

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*                  Filed herewith

**           Furnished herewith

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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

| Dated:   August 15, 2006 |       |                                                                                              |   |
|----------------------------------------------|------------|---------------------------------------------------------------------------------------------------|--------|
| ** **                                   | ** ** | **DUANE READE HOLDINGS, INC.**                                                                    |   |
|                                         |       | (Registrant)                                                                                      |   |
|                                         |       | /s/ Richard W. Dreiling                                                                           |   |
|                                         |       | Richard W. Dreiling                                                                               |   |
|                                         | * *   | *President and Chief Executive Officer  (Principal Executive Officer)*                            |   |
|                                         |       | /s/ John K. Henry                                                                                 |   |
|                                         |       | John K. Henry                                                                                     |   |
|                                         | * *   | *Senior Vice President and Chief Financial Officer  (Principal Accounting and Financial Officer)* |   |
|                                         |       |                                                                                              |   |   |   |   |   |
|                                              |            |                                                                                                   |        |  |  |  |  |  |  |  |

 

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