10-K 1 file001.htm FORM 10-K

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K


[X]  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 
 
  For The Fiscal Year Ended March 1, 2003  
  OR
[ ]  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 
  For The Transition Period From              / To               

Commission File Number 1-5742

RITE AID CORPORATION

(Exact name of registrant as specified in its charter)


Delaware
(State or other jurisdiction of
incorporation or organization)
23-1614034
(I.R.S. Employer Identification No.)
30 Hunter Lane, Camp Hill, Pennsylvania
(Address of principal executive offices)
17011
(Zip Code)

Registrant's telephone number, including area code:    (717) 761-2633

Securities registered pursuant to Section 12(b) of the Act:
Title of each class

Common Stock, $1.00 par value

Name of each exchange on which registered
New York Stock Exchange
Pacific Exchange

Securities registered pursuant to Section 12(g) of the Act:
None

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X]    No [ ]

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X]

The aggregate market value of the voting common stock of the registrant held by non-affiliates of the registrant based on the closing price at which such stock was sold on the New York Stock Exchange on September 1, 2002 was approximately $1,076,728,708. For purposes of this calculation, executive officers, directors and 5% shareholders are deemed to be affiliates of the registrant.

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes [X]    No [ ]

As of April 26, 2003 the registrant had outstanding 515,367,806 shares of common stock, par value $1.00 per share.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the proxy statement for the registrant's annual meeting of shareholders to be held on June 25, 2003 are incorporated by reference into Part III.

TABLE OF CONTENTS


    Page
Cautionary Statement Regarding Forward Looking Statements   3  
PART I          
ITEM 1. Business   4  
ITEM 2. Properties   10  
ITEM 3. Legal Proceedings   12  
ITEM 4. Submission of Matters to a Vote of Security Holders   14  
PART II          
ITEM 5. Market for Registrant's Common Equity and Related Stockholder Matters   15  
ITEM 6. Selected Financial Data   15  
ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations   17  
ITEM 7A. Quantitative and Qualitative Disclosures About Market Risks   37  
ITEM 8. Financial Statements and Supplementary Data   38  
ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure   38  
PART III          
ITEM 10. Directors and Executive Officers of the Registrant   39  
ITEM 11. Executive Compensation   39  
ITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters   39  
ITEM 13 Certain Relationships and Related Transactions   39  
ITEM 14 Controls and Procedures   39  
PART IV          
ITEM 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K   39  

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CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

This report includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are identified by terms and phrases such as "anticipate," "believe," "intend," "estimate," "expect," "continue," "should," "could," "may," "plan," "project," "predict," "will" and similar expressions and include references to assumptions and relate to our future prospects, developments and business strategies.

Factors that could cause actual results to differ materially from those expressed or implied in such forward-looking statements include, but are not limited to:

our high level of indebtedness;
our ability to make interest and principal payments on our debt and satisfy the other covenants contained in our senior secured credit facility and other debt agreements;
our ability to improve the operating performance of our existing stores in accordance with our management's long term strategy;
our ability to hire and retain pharmacists and other store personnel;
the outcomes of pending lawsuits and governmental investigations;
competitive pricing pressures and continued consolidation of the drugstore industry; and
the efforts of third party payors to reduce prescription drug costs, changes in state or federal legislation or regulations, the success of planned advertising and merchandising strategies, general economic conditions and inflation, interest rate movements, access to capital, and our relationships with our suppliers.

We undertake no obligation to revise the forward-looking statements included in this report to reflect any future events or circumstances. Our actual results, performance or achievements could differ materially from the results expressed in, or implied by, these forward-looking statements. Factors that could cause or contribute to such differences are discussed in the section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations—Overview and Factors Affecting Our Future Prospects" included in this annual report on Form 10-K.

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PART I

Item 1.    Business

Overview

We are the third largest retail drugstore chain in the United States based on revenues and number of stores. We operate our drugstores in 28 states across the country and in the District of Columbia. We have a first or second market position in 68 of the 117 major U.S. metropolitan markets in which we operate. As of March 1, 2003, we operated 3,404 stores. Since the beginning of fiscal 1997, we have relocated 979 stores, opened 476 new stores, remodeled 608 stores and closed or sold an additional 1,404 stores. As a result, we believe we have a modern store base.

In our stores, we sell prescription drugs and a wide assortment of other merchandise which we call "front-end" products. In fiscal 2003, our pharmacists filled more than 200 million prescriptions which accounted for 63.2% of our total sales. We believe that our pharmacy operations will continue to represent a significant part of our business due to favorable industry trends, including an aging population, increased life expectancy and the discovery of new and better drug therapies. We offer approximately 24,000 front-end products, which accounted for the remaining 36.8% of our total sales in fiscal 2003. Front-end products include over-the-counter medications, health and beauty aids, personal care items, cosmetics, household items, beverages, convenience foods, greeting cards, seasonal merchandise and numerous other everyday and convenience products, as well as photo processing. We distinguish our stores from other national chain drugstores, in part, through our private brands and our strategic alliance with GNC, a leading retailer of vitamin and mineral supplements. We offer more than 1,900 products under the Rite Aid private brand, which contributed approximately 10.8% of our front-end sales in the categories where private brand products are offered in fiscal 2003.

Our stores range in size from approximately 5,000 to 40,000 square feet. The overall average size of each store in our chain is approximately 12,750 square feet. The larger stores are concentrated in the western United States. Approximately 54% of our stores are freestanding; approximately 38% of our stores include a drive-thru pharmacy; approximately 69% include one-hour photo shops; and approximately 28% include a GNC store-within-Rite Aid store.

Our headquarters are located at 30 Hunter Lane, Camp Hill, Pennsylvania 17011, and our telephone number is (717) 761-2633. Our common stock is listed on the New York Stock Exchange and the Pacific Exchange under the trading symbol of "RAD". We were incorporated in 1968 and are a Delaware corporation.

Recent Events

Recent Changes to our Capital Structure and Proposed New Credit Facility

In February 2003, we issued $300.0 million aggregate principal amount of our 9.5% senior secured notes due 2011. In April 2003, we issued $360.0 million aggregate principal amount of our 8.125% senior secured notes due 2010. The 9.5% notes and 8.125% notes are unsecured, unsubordinated obligations of Rite Aid Corporation and rank equally in right of payment with all of our other unsecured, unsubordinated indebtedness. Our obligations under the notes are guaranteed, subject to certain limitations, by our subsidiaries that guarantee our obligations under our senior credit facility. The guarantees are secured, subject to permitted liens, by shared second priority liens granted by our subsidiary guarantors on all of their assets that secure our obligations under the senior credit facility, subject to certain exceptions. The indentures governing the senior secured notes contain customary covenant provisions that, among other things, include limitations on our ability to pay dividends or make investments or other restricted payments, incur debt, grant liens, sell assets and enter into sale leaseback transactions.

In connection with the offering of the 9.5% senior secured notes and other debt retirement activities through April 30, 2003:

We redeemed all $149.5 million aggregate principal amount of our senior secured (shareholder) notes due 2006 prior to March 1, 2003;

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We retired $118.6 million of our 6.0% fixed-rate senior notes due 2005, prior to March 1, 2003;
We retired $15.0 million of our 7.125% notes due 2007 prior to March 1, 2003;
We retired an additional $40.3 million of our 7.125% notes due 2007 subsequent to March 1, 2003; and
We retired an additional $33.2 million of our 6.0% fixed-rate senior notes due 2005 subsequent to March 1, 2003.

Separately, in March 2003, we made a scheduled principal payment of $7.5 million under our senior secured credit facility.

We used a portion of the net proceeds of the 8.125% senior secured notes to repay approximately $252.4 million of our term loan under our senior secured credit facility. The remaining $92.4 million will be used for general corporate purposes, which may include capital expenditures and repayments or repurchases of our outstanding indebtedness. In connection with the issuance of the 8.125% senior secured notes, we also permanently reduced our borrowing capacity under our revolving credit facility by the amount of the remainder of the net proceeds.

In April 2003, we announced that we intend to replace our existing senior secured credit facility with a new $2.0 billion senior secured credit facility that will consist of a $1.15 billion term loan and a $850 million revolving credit facility and will mature in April 2008. Our obligations under the proposed new senior secured credit facility will be guaranteed by substantially all of our wholly owned subsidiaries that guarantee our obligations under our existing senior credit facility. These subsidiary guarantees will be secured by a first priority security interest in substantially the same collateral that secures the guarantees under our existing senior credit facility. The proceeds of the new senior secured credit facility will be used to repay outstanding amounts under our existing credit facility, to refinance our synthetic lease, and to replace our existing revolving credit facility. Closing of the new facility is subject to negotiation of definitive documentation, successful syndication and satisfaction of customary closing conditions. We expect to enter into the new senior secured credit facility by the end of May 2003. Except as otherwise explicitly stated, this Annual Report on Form 10-K does not give effect to the new credit facility.

Management Changes

In April 2003, we announced that Mary F. Sammons, currently our President and Chief Operating Officer, will become our President and Chief Executive Officer effective June 25, 2003 at our annual meeting of stockholders. Robert G. Miller, currently our Chairman and Chief Executive Officer, will retain the position of Chairman. Mr. Miller will remain as Chairman until his term on our Board of Directors ends at our annual meeting in June, 2005. At that time, the decision will be made regarding his standing for re-election to our Board.

Strategy

Approximately 60% of our stores have been constructed, relocated or remodeled since the beginning of fiscal 1997. Although this substantial investment made in our store base over the last seven years has given us a modern store base, our store base has not yet achieved a level of sales productivity comparable to our major competitors. Accordingly, many of our new and relocated stores have not developed a critical mass of customers needed to achieve profitability. Our strategy is to focus on improving the productivity of our existing store base. We believe that improving the sales of existing stores is important to achieving profitability and continuing to improve cash flow. We believe that in the past year, the execution of this strategy has driven a 4.2% increase in revenues, from $15.2 billion in fiscal 2002 to $15.8 billion in fiscal 2003. We believe that the execution of our strategy has also led to a significant improvement in our operating results, as net loss has decreased from $827.7 million in fiscal 2002 to $112.1 million in fiscal 2003.

We believe the productivity of our existing store base will be improved by continuing to (i) grow our pharmacy prescription count and attract more customers; and (ii) improve customer satisfaction with focus on service and selection in our stores. Moreover, we estimate that pharmacy sales in the United States will increase at least 30% over the next three years based upon studies published by pharmacy

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benefit management companies and the Congressional Budget Office. This anticipated growth is expected to be driven by the "baby boom" generation entering their fifties, the increasing life expectancy of the American population, the introduction of several new successful drugs and inflation. We believe this growth will also help increase the sales productivity of our existing store base.

The following paragraphs describe in more detail the components of our strategy to improve store productivity:

Grow Our Pharmacy Prescription Count and Attract More Customers.     We have begun the installation of our next generation pharmacy system and we are piloting several e-prescription applications which will further enable our pharmacists to work directly with customers and adjudicate and fill prescriptions in a more efficient manner. We also drive prescription growth via our automatic refill program, prescription file buys and several initiatives aimed at managed care providers and doctors. We believe our focus on generic prescription drugs and Rite Aid brand products offer an attractive value to our existing customers and are an invitation to new customers. We believe that continued focus on weekly circulars, seasonal merchandising programs, cross-category merchandising and direct marketing efforts will attract new customers to our stores and increase sales per customer visit.

Grow Front End Sales.    We continue to expand the categories of our front-end products and increase the emphasis on our Rite Aid brand products. Through the use of technology and attention to customers' needs and preferences, we are increasing our efforts to identify inventory and product categories that will enable us to offer more personalized products and services to our customers. We also continue to develop our GNC stores-within-Rite Aid stores and one-hour photo development departments. We continue to improve inventory and product categories to offer more personalized products and services to our customers, including better management of seasonal items. We are also increasing ethnic product offerings targeted to selected markets to enhance front-end sales growth. We also continue to strengthen our relationships with our suppliers in order to offer customers a wider selection of products and categories.

Improve Customer Satisfaction With Focus On Service and Selection in Our Stores.     We continue to develop and implement programs designed to improve customer satisfaction. We believe that by executing our "With Us It's Personal" and "Ready When Promised" programs that are aimed at delivering more personalized service along with faster prescription delivery to our customers, our growth will continue. Although we are already an industry leader in dispensing generic drugs, we continue to take additional steps to further improve our generic efficiency, including adding functionality to our proprietary pharmacy information system to aid our pharmacists in dispensing generic prescriptions whenever possible. We are increasing customer loyalty by establishing a strong community presence through health expositions and not-for-profit activities, increasing promotional themes and exclusive offers, focusing on the attraction and retention of managed care customers, and partnering with several major drug suppliers to provide discount cards to senior citizens.

We continue to develop and implement associate training programs to improve customer service and educate our associates about the products we offer. We have implemented programs that create compensatory and other incentives for associates to provide customers with quality service, to promote our generic prescriptions and private label brands and to improve our corporate culture. We are also utilizing mystery shoppers and customer communications to improve our understanding of our customers' perceptions of us.

Contain Expenses.    We continue to execute our cost management programs. Our emphasis is on targeted expense areas. Those areas are subject to specific work plans for improvement that are continuously monitored.

Products and Services

During fiscal 2003, sales of prescription drugs represented 63.2% of our total sales, an increase from 61.3% in fiscal 2002 and 59.5% in fiscal 2001. In fiscal years 2003, 2002 and 2001, prescription drug sales were $10.0 billion, $9.3 billion and $8.6 billion, respectively.

We sell approximately 24,000 different types of non-prescription, or front-end products. The types and number of front-end products in each store vary, and selections are based on available space and

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customer needs and preferences. No single front-end product category contributed significantly to our sales during fiscal 2003 although certain front-end product classes contributed notably to our sales. Our principal classes of products in fiscal 2003 were the following:


Product Class Percentage of
Sales
Prescription drugs   63.2
Over-the-counter medications and personal care   10.0  
Health and beauty aids   4.9  
General merchandise and other   21.9  

We offer approximately 1,900 products under the Rite Aid private brand, which contributed approximately 10.8% of our front-end sales in the categories where private brand products are offered in fiscal 2003. During fiscal 2003, we added approximately 240 products under our private brand. We intend to increase the number and the sales of our private label brand products.

We have a strategic alliance with GNC under which we have agreed to open 1,000 GNC "stores-within-Rite Aid stores" across the country by July 2003. GNC is a leading nationwide retailer of vitamin and mineral supplements and personal care, fitness and other health-related products. As of March 1, 2003, we operated 966 GNC stores-within-Rite Aid-stores.

Store Location

Many of our stores are located at convenient locations in fast-growing metropolitan areas. We have significantly reduced our store development program over the past three years in order to focus our efforts and resources on improving the operations of our existing store base, although we routinely evaluate expansion opportunities, including acquisitions. Consistent with our operating strategy, during fiscal 2003, we opened 3 new stores, acquired 1 store, relocated 12 stores, remodeled 138 stores and closed 97 stores. Our current plan for fiscal 2004 is to open 1 new store, relocate 13 stores and remodel 180 stores. Our fiscal 2004 planned store relocations are not concentrated in any specific geographic region.

Technology

All of our stores are integrated into a common information system, which enables our pharmacists to fill prescriptions more accurately and efficiently with reduced chances of adverse drug interaction and which can be expanded to accommodate new stores. We continue to make modifications to our proprietary pharmacy information system in order to improve its user interface and information output. Our customers may also order prescription refills over the Internet through www.riteaid.com powered by drugstore.com, or over the phone through our telephonic rapid automated refill systems. As of March 1, 2003, we had installed ScriptPro automated pharmacy dispensing units, which are linked to our pharmacists' computers and fill and label prescription drug orders, in 874 stores. The efficiency of ScriptPro units allows our pharmacists to spend an increased amount of time consulting with our customers. We are also focusing on technology initiatives such as the roll-out of our next generation pharmacy system, expansion of e-prescribing and enhancing our automated refill system. Additionally, each of our stores employs point-of-sale technology that facilitates inventory replenishment, sales analysis and recognition of customer trends. In fiscal 2003, we developed and implemented several new technologies and applications, including productivity improvements related to our piece picking and inventory movement management. We also simplified our cash register or point-of-sale processes and continue to enhance category management applications through the development of price optimization and market basket analysis.

Suppliers

During fiscal 2003, we purchased approximately 90% of the dollar volume of our prescription drugs from a single supplier, McKesson Corp. ("McKesson"), under a contract which runs until April 2004. Under the contract, McKesson has agreed to sell to us all of our requirements of branded pharmaceutical products. With limited exceptions, we are required to purchase all of our branded pharmaceutical products from McKesson. If our relationship with McKesson was disrupted, we could temporarily have

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difficulty filling prescriptions until we found a replacement supplier, which would negatively affect our business. We purchase generic (non-brand name) pharmaceuticals from a variety of sources. We purchase our non-pharmaceutical merchandise from numerous manufacturers and wholesalers. We believe that competitive sources are readily available for substantially all of the non-pharmaceutical merchandise we carry and that the loss of any one supplier would not have a material effect on our business.

We sell private brand and co-branded products that generally are supplied by numerous competitive sources. The Rite Aid and GNC co-branded PharmAssure vitamin and mineral supplement products and the GNC branded vitamin and mineral supplement products that we sell in our stores are developed by GNC, and along with our Rite Aid brand vitamin and mineral supplements, are manufactured by GNC.

Customers and Third-Party Payors

During fiscal 2003, our stores served an average of 1.8 million customers per day. The loss of any one customer would not have a material adverse impact on our results of operations. No single customer or health plan contract accounted for more than 10% of our total revenues in fiscal 2003.

In fiscal 2003, 92.7% of our pharmacy sales were to customers covered by health plan contracts, which typically contract with a third-party payor (such as an insurance company, a prescription benefit management company, a governmental agency, a private employer, a health maintenance organization or other managed care provider) that agrees to pay for all or a portion of a customer's eligible prescription purchases in exchange for reduced prescription rates. During fiscal 2003, the top five third-party payors, which provide administrative and payment services for multiple health plan contracts and customers, accounted for approximately 29% of our total sales, the largest of which represented 10.4% of our total sales. During fiscal 2003, the top five state sponsored Medicaid agencies accounted for approximately 11% of our total sales, the largest of which was less than 3% of our total sales. Any significant loss of third-party payor business could have a material adverse effect on our business and results of operations.

Competition

The retail drugstore industry is highly competitive. We compete with, among others, retail drugstore chains, independently owned drugstores, mass merchandisers, discount stores and mail order pharmacies. We compete on the basis of store location and convenient access, customer service, product selection and price. We believe continued consolidation of the drugstore industry and continued new store openings will further increase competitive pressures in the industry.

Marketing and Advertising

In fiscal 2003, marketing and advertising expense was $242.0 million, which was spent primarily on nationwide weekly advertising circulars. We have implemented various programs that are designed to improve our image with customers. These include several customer events, including our Rite Aid Health and Beauty Expos. Our front-end and prescription suppliers are invited to participate in these events by displaying, demonstrating and sampling their products and services in exhibit booths. We continue to implement programs that are specifically directed to our pharmacy business. These include an increased focus on attracting and retaining managed care customers and partnering with the major drug suppliers to provide discount cards to senior citizens.

Associates

We believe that our relationships with our associates are good. As of March 1, 2003, we had approximately 72,000 associates, 13% of which were pharmacists, 44% of which were part-time and 36% of which were unionized. There is a national shortage of pharmacists. We have implemented various associate incentive plans, including the implementation of a stock option plan for field associates, in order to attract and retain qualified pharmacists. We are also implementing an initiative to increase recruitment of pharmacists in hard to staff areas.

Research and Development

We do not make significant expenditures for research and development.

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Licenses, Trademarks and Patents

The Rite Aid name is our most significant trademark and the most important factor in marketing our stores and private brand products. We hold licenses to sell beer, wine and liquor, cigarettes and lottery tickets. Additionally, we hold licenses granted to us by the Nevada Gaming Commission that allow us to place slot machines in our Nevada stores. We also hold licenses to operate our pharmacies and our distribution facilities. Together, these licenses are material to our operations.

Seasonality

We experience moderate seasonal fluctuations in our results of operations concentrated in the fourth fiscal quarter as the result of the concentration of the holidays. We tailor certain front-end merchandise to capitalize on holidays and seasons. We increase our inventory levels during our third fiscal quarter in anticipation of the seasonal fluctuations described above. Our results of operations in the fourth and first fiscal quarter may fluctuate based upon the timing and severity of the cold and flu season, both of which are unpredictable.

Regulation

Our business is subject to various federal and state regulations. For example, pursuant to the Omnibus Budget Reconciliation Act of 1990 ("OBRA") and comparable state regulations, our pharmacists are required to offer counseling, without additional charge, to our customers about medication, dosage, delivery systems, common side effects and other information deemed significant by the pharmacists and may have a duty to warn customers regarding any potential adverse effects of a prescription drug if the warning could reduce or negate such effect.

Our pharmacies and pharmacists must be licensed by the appropriate state boards of pharmacy. Our pharmacies and distribution centers are also registered with the Federal Drug Enforcement Administration and are subject to Federal Drug Enforcement Agency regulations relative to our pharmacy operations, including purchasing, storing and dispensing of controlled substances. Applicable licensing and registration requirements require our compliance with various state statutes, rules and/or regulations. If we were to violate any applicable statute, rule or regulation, our licenses and registrations could be suspended or revoked.

Our pharmacy business is subject to patient privacy and other obligations, including corporate, pharmacy and associate responsibility imposed by the Health Insurance Portability and Accountability Act. As a covered entity, we are required to implement privacy standards, train our associates on the permitted uses and disclosures of protected health information, provide a notice of privacy practice to our pharmacy customers and permit pharmacy customers to access and amend their records and receive an accounting of disclosures of protected health information. Failure to properly adhere to these requirements could result in the imposition of civil as well as criminal penalties.

We are also subject to laws governing our relationship with associates, including minimum wage requirements, overtime and working conditions. Increases in the federal minimum wage rate, associate benefit costs or other costs related to associates could adversely affect our results of operations.

In addition, in connection with the ownership and operations of our stores, distribution centers and other sites, we are subject to laws and regulations relating to the protection of the environment and health and safety matters, including those governing the management and disposal of hazardous substances and the cleanup of contaminated sites. Violations of or liabilities under these laws and regulations as a result of our current or former operations or historical activities at our sites, such as gasoline service stations and dry cleaners, could result in significant costs.

In recent years, an increasing number of legislative proposals have been introduced or proposed in Congress and in some state legislatures that would effect major changes in the healthcare system, either nationally or at the state level. The legislative initiatives include prescription drug benefit proposals for Medicare participants. Although we believe we are well positioned to respond to these developments, we cannot predict the outcome or effect of legislation resulting from these reform efforts.

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Available Information

Our investor relations website is www.riteaid.com. We make available on our website, free of charge, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, as soon as practical after we file these reports with the SEC.

Item 2.    Properties

We own our corporate headquarters, which is located in a 205,000 square foot building at 30 Hunter Lane, Camp Hill, Pennsylvania 17011. We lease a 100,000 square foot building near Harrisburg, Pennsylvania for use by additional administrative personnel. We lease 3,133 of our operating drugstore facilities under non-cancelable leases, many of which have original terms of 10 to 22 years. In addition to minimum rental payments, which are set at competitive market rates, certain leases require additional payments based on sales volume, as well as reimbursement for taxes, maintenance and insurance. Most of our leases contain renewal options, some of which involve rent increases.

As of March 1, 2003, we operated 3,404 retail drugstores. The overall average selling square feet of each store in our chain is 11,100 square feet. The overall average total square feet of each store in our chain is 12,700. The stores on the east coast average 8,700 selling square feet per store (9,600 average total square feet per store). The central stores average 9,500 selling square feet per store (10,200 average total square feet per store). The west coast stores average 16,800 selling square feet per store (20,600 average total square feet per store).

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The table below identifies the number of stores by state as of March 1, 2003:


State Store Count
Alabama   118  
Arizona   3  
California   584  
Colorado   29  
Connecticut   36  
Delaware   26  
District of Columbia   8  
Georgia   49  
Idaho   20  
Indiana   9  
Kentucky   117  
Louisiana   87  
Maine   80  
Maryland   138  
Michigan   323  
Mississippi   32  
Nevada   35  
New Hampshire   39  
New Jersey   167  
New York   389  
Ohio   237  
Oregon   70  
Pennsylvania   351  
Tennessee   47  
Utah   27  
Vermont   12  
Virginia   134  
Washington   134  
West Virginia   103  
Total   3,404  

Our stores have the following attributes at March 1, 2003:


Attribute Number Percentage
Freestanding   1,833     54
Drive through pharmacy   1,281     38
One-hour photo development department   2,355     69
GNC stores-within a Rite Aid-store   966     28

We operate the following distribution centers and overflow storage locations, which we own or lease as indicated:

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Location Owned or
Leased
Approximate
Square
Footage
Rome, New York   Owned     291,000  
Utica, New York (1)   Leased     172,000  
Poca, West Virginia   Owned     264,000  
Dunbar, West Virginia (1)   Leased     109,000  
Perryman, Maryland (2)   Leased     885,000  
Tuscaloosa, Alabama   Owned     238,000  
Cottondale, Alabama (1)   Leased     155,000  
Pontiac, Michigan   Owned     362,000  
Woodland, California   Owned     521,300  
Woodland, California (1)   Leased     200,000  
Wilsonville, Oregon   Leased     518,000  
Lancaster, California (2)   Leased     917,000  
(1) Overflow storage locations.
(2) These properties will be repurchased upon completion of the new senior secured credit facility which we expect to have in place by the end of May 2003.

The original terms of the leases for our distribution centers range from five to 22 years. In addition to minimum rental payments, certain distribution centers require tax reimbursement, maintenance and insurance. Most leases contain renewal options, some of which involve rent increases. Although from time to time, we may be near capacity at some of our distribution facilities, particularly at our older facilities, we believe that the capacity of our facilities is adequate for the foreseeable future.

We also own a 52,200 square foot ice cream manufacturing facility located in El Monte, California.

On a regular basis and as part of our normal business, we evaluate store performance and may reduce in size, close or relocate a store if the store is redundant, under performing or otherwise deemed unsuitable. When we reduce in size, close or relocate a store, we often continue to have leasing obligations. We attempt to sublease this space. As of March 1, 2003, we subleased 5,278,700 square feet of space and an additional 4,296,200 square feet of space in closed or relocated stores was not subleased.

Item 3.    Legal Proceedings

We are party to numerous legal proceedings, as described below.

Federal investigations

There are currently pending federal governmental investigations, both civil and criminal, by the United States Attorney, involving various matters related to former management. We are cooperating fully with the United States Attorney. We have begun settlement discussions with the United States Attorney for the Middle District of Pennsylvania. The United States Attorney has proposed that the government would not institute any criminal proceeding against us if we enter into a consent judgement providing for a civil penalty payable over a period of years. The amount of the civil penalty has not been agreed to and there can be no assurance that a settlement will be reached or that the amount of such penalty will not have a material adverse effect on our financial condition and results of operations. We have recorded an accrual of $20.0 million in connection with the resolution for these matters; however, we may incur charges in excess of that amount and we are unable to estimate the possible range of loss. We will continue to evaluate our estimate and to the extent that additional information arises or our strategy changes, we will adjust our accrual accordingly.

These investigations and settlement discussions are ongoing and we cannot predict their outcomes. If we were convicted of any crime, certain licenses and government contracts such as Medicaid plan reimbursement agreements that are material to our operations may be revoked, which would have a material adverse effect on our results of operations, financial condition or cash flows. In addition, substantial penalties, damages or other monetary remedies assessed against us, including a settlement, could also have a material adverse effect on our results of operations, financial condition or cash flows.

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The investigations conducted by the U.S. Department of Labor and by an independent trustee of matters related to our employee benefits plans have been concluded. In addition, the class action lawsuit filed on behalf of the plans and their participants in the United States District Court for the Eastern District of Pennsylvania has been settled. Under the agreement, our insurance companies paid $5.5 million and in November 2002 we paid $4.0 million into a settlement fund for the benefit of plan participants. We also agreed to implement certain changes in the way in which we administer our employee benefit plans and to maintain the current level of benefits through December 31, 2006. On March 11, 2003, the District Court approved the settlement and dismissed the complaint with prejudice.

Stockholder litigation

Our settlement of the consolidated securities class action lawsuits brought on behalf of securityholders who purchased our securities on the open market between May 2, 1997 and November 10, 1999 (and based on the allegation that our financial statements for fiscal 1997, fiscal 1998 and fiscal 1999 fraudulently misrepresented our financial position and results of operations for these periods) was approved by the United States District Court for the Eastern District of Pennsylvania by Order entered August 16, 2001. Although that Order was appealed by certain non-settling defendants (including our former auditor, KPMG, our former chief executive officer, Martin Grass, and our former chief financial officer, Frank Bergonzi), those non-settling defendants have now also settled with plaintiffs and have agreed to dismiss their appeal, which settlement has received preliminary approval by the District Court. A hearing to consider final approval of the settlement is scheduled for May 30, 2003. In accordance with the agreement settling plaintiffs' claims against us, in April 2002, we issued $149.5 million of senior secured (shareholder) notes (subsequently redeemed in February 2003) and paid $45.0 million in cash, which was fully funded by our officers' and directors' liability insurance. If the settlement does not become final, this litigation could result in a material adverse effect on the Company's results of operations, financial condition or cash flows. Several members of the class have elected to "opt-out" of the class and, as a result, they will be free to pursue their claims. Management believes that their claims, individually and in the aggregate, are not material.

A purported class action has been instituted by a stockholder against us in Delaware state court on behalf of stockholders who purchased shares of our common stock prior to March 1, 1997, and who continued to hold them after October 18, 1999, alleging claims similar to the claims alleged in the consolidated securities class action lawsuits described above. The amount of damages sought was not specified and may be material. We have filed a motion to dismiss this complaint for failure to state a claim for which relief could be granted. On December 19, 2002, the court dismissed the class action and breach of fiduciary duty claims with prejudice and the individual claims without prejudice. The plaintiffs have filed a notice of appeal in the Delaware Supreme Court.

Reimbursement Matters

We are being investigated by multiple state attorneys general for our reimbursement practices relating to partially filled prescriptions and fully filled prescriptions that are not picked up by ordering customers. We are supplying similar information with respect to these matters to the United States Department of Justice. We believe that these investigations are similar to investigations which were, and are being, undertaken with respect to the practices of others in the retail drug industry. We also believe that our existing policies and procedures fully comply with the requirements of applicable law and intend to fully cooperate with these investigations. We cannot, however, predict their outcomes at this time. An individual acting on behalf of the United States of America, has filed a lawsuit in the United States District Court for the Eastern District of Pennsylvania under the Federal False Claims Act alleging that we defrauded federal healthcare plans by failing to appropriately issue refunds for partially filled prescriptions and prescriptions which were not picked up by customers. The United States Department of Justice has intervened in this lawsuit, as is its right under the law. We have reached an agreement to settle these investigations and the lawsuit filed by the private individual for $7.2 million, which is subject to court approval. We have reserved $7.2 million against this potential liability.

These claims are ongoing and we cannot predict their outcome. If any of these cases result in a substantial monetary judgment against us or are settled on unfavorable terms, our results of operations, financial position and cash flows could be materially adversely affected.

13

Other

In June of 2002, the United States Attorney indicted several former executive officers on various criminal charges, including securities fraud, and one former executive officer pled guilty to charges of obstruction of an internal investigation. We currently have separation and other arrangements with some of these executives. As a result of these indictments, we ceased payments under these obligations. On December 11, 2002, we concluded our investigation of the separation and other arrangements relating to these employees, and we determined, effective December 11, 2002, that we have no binding obligation under these arrangements. Therefore, we recorded an adjustment of $27.7 million in fiscal 2003 to reverse our liability for these contractual obligations. The adjustment was recorded as a reduction in selling, general and administrative expenses.

On January 13, 2003 the Federal Trade Commission notified the Company that the investigation commenced on September 11, 2002 regarding the Company's pharmacy compliance center activities has been closed and that no further action would be taken.

We, together with a significant number of major U.S. retailers, have been sued by the Lemelson Foundation in a complaint which alleges that portions of the technology included in our point-of-sale system infringe upon a patent held by the plaintiffs. The amount of damages sought is unspecified and may be material. We cannot predict the outcome of this litigation or whether it could result in a material adverse effect on our results of operations, financial conditions or cash flows.

We are subject from time to time to lawsuits arising in the ordinary course of business. In the opinion of our management, these matters are adequately covered by insurance or, if not so covered, are without merit or are of such nature or involve amounts that would not have a material adverse effect on our financial condition, results of operations or cash flows if decided adversely.

Item 4.    Submission of Matters to a Vote of Security Holders

No matter was submitted to a vote of our security holders during the fourth quarter of our fiscal year covered by this report.

14

PART II

Item 5.    Market for Registrant's Common Equity and Related Stockholder Matters.

Our common stock is listed on the New York Stock Exchange and Pacific Exchanges under the symbol "RAD." On April 26, 2003, we had approximately 15,990 record shareholders. Quarterly high and low stock prices, based on the New York Stock Exchange composite transactions, are shown below.


Fiscal Year Quarter High Low
2004 (through April 26, 2003) First   3.49     2.17  
               
2003 First   4.22     3.01  
  Second   3.24     1.75  
  Third   2.65     1.79  
  Fourth   3.05     2.02  
               
2002 First   9.06     5.35  
  Second   9.74     7.37  
  Third   8.39     4.69  
  Fourth   5.06     2.06  

Equity Compensation Plan Information


  Number of securities
to be issued upon
exercise of outstanding
options
Weighted-avg
exercise price
Securities
available for
future
issuance
Plans approved by shareholders   30,449   $ 8.13     1,304  
Plans not approved by shareholders   34,227     3.57     4,677  
Total   64,676           5,981  

We have not declared or paid any cash dividends on our common stock since the third quarter of fiscal 2000 and we do not anticipate paying cash dividends in the foreseeable future. Our senior secured credit facility does not allow us to pay cash dividends. Some of the indentures that govern our other outstanding indebtedness also restrict our ability to pay dividends. See "Management's Discussion and Analysis of Financial Condition and Results of Operations."

We have not sold any unregistered equity securities during the period covered by this report that was not previously disclosed in one of our Quarterly Reports on Form 10-Q.

Item 6.    Selected Financial Data

The following selected financial data should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the audited consolidated financial statements and related notes appearing on pages 47-90.

15


  Fiscal Year Ended
  March 1,
2003
(52 weeks)
March 2,
2002
(52 weeks)
March 3,
2001
(53 weeks)(1)
February 26,
2000
(52 weeks)(1)
February 27,
1999
(52 weeks)
  (Dollars in thousands, except per share amounts)
Summary of Operations:
Revenues $ 15,800,920   $ 15,171,146   $ 14,516,865   $ 13,338,947   $ 12,438,442  
Costs and expenses:
Cost of goods sold, including occupancy costs   12,109,183     11,742,309     11,151,490     10,213,428     9,406,831  
Selling, general and administrative expenses   3,407,569     3,382,962     3,412,442     3,651,248     3,168,363  
Stock-based compensation expense (benefit)   4,806     (15,891   45,865     (43,438   32,200  
Goodwill amortization       21,007     20,670     24,457     26,055  
Store closing and impairment charges   135,328     251,617     388,078     139,448     195,359  
Interest expense   330,020     396,064     649,926     542,028     274,826  
Interest rate swap contracts   278     41,894              
Loss on debt and lease conversions and modifications       154,465     100,556          
Share of loss from equity investments       12,092     36,675     15,181     448  
(Gain) on sale of assets and investments, net   (18,620   (42,536   (6,030   (80,109    
Total cost and expenses   15,968,564     15,943,983     15,799,672     14,462,243     13,104,082  
 
Loss from continuing operations before income taxes, extraordinary item and cumulative effect of accounting
change
  (167,644   (772,837   (1,282,807   (1,123,296   (665,640
Income tax expense (benefit)   (41,940   (11,745   148,957     (8,375   (216,941
Loss from continuing operations before extraordinary items and cumulative effect of accounting change   (125,704   (761,092   (1,431,764   (1,114,921   (448,699
Income (loss) from discounted
operations, net of income tax
expense (benefit) of $13,846, $30,903, and $(5,925)
          11,335     9,178     (12,823
Loss on disposal of discontinued
operations, net of income tax benefit of $734
          (168,795        
Extraordinary item, gain (loss) on early extinguishment of debt, net of income taxes of $0   13,628     (66,589            
Cumulative effect of
accounting change, net of
income tax benefit of $18,200
              (27,300    
Net loss $ (112,076 $ (827,681 $ (1,589,224 $ (1,133,043 $ (461,522
Basic and diluted (loss) income per share:
Loss from continuing operations $ (0.31 $ (1.68 $ (5.15 $ (4.34 $ (1.74
Income (loss) from discontinued
operations
          (0.50   0.04     (0.05
Income (loss) from extraordinary item   0.03     (0.14            
Cumulative effect of accounting
change
              (0.11    
Net loss per share $ (0.28 $ (1.82 $ (5.65 $ (4.41 $ (1.79
Year-End Financial Position:                              
Working capital (deficit) $ 1,676,889   $ 1,580,218   $ 1,955,877   $ 752,657   $ (892,115
Property, plant and equipment (net)   1,868,579     2,096,030     3,041,008     3,445,828     3,328,499  
Total assets   6,133,515     6,491,759     7,913,911     9,845,566     9,778,451  
Total debt (2)   3,862,628     4,056,468     5,894,548     6,612,868     5,922,504  
Redeemable preferred stock   19,663     19,561     19,457     19,457     23,559  
Stockholders' equity (deficit)   (112,329   9,616     (354,435   432,509     1,339,617  

16


  Fiscal Year Ended
  March 1,
2003
(52 weeks)
March 2,
2002
(52 weeks)
March 3,
2001
(53 weeks)(1)
February 26,
2000
(52 weeks)(1)
February 27,
1999
(52 weeks)
  (Dollars in thousands, except per share amounts)
Other Data:                              
Cash flows from continuing operations provided by (used in):                              
Operating activities $ 305,383   $ 16,343   $ (704,554 $ (623,098 $ 278,947  
Investing activities   (72,214   342,531     677,653     (504,112   (2,705,043
Financing activities   (211,903   (107,109   (64,324   905,091     2,660,341  
Capital expenditures   116,154     187,383     141,504     641,070     1,314,423  
Cash dividends declared per common share $ 0   $ 0   $ 0   $ .3450   $ .4375  
Basic weighted average shares   515,129,000     474,028,000     314,189,000     259,139,000     258,516,000  
Diluted weighted average shares   515,129,000     474,028,000     314,189,000     259,139,000     258,516,000  
Number of retail drugstores   3,404     3,497     3,648     3,802     3,870  
Number of associates   72,000     75,000     75,500     77,300     89,900  
(1) PCS was acquired on January 22, 1999. On October 2, 2000, we sold PCS. Accordingly, our Pharmacy Benefit Management ("PBM") segment is reported as a discontinued operation for all periods presented. See note 21 of the notes to the consolidated financial statements.
(2) Total debt includes capital lease obligations of $176.2 million, $182.6 million, $1.1 billion, $1.1 billion, and $1.1 billion as of March 1, 2003, March 2, 2002, March 3, 2001, February 26, 2000, and February 27, 1999, respectively.

Item 7.    Management's Discussion and Analysis of Financial Condition and Results of Operations

Overview

Net loss for fiscal 2003 was $112.1 million, compared to $827.7 million in fiscal 2002 and $1,589.2 million in fiscal 2001. Reasons for the substantial improvement in our results in fiscal 2003 are described in more detail in the Results of Operations and Liquidity and Capital Resources sections of Item 7. However, some of the key factors that impacted this improvement are summarized as follows:

Productivity of Existing Store Base.    Our strategy is to focus on improving the productivity of our existing store base. We have focused our efforts on improving the productivity of our stores by implementing programs to drive prescription count growth, improving the consistency and focus of our marketing efforts, improving our product categories to offer more personalized products and service to our customers, increasing our mix of private brand and generic drug sales, developing programs that are specifically directed toward improving our pharmacy service and implementing associate programs that create compensatory and other incentives for associates to provide customers with better service. We believe that our improvements in revenues, gross margin as a percentage of sales and selling, general and administrative costs (SG&A) as a percent of sales that are detailed in the Results of Operations section are a direct result of our success in implementing the strategy of improving the productivity of our stores, evidenced by a rise in average revenue per store from $4.3 million in fiscal 2002 to $4.6 million in fiscal 2003.

Debt Refinancing.    In fiscal 2001 and 2002, we took several steps to reduce our debt load and improve our leverage. The most significant item was a substantial refinancing in fiscal 2002, which extended the maturity of the majority of our debt, converted a portion of our debt to equity and rescinded purchase options on certain sale-leaseback leases, resulting in their reclassification from capital leases to operating leases. These activities resulted in aggregate charges of $221.1 million in fiscal 2002. In fiscal 2001, we converted a portion of our debt to equity, which resulted in charges of $100.6 million. These steps have enabled us to reduce our debt from $6.6 billion as of February 26, 2000 to $3.9 billion as of March 1, 2003, and to extend the maturity of the majority of our debt to 2005 and beyond.

Divestiture of Non-Core Businesses.    During the past three years, we have divested our investments in non-core operations. These divestitures were necessary to enable us to focus on our core business of operating retail drug stores and resulted in significant charges or credits in the periods presented. These transactions are described below.

17

On October 2, 2000, we sold PCS, our PBM segment, to Advance Paradigm (now AdvancePCS). The selling price of PCS consisted of $710.5 million in cash, $200.0 million in principal amount of AdvancePCS 11% promissory notes and AdvancePCS equity securities. Accordingly, the PBM segment is presented as a discontinued operation in the fiscal 2001 financial statements and the operating income of the PBM segment through October 2, 2000, the date of sale, is reflected separately from the income from continuing operations. The loss on the disposal of the PBM segment was $168.8 million, which was recorded in fiscal 2001. Also recorded in fiscal 2001 was an increase to the tax valuation allowance and income tax expense of $146.9 million related to this disposal.

In March 2001, we sold our investment in AdvancePCS equity securities for $284.2 million, resulting in a gain of $53.2 million, which was recorded in fiscal 2002. Additionally, AdvancePCS repurchased the 11% promissory notes for $200.0 million, plus accrued interest.

In July 1999, we purchased shares of drugstore.com, an on-line pharmacy, and entered into an agreement to provide access to our networks of pharmacies and third party providers, advertising commitments and exclusivity agreements. During fiscal 2001, we recorded impairment charges of $112.1 million to write-down our investment in drugstore.com, based upon declines in the market value of drugstore.com stock which we concluded were other than temporary. In January 2002, April 2002 and May 2002, we sold our shares of drugstore.com, and as of March 1, 2003 have no investment in drugstore.com. We recorded gains from these sales of $15.8 million and $4.4 million in fiscal 2003 and 2002, respectively.

Closure of Under-Performing Stores.    In fiscal 2003, 2002 and 2001, we performed a rigorous review of underperforming stores, and, based on these reviews, decided to close 40, 116 and 144 stores in fiscal 2003, 2002 and 2001, respectively. As a result of these reviews, we have recorded store closing and related impairment charges of $135.3 million, $251.3 million and $271.9 million in fiscal 2003, 2002 and 2001, respectively. We believe that these closures were necessary to improve the productivity of our remaining store base and to eliminate underperforming stores. As part of our ongoing business activities, we will continue to assess stores for potential closure. There can be no assurance that other such actions may not be required in the future, or that such actions would not have a material adverse effect on our operating results for the period in which we take those actions.

Substantial Investigation Expenses.    We have incurred substantial expenses in connection with defense against litigation related to prior management's business practices and the defense of prior management. In fiscal 2001, we also incurred expenses in connection with the process of reviewing and reconciling our books and records, restating our 1998 and 1999 financial statements, investigating our prior accounting practices, preparing our financial statements and defending our company in pending investigations. We incurred $20.7 million in fiscal 2003, $17.5 million in fiscal 2002, and $82.1 million in fiscal 2001. We expect to incur approximately $20.0 million in fiscal 2004, and expect to continue to incur significant legal and other expenses until the resolution of the U.S. Attorney's case against certain of our former executive officers and the investigation of certain other matters.

Dilutive Equity Issuances.    At March 1, 2003, 515.1 million shares of common stock were outstanding and an additional 174.7 million shares of common stock were issuable related to outstanding stock options, convertible notes and preferred stock.

Our 174.7 million shares of common stock potentially issuable consist of the following:


(Shares in thousands)        
Strike price Outstanding
Stock Options (a)
Convertible
Notes (b)
Preferred
Stock
Total
  (Shares in thousands)
$5.50 and under   54,633         71,583     126,216  
$5.51 to $7.50   1,260     38,462         39,722  
$7.51 and over   8,783             8,783  
Total issuable shares   64,676     38,462     71,583     174,721  
(a) The exercise of these options would provide cash of $323.9 million.
(b) The conversion of these notes to equity would reduce the principal amount of debt by $250.0 million.

18

Working Capital.    We generally finance our inventory and capital expenditure requirements with internally generated funds and borrowings. We expect to use borrowings to finance inventories and to support our continued growth. The majority of our front-end sales are in cash. Third-party payors, which typically settle in fewer than 30 days, accounted for 92.7% of our pharmacy sales and 58.5% of our revenues in fiscal 2003.

Industry Trends.    We believe pharmacy sales in the United States will increase at least 30% over the next three years based upon studies published by pharmacy benefit management companies and the Congressional Budget Office. This anticipated growth is expected to be driven by the "baby boom" generation entering their fifties, the increasing life expectancy of the American population, the introduction of several new drugs and inflation. The retail drugstore industry is highly fragmented and has been experiencing consolidation. We believe that the continued consolidation of the drugstore industry will further increase competitive pressures in the industry. We expect to continue to compete on the basis of service and convenience, and therefore, will continue to focus on programs designed to improve our image with customers. Prescription drug sales continue to represent a greater portion of our business due to the general aging of the population, the use of pharmaceuticals to treat a growing number of healthcare problems and the introduction of a number of successful new prescription drugs. In addition, sales of generic pharmaceuticals continue to grow as a percentage of total prescription drug sales. The growth rate of prescription drug sales has also been impacted by factors such as the increased sales of lower-priced generic pharmaceuticals and slower introductions of successful new prescription drugs. In fiscal 2003 92.7% of our pharmacy sales were to third-party payors. Some third-party payors, especially state sponsored Medicaid agencies, have recently evaluated and reduced certain reimbursement levels. Also, modifications to the Medicare program are being studied that would expand coverage of prescription drugs. If third-party payors, including state sponsored Medicaid agencies, further reduce their reimbursement levels or if Medicare covers prescription drugs at reimbursement levels lower than our current retail prices, our margins on these sales would be reduced and the profitability of our business could be adversely affected.

Results of Operations

Revenue and Other Operating Data


  Year Ended
  March 1,
2003
(52 Weeks)
March 2,
2002
(52 Weeks)
March 3,
2001
(53 Weeks)
  (Dollars in thousands)
Revenues $ 15,800,920   $ 15,171,146   $ 14,516,865  
Revenue growth   4.2 %     4.5   8.8
Same store sales growth   6.7 %     8.3   9.1
Pharmacy sales growth   7.2 %     9.6   8.7
Same store pharmacy sales growth   9.7 %     11.4   10.9
Pharmacy as a % of total sales   63.2 %     61.3   59.5
Third-party sales as a % of total pharmacy sales   92.7 %     92.0   90.3
Front-end sales (decline) growth   (0.6 )%     1.9   3.8
Same store front-end sales growth   1.9 %     3.6   6.5
Front-end as a % of total sales   36.8 %     38.7   40.5
Store data:                  
Total stores (beginning of period)   3,497     3,648     3,802  
New stores   3     7     9  
Closed stores   (97   (168   (163
Store acquisitions, net   1     10      
Total stores (end of period)   3,404     3,497     3,648  
Remodeled stores   138     64     98  
Relocated stores   12     22     63  
Note: Except for revenue growth, all percentages in the above table are based on a comparable 52 week period.

19

Revenues

The 4.2% growth in revenues for fiscal 2003 was driven by pharmacy sales growth of 7.2%, offset slightly by a front-end sales decline of 0.6%. The decline in front-end sales was a direct result of closing 97 stores in fiscal 2003, partially offset by front-end same store sales growth of 1.9%.

Fiscal 2003 pharmacy same store sales increased by 9.7%, due to increases in both prescriptions filled and sales price per prescription. Factors contributing to our pharmacy same store sales increase include inflation, improved attraction and retention of managed care customers, our increased focus on pharmacy initiatives, such as predictive refill, and favorable industry trends. These trends include an aging population, the use of pharmaceuticals to treat a growing number of healthcare problems and the introduction of a number of successful new prescription drugs. These favorable factors were partially offset by the increase in generic sales mix, a reduction in hormone replacement therapy prescriptions and the impact of a less severe flu season than in the prior year.

Fiscal 2003 front-end same store sales increased 1.9%, primarily as a result of improvement in most core categories, such as over-the-counter items, consumables and vitamins and improved assortments.

Fiscal 2002 (52 weeks) revenues increased 4.5% over fiscal 2001 (53 weeks). Excluding the extra week, revenues would have increased 6.5%, driven by increases of 1.9% in front-end and 9.5% in pharmacy. Same store sales growth for fiscal 2002 was 8.3% (pharmacy of 11.4% and front-end of 3.6%). As fiscal 2001 was a 53 week year, same store sales are calculated by comparing the 52 week period ended March 2, 2002 with the 52 week period ended March 3, 2001.

Fiscal 2002 pharmacy sales led sales growth due to an increase in both prescriptions filled (on a comparable 52 week basis) and sales price per prescription. Factors contributing to our pharmacy same store sales increases include inflation, improved attraction and retention of managed care customers, our reduced cash pricing, our increased focus on pharmacy initiatives, such as predictive refill, and favorable industry trends. These trends include an aging population, the use of pharmaceuticals to treat a growing number of healthcare problems, and the introduction of a number of successful new prescription drugs.

Front-end fiscal 2002 sales also increased. The increase was primarily a result of increased sales volume due to improved assortments, lower prices on key items and distributing a nationwide weekly advertising circular.

Our total revenue growth in fiscal 2001 of 8.8% was also fueled by strong growth in pharmacy sales of 8.7%, an increase in front end sales of 3.8% and the additional week in fiscal 2001. Pharmacy sales led revenue growth with same store sales increases of 10.9% accompanied by very strong front-end same store sales growth of 6.5%. The pharmacy and front-end increases were due to the same factors as described above for fiscal 2002.

20

Costs and Expenses


  Year Ended
  March 1,
2003
(52 Weeks)
March 2,
2002
(52 Weeks)
March 3,
2001
(53 Weeks)
  (Dollars in thousands)
Cost of goods sold, including occupancy costs $ 12,109,183   $ 11,742,309   $ 11,151,490  
Gross profit   3,691,737     3,428,837     3,365,375  
Gross margin   23.4 %     22.6   23.2
Selling, general and administrative expenses $ 3,407,569   $ 3,382,962   $ 3,412,442  
Selling, general and administrative expenses as a percentage of revenues   21.6   22.3 %     23.5
Stock-based compensation expense (benefit) $ 4,806   $ (15,891 $ 45,865  
Goodwill amortization       21,007     20,670  
Store closing and impairment charges   135,328     251,617     388,078  
Interest expense   330,020     396,064     649,926  
Interest rate swap contracts   278     41,894      
Loss on debt and lease conversions and
modifications
      154,465     100,556  
Share of loss from equity investments       12,092     36,675  
Gain on sale of assets and investments, net   (18,620   (42,536   (6,030

Cost of Goods Sold

Gross margin was 23.4% for fiscal 2003 compared to 22.6% in fiscal 2002. Gross margin was positively impacted by improvements in pharmacy margin, driven by increased generic mix and improved third party reimbursements. Gross margin was also positively impacted by a decrease in the LIFO provision, due to a lower rate of inflation, and flat occupancy expense on a higher sales base. Although front-end margin rate was flat, the lower mix of front-end sales caused a decline in front-end margin contribution, which partially offset the positive pharmacy margin contribution.

Gross margin was 22.6% for fiscal 2002 compared to 23.2% in fiscal 2001. Gross margin was negatively impacted by the continuing trend of a shift in sales mix from front-end to pharmacy, inflation, increased third party reimbursed prescription sales as a percent of total prescription sales, and lower cash prices on pharmacy sales. Additionally, we incurred $31.4 million in inventory liquidation losses related to our closed stores compared to the $17.5 million incurred in fiscal 2001. Also negatively impacting gross margin were higher LIFO costs, higher shrink costs and the reclassification of certain leases from capital to operating in connection with the June 2001 refinancing, which caused an increase in fiscal 2002 occupancy costs. Partially offsetting these items was an increase in gross margin on front-end merchandise driven by increased markdown support from vendors, improvements in returns losses and lower depreciation expense.

We use the last-in, first-out (LIFO) method of inventory valuation. The LIFO charge was $19.7 million in fiscal 2003, $69.3 million in fiscal 2002, and $40.7 million in fiscal 2001.

Selling, General and Administrative Expenses

Selling, general and administrative ("SG&A") expenses for fiscal 2003 includes $20.7 million incurred primarily to defend against litigation related to prior management's business practices and to defend prior management. SG&A for fiscal 2003 also includes net charges of $9.1 million related to litigation. Offsetting these items is a net credit of $27.7 million related to the elimination of severance liabilities for former executives.

SG&A expenses for fiscal 2002 include $17.5 million incurred to defend against litigation related to prior management's business practices and to defend prior management. Also included in SG&A expense for fiscal 2002 is a charge of $8.8 million to terminate an exclusivity contract with a certain vendor. Offsetting these items are net receipts of $32.0 million related to litigation and $7.1 million of expense reduction resulting primarily from senior executives releasing their rights to their non-qualified defined benefit arrangements.

21

After considering the items described in the previous paragraphs, SG&A was lower in fiscal 2003 than fiscal 2002 due to decreased depreciation and amortization charges resulting from a reduced store count, reduction in professional fees and better leveraging of our fixed costs resulting from higher sales volume, partially offset by higher associate benefit costs.

SG&A expenses for fiscal 2001 were favorably impacted by credits of $40.1 million related to litigation, offset by charges of $82.1 million incurred in connection with the restatement of our historical financial statements and various governmental investigations. SG&A was lower in fiscal 2002 than fiscal 2001 due to decreased depreciation and amortization charges resulting from a reduced store count and better leveraging of our fixed costs resulting from higher sales volume, partially offset by higher associate benefit costs and higher advertising costs.

Store Closing and Impairment Charges

Store closing and impairment charges consist of:


  Year Ended
  March 1,
2003
March 2,
2002
March 3,
2001
  (Dollars in thousands)
Impairment charges $ 69,508   $ 157,962   $ 214,224  
Store and equipment lease exit charges   65,820     93,303     57,668  
Impairment of investments       352     116,186  
  $ 135,328   $ 251,617   $ 388,078  

Impairment Charges

In fiscal 2003, 2002 and 2001, store closing and impairment charges include non-cash charges of $69.5 million, $158.0 million and $214.2 million, respectively, for the impairment of long-lived assets (including allocable goodwill for fiscal 2002 and 2001) at 262, 365 and 495 stores, respectively. These amounts include the write-down of long-lived assets to estimated fair value at stores that were assessed for impairment as part of our on-going review of the performance of our stores or management's intention to relocate or close the store.

Store and Equipment Lease Exit Charges

In fiscal 2003, 2002 and 2001, we recorded charges for 40, 116 and 144 stores, respectively, to be closed or relocated under long-term leases. Charges incurred to close a store, which principally consist of lease termination costs, are recorded at the time management commits to closing the store, which is the date that the closure is formally approved by senior management, or in the case of a store to be relocated, the date the new property is leased or purchased. Effective January 1, 2003, we adopted SFAS 146, "Accounting for Costs Associated with Exit or Disposal Activities". SFAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. Pursuant to the adoption of SFAS 146, we now record costs to close the store at the time the store is closed and all inventory is liquidated. We calculate our liability for closed stores on a store-by-store basis. The calculation includes the future minimum lease payments and related ancillary costs, from the date of closure to the end of the remaining lease term, net of estimated cost recoveries that may be achieved through subletting properties or through favorable lease terminations. This liability is discounted using a risk-free rate of interest. We evaluate these assumptions each quarter and adjust the liability accordingly. Also included in store and equipment lease exit costs are charges of $1.3 million incurred in fiscal 2002 related to the early termination of an equipment lease.

Impairment of Investments

We had an investment in the common stock of drugstore.com, which was accounted for under the equity method. The initial investment was valued based upon the initial public offering price for drugstore.com. During fiscal 2001, we recorded an impairment of our investment in drugstore.com of $112.1 million. This write-down was based upon a decline in the market value of drugstore.com's stock that we believed to be other than temporary. Additionally, we recorded impairment charges of $4.1 million in fiscal 2001 for other investments.

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Interest Expense

Interest expense was $330.0 million in fiscal 2003 compared to $396.1 million in fiscal 2002. Interest expense for fiscal 2003 decreased from fiscal 2002 due to the reduction of debt resulting from the retirement and repurchase of certain notes, and the reduction in LIBOR rates, which reduced our interest rate on the senior secured credit facility.

Interest expense was $396.1 million in fiscal 2002 compared to $649.9 million in fiscal 2001. Interest expense for fiscal 2002 decreased from 2001 due to the reduction of debt resulting from the sale of PCS, debt for equity exchanges and the June 2001 refinancing, which included the relinquishment of certain renewal options on real estate leases that resulted in a reclassification from capital leases to operating leases.

The annual weighted average interest rates on our indebtedness in fiscal 2003, fiscal 2002 and fiscal 2001 were 7.3%, 8.2% and 8.2% respectively.

Interest Rate Swap Contracts

We entered into two year interest rate swap contracts in June and July of 2000 to hedge the exposure to increasing rates with respect to our variable rate debt. As a result of the June 2001 refinancing, the interest rate swap contracts no longer qualified for hedge accounting treatment, and therefore the changes in fair value of these interest rate swap contracts were required to be recorded as components of net loss. Accordingly, we recognized an initial charge of $31.0 million and subsequent changes in the market value of the interest rate swaps of $10.4 million, inclusive of cash payments, which resulted in a charge of $41.9 million for fiscal 2002. Changes in market value of the interest rate swaps in fiscal 2003 were not significant. These contracts expired and were fully funded during fiscal 2003 and have not been renewed. Correspondingly, there is no termination liability as of March 1, 2003.

Income Taxes

We had net losses in fiscal 2003, fiscal 2002 and fiscal 2001. A tax benefit of $41.9 million, a benefit of $11.7 million and expense of $149.0 million have been recorded for fiscal 2003, 2002 and 2001, respectively. The fiscal 2003 benefit resulted primarily from a federal law change, enacted on March 9, 2002, which increased the carryback period of net operating losses incurred in fiscal 2001 and 2002 from two years to five. The fiscal 2002 benefit is primarily due to the favorable outcome of federal income tax litigation. The fiscal 2001 expense is primarily due to the increase in the income tax valuation allowance caused by the sale of PCS. The benefit of the net operating loss carryforwards ("NOLs") generated in each period has been fully offset by a valuation allowance as a result of management's determination that, based on available evidence, it is more likely than not that the deferred tax assets will not be realized.

We have undergone an ownership change for statutory tax purposes during fiscal 2002, which resulted in a limitation on the future use of net operating loss carryforwards. We believe that this limitation does not further impair the net operating loss carryforwards because they are fully reserved.

During fiscal 2003, we received federal income tax refunds in the amount of $68.7 million based on the favorable outcome of federal income tax litigation and tax law changes permitting the five-year carryback of NOL's.

Other Significant Charges

In addition to the matters discussed above, our results in fiscal 2003, 2002 and 2001 have been impacted by other significant charges. We recorded losses of $12.1 million and $36.7 million in fiscal 2002 and 2001, respectively, representing our share of drugstore.com losses. We recorded $154.5 million and $100.6 million in fiscal 2002 and 2001, respectively, for losses on debt and lease conversions and modifications and extraordinary gains of $13.6 million and extraordinary losses of $66.6 million in fiscal 2003 and fiscal 2002, respectively, relating to early extinguishment of debt. We recorded stock-based compensation expense (benefit) of $4.8 million, ($15.9) million and $45.9 million in fiscal 2003, 2002 and 2001, respectively, resulting primarily from the impact of applying variable plan accounting to several of

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our stock-based compensation plans. We recorded a gain of $15.8 million in fiscal 2003 resulting from the sale of our investment in drugstore.com. We also recorded a gain of $53.2 million in fiscal 2002 resulting from the sale of AdvancePCS securities. In fiscal 2001, we recorded a net loss of $168.8 million on the disposal of the PBM segment.

Liquidity and Capital Resources

Recent Changes to our Capital Structure and Proposed New Credit Facility

In February 2003, we issued $300.0 million aggregate principal amount of our 9.5% senior secured notes due 2011. In April 2003, we issued $360.0 million aggregate principal amount of our 8.125% senior secured notes due 2010. The 9.5% notes and the 8.125% notes are unsecured, unsubordinated obligations of Rite Aid Corporation and rank equally in right of payment with all of our other unsecured, unsubordinated indebtedness. Our obligations under the notes are guaranteed, subject to certain limitations, by our subsidiaries that guarantee our obligations under our senior credit facility. The guarantees are secured, subject to permitted liens, by shared second priority liens granted by our subsidiary guarantors on all of their assets that secure our obligations under the senior credit facility, subject to certain exceptions. The indentures governing the senior secured notes contain customary covenant provisions that, among other things, include limitations on our ability to pay dividends or make investments or other restricted payments, incur debt, grant liens, sell assets and enter into sale leaseback transactions.

In connection with the offering of the 9.5% senior secured notes and other debt retirement activities through April 30, 2003:

We redeemed all $149.5 million aggregate principal amount of our senior secured (shareholder) notes due 2006 prior to March 1, 2003;
We retired $118.6 million of our 6.0% fixed-rate senior notes due 2005, prior to March 1, 2003;
We retired $15.0 million of our 7.125% notes due 2007 prior to March 1, 2003;
We retired an additional $40.3 million of our 7.125% notes due 2007 subsequent to March 1, 2003; and
We retired an additional $33.2 million of our 6.0% fixed-rate senior notes due 2005 subsequent to March 1, 2003

Separately, in March 2003, we made a scheduled principal payment of $7.5 million under our senior secured credit facility.

We used a portion of the proceeds of the 8.125% senior secured notes to repay approximately $252.4 million of our term loan under our senior secured credit facility. The remaining $92.4 million will be used for general corporate purposes, which may include capital expenditures and debt repurchases. In connection with the insurance of the 8.125% senior secured notes, we also permanently reduced our borrowing capacity under our revolving credit facility by the amount of the remainder of the net proceeds.

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The following table sets forth our cash and debt at April 30, 2003, following the completion of the transactions described above:


  April 30, 2003
  (in thousands)
Cash $ 371,194  
Long-term debt, including current portion:      
Secured Debt:      
Senior credit facility:      
Revolver $  
Term Loan   1,112,570  
12.5% senior secured notes due 2006   146,168  
9.5% senior secured notes due 2011   300,000  
8.125% senior secured notes due 2010   355,277  
Other secured debt   6,179  
    1,920,194  
Lease Financing Obligations   175,108  
Unsecured Debt:
6.0% dealer remarketable securities due 2003   58,125  
6.0% fixed-rate senior notes due 2005   42,685  
7.265% senior notes due 2005   198,000  
4.75% convertible notes due 2006   244,750  
7.125% senior notes due 2007   294,634  
6.125% fixed-rate senior notes due 2008   150,000  
11.25% senior notes due 2008   150,000  
6.875% senior debentures due 2013   200,000  
7.7% notes due 2027   300,000  
6.875% fixed-rate senior notes due 2028   150,000  
    1,788,194  
Total debt $ 3,883,496  

In April 2003, we announced that we intend to replace our existing senior secured credit facility with a new $2.0 billion senior secured credit facility that will consist of a $1.15 billion term loan and a $850 million revolving credit facility that will mature in April 2008. Our obligations under the proposed new senior secured credit facility will be guaranteed by substantially all of our wholly owned subsidiaries that guarantee our obligations under our existing senior credit facility. These subsidiary guarantees will be secured by a first priority security interest in substantially the same collateral that secures the guarantees under our existing senior credit facility and will secure the guarantees of the notes on a second priority basis. The proceeds of the new senior secured credit facility will be used to repay outstanding amounts under our existing credit facility, to refinance our synthetic lease, and to replace our existing revolving credit facility. Closing of the new facility is subject to negotiation of definitive documentation, successful syndication and satisfaction of customary closing conditions. We expect to enter into the new credit facility by the end of May 2003.

General

We have two primary sources of liquidity: (i) cash provided by operations and (ii) the revolving credit facility under our senior secured credit facility. Our principal uses of cash are to provide working capital for operations, service our obligations to pay interest and principal on debt, to provide funds for capital expenditures and to provide funds available for repurchases of our publicly traded debt.

Our ability to borrow under the senior credit facility is based on a specified borrowing base consisting of eligible accounts receivable and inventory. On March 1, 2003, we had $410.9 million in additional available borrowing capacity under the revolving credit facility net of outstanding letters of credit of $89.1 million. As of March 1, 2003, the term loan was fully drawn. In connection with the April 2003 issuance of $360.0 million of our 8.125% senior secured notes, we agreed to reduce our revolving credit commitment under our senior credit facility by $92.4 million.

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On December 23, 2002, we entered into an amendment of our senior secured credit facility to allow us to make optional repurchases of our publicly traded debt. For the period from December 23, 2002 to the end of our 2004 fiscal year, we will be permitted to utilize up to $300.0 million for optional debt repurchases, provided that we are in compliance with the capital expenditures covenant of our senior credit facility. For fiscal years after 2004, we will have an amount available for optional debt repurchases equal to the lesser of our availability under the capital expenditures covenant and a formula based upon our performance for the prior fiscal year. On February 6, 2003 we entered into an additional amendment to our senior credit facility to allow us more flexibility in making optional debt repurchases. The amendment enabled us to purchase an additional $150.5 million of our publicly traded debt with the net proceeds of additional debt issuances. The amendment also modified certain debt refinancing provisions, including extending the term that new refinancing debt must carry to at least December 31, 2008. After giving effect to these amendments, and adjusting for repurchases made since the amendment dates, we have the ability to repuchase debt of up to $255.6 million at April 30, 2003.

The senior secured credit facility, as amended, also allows us, at our option, to issue up to $1.5 billion of unsecured debt that is not guaranteed by any of our subsidiaries, reduced by the following debt to the extent incurred: (i) $150.0 million of financing transactions of existing owned real estate; (ii) $1.25 billion of additional debt secured by the facility's collateral on a second priority basis; and (iii) $100.0 million of financing transactions for property or assets acquired after June 27, 2001. The $1.5 billion of permitted debt, whether secured or unsecured, is reduced by the outstanding balances of specific debt and the synthetic lease such that, our remaining additional permitted debt under the senior secured credit facility at April 30, 2003 is $424.9 million. Our 11.25% senior notes due July 2008 also permit $150.0 million of real estate financing, $400.0 million of additional other debt and $600.0 million of additional permitted debt, which includes allowing us to increase our senior secured credit facility. As of April 30, 2003, our remaining additional permitted debt under the 11.25% senior notes due 2008, excluding availability under our senior secured credit facility, real-estate financing and after reduction for the outstanding balances of specific debt, was approximately $100.0 million. The indentures governing our 9.5% senior secured notes due 2011 and our 8.125% senior secured notes due 2010 also limit our ability to incur indebtedness.

The senior secured credit facility, as amended, requires us to meet various financial ratios and limits capital expenditures. Beginning with the 12 months ended March 1, 2003, the covenants require us to maintain a maximum leverage ratio of 8.30:1, which gradually decreases to 6.00:1 for the twelve months ending February 26, 2005. We must also maintain a minimum interest coverage ratio of 1.35:1 for the twelve months ending March 1, 2003, which gradually increases to 2.00:1 for the twelve months ending November 27, 2004. In addition, we must maintain a minimum fixed charge ratio of 1.00:1 for the twelve months ending March 1, 2003, gradually increasing to 1.10:1 for the twelve months ending August 28, 2004. Capital expenditures are limited to $150.0 million annually beginning with the twelve months ended March 1, 2003. These capital expenditure limits are subject to upward adjustment based upon availability of excess liquidity as defined in our senior secured credit facility and unused amounts from the prior fiscal year. We may also use amounts permitted for capital expenditures to make optional purchases of our publicly traded debt.

We were in compliance with the covenants of the senior secured credit facility, as amended, and our other credit facilities and debt instruments as of March 1, 2003. With continuing improvements in operating performance, we anticipate that we will remain in compliance with our debt covenants. However, variations in our operating performance and unanticipated developments may adversely affect our ability to remain in compliance with the applicable debt covenants.

The senior secured credit facility provides for customary events of default, including nonpayment, misrepresentation, breach of covenants and bankruptcy. It is also an event of default if any event occurs that enables, or which with the giving of notice or the lapse of time would enable, the holder of our debt to accelerate the maturity of debt having a principal amount of $25.0 million or more.

2002 Refinancing

On June 27, 2001, we completed a major refinancing that extended the maturity dates of the majority of our debt to 2005 or beyond, provided additional equity, converted a portion of our debt to equity and

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reclassified capital leases to operating leases. The components of the refinancing are described in detail in the notes to the consolidated financial statements. Major components of the refinancing are summarized below:

New Secured Credit Facility:    We entered into a new $1.9 billion syndicated senior secured credit facility with a syndicate of banks led by Citicorp USA, Inc. as senior agent. The new facility matures on June 27, 2005 unless more than $20.0 million of our 7.625% senior notes due April 15, 2005 are outstanding on December 31, 2004, in which event the maturity date is March 15, 2005. The new facility consists of a $1.4 billion term loan facility and a $500.0 million revolving credit facility. The term loan was used to prepay various outstanding debt balances.

High Yield Notes:    We issued $150.0 million of 11.25% senior notes due July 2008. These notes are unsecured and are effectively subordinate to our secured debt.

Debt for Debt Exchange:    We exchanged $152.0 million of our existing 10.50% senior secured notes for an equal principal amount of 12.50% senior secured notes due September 15, 2006. The 12.50% notes are secured by a second priority lien on the collateral of the senior secured credit facility. In addition, holders of these notes received warrants to purchase 3.0 million shares of our common stock at $6.00 per share. On June 29, 2001, the warrant holders elected to exercise these warrants, on a cashless basis, and as a result 1.0 million shares of common stock were issued.

Tender Offer:    On May 24, 2001, we commenced a tender offer for the 10.50% senior secured notes due 2002 at a price of 103.25% of the principal amount. The tender offer was closed on June 27, 2001, at which time $174.5 million principal was tendered. We incurred a tender offer premium of $5.7 million as a result of the transaction. We used proceeds from the new senior secured credit facility to pay for the tender offer.

Debt for Equity Exchanges:    We completed exchanges of $588.7 million of debt for 86.4 million shares of common stock.

Sales of Common Stock:    We issued 80.1 million shares of our common stock for net proceeds of $528.4 million.

Lease Obligations:    We relinquished certain renewal options which had been available under the terms of certain real estate leases on property previously sold and leased back and accordingly, we reclassified the related leases as operating leases thereby reducing outstanding capital lease obligations by $850.8 million.

Impact on Results of Operations for Fiscal 2002:    As a result of the refinancing, we: i) recorded an extraordinary loss on early extinguishment of debt of $66.6 million; ii) recognized a loss of $21.9 million related to debt and lease conversions and modifications; and iii) recognized a charge of $31.0 million related to our interest rate swap agreements.

Other Transactions

Convertible Notes:    We issued $250.0 million of our 4.75% convertible notes due December 2006 in November 2001. These notes were issued at a 3% discount resulting in cash proceeds of $242.5 million. These notes are unsecured and are effectively subordinate to our secured debt. The notes are convertible, at the option of the holder, into shares of our common stock at a conversion price of $6.50 per share, subject to adjustments to prevent dilution, at any time.

Retirement and Repurchases of Debt:    We retired $150.5 million of our 5.25% convertible subordinated notes due 2002 and $20.9 million of our 10.5% senior secured notes due 2002 at maturity in fiscal 2003. In addition, we repurchased $25.4 million of our 6.0% dealer remarketable securities, $118.6 million of our 6.0% fixed rate senior notes due 2005 and $15.0 million of our 7.125% notes due 2007. We repurchased $24.2 million of our 6.0% dealer remarketable securities due 2003, $1.0 million of our 10.50% notes due 2002 and $1.5 million of our 5.25% convertible subordinated notes due 2002 during fiscal 2002.

Other

Debt Maturities and Other Obligations:    The following table details the maturities of our indebtedness and lease financing obligations as of March 1, 2003, as well as other contractual cash obligations and

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commitments, without giving effect to the 8.125% senior secured notes issued in April 2003 or the completion of a new senior secured credit facility before the end of May 2003.

Contractual Obligations and Commitment


  Less Than 1 Year 1 to 3 Years 4 to 5 Years After 5 Years Total
  (Dollars in thousands)        
Contractual Cash Obligations
Long-term debt $ 96,577   $ 1,611,859   $ 726,578   $ 1,251,428   $ 3,686,442  
Capital lease obligations   7,138     15,752     15,173     138,123     176,186  
Operating leases   569,864     1,035,310     881,240     3,694,992     6,181,406  
Total contractual cash
obligations
$ 673,579   $ 2,662,921   $ 1,622,991   $ 5,084,543   $ 10,044,034  
Commitments                              
Lease guarantees   21,164     124,494     34,978     164,155     344,791  
Outstanding letters of credit   89,071                 89,071  
Total commitments $ 110,235   $ 124,494   $ 34,978   $ 164,155   $ 433,862  
                         

We lease certain distribution facilities under a synthetic lease agreement. The agreement is accounted for as an operating lease and the related operating lease payments are included in the above table. These properties will be repurchased upon expected completion of the new senior secured credit facility in May 2003. At that time, we expect that the synthetic lease will be terminated for approximately $106.9 million. Our guaranteed residual obligation of $85.5 million under the agreement is included in the table above in lease guarantees.

Net Cash Provided By (Used In) Operating, Investing and Financing Activities

Cash provided by operations was $305.4 million in fiscal 2003. Cash was provided primarily through improved operating results, income tax refunds of $68.7 million and decreases in accounts receivable and inventory, which more than offset $288.0 million in interest payments and a decrease in accounts payable.

Cash provided by operations was $16.3 million in fiscal 2002. Cash was provided primarily through improved operating results, a significant reduction in interest payments and a reduction in inventory levels net of a decrease in accounts payable.

We used $704.6 million of cash to fund continuing operations in fiscal 2001. Operating cash flow was negatively impacted by $543.3 million of interest payments. Operating cash flow was also negatively impacted from an increase in current assets, primarily resulting from repurchasing $300.0 million of accounts receivable when we refinanced the accounts receivable securitization facility and a decrease in accounts payable and other liabilities.

Cash used in investing activities was $72.2 million in fiscal 2003. Cash of $104.5 million was used for the purchase of fixed assets and cash of $11.6 million was used for the purchase of prescription files. Cash of $43.9 million was provided by the disposition of fixed assets and other investments.

Cash provided by investing activities was $342.5 million for fiscal 2002. Cash was provided from the sale of our investment in AdvancePCS, less expenditures for fixed assets and prescription file purchases.

Cash provided by investing activities was $677.7 million for fiscal 2001. Cash was provided from the sale of our discontinued operations, less expenditures for fixed assets and prescription file purchases.

Cash used in financing activities was $211.9 million in fiscal 2003. The cash used consisted of the repayments of long-term debt and deferred financing fees, offset with proceeds from the issuance of bonds.

Cash used in financing activities was $107.1 million for fiscal 2002. The cash used consisted of repayments of long-term debt of $2.3 billion and payments of deferred financing costs of $83.1 million,

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offset with new borrowing of $1.4 billion, bond proceeds of $392.5 million and $530.6 million of proceeds from the issuance of common stock.

Cash used in financing activities was $64.3 million for fiscal 2001. The cash used consisted of payments of $78.1 million of deferred financing costs partially offset by net debt borrowings of $6.8 million and proceeds from sale-leaseback transactions of $7.0 million. During fiscal 2001, we used the proceeds from the sale of our PBM segment to reduce our borrowings.

Capital Expenditures

We plan to make total capital expenditures of approximately $170 million during fiscal 2004, consisting of approximately $75 million related to new store construction, store relocation and store remodel projects. An additional $60 million will be dedicated to the purchase of prescription files from independent pharmacists and technology enhancements, with the remaining $35 million dedicated to improvements to distribution centers and other corporate requirements. Management expects that these capital expenditures will be financed primarily with cash flow from operations and borrowings under the revolving credit facility available under our senior secured facility.

Future Liquidity

We are highly leveraged. Our high level of indebtedness: (i) limits our ability to obtain additional financing; (ii) limits our flexibility in planning for, or reacting to, changes in our business and the industry; (iii) places us at a competitive disadvantage relative to our competitors with less debt; (iv) renders us more vulnerable to general adverse economic and industry conditions; and (v) requires us to dedicate a substantial portion of our cash flow to service our debt. Based upon current levels of operations and planned improvements in our operating performance, management believes that cash flow from operations together with available borrowings under the senior secured credit facility and other sources of liquidity will be adequate to meet our anticipated annual requirements for working capital, debt service and capital expenditures for the next twelve months. We will continue to assess our liquidity position and potential sources of supplemental liquidity in light of our operating performance and other relevant circumstances. Should we determine, at any time, that it is necessary to obtain additional short-term liquidity, we will evaluate our alternatives and take appropriate steps to obtain sufficient additional funds. Obtaining any such supplemental liquidity through the increase of indebtedness or asset sales may require the consent of the lenders under one or more of our debt agreements. There can be no assurance that any such supplemental funding, if sought, could be obtained or that our lenders would provide the necessary consents, if required.

Recent Accounting Pronouncements

We adopted Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets" effective March 3, 2002. SFAS No. 142 specifies that all goodwill and indefinite life intangibles shall no longer be amortized. Goodwill must be allocated to reporting units and evaluated for impairment on an annual basis with an initial impairment assessment to be performed upon adoption of SFAS No. 142. We completed the transitional assessment as of March 3, 2002, and determined that there was no impairment loss to be recognized upon adoption of SFAS No. 142. Impairment is reassessed on an annual basis.

We adopted SFAS No. 144, "Accounting for the Impairment of Disposal of Long-Lived Assets" effective March 3, 2002. SFAS No. 144 addressed the financial accounting and reporting for the impairment or disposal of long-lived assets. We have determined that there was no impact on our consolidated financial position or results of operations as a result of the adoption of SFAS No. 144.

In April 2002, the Financial Accounting Standards Board ("FASB") issued SFAS No. 145, "Rescission of FASB Statements No. 4, "Reporting Gains and Losses from Extinguishment of Debt," SFAS No. 44, "Accounting for Intangible Assets of Motor Carriers" and SFAS No. 64, "Extinguishments of Debt Made to Satisfy Sinking Fund Requirements," Amendment of SFAS No. 13, "Accounting for Leases," and Technical Corrections." The provisions of SFAS No. 145 that relate to the rescission of SFAS

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No. 4 are required to be applied in fiscal years beginning after May 15, 2002. Any gain or loss on extinguishment of debt that was classified as an extraordinary item in prior periods presented that does not meet the criteria in APB Opinion No. 30, "Reporting the Results of Operations – Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" for classification as an extraordinary item shall be reclassified. Beginning with fiscal 2004, our financial statements for prior years with extraordinary items for the early extinguishment of debt will show such items as reclassified to operations. The provisions related to SFAS No. 13 are effective for transactions occurring after May 15, 2002 and have been adopted without material impact. All other provisions of SFAS No. 145, which are effective for financial statements issued on or after May 15, 2002, have been adopted without material impact.

In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities." This Statement addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies EITF 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)." SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. This differs from the guidance in EITF 94-3, which requires that a liability for costs associated with an exit plan or disposal activity be recognized at the date of an entity's commitment to an exit plan. SFAS No. 146 also requires all charges related to an exit activity, including accretion of interest related to the discounting of the future liability related to that activity, to be classified in the same line item on the statement of operations. The provisions of the Statement are effective for exit or disposal activities that are initiated after December 31, 2002. We have adopted SFAS No. 146 effective January 1, 2003. This adoption impacts the timing of recognition of liabilities for exit or severance plans committed to after the adoption date, but has no impact on liabilities recorded by the Company for exit or severance costs as of December 31, 2002. Effective January 1, 2003, we record accretion of interest related to the discounting of the future liability related to that activity as a component of store closing and impairment charges on the statement of operations.

In September 2002, EITF Issue No. 02-16, "Accounting by a Reseller for Cash Consideration Received from a Vendor" was issued. The pronouncement addresses two issues. The first issue requires that vendor consideration received by a reseller be characterized as a reduction of cost of sales unless the consideration is either (i) a payment for assets or services delivered to the vendor, in which case the consideration should be characterized as revenue or (ii) a reimbursement of costs incurred to sell the vendor's products, in which case, the consideration should be characterized as a reduction of that cost. The requirements for this issue are to be applied to new arrangements, including modifications of existing arrangements, entered into after December 31, 2002. The second issue requires that rebates or refunds payable only if the customer completes a specified cumulative level of purchases or remains a customer for a specified period of time should be recognized as a reduction of cost of sales based on a systematic and rational allocation over the purchase period provided the amounts are probable and reasonably estimable. This portion of the pronouncement is to be applied to all new arrangements initiated after November 21, 2002. The adoption of this pronouncement had no impact on our consolidated results of operations or financial position.

In December 2002, the FASB issued Statement No. 148, "Accounting for Stock-Based Compensation — Transition and Disclosure." This statement provides alternative methods of transition for a voluntary change to the fair value method of accounting for stock-based employee compensation. In addition, this statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures about the method of accounting for stock-based compensation and the effect of the method used on reported interim and annual results. As of March 1, 2003, we have elected to continue accounting for stock-based compensation in accordance with APB Opinion No. 25. The adoption of SFAS No. 148 had no impact on our consolidated results of operations or financial position. We have adopted the disclosure requirements of SFAS No. 148.

In November of 2002, the FASB issued FASB Interpretation ("FIN") No. 45, "Guarantor's Accounting and Disclosure Requirements of Guarantees Including Guarantees of Indebtedness of Others". FIN No. 45 requires entities to establish liabilities for certain types of guarantees and expands financial statement disclosures for others. The accounting requirements of FIN No. 45 are effective for

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guarantees issued or modified after December 31, 2002, and the disclosure requirements are effective for financial statements of interim or annual periods ending after December 15, 2002. The adoption of FIN No. 45 did not have any impact on our financial position or results of operations. We have adopted the disclosure requirements of FIN No. 45.

In January of 2003, the FASB issued FIN No. 46, "Consolidation of Variable Interest Entities". FIN No. 46 requires the consolidation of entities that cannot finance their activities without the support of other parties and that lack certain characteristics of a controlling interest, such as the ability to make decisions about the entity's activities via voting rights or similar rights. The entity that consolidates the variable interest entity is the primary beneficiary of the entity's activities. FIN No. 46 applies immediately to variable interest entities created after January 31, 2003, and must be applied in the first period beginning after June 15, 2003 for entities in which an enterprise holds a variable interest entity that it acquired before February 1, 2003. We plan to adopt this Interpretation in the third quarter of fiscal 2004. Upon adoption, without regard to the outcome of the announced intention to replace the existing senior secured credit facility and related activities, we will capitalize our existing synthetic lease, which will increase our fixed assets and debt balances.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to allowance for uncollectible receivables, inventory shrink, impairment, self insurance liabilities, pension benefits, lease exit liabilities, income taxes and litigation. We base our estimates on historical experience, current and anticipated business conditions, the condition of the financial markets and various other assumptions that are believed to be reasonable under existing conditions. Actual results may differ from these estimates.

We believe that the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements:

Allowance for uncollectible receivables:    The majority of our prescription sales are made to customers that are covered by third party payors, such as insurance companies, government agencies and employers. We carry receivables that represent the amount owed to us for sales made to customers or employees of those payors that have not yet been paid. We maintain a reserve for the amount of these receivables deemed to be uncollectible. This reserve is calculated based upon historical collection activity adjusted for current conditions. If the financial condition of the payors were to deteriorate, resulting in an inability to make payments, then an additional reserve would be required.

Inventory:    Included in our valuation of inventory are estimates of the losses related to shrink, which occurs during periods between physical inventory counts. When estimating these losses, we consider historical loss results at specific locations as well as overall loss trends. Should actual shrink losses differ from the estimates that our reserves are based on, our operating results will be impacted.

Impairment:    We evaluate long-lived assets, including stores and excluding goodwill, for impairment annually, or whenever events or changes in circumstances indicate that the assets may not be recoverable. The impairment is measured by calculating the estimated future cash flows expected to be generated by the store, and comparing this amount to the carrying value of the store's assets. Cash flows are calculated utilizing individual store forecasts and total company projections for the remaining estimated lease lives of the stores being analyzed. Should actual results differ from those forecasted and projected, we are subject to future impairment charges related to these facilities.

Goodwill impairment:    As disclosed in the consolidated financial statements, we have unamortized goodwill in the amount of $684.5 million. In connection with the provisions of SFAS No. 142, we perform an annual impairment test of goodwill. Our test as of March 1, 2003, resulted in no impairment being identified. However, the process of evaluating goodwill for impairment involves the determination of the

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fair value of our company. Inherent in such fair value determinations are certain judgements and estimates, including the interpretation of economic indicators and market valuations and assumptions about our strategic plans. To the extent that our strategic plans change, or that economic and market conditions worsen, it is possible that our conclusion regarding goodwill impairment could change and result in a material effect on our financial position or results of operations.

Self-insurance liabilities:    We record estimates for self-insured medical, dental, worker's compensation and general liability insurance coverage. Should a greater amount of claims occur compared to what was estimated, or medical costs increase beyond what was anticipated, reserves recorded may not be sufficient, and additional expense may be recorded.

Benefit plan accrual:    We have several defined benefit plans, under which participants earn a retirement benefit based upon a formula set forth in the plan. We record expense related to these plans using actuarially determined amounts that are calculated under the provisions of SFAS No. 87, "Employer's Accounting for Pensions". Key assumptions used in the actuarial valuations include the discount rate, the expected rate of return on plan assets and rate of increase in future compensation levels. These rates are based on market interest rates, and therefore fluctuations in market interest rates could impact the amount of pension expense recorded for these plans.

Lease exit liabilities:    We record reserves for closed stores based on future lease commitments, anticipated ancillary occupancy costs, anticipated future subleases of properties and current risk free interest rates. If interest rates or real estate leasing markets change, reserves may be increased or decreased.

Income taxes:    We currently have net operating loss ("NOL") carryforwards that can be utilized to offset future income for federal and state tax purposes. These NOLs generate a significant deferred tax asset. However, we have recorded a valuation allowance against this deferred tax asset as we have determined that it is more likely than not that we will not be able to fully utilize the NOLs. Should our assumptions regarding the utilization of these NOLs change, we may reduce some or all of this valuation allowance, which would result in the recording of an income tax benefit.

Litigation reserves:    We are involved in litigation on an on-going basis. We accrue our best estimate of the probable loss related to legal claims. Such estimates are developed in consultation with in-house and outside counsel, and are based upon a combination of litigation and settlement strategies. To the extent additional information arises or our strategies change, it is possible that our best estimate of the probable liability may also change.

Factors Affecting our Future Prospects

Risks Related to Our Financial Condition

We are highly leveraged. Our substantial indebtedness will severely limit cash flow available for our operations and could adversely affect our ability to service debt or obtain additional financing if necessary.

We had, as of March 1, 2003, $3.9 billion of outstanding indebtedness and stockholders' deficit of $112.3 million. We also had additional borrowing capacity under our revolving credit facility of $410.9 million at that time (without giving effect to a $92.4 million reduction in our borrowing capacity under our revolving credit facility in connection with our April 2003 offering of our 8.125% senior secured notes), net of outstanding letters of credit of $89.1 million. Our debt obligations adversely affect our operations in a number of ways and while we believe we have adequate sources of liquidity to meet our anticipated requirements for working capital, debt service and capital expenditures through fiscal year 2004, there can be no assurance that our cash flow from operations will be sufficient to service our debt, which may require us to borrow additional funds for that purpose, restructure or otherwise refinance our debt. Our earnings were insufficient to cover our fixed charges for fiscal 2003 by $217.5 million. It was also necessary for us to supplement our cash from operations with borrowings under our senior secured credit facility for fiscal 2001 and 2000.

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Our high level of indebtedness will continue to restrict our operations. Among other things, our indebtedness will:

limit our ability to obtain additional financing;
limit our flexibility in planning for, or reacting to, changes in the markets in which we compete;
place us at a competitive disadvantage relative to our competitors with less indebtedness;
render us more vulnerable to general adverse economic and industry conditions; and
require us to dedicate a substantial portion of our cash flow to service our debt.

Our ability to make payments on our debt depends upon our ability to substantially improve our future operating performance, which is subject to general economic and competitive conditions and to financial, business and other factors, many of which we cannot control. If our cash flow from our operating activities is insufficient, we may take certain actions, including delaying or reducing capital or other expenditures, attempting to restructure or refinance our debt, selling assets or operations or seeking additional equity capital. We may be unable to take any of these actions on satisfactory terms or in a timely manner. Further, any of these actions may not be sufficient to allow us to service our debt obligations or may have an adverse impact on our business. Our existing debt agreements limit our ability to take certain of these actions. Our failure to earn enough to pay our debts or to successfully undertake any of these actions could have a material adverse effect on us.

A substantial amount of our indebtedness, including the debt outstanding under our senior secured credit facility, will mature in 2005 if we do not enter into our proposed new senior secured credit facility.

Some of our debt, including borrowings under our senior secured credit facility, is based upon variable rates of interest, which could result in higher interest expense in the event of increases in interest rates.

Approximately $1.4 billion of our outstanding indebtedness (excluding our synthetic lease and without giving effect to our repayment of $252.4 million of the term loan under our senior secured credit facility in connection with our April 2003 offering of our 8.125% senior secured notes) as of March 1, 2003 bears an interest rate that varies depending upon LIBOR. If we borrow additional amounts under our senior credit facility, the interest rate on those borrowings will vary depending upon LIBOR. If LIBOR rises, the interest rates on this outstanding debt will also increase. Therefore an increase in LIBOR would increase our interest payment obligations under these outstanding loans and have a negative effect on our cash flow and financial condition.

The covenants in our outstanding indebtedness impose restrictions that may limit our operating and financial flexibility.

The covenants in the instruments that govern our outstanding indebtedness restrict our ability to:

incur liens and debt;
pay dividends;
make redemptions and repurchases of capital stock;
make loans, investments and capital expenditures;
prepay, redeem or repurchase debt;
engage in mergers, consolidations, assets dispositions, sale-leaseback transactions and affiliate transactions;
change our business;
amend certain debt and other material agreements;
issue and sell capital stock of subsidiaries;
restrict distributions from subsidiaries; and
grant negative pledges to other creditors.

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We would expect our proposed new credit facility to include similar covenants. Moreover, if we are unable to meet the terms of the financial covenants or if we breach any of these covenants, a default could result under one or more of these agreements. A default, if not waived by our lenders, could result in the acceleration of our outstanding indebtedness and cause our debt to become immediately due and payable. If acceleration occurs, we would not be able to repay our debt and it is unlikely that we would be able to borrow sufficient additional funds to refinance such debt. Even if new financing is made available to us, it may not be available on terms acceptable to us.

If we obtain modifications of our agreements, or are required to obtain waivers of defaults, we may incur significant fees and transaction costs. In fiscal 2003, as well as in fiscal 2002 and 2001, we modified certain covenants contained in our senior secured credit facility and loan agreements. In fiscal 2000, we obtained waivers of compliance contained in our credit facilities and public indentures. In connection with obtaining these modifications and waivers, we paid significant fees and transaction costs.

Risks Related to Our Operations

Major lawsuits have been brought against us and certain of our subsidiaries, and there are currently pending both civil and criminal investigations by the United States Attorney. In addition to any fines or damages that we might have to pay, any criminal conviction against us may result in the loss of licenses and contracts that are material to the conduct of our business, which would have a negative effect on our results of operations, financial condition and cash flows.

There are several major ongoing lawsuits and investigations in which we are involved. While some of these lawsuits have been settled, pending court approval or appeal, we are unable to predict the outcome of any of these matters at this time. If any of these cases result in a substantial monetary judgment against us or are settled on unfavorable terms, our results of operations, financial condition or cash flows could be materially adversely affected.

There are currently pending both civil and criminal governmental investigations by the United States Attorney concerning our operations under prior management and other matters. Settlement discussions have begun with the United States Attorney of the Middle District of Pennsylvania, who has proposed that the government would not institute any criminal proceeding against us if we enter into a consent judgment providing for a civil penalty payable over a period of years. The amount of the civil penalty has not been agreed to and there can be no assurance that a settlement will be reached or that the amount of such penalty will not have a material adverse effect on our financial condition and results of operations. We have recorded an accrual of $20.0 million in fiscal 2003 in connection with the resolution of these matters; however, we may incur charges in excess of that amount and we are unable to estimate the possible range of loss. We will continue to evaluate our estimate and to the extent that additional information arises or our strategy changes, we will adjust our accrual accordingly.

If we were convicted of any crime, certain licenses and government contracts, such as Medicaid plan reimbursement agreements, that are material to our operations may be revoked, which would have a material adverse effect on our results of operations and financial condition. In addition, substantial penalties, damages or other monetary remedies assessed against us could also have a material adverse effect on our results of operations, financial condition and cash flows.

Given the size and nature of our business, we are subject from time to time to various lawsuits which, depending on their outcome, may have a negative impact on our results of operations, financial condition and cash flows.

We are substantially dependent on a single supplier of pharmaceutical products to sell products to us on satisfactory terms. A disruption in this relationship would have a negative effect on our results of operations, financial condition and cash flow.

We obtain approximately 90% of our pharmaceutical products from a single supplier, McKesson, pursuant to a contract that runs until April 2004. Pharmacy sales represented approximately 63.2% of our total sales during fiscal 2003, and, therefore, our relationship with McKesson is important to us. Any significant disruptions in our relationship with McKesson would make it difficult for us to continue to operate our business, and would have a material adverse effect on our results of operations, financial condition and cash flows.

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We need to continue to improve our operations in order to improve our financial condition, but our operations will not improve if we cannot continue to effectively implement our business strategy or if our strategy is negatively affected by general economic conditions.

Our operations during fiscal 2000 were adversely affected by a number of factors, including our financial difficulties, inventory shortages, allegations of violations of the law, including drug pricing issues, disputes with suppliers and uncertainties regarding our ability to produce audited financial statements. To improve operations, new management developed, and in fiscal 2001 began implementing and continues to implement, a business strategy to improve our stores and enhance our relationships with our customers by improving the pricing of products, providing more consistent advertising through weekly circulars, eliminating inventory shortages and out-dated inventory, strengthening our relationships with our vendors, developing programs intended to provide better customer service, purchasing prescription files and other means.

Since the beginning of fiscal 1997, we have relocated 979 stores, remodeled 608 stores, opened 476 stores and closed or sold an additional 1,404 stores. These new, relocated and remodeled stores represented approximately 60% of our total stores at March 1, 2003 . Although this substantial investment made in our store base over the last seven years has given us a modern store base, our store base has not yet achieved a level of sales productivity comparable to our major competitors. Accordingly, many of our new and relocated stores have not developed a critical mass of customers needed to achieve profitability. Our strategy is to focus on improving the productivity of our existing store base. We believe that improving the sales of existing stores is important to achieving profitability and continuing to improve operating cash flow.

If we are not successful in implementing our strategy, or if our strategy is not effective, we may not be able to continue to improve our operations. In addition, any adverse change in general economic conditions can adversely effect consumer buying practices and reduce our sales of front-end products, which are our higher margin products, and cause a proportionately greater decrease in our profitability. Failure to continue to improve operations or a decline in general economic conditions would adversely affect our results of operations, financial condition and cash flows and our ability to make principal or interest payments on our debt.

We are dependent on our management team, and the loss of their services could have a material adverse effect on our business and the results of our operations or financial condition.

The success of our business is materially dependent upon the continued services of our executive management team. The loss of key personnel could have a material adverse effect on the results of our operations, financial condition or cash flows. Additionally, we cannot assure you that we will be able to attract or retain other skilled personnel in the future.

On April 10, 2003 we announced that Mary F. Sammons, currently our President and Chief Operating Officer, will become our President and Chief Executive Officer effective June 25, 2003. Robert G. Miller, currently our Chairman and Chief Executive Officer, will retain the position of Chairman.

Terrorist attacks, such as the attacks that occurred in New York and Washington, D.C. on September 11, 2001, and other attacks or acts of war may adversely affect the markets in which we operate, our operations and our profitability.

The attacks of September 11, 2001 and subsequent events, including the current military action in Iraq, have caused instability in the United States and other financial markets and have led, and may continue to lead, to further armed hostilities, prolonged military action in Iraq or further acts of terrorism in the United States or abroad, which could cause further instability in financial markets and reduced consumer confidence. The threat of terrorist attacks, the current military action in Iraq and other related developments may adversely affect prevailing economic conditions, resulting in reduced consumer spending and reduced sales in our stores. These developments will subject us to increased risks and, depending on their magnitude, could have a material adverse effect on our business.

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Risks Related to Our Industry

The markets in which we operate are very competitive and further increases in competition could adversely affect us.

We face intense competition with local, regional and national companies, including other drugstore chains, independently owned drugstores, supermarkets, mass merchandisers, discount stores and mail order pharmacies. We may not be able to effectively compete against them because our existing or potential competitors may have financial and other resources that are superior to ours. In addition, we may be at a competitive disadvantage because we are more highly leveraged than our competitors. Because many of our stores are new, their ability to achieve profitability depends on their ability to achieve a critical mass of customers. While customer growth is often achieved through purchases of prescription files from existing pharmacies, our ability to achieve this critical mass through purchases of prescription files could be confined by liquidity constraints. Although in the recent past, our competitiveness has been adversely affected by problems with inventory shortages, uncompetitive pricing and customer service, we have taken steps to address these issues. We believe that the continued consolidation of the drugstore industry and additional store openings will further increase competitive pressures in the industry. As competition increases, a significant increase in general pricing pressures could occur, which would require us to increase our sales volume and to sell higher margin products and services in order to remain competitive. We cannot assure you that we will be able to continue effectively to compete in our markets or increase our sales volume in response to further increased competition.

Changes in third-party reimbursement levels for prescription drugs could reduce our margins and have a material adverse effect on our business.

Sales of prescription drugs, as a percentage of sales, and the percentage of prescription sales with third parties, have been increasing and we expect them to continue to increase. In fiscal 2003, sales of prescription drugs represented 63.2% of our sales and 92.7% of all of the prescription drugs that we sold were with third party payors. During fiscal 2003, the top five third-party payors accounted for approximately 29% of our total sales. Any significant loss of third-party provider business could have a material adverse effect on our business and results of operations. Also, these third-party payors could reduce the levels at which they will reimburse us for the prescription drugs that we provide to their members. Furthermore, if Medicare is reformed to include prescription benefits, we may be reimbursed for some prescription drugs at prices lower than our current reimbursement levels. In fiscal 2003, approximately 11% of our revenues were from state sponsored Medicaid agencies. There have been a number of recent proposals and enactments by various states to reduce Medicaid reimbursement levels in response to budget problems, some of which propose to reduce reimbursement levels in the applicable states significantly, and we expect other similar proposals in the future. If third-party payors reduce their reimbursement levels or if Medicare covers prescription drugs at reimbursement levels lower than our current retail prices, our margins on these sales would be reduced, and the profitability of our business and our results of operations, financial condition or cash flows could be adversely affected.

We are subject to governmental regulations, procedures and requirements; our noncompliance or a significant regulatory change could adversely affect our business, the results of our operations or our financial condition.

Our pharmacy business is subject to federal, state and local regulation. These include local registrations of pharmacies in the states where our pharmacies are located, applicable Medicare and Medicaid regulations and prohibitions against paid referrals of patients. Failure to properly adhere to these and other applicable regulations could result in the imposition of civil and criminal penalties and could adversely affect the continued operation of our business. Furthermore, our pharmacies could be affected by federal and state reform programs, such as healthcare reform initiatives which could, in turn, negatively affect our business. The passing of these initiatives or any new federal or state programs could adversely affect our results of operations, financial condition or cash flows.

Our pharmacy business is subject to the patient privacy and other obligations including corporate, pharmacy and associate responsibility, imposed by the Health Insurance Portability and Accountability Act. As a covered entity, we are required to implement privacy standards, train our associates on the

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permitted use and disclosures of protected health information, provide a notice of privacy practice to our pharmacy customers and permit pharmacy health customers to access and amend their records and receive an accounting of disclosures of protected health information. Failure to properly adhere to these requirements could result in the imposition of civil as well as criminal penalties.

Certain risks are inherent in providing pharmacy services; our insurance may not be adequate to cover any claims against us.

Pharmacies are exposed to risks inherent in the packaging and distribution of pharmaceuticals and other healthcare products, such as with respect to improper filling of prescriptions, labeling of prescriptions and adequacy of warnings. Although we maintain professional liability and errors and omissions liability insurance, from time to time, claims result in the payment of significant amounts, some portions of which are not funded by insurance. We can offer no assurance that the coverage limits under our insurance programs will be adequate to protect us against future claims, or that we will maintain this insurance on acceptable terms in the future. Our results of operations, financial condition or cash flows may be adversely affected if in the future our insurance coverage proves to be inadequate or unavailable or there is an increase in liability for which we self insure or we suffer reputational harm as a result of an error or omission.

We will not be able to compete effectively if we are unable to attract, hire and retain qualified pharmacists.

There is a nationwide shortage of qualified pharmacists. In response, we have implemented improved benefits and training programs in order to attract, hire and retain qualified pharmacists. However, we may not be able to attract, hire and retain enough qualified pharmacists. This could adversely affect our operations.

Item 7A.    Quantitative and Qualitative Disclosures About Market Risks

Our future earnings, cash flow and fair values relevant to financial instruments are dependent upon prevalent market rates. Market risk is the risk of loss from adverse changes in market prices and interest rates. Our major market risk exposure is changing interest rates. Increases in interest rates would increase our interest expense. We enter into debt obligations to support capital expenditures, acquisitions, working capital needs and general corporate purposes. Our policy is to manage interest rates through the use of a combination of variable-rate credit facilities, fixed-rate long-term obligations and derivative transactions.

The table below provides information about our financial instruments that are sensitive to changes in interest rates. The table presents principal payments and the related weighted average interest rates by expected maturity dates as of March 1, 2003, before giving effect to the transactions described in Item 1 – "Business—Recent Events".


  2004 2005 2006 2007 2008 Thereafter Total Fair Value
at March 1,
2003
  (dollars in thousands)
Long-term debt,                                                
Including current portion                                                
Fixed rate $ 59,077   $ 2,528   $ 274,332   $ 725,887   $ 691   $ 1,251,427   $ 2,313,942   $ 2,027,603  
Average interest rate   6.05 %     11.50   7.18 %     7.53 %     8.00   8.14 %     7.79      
Variable rate   37,500     60,000     1,275,000               $ 1,372,500   $ 1,372,500  
Average interest rate   5.19   5.19 %     5.19 %                   5.19      
                                                 

Our ability to satisfy our interest payment obligations on our outstanding debt will depend largely on our future performance, which, in turn, is subject to prevailing economic conditions and to financial, business and other factors beyond our control. If we do not have sufficient cash flow to service our interest payment obligations on our outstanding indebtedness and if we cannot borrow or obtain equity financing to satisfy those obligations, our business and results of operations will be materially adversely affected. We cannot be assured that any replacement borrowing or equity financing could be successfully completed.

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The ratings on the senior credit facility as of April 30, 2003 were BB by Standard & Poor's and B1 by Moody's. The interest rate on the variable-rate borrowings under the senior credit facility as of April 30, 2003 is LIBOR plus 3.50%.

Downgrades of our credit ratings could have an impact upon the rate on the borrowings under these credit facilities.

Changes in one month LIBOR affect our cost of borrowings because the interest rate on our variable-rate obligations is based on LIBOR. If the market rates of interest for one month LIBOR change by 10% (approximately 13 basis points) as compared to the LIBOR rate of 1.31% as of March 1, 2003 our annual interest expense would change by approximately $1.8 million based upon our variable-rate debt outstanding of approximately $1,372.5 million on March 1, 2003.

A change in interest rates generally does not have an impact upon our future earnings and cash flow for fixed-rate debt instruments. As fixed-rate debt matures, however, and if additional debt is acquired to fund the debt repayment, future earnings and cash flow may be affected by changes in interest rates. This effect would be realized in the periods subsequent to the periods when the debt matures.

Item 8.    Financial Statements and Supplementary Data

Our consolidated financial statements and notes thereto are included elsewhere in this Annual Report on Form 10-K and are incorporated by reference herein. See Item 15 of Part IV.

Item 9.    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

Not applicable

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PART III

We intend to file with the Securities and Exchange Commission a definitive proxy statement for our 2003 Annual Meeting of Stockholders, to be held on June 25, 2003, pursuant to Regulation 14A not later than 120 days after March 1, 2003. The information called for by these Items 10, 11, 12 and 13 are incorporated by reference to that proxy statement.

Item 14.    Controls and Procedures

(a)    Evaluation of Disclosure Controls and Procedures. Our Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Exchange Act Rules 13a-14(c) and 15d-14(c) under the Securities and Exchange Act of 1934, as amended (the "Exchange Act")) as of a date within 90 days prior to the filing of this report (the "Evaluation Date"). Based on such evaluation, such officers have concluded that, as of the Evaluation Date, our disclosure controls and procedures are effective in alerting them on a timely basis to material information relating to us (including our consolidated subsidiaries) required to be included in our periodic filings under the Exchange Act.

(b)    Changes in Internal Controls. Since the Evaluation Date, there have not been any significant changes in our internal controls or in other factors that could significantly affect such controls.

PART IV

Item 15.    Exhibits, Financial Statement Schedules and Reports on Form 8-K

(a) The consolidated financial statements of the Company and reports of independent accountants identified in the following index are incorporated by reference into this report from the individual pages filed as a part of this report:

1.    Financial Statements

The following financial statements and report of independent auditors are included herein:


Independent Auditor's Report   47  
Consolidated Balance Sheets as of March 1, 2003 and March 2, 2002   48  
Consolidated Statements of Operations for the fiscal years ended
March 1, 2003, March 2, 2002 and March 3, 2001
  49  
Consolidated Statements of Stockholders' (Deficit) Equity for the fiscal years ended
March 1, 2003, March 2, 2002 and March 3, 2001
  50  
Consolidated Statements of Cash Flows for the fiscal years ended March 1, 2003,
March 2, 2002 and March 3, 2001
  52  
Notes to Consolidated Financial Statements   53  

2.    Financial Statement Schedules

Schedule II — Valuation and Qualifying Accounts

All other schedules are omitted because they are not applicable, not required or the required information is included in the consolidated financial statements or notes thereto.

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3.    Exhibits


Exhibit
Numbers
Description Incorporation by Reference to
  3.1 Restated Certificate of Incorporation dated December 12, 1996 Exhibit 3(i) to Form 8-K filed on November 2, 1999
  3.2 Certificate of Amendment to the Restated Certificate of Incorporation dated October 25, 1999 Exhibit 3(ii) to Form 8-K filed on November 2, 1999
  3.3 Certificate of Amendment to Restated Certificate of Incorporation dated June 27, 2001 Exhibit 3.4 to Registration Statement on Form S-1, File No. 333-64950, filed on July 12, 2001
  3.4 8% Series D Cumulative Pay-in-kind Preferred Stock Certificate of Designation dated October 3, 2001 Exhibit 3.5 to Form 10-Q filed on October 12, 2001
  3.5 By-laws, as amended on November 8, 2000 Exhibit 3.1 to Form 8-K filed on November 13, 2000
  3.6 Amendment to By-laws, adopted January 30, 2002 Exhibit T3B.2 to Form T-3 filed on March 4, 2002
  4.1 Indenture dated August 1, 1993 by and between Rite Aid Corporation, as issuer, and Morgan Guaranty Trust Company of New York, as trustee, related to the Company's 6.70% Notes due 2001, 7.125% Notes due 2007, 7.70% Notes due 2027, 7.625% Notes due 2005 and 6.875% Notes due 2013 Exhibit 4A to Registration Statement on Form S-3, File No. 333-63794, filed on June 3, 1993
  4.2 Supplemental Indenture dated as of February 3, 2000, between Rite Aid Corporation, as issuer, and U.S. Bank Trust National Association, to the Indenture dated as of August 1, 1993 and Morgan Guaranty Trust Company of New York, relating to the Company's 6.70% Notes due 2001, 7.125% Notes due 2007, 7.70% Notes due 2027, 7.625% Notes due 2005 and 6.875% Notes due 2013 Exhibit 4.1 to Form 8-K filed on February 7, 2000
  4.3 Indenture dated as of September 22, 1998 by and between Rite Aid Corporation, as issuer, and Harris Trust and Savings Bank, as trustee, related to the Company's 6% Dealer Remarketable Securities Exhibit 4.1 to Registration Statement on Form S-4, File No. 333-66901, filed on November 6, 1998
  4.4 Supplemental Indenture, dated as of February 3, 2000, between Rite Aid Corporation and Harris Trust and Savings bank, to the Indenture dated September 22, 1998, between Rite Aid Corporation and Harris Trust and Savings Bank, related to the Company's 6% Dealer Remarketable Securities Exhibit 4.3 to Form 8-K filed on February 7, 2000

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Exhibit
Numbers
Description Incorporation by Reference to
  4.5 Indenture dated as of December 21, 1998, between Rite Aid Corporation, as issuer, and Harris Trust and Savings Bank, as trustee, related to the Company's 5.50% Notes due 2000, 6% Notes due 2005, 6.125% Notes due 2008 and 6.875% Notes due 2028 Exhibit 4.1 to Registration Statement on Form S-4, File No. 333-74751, filed on March 19, 1999
  4.6 Supplemental Indenture, dated as of February 3, 2000, between Rite Aid Corporation and Harris Trust and Savings Bank, to the Indenture dated December 21, 1998, between Rite Aid Corporation and Harris Trust and Savings Bank, related to the Company's 5.50% Notes due 2000, 6% Notes due 2005, 6.125% Notes due 2008 and 6.875% Notes due 2028 Exhibit 4.4 to Form 8-K filed on February 7, 2000
  4.7 Indenture, dated as of June 27, 2001, between Rite Aid Corporation, as issuer and State Street Bank and Trust Company, as trustee, related to the Company's 12.50% Senior Secured Notes due 2006 Exhibit 4.7 to Registration Statement on Form S-1, File No. 333-64950, filed on July 12, 2001
  4.8 Indenture, dated as of June 27, 2001 between Rite Aid Corporation, as issuer and BNY Midwest Trust Company, as trustee, related to the Company's 11 1/4% Senior Notes due 2008 Exhibit 4.8 to Registration Statement on Form S-1, File No. 333-64950, filed on July 12, 2001
  4.9 Indenture dated as of November 19, 2001, between Rite Aid Corporation, as issuer, and BNY Midwest Trust Company, as trustee, related to the Company's 4.75% Convertible Notes due December 1, 2006 Exhibit 4.3 to Form 10-Q filed on January 15, 2002
  4.10 Indenture dated as of February 12, 2003, between Rite Aid Corporation, as issuer, and BNY Midwest Trust Company, as trustee, related to the Company's 9½% Senior Secured Notes due 2011 Exhibit 4.1 to Form 8-K filed on March 5, 2003
  4.11 Indenture, dated as of April 22, 2003, between Rite Aid Corporation, as issuer, the Subsidiary Guarantors named therein, and BNY Midwest Trust Company, as trustee, related to the Company's 8.125% Senior Secured Notes due 2010 Filed herewith
10.1 1999 Stock Option Plan* Exhibit 10.1 to Form 10-K filed on May 21, 2001
10.2 2000 Omnibus Equity Plan* Included in Proxy Statement dated October 24, 2000
10.3 2001 Stock Option Plan* Exhibit 10.3 to Form 10-K filed on May 21, 2001
10.4 Rite Aid Corporation Special Deferred Compensation Plan* Exhibit 10.21 to Form 10-K filed on July 11, 2000

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Exhibit
Numbers
Description Incorporation by Reference to
10.5 Employment Agreement by and between Rite Aid Corporation and Robert G. Miller dated as of December 5, 1999* Exhibit 10.1 to Form 8-K filed on January 18, 2000
10.6 Amendment No. 1 to Employment Agreement by and between Rite Aid Corporation and Robert G. Miller, dated as of May 7, 2001* Exhibit 10.9 to Form 10-K filed on May 21, 2001
10.7 Employment Agreement by and between Rite Aid Corporation and Robert G. Miller, dated as of April 9, 2003 Filed herewith
10.8 Employment Agreement by and between Rite Aid Corporation and Mary F. Sammons, dated as of December 5, 1999* Exhibit 10.2 to Form 8-K filed on January 18, 2000
10.9