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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

Commission file number 1-8978

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

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

There were 38,449,733 shares of common stock outstanding as of November 28, 2002.

Table of Contents

PART I—FINANCIAL INFORMATION

Item 1. Condensed Consolidated Financial Statements

Condensed Consolidated Statements of Income (unaudited)

See notes to condensed consolidated financial statements.

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Condensed Consolidated Balance Sheets

See notes to condensed consolidated financial statements.

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Condensed Consolidated Statements of Cash Flows (unaudited)

See notes to condensed consolidated financial statements.

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Condensed Consolidated Statements of Stockholders' Equity
For the 53 weeks ended January 31, 2002 and the 39 weeks ended October 31, 2002

See notes to condensed consolidated financial statements.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1.    Basis of Presentation

        The accompanying condensed consolidated financial statements include Longs Drug Stores Corporation ("Longs" or the "Company") and its wholly owned subsidiaries. All significant inter-company accounts and transactions have been eliminated. The condensed consolidated financial statements reflect all adjustments that are, in management's opinion, necessary for a fair statement of the results for the periods presented. These financial statements should be read in conjunction with the Annual Report of the Company on Form 10-K for the fiscal year ended January 31, 2002. The condensed consolidated financial statements as of and for the periods ended October 31, 2002 and October 25, 2001 are unaudited. The condensed consolidated balance sheet as of January 31, 2002, and condensed consolidated statement of stockholders' equity for the year then ended, presented herein, have been derived from the audited consolidated financial statements of the Company included in the Form 10-K for the fiscal year ended January 31, 2002. Certain reclassifications have been made to prior year financial statements to conform to the current presentation.

2.    Significant Accounting Policies

        Cash and equivalents include investments with original maturities of three months or less when purchased.

        Pharmacy and other receivables primarily include amounts due from third party providers (e.g., pharmacy benefit managers, insurance companies, governmental agencies and vendors) on the sale of prescription drugs. Receivables are stated net of an allowance for uncollectible accounts.

        Merchandise inventories are stated at the lower of cost or market value. Cost is determined using the last-in, first-out (LIFO) method. The excess of specific cost over LIFO values was $169.7 million at October 31, 2002, $160.4 million at October 25, 2001 and $165.3 million at January 31, 2002. LIFO costs for interim financial statements are estimated based on projected annual inflation rates. Actual LIFO costs are calculated during the fourth quarter of the fiscal year when final inflation rates and inventory levels are determined.

        Property is depreciated using the straight-line method with estimated useful lives of twenty to thirty-three years for buildings, the shorter of the life of the lease or estimated useful life for leasehold improvements and three to twenty years for equipment and fixtures. The Company capitalizes costs that relate to the application and infrastructure development stage of web site development. Such costs are included in equipment and fixtures and are amortized over seven years.

        Buildings and leasehold improvements include assets under capital leases of $7.6 million at October 31, 2002 and $4.4 million as of January 31, 2002. The corresponding capital lease obligation is included in long-term liabilities. The amount capitalized for assets under capital leases is the present value at the beginning of the lease term of the aggregate future minimum lease payments. The amortization of such assets is included in depreciation expense. Accumulated amortization on assets under capital leases was not significant as of October 31, 2002 or January 31, 2002.

        Repairs and maintenance costs are expensed as incurred. Costs for improvements that enhance the usefulness or extend the useful life of an asset are capitalized and depreciated over the asset's estimated useful life.

        Goodwill represents the excess of acquisition cost over the fair value of the net assets of acquired entities. Effective with the first quarter of fiscal 2003, goodwill is not amortized, but is subject to annual impairment testing (see "New Accounting Pronouncements").

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        Intangible assets consist primarily of purchased pharmacy customer lists, non-compete agreements and beverage licenses. Effective with the first quarter of fiscal 2003, intangible assets with indefinite useful lives are not amortized, but are subject to annual impairment testing (see "New Accounting Pronouncements"). Intangible assets with finite useful lives are amortized using the straight-line method over those useful lives.

        Other assets include joint venture investments accounted for under the equity method.

        Impairment of Long-Lived Assets—The Company reviews long-lived tangible and intangible assets for impairment whenever events or changes in circumstances indicate that their carrying values may not be recoverable. Using its best estimates based on reasonable and supportable assumptions and projections, the Company records 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.

        Store Closure Reserves—The Company records the estimated costs associated with closing a store in accordance with Emerging Issues Task Force Issue No. 94-3 ("Issue 94-3"). Issue 94-3 requires that such store closing costs be recorded in 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 direct costs to terminate a lease or sub-lease a property, net of expected sublease income, and the difference between the carrying values and estimated recoverable values of long-lived tangible and intangible assets. Severance and other employee-related costs are recorded in the period in which the closure and related severance packages are communicated to the affected employees. Losses on the liquidation of inventories are recorded in cost of merchandise sold when the inventories are sold or otherwise disposed of.

        Beginning January 1, 2003, the Company will recognize the costs associated with closing a store when the liability is incurred, in accordance with SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities (see "New Accounting Pronouncements").

        Fair Value of Financial Instruments—The carrying values of the Company's cash and equivalents, receivables and payables approximate their estimated fair values due to their short-term nature. To estimate the fair value of long-term debt, the Company uses those interest rates that are currently available to it for issuance of debt with similar terms and remaining maturities. As of October 31, 2002, the carrying value of the Company's long-term debt approximated its estimated fair value.

        Revenue Recognition—The Company recognizes revenue from the sale of merchandise, net of an allowance for estimated returns, at the time the merchandise is sold. The allowance for sales returns is estimated based on the Company's historical experience.

        The Company's pharmacy benefit management ("PBM") segment, operated through the Company's RxAmerica subsidiary, 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. Revenue from the PBM segment is recognized when RxAmerica has completed its service obligations under its contracts, including the approval or denial of the authorization request to the participating pharmacy. The Company does not recognize or otherwise reflect in its financial statements co-payments made to participating pharmacies by health plan members. RxAmerica does not take title to the prescription drug inventories or assume substantial risks and rewards of ownership. Therefore, revenues from third-party health plans are recognized net of the reimbursements due to participating pharmacies.

        Cost of merchandise sold includes the cost of inventory sold during the period (net of merchandise rebates and allowances), including in-bound freight, receiving, warehousing and certain purchasing and distribution costs.

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        Operating and administrative expenses include costs for store and administrative payroll and benefits, facilities and occupancy, advertising (net of advertising rebates and allowances), and other miscellaneous expenses.

        Vendor Rebates and Allowances—Merchandise rebates and allowances are originally recorded as a reduction of the cost of the related inventory purchased and then recognized as a reduction of cost of merchandise sold when the related inventory is sold. Advertising rebates and allowances are recognized as a reduction of advertising expense, a component of operating and administrative expenses, when the related advertising expense is incurred or the required performance is completed. Lump-sum payments received from vendors in connection with a contractual arrangement are deferred and recognized over the contract term. Such payments are recognized as a reduction of cost of merchandise sold or of advertising expense, depending on the nature of the contract.

        Advertising—Net advertising costs are expensed as incurred.

        New store opening costs, primarily labor, advertising and store supplies, are expensed as incurred.

        Deferred Rent—Rent expense is recorded on a straight-line basis over the lease term. When a lease provides for fixed escalations of the minimum rental payments, the difference between the straight-line rent charged to expense and the actual cash payments under the lease is recognized as deferred rent, which is included in other long-term liabilities.

        Income taxes—The Company accounts for its taxes in accordance with Statement of Financial Accounting Standards (SFAS) No. 109, which requires the use of the asset and liability method of accounting for deferred income taxes. Deferred income taxes are recorded based upon the differences between the financial statement and tax basis of assets and liabilities.

        Stock-based compensation—The Company accounts for employee stock-based compensation using the intrinsic value method in accordance with the provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees, as allowed by SFAS No. 123, Accounting for Stock-Based Compensation.

        Net income per share—Basic net income per share is computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted net income per share is computed by dividing net income by the weighted average number of common shares and dilutive common equivalent shares (restricted stock awards and stock options) outstanding during the period. The following is a reconciliation of the number of shares used in the Company's basic and diluted net income per share computations:

        The Company excluded 209,900 stock options from the calculation of diluted earnings per share in the 13 weeks ended October 31, 2002, and 69,967 stock options from the calculation of diluted earnings per share in the 39 weeks ended October 31, 2002, because their effect would have been anti-dilutive.

        Comprehensive income equals net income for all periods presented.

        New Accounting Pronouncements—In June 2001, the Financial Accounting Standards Board ("FASB") issued SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other

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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 for impairment annually, or more frequently if events and circumstances indicate there may be an impairment. The Company adopted SFAS No. 141 and SFAS No. 142 in the first quarter of fiscal 2003. The adoption of SFAS No. 141 did not have a material impact on the Company's financial position or results of operations. Upon adoption of SFAS No. 142, the Company discontinued the amortization of goodwill with a carrying value of $123.3 million as of January 31, 2002, and of certain other intangible assets with indefinite lives. Following is a reconciliation of reported earnings and earnings per share to the amounts adjusted for the exclusion of amortization of goodwill and other intangible assets with indefinite lives, net of the related income tax effects:

        As required by SFAS No. 142, the Company performed a transitional goodwill impairment test as of February 1, 2002, the date of adoption of the standard. Based on an independent valuation, the Company identified certain regional reporting units in its retail drug store segment that have experienced declines in their fair values below their net carrying values. Accordingly, the Company recognized a goodwill impairment charge of $41.0 million ($24.6 million or $0.65 per diluted share after tax) for these reporting units in the first quarter of fiscal 2003 as the cumulative effect of a change in accounting principle.

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        In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. SFAS No. 144 establishes accounting and reporting standards for the impairment of long-lived assets and for long-lived assets to be disposed of. The Company adopted SFAS No. 144 in the first quarter of fiscal 2003. The initial adoption of SFAS No. 144 did not have a material impact on the Company's financial position or results of operations.

        In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which addresses accounting for restructuring and similar costs. SFAS No. 146 supersedes previous accounting guidance, principally Issue 94-3. The Company will adopt the provisions of SFAS No. 146 for restructuring activities, if any, initiated after December 31, 2002. SFAS No. 146 requires that the liability for costs associated with an exit or disposal activity be recognized when the liability is incurred. Under Issue 94-3, a liability for an exit cost was recognized at the date of the Company's commitment to an exit plan. SFAS No. 146 also establishes that the liability should initially be measured and recorded at fair value. Accordingly, SFAS No. 146 may affect the timing of recognizing future restructuring costs, if any, as well as the amounts recognized.

3.    Segment Information

        The Company operates in two business segments, retail drug stores and pharmacy benefit management ("PBM"). These segments were identified based on their separate and distinct products and services, technology, marketing strategies and management reporting. Management evaluates the segments' operating performance separately and allocates resources based on their respective financial condition, results of operations and cash flows. Inter-segment transactions and balances are eliminated in consolidation.

        Pharmacy is the cornerstone of the retail drug store segment, 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. As of October 31, 2002, the retail drug store segment operated 447 stores in six western states under the names Longs, Longs Drugs, Longs Drug Stores and Longs Pharmacy.

        The PBM segment, operated through the Company's RxAmerica subsidiary, 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.

        Prior to the Company's September 2001 acquisition of 100% ownership in RxAmerica, the Company operated in one business segment, retail drug stores. RxAmerica was a joint venture between the Company and Albertson's Inc., and the Company accounted for its interest in the joint venture using the equity method of accounting. Therefore, PBM segment results for the 13-week and 39-week periods ended October 25, 2001 reflect RxAmerica's operations since the Company's acquisition of 100% ownership in the PBM in September 2001.

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        The following table summarizes significant financial information by segment as of and for the 13-week and 39-week periods ended October 31, 2002 and October 25, 2001:

(1)

Reflects RxAmerica's operations since the Company's acquisition of 100% ownership in the PBM in September 2001.

        Consolidated total sales include the following product and service types:

4.    Goodwill and Other Intangible Assets

        All of the Company's goodwill and other intangible assets are included in the retail drug store segment. As discussed in note 2, goodwill and other intangible assets with indefinite useful lives are not amortized, but are subject to annual impairment testing. Intangible assets with finite useful lives are

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amortized over those useful lives. The Company's intangible assets other than goodwill include the following:

        The net decreases in the gross carrying amounts and accumulated amortization of pharmacy customer lists and non-compete agreements were primarily due to the removal of fully amortized assets. The increase in the carrying value of beverage licenses was due to the acquisition of additional licenses. Acquisitions of pharmacy customer lists and non-compete agreements were not significant in the 39 weeks ended October 31, 2002.

        The changes in the carrying value of goodwill for the 39 weeks ended October 31, 2002 were as follows (in thousands):

        Amortization expense for intangible assets with finite useful lives was $64,000 and $212,000 for the 13-week and 39-week periods ended October 31, 2002, respectively. Estimated annual amortization expense on these intangibles for fiscal 2003 and each of the succeeding five fiscal years is as follows (in thousands):

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5.    Debt

        Long-term debt at October 31, 2002 and January 31, 2002 consisted of the following:

        The Company's 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. As of October 31, 2002, the Company was in compliance with the restrictions and limitations included in these provisions.

6.    Provision for Store Closures

        The Company closed 3 stores in the 39 weeks ended October 31, 2002 and 15 stores in the 39 weeks ended October 25, 2001. Costs incurred for closed stores and adjustments to the related reserves are summarized as follows:

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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

        This quarterly 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, promotional activities, prescription margins, margin improvement, cost reductions, changes in supply chain practices, inflation rates, workers compensation costs, 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: 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 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; our ability to obtain adequate insurance coverage; 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 quarterly report under "Risk Factors" and elsewhere or in any of our other SEC filings. We assume no obligation to update our forward-looking statements to reflect subsequent events or circumstances.

RESULTS OF OPERATIONS

Sales

        Sales increased 4.6% and 5.3% in the third quarter and first nine months of fiscal 2003 over the same periods in fiscal 2002. Same-store sales increased 2.7% during the quarter and 3.4% during the first nine months over the corresponding periods of fiscal 2002. The net increase in the number of stores accounted for 1.5% and 1.4% of total sales growth during the respective periods. Additionally,

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our September 2001 acquisition of full ownership of RxAmerica, our pharmacy benefit management (PBM) subsidiary, contributed 0.4% and 0.5% of total sales growth in the third quarter and first nine months of fiscal 2003. Prior to the acquisition, RxAmerica was a joint venture between Longs and Albertson's, Inc., and we accounted for our interest in the joint venture using the equity method of accounting.

        Pharmacy sales increased 6.1% and 7.4% in the third quarter and first nine months of fiscal 2003 over the same periods last year, with same-store pharmacy sales increasing 5.4% and 6.5%. Pharmacy sales were 45.4% and 45.2% of total drug store sales during the third quarter and first nine months of fiscal 2003, compared to 44.5% and 44.1% in the same periods of fiscal 2002. Our pharmacy sales continue to grow as a result of favorable industry trends, including an aging U.S. population and the increased usage of newer and more expensive prescription drugs. These trends have been partially offset by the recent introduction of several lower-priced generic drugs, which negatively impacted same-store pharmacy sales by approximately 2.4% (240 basis points) in the third quarter and 1.5% (150 basis points) in the first nine months of fiscal 2003. Despite the increased generic utilization rates, overall average pharmaceutical prices have continued to rise. In the third quarter and first nine months of fiscal 2003, the average retail price per prescription increased 7.9% and 7.6% over the comparable periods in fiscal 2002. We expect these trends to continue.

        The percentage of pharmacy sales wholly or partially reimbursed by third-party health plans continues to increase as a result of growing participation in managed care and other third-party plans. Third-party sales represented 90.9% of total pharmacy sales during the third quarter and first nine months of fiscal 2003, compared to 88.9% and 89.1% in the same periods last year. We expect this trend to continue.

        Front-end sales increased 2.7% and 2.8% in the third quarter and first nine months of fiscal 2003 over the same periods last year, with same-store front-end sales increasing 0.5% and 1.0%. These increases were primarily due to increased promotional sales resulting from a refocused and event-driven advertising and marketing campaign, which partially offset the effects of sluggish economic growth in our primary markets. We expect that our promotional sales will continue to increase in the fourth quarter of fiscal 2003 in light of continued softness in the economy and promotional activities by our competitors. We will continue to make decisions about our promotional activities based on competitive and economic conditions.

Gross Profit

        The increase in gross margin as a percent of sales was partially due to the inclusion of RxAmerica's gross profit in our consolidated total. We recognize RxAmerica's revenues from third-party health plans net of the related reimbursements due to participating pharmacies. We do not record any of RxAmerica's expenses in cost of merchandise sold. Therefore, all of RxAmerica's revenues ($6.0 million and $16.4 million in the third quarter and first nine months of fiscal 2003) are included in gross profit. Prior to our acquisition of 100% ownership in RxAmerica in September 2001, it was a joint venture between Longs and Albertson's, Inc., and we recorded our share of its profits in operating and administrative expenses using the equity method of accounting. Excluding RxAmerica, our gross margin percentage was 26.1% and 25.8% in the third quarter and first nine months of fiscal 2003, compared to 25.1% and 25.5% in the comparable periods of fiscal 2002.

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        The increased usage of generic drugs, which have higher gross margins than name-brand drugs, helped offset a multiyear trend of declining pharmacy margin percentages experienced throughout the retail drug store industry. This decline reflects the increasing percentage of pharmacy sales reimbursed by third-party health plans, which have lower margins than non third-party 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. We anticipate that the percentage of pharmacy sales reimbursed by third-party health plans will continue to increase, resulting in further pressure on pharmacy margins. Pharmacy sales also have lower margins than front-end sales, and as pharmacy sales continue to grow as a percent of total sales, overall margins will be adversely impacted. However, despite decreases in pharmacy margins, pharmacy gross profit in dollars continues to increase with the growth in sales.

        In the first quarter of fiscal 2003, we commenced a series of initiatives to increase efficiency and enhance profitability. One of those initiatives is an upgrade of our supply chain practices. Improvements in our supply chain, including more efficient distribution center operations and more favorable merchandise buying terms, combined with better category pricing, helped offset the negative front-end margin impact of increased promotional sales.

        The LIFO provision, which is included in cost of merchandise sold, fluctuates with inflation rates and inventory levels and mix. We estimate LIFO costs for interim financial statements based on projected annual inflation rates. We calculate actual LIFO costs during the fourth quarter of the fiscal year when we determine final inflation rates and inventory levels. The decreases in the LIFO provision in the third quarter and first nine months of fiscal 2003 from the same periods of fiscal 2002 reflect lower projected inflation rates.

Operating and Administrative Expenses

        Operating and administrative expenses were 24.0% and 22.9% of sales in the third quarter and first nine months of fiscal 2003, compared to 22.6% and 22.0% in the same periods of fiscal 2002. Several factors contributed to these increases. We included RxAmerica's operating and administrative expenses of approximately $3.2 million and $9.3 million, or 0.3% of sales, in our consolidated totals for the third quarter and first nine months of fiscal 2003. Prior to our acquisition of 100% ownership of RxAmerica in September 2001, it was a joint venture between Longs and Albertson's, Inc., and we recorded our share of its profits in operating and administrative expenses using the equity method of accounting. Such equity-method profits were not material to us.

        Workers compensation expenses increased $3.7 million, or 0.3% of sales, and $6.4 million, or 0.2% of sales, in the third quarter and first nine months of fiscal 2003 over the comparable periods of fiscal 2002. The increase was a result of a revaluation of our reserves for outstanding claims to reflect regulatory changes in our principal markets. We expect that rising medical costs and changes in the regulatory environment will continue to drive workers compensation claim costs higher in the near future.

        We incurred operating and administrative expenses of $3.1 million and $8.7 million, or 0.3% of sales, in the third quarter and first nine months of fiscal 2003 related to the supply chain initiative discussed above. We expect that we will continue to incur operating and administrative expenses related to the supply chain initiative for the next several fiscal years. However, we believe that the initiative's benefits, including improved gross margins and greater operating efficiencies, will offset those expenses and result in higher operating profits.

        Costs for certain consulting projects, employee terminations and new hire activities caused operating and administrative expenses to increase by approximately 0.3% of sales in the third quarter and 0.1% of sales in the first nine months of fiscal 2003 over fiscal 2002.

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        Finally, as previously noted, the increased usage of lower-priced generic drugs had a negative impact on our sales. This in turn resulted in higher operating and administrative expenses when measured as a percent of sales, but increased gross margins.

Depreciation and Amortization

        Depreciation and amortization were $19.6 million and $57.7 million in the third quarter and first nine months of fiscal 2003, compared to $18.7 million and $56.2 million in the same periods of fiscal 2002. Effective with the first quarter of fiscal 2003, we no longer record amortization expense for goodwill and certain other intangible assets with indefinite useful lives, in accordance with SFAS No. 142, Goodwill and Other Intangible Assets. Amortization for these assets was $1.6 million and $5.0 million in the third quarter and first nine months of fiscal 2002. Excluding discontinued amortization, depreciation and amortization increased by $2.5 million and $6.5 million in the third quarter and first nine months of fiscal 2003, primarily due to increased depreciation expense resulting from capital expenditures for new store investments, improvements to existing stores, supply chain improvements and technology.

Provision for Store Closures and Asset Impairment

        We regularly evaluate our store closure reserves and adjust them accordingly based on the estimated future costs to complete the store closures. In the first quarter of fiscal 2002 we recorded a benefit of $1.0 million from the reduction of our store closure reserve. We closed 3 stores in the first nine months of fiscal 2003 and 15 stores in the first nine months of fiscal 2002.

Legal Settlements and Other Disputes

        In the second quarter of fiscal 2003, we recorded a net charge of $0.5 million for the settlement of certain legal matters. These matters, a brand name lawsuit and a class action lawsuit involving the employment classification of certain employees, were settled in fiscal 2001 and 2002. As final payments were made during the second quarter of fiscal 2003, we incurred additional costs over those previously estimated.

Net Interest Expense

        Net interest expense was $3.3 million and $9.4 million in the 13-week and 39-week periods ended October 31, 2002, compared to $3.4 million and $10.7 million in the comparable periods last year. The decrease was primarily due to lower interest rates.

Income Taxes

        Our effective income tax rate was 26.5% and 36.6% in the 13-week and 39-week periods ended October 31, 2002, compared to 40.0% and 39.8% in the comparable periods last year. The decrease was primarily due to a federal tax law change enacted in fiscal 2002 that allows us to deduct dividends paid on 100% vested shares held in our employee stock ownership plan, and the benefits of additional tax credits. We expect our effective income tax rate to be approximately 36.6% for the fiscal year ending January 30, 2003.

Cumulative Effect of Accounting Change

        As a result of adopting SFAS No. 142, Goodwill and Other Intangible Assets, we recognized a goodwill impairment charge of $41.0 million ($24.6 million or $0.65 per diluted share after tax) in the first quarter of fiscal 2003 as the cumulative effect of a change in accounting principle (see "New Accounting Pronouncements" below).

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LIQUIDITY AND CAPITAL RESOURCES