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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTION 13
OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

(Mark One)

For the fiscal year ended January 31, 2002

For the transition period from                              to                             

Commission file number 1-8978

LONGS DRUG STORES CORPORATION
(Exact name of registrant as specified in its charter)

Registrant's telephone number, including area code: (925) 937-1170

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

Common stock                New York Stock 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 ý        No o

        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. ý

        The aggregate market value of voting stock held by non-affiliates of the registrant as computed by the price of the registrant's shares on the New York Stock Exchange at the close of business on April 4, 2002, was approximately $1,054,240,000.

        There were 38,229,857 shares of common stock outstanding as of April 4, 2002.

DOCUMENTS INCORPORATED BY REFERENCE

        The information required by Part III of this Annual Report on Form 10-K, to the extent not set forth herein, is incorporated by reference from specified portions of our definitive Proxy Statement for our 2002 Annual Meeting of Stockholders.

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

        This annual report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Securities Exchange Act. Such statements relate to, among other things, pharmacy and front-end sales trends, prescription margins, margin improvement, cost reductions, distribution center performance, changes in supply chain practices, the number of store openings and the level of capital expenditures, and are indicated by words or phrases such as "continuing," "expects," "estimates," "believes" and other similar words or phrases. These statements are based on our current plans and expectations and involve risks and uncertainties that could cause actual events and results to vary materially from those included in or contemplated by such statements. These risks and uncertainties include, but are not limited to, among other things, changes in economic conditions generally or in the markets we serve; consumer preferences and spending patterns; continuing softness in the economy; competition from other drugstore chains, supermarkets, on-line retailers, other retailers and mail order companies; changes in state or federal legislation or regulations; the efforts of third-party payers to reduce prescription drug costs; the success of planned advertising and merchandising strategies; the ability of our automated fill center to meet expectations in filling prescriptions; the availability and cost of real estate for, and construction of, new stores; accounting policies and practices; our ability to hire and retain pharmacists and other store and management personnel; our relationships with our suppliers; our ability to improve our purchasing of front-end products; our ability to successfully implement new computer systems and technology; the impact of rising energy costs on our operations; changes in internal business processes associated with supply chain and other initiatives; adverse determinations with respect to litigation or other claims; and other factors discussed in this annual report or any of our other SEC filings. We assume no obligation to update our forward-looking statements to reflect subsequent events or circumstances.

Table of Contents

PART I

Item 1. Business

        Longs Drug Stores Corporation was founded in 1938 in Oakland, California. Longs is one of the largest drug store chains in North America, with 436 stores in California, Colorado, Hawaii, Nevada, Washington and Oregon. Our goal is to provide our customers with a satisfying shopping experience, with quality service and merchandise. We believe that establishing trust and building Longs brand loyalty are essential to earning repeat business.

        We operate in two business segments, retail drug stores and, through our RxAmerica subsidiary, pharmacy benefit management, or PBM. For financial information about these segments, see "Segment Information" in the footnotes to our financial statements.

        Pharmacy is the cornerstone of our retail drug store business, complemented by such "front-end" categories as over-the-counter medications, health care products, photo and photo processing, cosmetics, greeting cards, food and beverage items, housewares, toiletries, mail centers and seasonal merchandise.

        Our PBM segment contracts with drug manufacturers, third-party health plans and retail pharmacies to provide a range of services to third-party health plan members, including pharmacy benefit plan design and implementation, formulary management, claims processing and generic substitution.

Recent developments

        In November 1997, we formed a joint venture with American Drug Stores, Inc. (now Albertson's, Inc.) to provide PBM services under the name RxAmerica. In September 2001, we exercised an option to purchase Albertson's interest in the joint venture.

        In February 2001, we formed a joint venture with AmerisourceBergen to establish a highly automated central prescription fill center to increase productivity and reduce prescription fill costs while addressing an industry-wide shortage of pharmacists. Certain of the prescriptions that we receive via phone, fax and the Internet are routed to the central prescription fill center and then delivered to the stores in advance of the scheduled pickup. The fill center allows our in-store pharmacy personnel to spend more time serving customers and filling prescriptions that are needed on an immediate basis. The center began filling prescriptions in June 2001, and is currently filling more than 35,000 prescriptions per week.

        In July 2001, we terminated our agreement with our third-party distribution center operator in California. During the third and fourth quarters we transitioned to self-operation of our distribution centers.

        In February 2002, the board of directors approved a program for upgrading our supply chain practices in an effort to increase efficiency and enhance profitability, along with initiatives to increase front-end sales and pharmacy margins, enhance customer service and improve operational efficiencies.

Merchandising

        We strive to provide our customers with a broad range of name brand and private label merchandise. To enhance customer service and build customer loyalty, we attempt to maintain a consistent in-stock position in all of our merchandise categories.

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Purchasing

        We have historically had a decentralized approach to purchasing, with store managers exerting significant control over their product mix based on their customers' preferences and needs. As we upgrade our supply chain practices in order to achieve greater efficiencies and economies of scale, we intend to transition to a more centralized purchasing approach for most of our products, while allowing store managers to retain some degree of customization to suit their customers' preferences.

Advertising

        We advertise primarily through promotional ads in major daily newspapers and on radio and television. Our approach is to regionalize our advertising and use the most efficient media mix within a geographic area.

Internet

        In fiscal 2001, we introduced our Internet prescription refill business, Longs e-fills™. Through our website, www.longs.com, our customers can access our company information and extensive health and welfare information, refill prescriptions and purchase over 7,000 over-the-counter medications, health care products and other non-pharmacy related items 24 hours a day, 7 days a week. Customers may have items mailed to them or may pick them up at their local store. We believe that this sales channel provides customers with added flexibility and further improves their Longs shopping experience.

Technology

        All of our stores have point-of-sale scanning systems and pharmacy systems that facilitate prescription fills, drug interaction analysis and third-party adjudication. We also utilize rapid replenishment systems for certain goods that track sales and merchandise on hand and plan orders as necessary.

Trademarks

        We hold various trademarks, trade names (including Longs, Longs Drugs, Longs Drug Stores, Longs Pharmacy, Longs Express, Longs e-fills and RxAmerica) and business licenses that are essential to the operation of our business. These trademarks and licenses have varying statutory lives and are generally renewable indefinitely.

Employees

        As of January 31, 2002, we had approximately 22,200 full-time and part-time employees. We hire additional temporary employees as needed, especially during peak seasons. Virtually all of our employees are non-union, and we believe that our relationship with our employees is good.

Regulation

        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. Applicable licensing and registration requirements require our compliance with various state statutes, rules and regulations. If we were to violate any applicable statute, rule or regulation, our licenses and registrations could be suspended or revoked.

        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. Also, in recent years, both federal and state authorities have proposed or passed

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new legislation that imposes on healthcare providers, including pharmacies, significant additional obligations concerning the protection of confidential patient medical records and information. 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.

Competition

        The retail drug store industry is highly competitive. We compete with regional and national drug store chains, independent drug stores, Internet and mail order prescription providers, supermarkets, variety stores and mass merchandise discount stores. We compete on the basis of price, merchandise quality, product mix, convenience and customer service.

Concentrations

        All of our sales occur within the United States. We do not derive revenues from sales in foreign countries or export sales. No single customer accounts for 1% or more of our total sales. The loss of any one customer or group of customers under common control would not have a material effect on our business.

        We obtain approximately 54% of our total merchandise, including 95% of our pharmaceutical inventories, from a single supplier, AmerisourceBergen, pursuant to a long-term supply contract. Any significant disruptions in our relationship with AmerisourceBergen could have a material adverse effect on our business.

        We also depend on fuel and other energy sources for the distribution of inventories and the operation of our stores. As of January 31, 2002, we operated 361 stores in the state of California, which has experienced energy shortages causing some power outages. To date we have not experienced significant disruption of our business resulting from energy shortages. However, continued power outages and increases in energy costs could have a material adverse effect on us.

Seasonality

        Our business is seasonal, peaking in the fourth quarter when front-end sales benefit from the holiday season. Pharmacy sales and over-the-counter medications also benefit from the winter cold and flu season.

Item 2. Properties

Stores

        As of January 31, 2002, we operated 436 stores: 361 in California, 32 in Hawaii, 17 in Washington, 15 in Nevada, 9 in Colorado and 2 in Oregon. Our stores vary in size, with the majority ranging from 15,000 to 30,000 square feet, approximately 70% of which is devoted to selling space. The average size of the stores we opened fiscal 2002 is 20,097 square feet. We lease 251 of our stores from third parties.

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Of the remaining stores, 133 are company-owned buildings on company-owned land, and 52 are company-owned buildings on leased land.

        We plan to open between 25 and 30 new stores in fiscal 2003, and consistent with prior years, we may make decisions to close some stores in the normal course of business.

Distribution Centers

        We operate the following distribution centers:

        Store deliveries take place on a daily basis through a combination of company-owned trucks and common carriers.

Other Properties

        We have two principal company-owned corporate office facilities in California, with a total of 142,000 square feet. We also lease a 33,000 square foot corporate office building for our PBM segment in Salt Lake City, Utah. Our remaining properties are not material, either individually or in the aggregate.

Item 3. Legal Proceedings

        We are subject to various lawsuits and claims arising in the normal course of our businesses. In the opinion of management, after consultation with counsel, the disposition of these matters is not likely to have a material adverse effect, individually or in the aggregate, on our financial position or results of operations.

Item 4. Submission of Matters to a Vote of Stockholders

        There were no matters submitted to a vote of stockholders during the fourth quarter of fiscal 2002.

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PART II

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

        The New York Stock Exchange is the principal market for our common stock, which is traded under the symbol "LDG." Our transfer agent is Mellon Investor Services LLC, P.O. Box 3315, South Hackensack, NJ 07606-1915. There were approximately 18,996 stockholders of record as of April 4, 2002.

        Quarterly high and low stock prices, based on the New York Stock Exchange composite transactions, together with dividend information and other key select financial data are shown below:

(1)

The fourth quarter of fiscal 2002 included 14 weeks of operations, compared to 13 weeks for all other quarters of fiscal 2002 and fiscal 2001.

(2)

We acquired full ownership of RxAmerica, our PBM segment, in the third quarter of fiscal 2002. Prior to the acquisition, RxAmerica was a joint venture between Longs and Albertson's, and its results of operations, which were reported using the equity method of accounting, were not material to us. In the fourth quarter of fiscal 2002, its first full quarter under our ownership, RxAmerica accounted for $2.9 million of net income ($0.08 per diluted share).

(3)

Net income in the second and third quarters of fiscal 2001 included income of $3.9 million ($2.3 million after tax or $0.06 per diluted share) and $2.9 million ($1.8 million after tax or $0.05 per diluted share), respectively, from net gains on the settlement of certain legal matters.

(4)

Net income in the third quarter of fiscal 2001 included a charge of $1.6 million ($1.0 million after tax or $0.03 per diluted share) for our share of the loss on the partial sale of certain joint venture assets.

(5)

Net income in the fourth quarter of fiscal 2001 included a charge of $25.6 million ($15.4 million after tax or $0.41 per diluted share) associated with the closing of 14 stores.

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Item 6. Selected Financial Data

Five Year Selected Financial Data

(1)

Fiscal 2002 included 53 weeks of operations, compared to 52 weeks in fiscal 2001, 2000, 1999 and 1998.

(2)

We acquired full ownership of RxAmerica, our PBM segment, in the third quarter of fiscal 2002. Prior to the acquisition, RxAmerica was a joint venture between Longs and Albertson's, and its results of operations, which were reported using the equity method of accounting, were not material to us. RxAmerica accounted for $4.3 million of net income ($0.11 per diluted share), including joint venture income recorded prior to the acquisition, in fiscal 2002.

(3)

Net income in fiscal 2001 included a charge of $25.6 million ($15.4 million after tax or $0.41 per diluted share) associated with the closing of 14 stores, income of $6.8 million ($4.1 million after tax or $0.11 per diluted share) from net gains on the settlement of certain legal matters, and a charge of $1.6 million ($1.0 million after tax or $0.03 per diluted share) for our share of the loss on the sale of certain joint venture assets.

(4)

In October 1999, we completed the net acquisition of 31 stores (32 stores were acquired and one store was closed) located in California from the Rite Aid Corporation. These stores have been consolidated since the date of acquisition.

(5)

In July 1998, we completed the acquisition of Western Drug Distributors, Inc., a Drug Emporium franchise that operated 20 stores in the Pacific Northwest. These stores have been consolidated since the date of acquisition.

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

RESULTS OF OPERATIONS

Sales

        Sales increased 6.9% in fiscal 2002 over fiscal 2001, and 9.7% in fiscal 2001 over fiscal 2000. Fiscal 2002 included 53 weeks of operations compared to 52 weeks in fiscal 2001. The 53^rd week accounted for 1.9% of the increase in sales. Same-store sales, on a comparative 52-week to 52-week basis, increased 4.0% in fiscal 2002, and new stores accounted for an increase of 0.8%. RxAmerica's net sales, measured from our acquisition of full ownership in the PBM in September 2001, contributed the remaining 0.2% of total sales growth in fiscal 2002. The increase in sales in fiscal 2001 over fiscal 2000 was due largely to the contribution from new stores, including a full year of sales from the 31-store net acquisition in California in October 1999. Incremental sales from this acquisition contributed 5.2% of total sales growth in fiscal 2001. Fiscal 2001 same-store sales increased 3.3%. The increased usage of newer and more costly prescription drugs and the aging U.S. population have fueled sales growth for each of the last two fiscal years.

        Pharmacy sales were 43.8% of total drug store sales in fiscal 2002, compared to 41.1% in fiscal 2001 and 39.1% in fiscal 2000. We expect this trend to continue due to the increased usage of newer and more costly prescription drugs and the aging U.S. population. These factors contributed to same-store pharmacy sales increases of 10.9% in fiscal 2002 and 9.4% in fiscal 2001.

        Pharmacy sales reimbursed by third-party health plans represented 89.5% of total pharmacy sales, compared to 88.1% and 85.1% in the two previous fiscal years. We expect this trend to continue due to the ongoing shift to managed care.

        Same-store front-end sales declined 0.8% in fiscal 2002 and 0.7% in fiscal 2001, due to increased competition from mass merchants, national drug store chains and supermarket pharmacies; an economic slowdown, exacerbated by the terrorist attacks of September 11, 2001; a weak holiday shopping season and a mild cold and flu season that resulted in lower over-the-counter drug sales. In addition, problems with the distribution of front-end merchandise related to our third-party distribution center operator in California negatively impacted operations. We terminated our agreement with our third-party distribution center operator during the second quarter of fiscal 2002.

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Gross Profit

        Gross margin as a percent of sales was 25.6% in fiscal 2002, down from 26.1% and 26.5% in fiscal 2001 and 2000. The declining gross margin percentages reflect the increase in pharmacy sales as a percentage of total sales. Pharmacy sales have lower margins than front-end sales. In addition, pharmacy margin percentages continue to decline throughout the retail drug store industry due to the increasing percentage of pharmacy sales reimbursed by third-party health plans. Third-party health plans continue to reduce reimbursement levels, resulting in lower gross margins for these sales than for non third-party sales. However, despite decreases in pharmacy gross margin percentages, pharmacy gross profit in dollars has continued to rise with the growth in sales.

        Gross margin percentages on front-end sales have remained relatively constant for the past three fiscal years.

        Our gross profit includes LIFO provisions of $9.6 million, $4.7 million and $4.4 million in fiscal 2002, 2001 and 2000, included in cost of merchandise sold. The LIFO provision fluctuates with inflation rates and inventory levels and mix. The increase in the LIFO provision in fiscal 2002 over fiscal 2001 was primarily due to increased inflation rates for pharmaceutical inventories.

Operating and Administrative Expenses

        Operating and administrative expenses were 23.6% of sales in fiscal 2002, compared to 23.2% in both fiscal 2001 and 2000. The increase in fiscal 2002 was primarily due to newly opened stores, which have lower sales than our established stores. We opened 25 new stores in fiscal 2002, compared to 17 in fiscal 2001 and 19 in fiscal 2000. We also experienced increased distribution expenses as we transitioned from our third-party distribution center operator to self-operation of our distribution centers.

        Operating and administrative expenses included $6.3 million, $6.4 million and $3.2 million of goodwill amortization in fiscal 2002, 2001 and 2000. With the adoption of SFAS No. 142, Goodwill and Other Intangible Assets (discussed further below), we will discontinue the amortization of goodwill in fiscal 2003, and we will review goodwill for impairment annually.

Provision for Store Closures and Asset Impairment

        In January 2001, our board of directors approved a plan (the "2001 Closure Plan") to close 15 stores, and we recorded a related charge of $25.6 million. We closed 14 stores pursuant to the 2001 Closure Plan during the first quarter of fiscal 2002, and we elected not to close the remaining store. As of January 31, 2002, we had successfully terminated the leases and sublet or sold the properties for 13 of the 14 closed stores, and we are currently marketing the remaining property. Based on the results of the 2001 Closure Plan to date and estimated future costs to complete the plan, we recorded a benefit of $1.5 million from the reduction of the related reserve in the fourth quarter of fiscal 2002.

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        Additionally, consistent with previous years, we make decisions to close stores in the normal course of business. We closed 5, 3 and 15 stores not included in the 2001 Closure Plan in fiscal 2002, 2001 and 2000. During fiscal 2002, we recorded a benefit of $1.0 million from the reduction of the provision for store closures not included in the 2001 Closure Plan, offset by an impairment charge of $0.8 million reflecting the write-down of certain long-lived tangible assets associated with three stores to their estimated net recoverable values. In fiscal 2001 and 2000, we recorded expenses of $2.8 million and $4.9 million, related to the closure of stores not included in the 2001 Closure Plan.

Other Items

        In fiscal 2002, we recorded a net charge of $0.9 million for the settlement of a lease-related dispute with a landlord, partially offset by gains on the settlement of other disputes. In fiscal 2001 we recorded a net benefit of $6.8 million related to our share of a brand name litigation settlement, partially offset by the settlement of a class action lawsuit regarding the employment classification of certain employees and the resolution of a contractual dispute with a vendor. We also recorded a loss of $1.6 million reflecting our share of the loss on the partial sale of joint venture assets in fiscal 2001.

RxAmerica

        We acquired full ownership of RxAmerica, our PBM segment, in the third quarter of fiscal 2002. Prior to the acquisition, RxAmerica was a joint venture between Longs and Albertson's, and its results of operations, which were reported using the equity method of accounting, were not material to us. RxAmerica accounted for $4.3 million of net income ($0.11 per diluted share), including joint venture income recorded prior to the acquisition, in fiscal 2002.

Net Interest Expense

        Net interest expense was $14.0 million in fiscal 2002, compared to $16.3 million in fiscal 2001 and $4.6 million in fiscal 2000. The decrease in fiscal 2002 as compared to fiscal 2001 was due to lower average borrowings and interest rates. The increase in fiscal 2001 over fiscal 2000 was due to higher borrowings to finance stock repurchases and the net acquisition of 31 stores in California.

Income Taxes

        Our effective income tax rates were 37.3%, 39.6% and 39.4% in fiscal 2002, 2001 and 2000. We benefited in fiscal 2002 from a federal tax law change that allows us to deduct dividends paid on allocated shares held in our employee stock ownership plan.

LIQUIDITY AND CAPITAL RESOURCES

        Cash and equivalents were $123.2 million at January 31, 2002, compared to $44.7 million at January 25, 2001. The increase was due to higher cash flows provided by operating activities and lower cash used in investing and financing activities as compared to fiscal 2001. RxAmerica accounted for $41.1 million of cash and equivalents as of January 31, 2002.

Operating Cash Flows

        Net cash provided by operating activities was $202.2 million in fiscal 2002, primarily due to $146.0 million of net income before non-cash depreciation, amortization, asset impairment, deferred income tax and stock compensation charges. Reductions in inventory levels and increases in current liabilities also had a significant positive impact on operating cash flows.

        Net cash provided by operating activities was $192.7 million in fiscal 2001, primarily due to $110.5 million of net income before non-cash depreciation, amortization, deferred income tax and stock compensation charges. Operating cash flows also increased due to an increase of $76.7 million in

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current liabilities, including the $25.6 million reserve for the 2001 Closure Plan and increases in payables associated with the growth in the number of our stores.

        Net cash provided by operating activities was $103.5 million in fiscal 2000, primarily due to $141.2 million of net income before non-cash depreciation, amortization, deferred income tax and stock compensation charges. This amount was partially offset by increases in receivables, inventories and other current assets associated with the growth in the number of our stores.

Investing Cash Flows

        Net cash used in investing activities was $94.6 million in fiscal 2002, compared to $128.8 million in fiscal 2001 and $240.0 million in fiscal 2000. Capital expenditures in fiscal 2002 decreased from fiscal 2001 levels, which included expenditures of approximately $28.8 million for e-commerce and renovations of stores acquired in fiscal 2000. Additionally, receipts from property disposals increased from $5.3 million in fiscal 2001 to $22.6 million in fiscal 2002 as a result of several sale-leaseback transactions. Fiscal 2002 investing activities also included $5.8 million for the acquisition of the remaining 50% of RxAmerica, net of cash acquired. Fiscal 2000 capital expenditures included approximately $151 million for the 31-store net acquisition in California. Capital expenditures also included amounts related to the opening of 25, 17 and 19 new stores in fiscal 2002, 2001 and 2000.

        We plan to open between 25 and 30 stores in fiscal 2003. We expect net capital expenditures in fiscal 2003 to be approximately $120 million, including $40 million in net new store investments, $20 million for improvements in existing stores, $15 million for technology, $25 million for supply chain improvements (including expenditures under the supply chain program discussed further below) and $20 million for other items.

        In February 2002, the board of directors approved a program for upgrading our supply chain practices in an effort to increase efficiency and enhance profitability. We expect to spend approximately $60 million in capital expenditures for supply chain improvements under this program over the next four fiscal years.

Financing Cash Flows

        Net cash used in financing activities was $29.2 million in fiscal 2002. We obtained an additional $50 million in privately placed debt financing in the third quarter, offset by $58 million in repayments of long-term and short-term borrowings and dividends of $21.2 million. Net cash used in financing activities was $35.6 million in fiscal 2001, reflecting net stock repurchases of $52.4 million and dividends of $21.3 million, offset by $38.1 million of long-term and short-term borrowings. Net cash provided by financing activities was $137.9 million in fiscal 2000, including $115 million in proceeds from privately placed debt financing and $42.9 million in other net borrowings, primarily for the 31-store net acquisition in California, offset by dividends of $22.0 million.

        In October 2001, we replaced our $130 million unsecured revolving line of credit with an Amended and Restated $150 million unsecured revolving line of credit, which expires in October 2004 and accrues interest at LIBOR-based rates. Borrowings on the line of credit do not require repayment until the expiration date. As of January 31, 2002, $40.0 million was outstanding under this line of credit with a weighted average interest rate of 3.08%.

        Additionally, as of January 31, 2002, we have $160.7 million in privately placed promissory notes, including $50 million completed in the third quarter of fiscal 2002. These notes mature at various dates through 2014 and bear interest at fixed rates ranging from 5.85% to 7.85%. We used the proceeds from the $50 million private placement borrowing in fiscal 2002 to pay down the revolving line of credit and to provide cash funding for the acquisition of the remaining 50% of RxAmerica. Our note payable to RxAmerica was eliminated upon acquisition of full ownership of the PBM subsidiary.

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        Our debt agreements contain limits on borrowings, dividend payments and repurchases of company stock, and various quarterly financial covenants that set maximum leverage ratios and minimum fixed charge coverage ratios. The agreements allowed for the exclusion of the $25.6 million charge associated with the 2001 Closure Plan in the computation of the fixed charge coverage ratio. As of January 31, 2002, we were in compliance with the restrictions and limitations included in these provisions.

        In November 1999, our board of directors authorized the repurchase of up to 2,000,000 shares of our common stock through November 2004, for a maximum total expenditure of $80 million. During fiscal 2001, we purchased 1,146,868 shares under this authorization at a total cost of $22.5 million. We also repurchased 1,614,157 shares of common stock from the Estate of Vera M. Long at a total cost of $31.0 million pursuant to a separate authorization by the board of directors in February 2000. In addition, we sold 45,688 shares of common stock back to the Profit Sharing Plan in fiscal 2001 for $1.1 million, resulting in net stock repurchases of $52.4 million.

        We believe that cash on hand, together with cash provided by operating activities and borrowings on our line of credit, will be sufficient to meet our working capital and capital expenditure requirements for at least the next 12 months.

        The following table summarizes our contractual obligations as of January 31, 2002:

        We utilize normal operating leases for many of our store locations, but we do not engage in lease financing of a special-purpose entity nature.

        In addition, we had the following commercial commitments as of January 31, 2002:

        Our surety bonds secure obligations related to workers' compensation claims and will continue to be renewed as long as the related payment obligations are in effect.

Critical Accounting Policies

        The preparation of our financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of our assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results may differ from those estimates. We believe the following critical

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accounting policies require the most significant judgments and estimates used in the preparation of our consolidated financial statements:

Impairment of Long-Lived Assets

        We review long-lived tangible and intangible assets for impairment whenever events or changes in circumstances indicate that their carrying values may not be recoverable. Using our best estimates based on reasonable and supportable assumptions and projections, we record an impairment loss to write the assets down to their fair values if the carrying values of such assets exceed their related expected future cash flows.

        In fiscal 2002, we identified three stores with a history of operating and cash flow losses combined with projections of continuing losses in the foreseeable future. Our projections indicate that the carrying values of certain long-lived tangible assets associated with these stores will not be recovered through future cash flows. Accordingly, we recorded an impairment charge of $0.8 million to write such assets down to their estimated fair values, based on discounted projected future cash flows.

Store Closure Reserves

        We record the estimated costs associated with closing a store during the period in which the store is identified and approved by management under a plan of termination, which includes the method of disposition and the expected date of completion. These costs include amounts that we are contractually obligated to pay during the remainder of the lease, net of any expected sublease income, and the difference between the carrying values and estimated recoverable values of long-lived tangible and intangible assets. We record severance and other employee-related costs in the period in which the closure and related severance packages are communicated to the affected employees. We record losses on the liquidation of inventories in cost of merchandise sold when the inventories are sold or otherwise disposed of. We evaluate our store closure reserves and adjust them accordingly based on the estimated future costs to complete the store closures.

New Accounting Pronouncements

        In fiscal 2002, we adopted Statement of Financial Accounting Standards ("SFAS") No. 133, Accounting for Derivative Instruments and Hedging Activities, which established accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. SFAS No. 133 requires that an entity recognize all derivative instruments as either assets or liabilities in the statement of financial position and measure those instruments at fair value. We have no derivative instruments, and therefore adoption of SFAS No. 133 had no impact on our financial statements.

        In June 2001, the Financial Accounting Standards Board ("FASB") issued SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 141 requires that all business combinations be accounted for using the purchase method of accounting and addresses the initial recognition and measurement of goodwill and other intangible assets acquired in a business combination. Under SFAS No. 142, goodwill and certain other intangible assets deemed to have indefinite lives will no longer be amortized, but must be tested annually for impairment. We will adopt SFAS No. 141 and SFAS No. 142 in the first quarter of fiscal 2003. We do not expect the adoption of SFAS No. 141 to have a material impact on our financial position or results of operations. Upon adoption of SFAS No. 142, we will discontinue the amortization of goodwill with a carrying value of $123.3 million as of January 31, 2002 and annual amortization of approximately $6.3 million.

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        As required by SFAS No. 142, we have performed a transitional goodwill impairment test as of February 1, 2002, the date of adoption of the standard. Based on an independent valuation, we have identified certain regional reporting units that have experienced declines in their fair values below their net carrying values. Accordingly, we will recognize a goodwill impairment charge of approximately $41 million (approximately $25 million after tax) for these reporting units in the first quarter of fiscal 2003 as the cumulative effect of a change in accounting principle.

        During the year, the FASB also issued SFAS No. 143, Accounting for Asset Retirement Obligations, and SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. SFAS No. 143, which addresses the accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs, is effective for us beginning in fiscal 2004. SFAS No. 144 establishes accounting and reporting standards for the impairment of long-lived assets and for long-lived assets to be disposed of, and is effective for us beginning in fiscal 2003. We do not expect the adoption of SFAS No. 143 or SFAS No. 144 to have a material impact on our financial position or results of operations.

Risk Factors

        You should carefully read the following risk factors.

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

        We face intense competition with local, regional, and national companies, including other drug store chains, independent drug stores, on-line retailers, supermarket chains and mass merchandisers. Many of our competitors have substantially greater resources, including name recognition and capital resources, than we do. As competition increases in the markets in which we operate, 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 at reduced prices to remain competitive. We cannot assure you that we will be able to continue to compete effectively in our markets or increase our sales volume or margins in response to further increased competition.

Our ability to successfully implement supply chain improvements and other strategic initiatives is critical to the ongoing success of our business.

        In February 2002, our board of directors approved a program to upgrade our supply chain practices in an effort to increase efficiency and enhance profitability, along with initiatives to increase front-end sales and pharmacy margins, enhance customer service and improve operational efficiencies. We expect to spend approximately $60 million in capital expenditures for supply chain improvements under this program over the next four fiscal years. The success of these initiatives is important to our future profitability. We cannot assure you that we will be able to execute these initiatives successfully.

Changes in third-party reimbursement levels for prescription drugs continue to reduce our margins on pharmacy sales and could have a material adverse effect on our overall performance.

        We are reimbursed by third-party health plans for approximately 90% of all the prescription drugs that we sell, and this percentage has continued to increase. Pharmacy sales to third parties have lower gross margins than non third-party pharmacy sales. Third-party health plans continue to reduce the levels at which they reimburse us for the prescription drugs that we provide to their members. Furthermore, if Medicare is reformed to include prescription benefits, Medicare may cover some of the prescription drugs that we now sell at retail prices, and we may be reimbursed at prices lower than our current retail prices. If third-party health plans continue to reduce their reimbursement levels, or if

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Medicare covers prescription drugs at reimbursement levels lower than our current retail prices, our margins on these sales will continue to be reduced, and our profitability will be adversely affected.

The transition from third-party distribution to self-distribution could result in increased costs.

        We terminated our agreement with our third-party distribution center operator in California during the second quarter of fiscal 2002. We incurred additional costs during the third and fourth quarters as we continued to transition the operation of the distribution centers, and these costs could continue to adversely affect net income in the near future.

A continued economic slowdown could adversely affect consumer-buying practices and reduce our sales of front-end products, which are our higher margin products.

        The economy began showing signs of slowing in fiscal 2002. The terrorist attacks on September 11, 2001 adversely affected sales for that week and have had a continuing negative impact on tourism. We operate 32 stores in the state of Hawaii, which have been adversely impacted by the decline in tourism. If the economy continues to slow and unemployment increases or inflationary conditions worry consumers, they may decrease their purchases, particularly of products other than pharmaceutical products that they need for health reasons. We make a higher profit on our sales of front-end products than we do on sales of pharmaceutical products. Therefore, any decrease in our sales of front-end products will decrease our profitability.

Our ability to attract and retain pharmacy personnel or develop alternate fill sources is important to the continued success or our business.

        Our industry is experiencing a shortage of licensed pharmacists in the markets in which we operate. Our inability to attract and retain pharmacists and other key personnel could adversely affect us. In response to the pharmacist shortage we recently entered into a joint venture agreement with AmerisourceBergen to operate a central prescription fill center. The success of this fill center is important to our ability to address the shortage of pharmacists.

We are substantially dependent on a single supplier of pharmaceutical products to sell products to us on satisfactory terms; a disruption in our relationship with this supplier could have a material adverse effect on our business.

        We obtain approximately 54% of our total merchandise, including 95% of our pharmaceutical supplies, from a single supplier, AmerisourceBergen, pursuant to a long-term supply contract. Any significant disruptions in our relationships with AmerisourceBergen could have a material adverse effect on us.

We are subject to governmental regulations, procedures and requirements; our noncompliance or their significant change could have a material adverse effect on us.

        Our pharmacy business is subject to numerous federal, state and local regulations. These include local registrations of pharmacies in the states where our pharmacies are located, applicable Medicare and Medicaid regulations, prohibitions against paid referrals of patients and protection of confidential patient medical records and information. Failure to properly adhere to these and other applicable regulations could result in the imposition of civil and criminal penalties. Furthermore, federal and state reform programs, such as healthcare reform initiatives, could adversely affect our pharmacies, and any new federal or state programs could also adversely affect us.

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Certain risks are inherent in providing pharmacy services, and 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. Although we maintain professional liability and errors and omissions liability insurance, we cannot assure you 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.

The energy crisis in the state of California may result in increased operating and administrative expenses in fiscal 2003.

        As of January 31, 2002, we operated 361 stores in the state of California, which has experienced energy shortages causing some power outages. California utility companies announced significant increases in energy rates, which were reflected in utility bills received beginning in the third quarter of fiscal 2002. These shortages may expand to other markets in which we operate. We have taken such steps as reducing store lighting, raising store temperatures and disconnecting unused electrical equipment to conserve energy, but the volatility of energy rates has resulted in increased operating and administrative expenses and our energy-related expenses may continue to increase in fiscal 2003.

Item 7a. Quantitative and Qualitative Disclosures of Market Risk

        Our major market risk exposure is changing interest rates. We use debt financing in combination with operating cash flows to support capital expenditures, acquisitions, working capital needs and general corporate purposes. A portion of our debt bears interest at LIBOR-based rates, and therefore an increase in interest rates could increase our interest expense. We do not undertake any specific actions to cover our exposure to interest rate risk and we are not a party to any interest rate risk management transactions. We have not purchased and do not hold any derivative financial instruments.

        A 10% change in interest rates (31 basis points on our floating-rate debt as of January 31, 2002) would have an immaterial effect on our earnings and cash flows and on the fair value of our fixed rate debt.

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Item 8. Financial Statements and Supplementary Data

STATEMENTS OF CONSOLIDATED INCOME

See notes to consolidated financial statements.

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CONSOLIDATED BALANCE SHEETS

See notes to consolidated financial statements.

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STATEMENTS OF CONSOLIDATED CASH FLOWS

See notes to consolidated financial statements.

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STATEMENTS OF CONSOLIDATED STOCKHOLDERS' EQUITY