Overview

The Smith's Acquisition was accounted for under the purchase method of accounting. Accordingly, the results for 1997 reflect only 21 weeks of operations from the Smith's stores. As a result of the purchase, the assets and liabilities of Smith's have been recorded at their fair value as of September 9, 1997. The purchase price in excess of the fair value of Smith's assets and liabilities is recorded as goodwill and is being amortized over a 40-year period. See Note 3 of the Notes to the Consolidated Financial Statements of the Company included elsewhere herein.

The Company used the proceeds from a new bank credit facility (the "1997 Senior Credit Facility") to refinance debt assumed in the Smith's Acquisition and to repay a substantial portion of the Company's existing indebtedness. The 1997 Senior Credit Facility provided a five year $1.03 billion revolving credit facility, a $500.0 million 364-day revolving credit facility and a five year $500.0 million bridge facility. As a result of prepaying certain indebtedness, the Company recorded an extraordinary charge, net of taxes, of $91.2 million consisting of fees incurred in the prepayment and the write-off of debt issuance costs.

On August 17, 1997, the Company acquired substantially all of the assets and liabilities of Fox Jewelry Company ("Fox"), a regional jewelry store chain operating 44 stores, in exchange for common stock with a fair value of $9.2 mil-lion. The Fox acquisition was accounted for under the purchase method of accounting. Accordingly, the results for 1997 reflect only 24 weeks of operations from the Fox stores.

In March 1998, the Company acquired Quality Food Centers, Inc. ("QFC") and Food 4 Less Holdings, Inc. ("Ralphs/Food 4 Less") in separate mergers, and QFC and Ralphs/Food 4 Less became wholly owned subsidiaries of the Company. These mergers occurred after the end of the Company's fiscal year ended January 31, 1998 and are not reflected in the financial statements of the Company included herein and discussed below. In connection with these mergers, substantially all of the debt of the Company and these companies was refinanced. See Note 13 of the Notes to Consolidated Financial Statements.

The following discussion summarizes the Company's operating results for the fiscal year ended January 31, 1998 ("1997") compared with the fiscal year ended February 1, 1997 ("1996") and for 1996 compared with the fiscal year ended February 3, 1996 ("1995"). Also included are discus-sions of the Company's liquidity and capital resources, effect of LIFO, effect of inflation and recent accounting changes. This discussion and analysis should be read in conjunction with the Company's consolidated financial statements.

Results of Operations - 1997 Compared with 1996

Operating and administrative expenses increased 42.7% to $1,386.3 million in 1997 from $971.7 million in 1996, and as a percent of net sales were 25.3% in 1997 and 26.1% in 1996. Operating and administrative expenses decreased as a per-cent of sales primarily due to the lower operating and administrative costs as a percent of sales at Smith's. Amorti-zation of goodwill increased to $10.5 million in 1997 from $308,000 in 1996 as a result of goodwill recorded in the Smith's Acquisition.

Net interest expense increased to $75.5 million in 1997 from $39.4 million in 1996. The increase primarily reflects the increased amount of indebtedness incurred in conjunction with the Smith's Acquisition.

The effective tax rate was 40.6% for 1997 and 38.0% for 1996. The increase in the effective tax rate results from the increase in amortization of goodwill which is not deductible for tax purposes.

Income before extraordinary charge was $103.3 million for 1997 and $58.5 million for 1996. This increase is primarily the result of the above-mentioned factors.

The extraordinary charge of $91.2 million recorded in the third quarter of 1997 consists of fees incurred in the prepayment of certain indebtedness and write-off of debt issuance costs.

Net income was $12.1 million for 1997 and $58.5 million for 1996. This decrease is primarily the result of the increase in income before extraordinary charge offset by the extra-ordinary charge.

Results of Operations- 1996 Compared with 1995

Gross margin as a percent of net sales was 29.7% in 1996 compared with 28.4% in 1995. Gross margin increased pri-marily due to significant reductions in markdowns in 1996 versus 1995, the effects of increased sales of higher-margin jewelry, primarily from the 71 acquired fine jewelry stores, and lower distribution costs as a percent of sales.

Operating and administrative expenses increased 9.8% to $971.7 million in 1996 from $885.1 million in 1995, and as a percent of net sales were 26.1% in 1996 and 25.9% in 1995. Operating and administrative expenses increased as a percent of sales due to the higher expense structure at the fine jewelry stores and increased wages for additional staffing in some nonfood sections of the multidepartment stores.These increases were partially offset by reduced advertising expense as a percent of sales.

Net interest expense decreased to $39.4 million in 1996 from $39.6 million in 1995. The decrease primarily reflects lower borrowings due to the impact of the Company's third quarter $108.0 million sale-leaseback of 10 stores and to improved cash flow from operations, offset in part by the third quarter repurchase of $70.0 million of common stock.

The effective tax rate was 38.0% for both 1996 and 1995.

Net income was $58.5 million for 1996 and $30.3 million for 1995. This increase is primarily the result of the above-mentioned factors.

Liquidity and Capital Resources

In conjunction with the Smith's Acquisition, the Company entered into a new bank credit facility on September 9, 1997 that refinanced a substantial portion of the indebtedness of Fred Meyer Stores and Smith's. The Company entered into a five-year $1.03 billion revolving credit facility, a $500.0 million 364-day revolving credit facility, and a five-year $500.0 million bridge facility, each guaranteed by the accompanying subsidiaries (including Smith's and Fred Meyer Stores). In addition to the committed 1997 Senior Credit Facility, at January 31, 1998, the Company had $125.0 million of uncommitted money market lines with four banks and $500.0 million in unrated commercial paper facilities with three banks. The uncommitted money market lines and unrated commercial paper are used primarily for seasonal inventory requirements, new store construction and financing existing store remodeling, acquisition of land, and major projects such as management information systems. At January 31, 1998, the Company had borrowings under the 1997 Senior Credit Facility of $1.746 billion which includes outstanding unrated commercial paper in the amount of $367.2 million and borrowings under uncommitted money market lines of $79.0 million. A total of approximately $283.8 million was available for borrowings under the 1997 Senior Credit Facility, and $46.0 million was available for borrowings from the uncommitted money market lines. In addition to the 1997 Senior Credit Facility, the Company entered into two lease lines of credit for various stores and a distribution center. On September 9, 1997, Fred Meyer Stores entered into a lease financing facility of up to $270.0 million, which refinanced approximately $229.0 million in existing operating leases. The balance of this facility was planned for financing of construction costs on three new stores. On January 27, 1998, Fred Meyer Stores entered into a lease financing facility for $53.0 million for various stores.

The Company has entered into interest rate swap, cap and collar agreements to reduce the impact of changes in interest rates on its floating rate long-term debt and rent expense on its lease lines of credit.At January 31, 1998, the Company had outstanding four interest rate contracts for a total notional amount of $180.0 million, and seven rent rate contracts, for a total notional amount of $80.0 million. The interest rate contracts effectively fix the Company's interest rates between 5.0% and 9.0% on the notional amount and expire through 1999. The rent rate contracts effectively fix the Company's rental rates between 6.28% and 7.25% on the notional amount and expire through 2000. All contracts are with "A" rated or better commercial banks and the Company does not anticipate nonperformance by the counter parties. The Company is exposed to credit loss in the event of nonperformance by the counterparties to the interest rate and rent rate agreements.

On March 11, 1998 and in conjunction with the acquisition of Ralphs/Food 4 Less and QFC, the Company entered into new financing arrangements (the "1998 Senior Credit Facilities") which included a public issue of $1.75 billion of senior unsecured notes and bank credit facilities which include a $1.875 billion five-year revolving credit agreement and a $1.625 billion five-year term loan. The term loan amortization is scheduled over five years with $18.75 million due in fiscal year 1998; $118.75 million in fiscal year 1999; $225.0 million in fiscal year 2000; $362.5 million in fiscal year 2001; $475.0 million in fiscal year 2002; and $425.0 million in fiscal year 2003. In addition to the 1998 Senior Credit Facilities, the Company entered into a $500 million five-year operating lease facility, which refinanced $303 million in existing lease financing facilities. The balance of this lease facility will be used for land and construction costs for new stores.The senior unsecured notes which were part of a $2.5 billion shelf registration were issued on March 11, 1998 with $250 million of five-year notes at 7.15%, $750 million of seven-year notes at 7.38% and $750 million of ten-year notes at 7.45%. The 1998 Senior Credit Facilities contain certain restrictions on payments by the Company of cash dividends, repurchase of common stock, the handling of proceeds from the sale or disposition of assets, other than in the normal course of business, and require, among other things, that the Company maintain a maximum leverage ratio and a minimum fixed charge ratio. The leverage ratio compares debt to earnings before interest, taxes, depreciation and amortization ("EBITDA").The fixed charge ratio com-pares EBITDA to interest expense. The obligations of the Company under the senior unsecured notes are guaranteed by certain subsidiaries. The obligations of the Company under the 1998 Senior Credit Facilities are guaranteed by certain subsidiaries and are also collateralized by the stock of certain subsidiaries.

The Company had $16.5 million of outstanding Letters of Credit as of January 31, 1998. The Letters of Credit are used to support the importation of goods and to support the per-formance, payment, deposit or surety obligations of the Company. The Company pays annual commitment fees ranging from .04% to 1.00% on the outstanding portion of these Letters of Credit.

The Company believes that the combination of cash flows from operations and borrowings under its credit facilities will permit it to finance its capital expenditure requirements for 1998, currently budgeted to be approximately $600 million, net of estimated real estate sales and stores financed on leases. If the Company determines that it is preferable, it may fund its capital expenditure requirements by mortgaging facilities, entering into sale/leaseback transactions, or by issuing additional debt or equity. The Company currently owns real estate with a net book value of approximately $1.4 billion.

Effect of LIFO

Effect of Inflation

Recent Accounting Changes

Year 2000

Forward-looking Statements