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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 29, 2004

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:

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

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

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

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

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 July 31, 2003 was approximately $703,597,000.

There were 37,395,394 shares of common stock outstanding as of April 1, 2004.

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 2004 Annual Meeting of Stockholders.

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CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

This annual report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Such statements relate to, among other things, pharmacy and front-end sales and gross profits, cost reductions, depreciation and amortization, changes in supply chain practices, workers’ compensation costs, income tax rates, liquidity and cash requirements, working capital reductions, the number of store openings, closures and remodels, the level of capital expenditures and contractual commitments, and are indicated by words or phrases such as “continuing,” “expects,” “estimates,” “believes,” “plans,” “anticipates,” “will” and other similar words or phrases.

These forward-looking 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 forward-looking statements we make. These risks and uncertainties include, but are not limited to, those set forth below:

In addition, because we lack a perpetual inventory system, our ability to accurately forecast and track our gross profits and inventory levels during periods between our quarterly physical inventories is reduced. Therefore, our actual gross profits and inventory levels may vary materially from the gross profits and inventory levels included in or contemplated by forward-looking statements we make.

We assume no obligation to update our forward-looking statements to reflect subsequent events or circumstances.

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PART I

Item 1. Business

Overview

Longs Drug Stores Corporation was founded in 1938 in Oakland, California by two bothers, Tom and Joe Long. Today, 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 Note 11, “Segment Information” in the accompanying notes to our consolidated financial statements. We operate on a 52/53-week fiscal year ending on the last Thursday in January. Our 2004 fiscal year contained 52 weeks of operations and ended on January 29, 2004.

Through our retail drug store segment, we are one of the most recognized retail drug store chains on the West Coast of the United States and in Hawaii, with 470 stores in California, Colorado, Hawaii, Nevada, Washington and Oregon and one mail order pharmacy as of January 29, 2004. Our retail drug stores have a long history of serving the health and well-being needs of customers through customer-oriented pharmacy services and convenient product offerings that include over-the-counter medications, health and beauty products, cosmetics, photo and photo processing, food and beverage items and greeting cards.

Our PBM segment provides a range of services, including plan design and implementation, formulary management and claims administration to third-party health plans and other organizations.

Our corporate offices are located at 141 North Civic Drive, Walnut Creek, California 94596, telephone (925) 937-1170. Our common stock is listed on the New York Stock Exchange under the stock symbol “LDG.” General information, financial news releases and filings with the Securities and Exchange Commission, including annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to these reports are available free of charge on our website at www.longs.com as soon as reasonably practicable after we file them with the Securities and Exchange Commission.

Recent developments

In February 2002, our board of directors approved a program to significantly upgrade our supply chain systems and processes along with initiatives to increase front-end sales, improve pharmacy profitability, enhance customer service and improve operational efficiencies. Through January 29, 2004, we have invested approximately $29 million of capital expenditures for the supply chain program, largely related to technology systems changes. We have implemented a new distribution management system in our front-end distribution center serving our Northern California stores and have undergone preliminary testing of a new price and cost file maintenance system for our stores. We have also laid the groundwork for later stages of the project, which include the rollout of these new systems and processes at our remaining stores and distribution centers, the implementation of a perpetual inventory system and improved purchasing systems that will facilitate merchandise replenishments and improve our real-time visibility into inventories and gross profits. We expect, over the next two years, to invest an additional $34 million in capital and incur significant operating and administrative expenses as we complete this project.

In October 2002, our board of directors elected Warren F. Bryant President and Chief Executive Officer. In August 2003, the board of directors elected Mr. Bryant as Chairman of the Board in addition to his duties as President and Chief Executive Officer. He succeeded Robert M. Long, Chairman of the Board since 1991, who will remain on the board of directors as its Chairman Emeritus.

In February 2003, we announced a series of actions designed to reduce operating and administrative expenses. These actions, which were taken over the course of fiscal 2004, included a reduction of our

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administrative workforce by approximately 170 people in our California offices, the closure of certain support facilities, store labor savings through workflow and staffing changes and a restructuring of our incentive compensation arrangements.

In March 2003, our board of directors authorized the repurchase of up to 2,000,000 shares of our common stock through January 2008, for a maximum total expenditure of $50 million. Through the end of fiscal 2004, we have repurchased 509,100 shares under this authorization at a total cost of $8.0 million.

In July 2003, we announced a voluntary separation program for our store managers. This program offered financial incentives based on years of service and base salary, as well as company-paid health insurance benefits and outplacement services. A total of 69 store managers opted to participate in the program. The employee termination and related costs of this program totaled approximately $3.7 million.

Strategic Initiatives

In February 2002, our board of directors approved five enterprise-wide strategic initiatives focused on improving our overall performance. These initiatives are as follows:

Products and Services

The following table summarizes our product and service types, as a percentage of our total consolidated sales:

Our retail drug stores sell prescription drugs and a wide assortment of high-quality, nationally advertised brand name and private label general merchandise, which we refer to as “front-end” products. Our core front-end categories include over-the-counter medications, health and beauty products, cosmetics, photo and photo

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processing, convenience food and beverage items and greeting cards. In addition, we sell merchandise in non-core front-end categories such as gifts, seasonal items and sporting goods. We are known for offering merchandise and assortments that reflect the local tastes and preferences of individual markets, and as a result, we have gained significant name recognition and brand loyalty from our customers. To enhance customer service and build customer loyalty, we seek to consistently maintain in-stock positions in all of our merchandise categories. We will continue to develop our mix of front-end merchandise in our stores in response to the changing needs and preferences of our customers. In addition, we offer educational information to our customers about their health and well-being concerns through the Live Healthy section of our website, www.longs.com, as well as through new Learning Centers in some of our stores. We also provide influenza vaccinations and offer a variety of health screening services in many of our stores, such as blood, glucose, osteoporosis, stroke and cholesterol testing.

Our RxAmerica subsidiary provides comprehensive PBM services nationwide including prescription benefit plan design and implementation, formulary management, claims administration and account management to third party health plans and other organizations. We have designed our PBM services to help lower prescription benefit costs for plan providers while improving healthcare access, service and treatment for covered members. We manage prescription benefit plans covering more than 4.5 million lives with a network of pharmacies in all 50 states and Puerto Rico.

Purchasing and Distribution

We are in the process of centralizing our merchandise procurement and replenishment. Previously, store managers had significant control over their product mix and purchased from numerous manufacturers and distributors under a decentralized organizational structure. As we upgrade our supply chain to achieve greater efficiencies and economies of scale, we have begun to transition to a more centralized purchasing and replenishment structure for most of our merchandise. In addition, we have established more stringent parameters for merchandise purchased by store managers in order to preserve our ability to respond to the local preferences and needs of our customers while improving our profitability.

We distribute centrally procured merchandise to our stores through our distribution centers in California and Hawaii, while merchandise purchased by our store managers is delivered directly to our stores by our vendors. As we shift to a more centralized purchasing approach, we have substantially increased the volume of merchandise received, stored and delivered through our distribution centers. Store deliveries from our distribution centers take place primarily through a leased fleet and contract drivers.

Advertising

We advertise primarily through promotional advertisements and circulars in major daily newspapers and advertisements on radio and television. We centrally manage the majority of our advertising efforts. Our approach is to regionalize our advertising and use the most efficient media mix within a geographic area. We use rebates and allowances received from vendors to fund a significant portion of our total advertising spending.

Technology

All of our stores utilize pharmacy systems to facilitate filling prescriptions, analyze drug interactions and adjudicate third-party claims, which allows our pharmacists to fill prescriptions accurately and efficiently with reduced risk of adverse drug interaction. We route some of the prescriptions that we receive to our automated central prescription fill centers, which provide increased productivity and reduced prescription fill costs. We have also installed advanced pill-dispensing robotics in many of our pharmacies. The fill centers and robotic technology enable our pharmacists to spend more time with customers while maintaining high quality customer service standards.

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Our stores utilize computer-assisted ordering and replenishment systems for certain goods that track sales and merchandise on hand and plan orders as necessary. During fiscal 2004, we upgraded all of our stores’ point-of-sale systems to increase the speed of customer check-out and improve our ability to handle a high volume of transactions. We also installed digital photo technology systems in over 85% of our stores in response to our customers’ continued migration to digital technology.

We are making extensive systems changes as part of our efforts to upgrade our supply chain. We have implemented a new distribution management system in our front-end distribution center serving our Northern California stores and have undergone preliminary testing of a new price and cost file maintenance system for our stores. We also have laid the groundwork for later stages of the project, which include the rollout of these systems at our remaining stores and distribution centers, the implementation of a perpetual inventory system and improved purchasing systems that will facilitate merchandise replenishments and improve our real-time visibility into inventories and gross profits.

In an effort to upgrade our technology, we have begun to phase out and replace older and inefficient pharmacy and other information systems, including a targeted marketing database that was originally developed as a component of our e-retail strategy, an inefficient pharmacy processing system used in our stores and other information technology assets.

Mail Order

In April 2003, we added mail-order prescription services through our acquisition of American Diversified Pharmacies, Inc. (ADP). With this acquisition, we gained entry into one of the fastest growing distribution channels for prescription drugs in the United States. Our mail order capabilities complement our in-store pharmacies as well as our PBM service offerings.

Internet

Through our website, www.longs.com, our customers can access our company information and extensive health and welfare information, refill prescriptions and purchase certain over-the-counter medications 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 convenience.

Trademarks

We hold various trademarks, trade names (including, but not limited to, Longs, Longs Drugs, Longs Pharmacy, 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 29, 2004, we had approximately 22,900 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 are licensed by the appropriate state boards of pharmacy. Our distribution centers are also registered with the Federal Drug Enforcement Administration. Applicable licensing and registration requirements necessitate our compliance with various state statutes, rules and regulations.

In recent years, an increasing number of legislative proposals have been introduced and passed in Congress and in some state legislatures that could result in major changes in health care coverage, delivery and

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reimbursement, both nationally and at the state level. For example, recently Congress passed the Medicare Prescription Drug Improvement and Modernization Act of 2003, which includes new prescription drug benefits for Medicare participants.

Also, in recent years, both federal and state authorities have proposed or passed new legislation that imposes on healthcare providers, including pharmacies, significant additional obligations concerning the protection of confidential patient medical records and information. The Health Insurance Portability and Accountability Act, or HIPAA, imposes certain requirements, including the protection of confidential patient medical records and other information. Compliance with these regulations, particularly HIPAA, requires that we implement complex changes to our systems and processes.

As a publicly traded corporation, we are subject to numerous federal securities laws and regulations, including the Securities Act of 1933 and the Securities Exchange Act of 1934 and related rules and regulations promulgated by the SEC. These laws and regulations impose significant requirements in the areas of accounting and financial reporting, corporate governance and insider trading, among others.

Competition

The retail drug store industry is highly competitive. We compete with local, regional and national companies, including other drug store chains, independent drug stores, supermarket chains, discount retailers, on-line retailers, mail order pharmacies, and mass merchandisers. We compete on the basis of price, merchandise quality, product mix, convenience and customer service. We believe continued consolidation of the drug store industry and continued new store openings will further increase competitive pressures in the industry.

In the PBM industry, our competitors include large regional and national PBMs, some of which are owned by our competitors in the retail drug store industry. We compete on the basis of our ability to facilitate the reduction of prescription drug costs for our customers through plan design and implementation as well as the quality and scope of the services we offer.

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 10% or more of our total sales. We do not believe that the loss of any one customer or group of customers under common control would have a material effect on our business.

We obtain approximately half of our total merchandise, including over 90% of our pharmaceuticals, from a single supplier, AmerisourceBergen Corporation, with whom we have a long-term supply contract. Any significant disruptions in our relationship with AmerisourceBergen Corporation could have a material adverse effect on us.

Our stores, mail order pharmacy, distribution centers and corporate offices are located in the western United States, with the majority of our stores in California. Risks prevalent in this region include, but are not limited to, the adverse economic effects of a state budget crisis, legislative or other governmental actions reducing prescription reimbursement payments to us or increasing our liability with respect to workers’ compensation, major earthquakes, periodic energy shortages and rising energy costs, and shipping and other transportation-related disruptions. Because of our geographic concentration, these risks could result in significant disruptions to our business or increased operating expenses.

Seasonality

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

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Item 2. Properties

Stores

We also remodeled 20 stores during fiscal 2004, and we plan to remodel up to 40 additional stores in fiscal 2005.

Our stores are located in the following states:

Our stores vary in size, with the majority ranging from 15,000 to 30,000 square feet. Our stores average approximately 23,000 square feet in size, of which approximately 16,000 square feet is devoted to selling space. The average age of our stores is 14 years with 33% of our stores opened within the last five years. The average size of the stores we opened in fiscal 2004 is approximately 16,000 square feet. We lease 274 of our stores from third parties. Of the remaining stores, 142 are company-owned buildings on company-owned land, and 54 are company-owned buildings on leased land.

Distribution Centers

We operate the following distribution centers:

We often lease supplemental warehouse space as needed, especially during our high-volume seasonal periods.

Other Properties

We have two principal company-owned corporate office facilities in California, with a total of 142,000 square feet, and we lease an additional 72,000 square feet of office space, also in California. We also lease a 26,000 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.

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Item 3. Legal Proceedings

On February 17, 2004 and March 23, 2004, two purported class action lawsuits entitled Darien Goddard, et al v. Longs Drug Stores Corporation, et al and David Robotnick v. Longs Drug Stores California, Inc. were filed in the Superior Court of California, Alameda County and the Superior Court of California, Los Angeles County, respectively. The lawsuits were filed by plaintiffs who are current or former store managers or assistant managers on behalf of themselves and other similarly situated California store managers and assistant store managers. The lawsuits allege that we improperly classified such employees as exempt under California’s wage and hour and unfair business practice laws and seek damages, penalties under California’s wage and hour laws, restitution, reclassification and attorneys’ fees and costs. We are vigorously investigating and defending this litigation. Because the cases are in the very early stages, the financial impact to us, if any, cannot be predicted.

In addition to the lawsuits described above, 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 arising in the normal course of business 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 Security Holders

There were no matters submitted to a vote of stockholders during the fourth quarter of fiscal 2004.

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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 Wells Fargo Shareowner Services, P.O. Box 64854, St. Paul, MN 55164-0854. There were approximately 2,762 stockholders of record as of April 1, 2004.

Quarterly high and low closing stock prices, based on the New York Stock Exchange composite transactions, are shown below:

Quarterly dividends per share are summarized as follows:

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Item 6. Selected Financial Data

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

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our consolidated financial statements and the related notes. This discussion contains forward-looking statements based upon our current expectations that involve risks and uncertainties, such as our plans, objectives, expectations and intentions, as set forth under “Cautionary Statement Regarding Forward-Looking Statements.” Our actual results and the timing of events could differ materially from those anticipated in these forward-looking statements as a result of many factors, including, but not limited to, those set forth in the following discussion and under “Risk Factors” and elsewhere in this Form 10-K.

OVERVIEW

Fiscal 2004 brought continued change, with new challenges and opportunities for Longs. The economy continues to be sluggish and unemployment remains high, particularly in California, our primary market. A budget crisis and the recall of the state’s governor have fueled an environment of political and economic uncertainty in the state of California. Additionally, the competitive landscape is changing in many of the markets in which we do business. Other large retail drug store chains and mass merchandisers are expanding in our markets, and we are facing increased competition from non-traditional channels such as the Internet and mail-order pharmacies.

In this economic environment, we are undertaking significant organizational and operational changes. These changes affect our store operations, merchandising and marketing strategies, information technology systems, compensation arrangements, and senior management organizational structure and responsibilities. In a difficult and uncertain economy, and a highly competitive market, we believe these changes are necessary to become a stronger competitor and build a foundation for profitable long-term growth.

In February 2002, our board of directors approved five strategic initiatives for our company, as follows:

We have also undertaken numerous other initiatives and programs to support these five broad strategic initiatives:

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We expect continued economic sluggishness and intense competitive activity in our markets in fiscal 2005. We also expect legislative actions in the state of California surrounding Medi-Cal and workers’ compensation prescription reimbursement rates and workers’ compensation insurance reform—all at levels that are difficult to predict. We plan to continue to make significant changes to our operations under our five strategic initiatives in an effort to strengthen our competitive position while improving our profitability and long-term growth prospects.

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RESULTS OF OPERATIONS

Sales

Fiscal 2004 versus Fiscal 2003

Sales increased 2.3% in fiscal 2004 over fiscal 2003. Growth in the number of stores accounted for a 2.4% increase in total sales, offset by a 0.2% decrease in same-store sales. Growth in revenues at RxAmerica, our pharmacy benefit management, or PBM subsidiary, contributed the remaining 0.1% of total sales growth.

On October 11, 2003, union workers initiated a strike against three major grocery chains in Southern California, resulting in increased sales in some of our Southern California stores. We estimate that the strike increased our fiscal 2004 same-store sales by 0.8 to 1.0 percentage points, resulting in an estimated earnings increase of $0.03 to $0.04 per diluted share.

Pharmacy sales increased 6.4% in fiscal 2004 over fiscal 2003, with same-store pharmacy sales increasing 3.5%. Pharmacy sales were 46.3% of total retail drug store sales in fiscal 2004, compared to 44.4% in fiscal 2003. We expect pharmacy sales to continue to increase as a percentage of total retail drug store sales as pharmacy sales continue to increase faster than front-end sales. We expect our pharmacy sales to continue to increase as a result of favorable industry trends, such as an aging U.S. population consuming a greater number of prescription drugs, the increased usage of newer and more expensive drugs and increasing consumer awareness of the introduction of new drugs due to pharmaceutical manufacturers’ direct-to-consumer marketing efforts.

The increase in same-store pharmacy sales was primarily driven by a 5.3% increase in the average retail price per prescription over fiscal 2003. We expect that average retail prices for prescription drugs will continue to rise due to the continued introduction and usage of newer and more expensive drugs. This has been offset in part by the increased utilization of low-priced, high-volume generic drugs.

Same-store prescription volumes in fiscal 2004 were down 1.8% from last year. The conversion of the allergy drug Claritin from prescription to over-the-counter status in December 2002 negatively impacted prescription volumes. This effect on comparable period volumes ended in the fourth quarter of fiscal 2004 after we reached the anniversary of Claritin’s conversion from prescription status. Health concerns over hormone replacement therapy drugs as well as continued sluggish economic growth also had a negative impact on prescription volumes.

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Third-party health plans covered 91.2% of our pharmacy sales in fiscal 2004, compared to 90.7% last year. We expect third-party sales to remain at or near 90% of our total pharmacy sales for the foreseeable future due to significant consumer participation in managed care and other third-party plans.

Front-end sales decreased 1.2% in fiscal 2004 from last year, with same-store front-end sales decreasing 3.2%. Several factors contributed to the decline in our front-end sales:

We are taking several actions as part of our initiatives to increase our front-end sales in a difficult economic environment and highly competitive market. These actions include the following:

Fiscal 2003 versus Fiscal 2002

Sales increased 2.8% in fiscal 2003 over fiscal 2002. Fiscal 2003 included 52 weeks of operations compared to 53 weeks in fiscal 2002, resulting in a negative impact of 1.8 percentage points on sales growth in fiscal 2003 compared to 2002. Same-store sales, on a comparative 52-week basis, increased 2.8%, and new stores accounted for an increase of 1.4%. Our September 2001 acquisition of full ownership of RxAmerica contributed the remaining 0.4% of total sales growth in 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.

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Pharmacy sales increased 4.6% in fiscal 2003, with same-store pharmacy sales increasing 5.8%. Pharmacy sales were 44.4% of total drug store sales in fiscal 2003, compared to 43.5% in fiscal 2002. Our pharmacy sales increased as a result of favorable industry trends, including an aging U.S. population and the increased usage of newer and more expensive prescription drugs.

Sluggish economic growth and increased competition resulted in a 1.6% decrease in our same-store prescriptions in fiscal 2003. However, the average retail price per prescription increased 7.4%. Increased utilization of lower-priced, high-volume generic drugs negatively impacted same-store pharmacy sales by approximately 1.8% in fiscal 2003.

Front-end sales increased 0.8% in fiscal 2003, with same-store front-end sales increasing 0.5%. The increase in same-store front-end sales in fiscal 2003 was primarily due to increased promotional sales resulting from a refocused and event-driven advertising and marketing campaign. Front-end sales were adversely affected by sluggish economic growth in our primary markets, particularly in California, and increased competition from mass merchants, national drug store chains and supermarkets. We also experienced a weak holiday shopping season and a mild cold and flu season that resulted in lower over-the-counter drug sales.

Gross Profit

Fiscal 2004 versus Fiscal 2003

Gross profit was 25.3% of sales in fiscal 2004, compared to 25.7% in fiscal 2003. Several factors contributed to the decline in our gross profit percentage:

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More disciplined purchasing and economies of scale resulting from our progress in centralizing procurement, advertising and promotional activities as part of our initiative to upgrade our supply chain practices partially offset the decline in our gross profit.

Our gross profit included LIFO provisions, which are included in cost of sales, of $1.4 million in fiscal 2004 and $6.2 million in fiscal 2003. The decrease in the LIFO provision, which had a positive impact on our gross profit as a percentage of sales, is primarily due to lower overall net inflation on our front-end merchandise costs during the year. The LIFO provision fluctuates with inflation rates, inventory levels and merchandise mix.

In the first quarter of fiscal 2004, we began classifying advertising expenses as a component of cost of sales. Previously, we classified advertising expense as a component of operating and administrative expenses. We reclassified results for fiscal 2003 to conform to this new presentation, resulting in a $21.9 million increase in cost of sales and an offsetting decrease in previously reported operating and administrative expenses, with no effect on reported net income.

In addition to the acquisition cost of inventory sold (net of merchandise rebates and allowances), we include in-bound freight, receiving, warehousing, purchasing and distribution costs, and advertising expenses (net of advertising rebates and allowances) in our cost of sales. Our gross profit percentages may not be comparable to those of some other retailers who include distribution and advertising costs in their operating expenses.

Fiscal 2003 versus Fiscal 2002

Gross profit was 25.7% of sales in fiscal 2003, compared to 25.1% in fiscal 2002. Almost half of the increase was attributable to the inclusion of RxAmerica’s gross profit in our consolidated total. We recognize in our consolidated sales 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 sales. Therefore, all of RxAmerica’s net revenues ($23.3 million in fiscal 2003 and $7.9 million in fiscal 2002) are included in gross profit. 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. The increased usage of generic drugs, which have higher gross profit percentages than name-brand drugs, also favorably affected our gross profit percentage. Pricing pressure from third-party health plans and increased promotional sales adversely affected our gross profits in fiscal 2003, and partially offset these favorable effects.

Gross profit in fiscal 2003 included a LIFO provision of $6.2 million, compared to $9.6 million in fiscal 2002, included in cost of sales. The LIFO provision fluctuates with inflation rates, inventory levels and merchandise mix. The decrease in the LIFO provision in fiscal 2003, which had a positive impact on our gross profit as a percent of sales, was primarily due to lower inflation rates in our front-end categories.

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Operating and Administrative Expenses

Fiscal 2004 versus Fiscal 2003

Operating and administrative expenses were 22.1% of sales in fiscal 2004, compared to 22.4% in fiscal 2003. A decrease in labor costs and related benefit costs reduced our operating and administrative expense rate by 0.7% of sales. This decrease was the result of a series of steps we took during the fiscal year to improve our productivity and reduce our costs. These steps included a reduction of our administrative workforce by approximately 170 people in our California offices, the closure of certain support facilities, store labor savings through workflow and staffing changes, modifications to many of our incentive compensation arrangements and the voluntary separation program for store managers announced in July 2003. These actions resulted in lower operating and administrative expenses as a percentage of sales compared to fiscal 2003 beginning in the second half of fiscal 2004, and we expect this trend to continue in the first half of fiscal 2005. Operating and administrative expenses for fiscal 2004 also benefited from net gains of $3 million (0.1% of sales) on the disposition of properties.

In connection with the reduction of our administrative workforce, closure of facilities and the voluntary separation program for store managers we recorded charges totaling $7.1 million, or 0.2% of sales, in operating and administrative expenses for employee termination, facility closure and other related costs.

Workers’ compensation and other insurance-related expenses increased $12.8 million, or 0.3% of sales, in fiscal 2004 over fiscal 2003. We are self-insured for a substantial portion of our workers’ compensation and general liability costs. The increase in our insurance-related expenses during fiscal 2004 included a $5.5 million net increase in our self-insurance reserves based on a third-party actuarial study of our self-insured programs and reserves, particularly workers’ compensation, in the fourth quarter. Insurance costs across industries have increased significantly over the last two years as a result of rising health care costs, legislative and regulatory changes, economic conditions and terrorism. The California State Legislature is currently considering changes to the state’s workers’ compensation laws in an effort to reduce costs, and we cannot predict the outcome of such deliberations. However, we are continuing to develop our existing workplace safety practices in an effort to partially mitigate this increase in costs over time by reducing the number of work related injuries.

Fiscal 2003 versus Fiscal 2002

Operating and administrative expenses were 22.4% of sales in fiscal 2003, compared to 21.2% in fiscal 2002. Several factors contributed to the increase. We included RxAmerica’s operating and administrative expenses of approximately $12.8 million, or 0.3% of sales, in our consolidated totals for all 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. These equity-method profits were not material to us.

We incurred operating and administrative expenses of $11.8 million, or 0.3% of sales, in fiscal 2003 related to the supply chain initiative, which began in February 2002. Workers’ compensation expenses increased $9.8 million, or 0.2% of sales, in fiscal 2003. The increase was a result of a revaluation of our reserves for outstanding claims to reflect regulatory changes in our principal markets and lower interest rates used to discount our liability.

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

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increased gross profit margins. We estimate that the higher generic utilization resulted in an increase of approximately 0.2% in operating expenses as a percent of sales.

Other elements of the increase in operating and administrative expenses include costs for certain consulting projects relating to strategic, operational and tax initiatives, employee terminations and increased debit and credit card processing fees.

Depreciation and Amortization

Depreciation and amortization expenses were $83.6 million in fiscal 2004, compared to $77.7 million in fiscal 2003. The increase of $5.9 million was primarily due to accelerated depreciation of $5.2 million in the first six months of fiscal 2004 arising from the abandonment of a pharmacy processing system.

Depreciation and amortization expenses were $77.7 million in fiscal 2003 compared to $78.2 million in 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 $6.8 million in fiscal 2002. Excluding discontinued amortization, depreciation and amortization increased by $6.3 million in fiscal 2003 over fiscal 2002, primarily due to increased depreciation expense resulting from capital expenditures for new store investments, improvements to existing stores, supply chain improvements and technology.

Provision (Benefit) for Store Closures and Asset Impairments

The provision (benefit) for store closures and asset impairments is summarized as follows:

Store Closures

The following is a summary of the provision (benefit) for store closures and related reserves, which are included in long-term liabilities:

We periodically review store operating results and projections and make decisions to close stores in the normal course of business. We recognize costs associated with store closures when the related liabilities are

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incurred. In fiscal 2004, we closed 3 stores and recorded a provision for the present value of noncancellable lease payments, net of estimated future sublease income, of $1.4 million. In addition, we recorded a provision of $2.2 million related to changes in our assumptions about estimated future sublease income for previously closed stores.

In fiscal 2003, we closed 6 stores and recorded a provision of $0.6 million related to changes in our assumptions about estimated future sublease income for previously closed stores.

In fiscal 2002, we closed 18 stores, 14 of which were closed pursuant to a store closure plan approved by our board of directors in January 2001 (“2001 Closure Plan”). We also recorded a provision in fiscal 2002 for employee termination costs of $1.0 million related to the stores included in the 2001 Closure Plan. Based on the results of store closure activities in fiscal 2002 and resulting changes in assumptions about estimated future costs, net of estimated future sublease income, we recorded a benefit of $3.5 million for the reduction of the reserve for store closures in fiscal 2002.

Our calculation of store closure costs includes significant estimates about the amounts and timing of future sublease income. These estimates are based on our historical experience, the condition and location of the properties, the lease terms and current real estate leasing market conditions. Many of our previously closed stores have long remaining lease terms, with the longest lease term ending January 2026. As a result, changes in these assumptions can significantly impact our store closure reserves.

Asset Impairments

In each of the last three fiscal years, we have identified certain underperforming stores with assets whose carrying values exceeded their related undiscounted expected future cash flows. Accordingly, in fiscal 2004, we recorded impairment charges of $1.3 million to write down such assets to their estimated fair values. Also during fiscal 2004, we recorded a provision of $1.5 million for asset impairments related to the write-off of abandoned information technology assets as well as impairments of $1.1 million related to the long-lived assets of the stores we closed during the year.

In fiscal 2003, we recorded $5.0 million of impairment charges for underperforming stores to write down the related assets to their estimated fair values. Also in fiscal 2003, we abandoned a targeted marketing database that was originally developed as a component of our e-retail strategy and recorded an impairment charge of $5.2 million to write off the remaining net book value of this database.

In fiscal 2002, we recorded impairment charges for underperforming stores of $0.8 million to write down the related assets to their estimated fair values.

Legal Settlements and Other Disputes

In fiscal 2004, we recorded a combined benefit of $7.0 million related to settlements of a lease-related dispute with one of our landlords and a contract dispute with a former service provider. In fiscal 2003, we recorded a net charge of $0.5 million for the settlement of certain legal matters. The fiscal 2003 matters were settled in earlier fiscal years, and as final payments were made during fiscal 2003, we incurred additional costs over those previously estimated. 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.

Net Interest Expense

Net interest expense was $13.4 million in fiscal 2004, compared to $13.0 million in fiscal 2003 and $14.0 million in fiscal 2002. The increase from fiscal 2003 to fiscal 2004 was due to higher average borrowings, partially offset by increased interest capitalization on current construction and systems projects. The decrease from fiscal 2002 to fiscal 2003 was due to lower average borrowings and interest rates.

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Income Taxes

Our effective income tax rates were 35.3%, 29.8% and 37.3% in fiscal 2004, 2003 and 2002. The lower tax rate in fiscal 2003 was primarily due to the benefits of wage and other tax credits, which reduced our effective income tax rate by 5.85 percentage points. We expect that our effective income tax rate will be approximately 37.6% in fiscal 2005.

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 after tax or $0.64 per diluted share) in fiscal 2003 as the cumulative effect of a change in accounting principle.

LIQUIDITY AND CAPITAL RESOURCES

General

Our primary sources of liquidity are operating cash flows and borrowings on our line of credit. We use cash to provide working capital for our operations, finance capital expenditures and acquisitions, repay debt, pay dividends and repurchase shares of our common stock.

We have an unsecured revolving line of credit with a syndication of banks, which expires in October 2004 and accrues interest at LIBOR-based rates. During the second quarter of fiscal 2004, we exercised an option to increase the borrowing capacity of this credit facility, resulting in a $45 million increase in our total borrowing and letter-of-credit capacity from $150 million to $195 million. Borrowings on the line of credit do not require repayment until the October 2004 expiration date. As of January 29, 2004, borrowings of $50 million were outstanding under this line of credit with a weighted average interest rate of 2.86%. We also had $24.8 million in letters of credit outstanding under the line of credit as of January 29, 2004. We have classified all borrowings under the line of credit as current liabilities as of January 29, 2004 because of the October 2004 expiration date. However, we intend to renew or replace the line of credit prior to its expiration.

Additionally, as of January 29, 2004 we had $156.4 million in outstanding unsecured privately placed promissory notes. These notes mature at various dates through 2014 and bear interest at fixed rates ranging from 5.85% to 7.85%. The notes include penalties for repayment prior to their scheduled maturities. Included in the current maturities of long-term debt as of January 29, 2004 are $41.9 million of regularly scheduled principal payments, the majority of which are due in the fourth quarter of fiscal 2005. It is likely that we will refinance all or a portion of the current maturities of the private placement notes.

Our debt agreements contain limits on borrowings and repurchases of company stock, and various quarterly financial covenants that set maximum leverage ratios and minimum fixed charge and asset coverage ratios. During the first quarter of fiscal 2004, we amended our unsecured revolving line of credit agreement to revise certain financial covenants and limitations and increase our maximum allowable repurchases of company stock. As of January 29, 2004, we were in compliance with the restrictions and limitations included in these provisions. Failure to comply with all of our debt covenants could adversely affect our ability to manage our cash requirements, as well as result in higher interest costs and potentially accelerated repayment requirements.

We believe that cash on hand, together with cash provided by operating activities and borrowings on our line of credit or replacement facilities, will be sufficient to meet our working capital, capital expenditure and debt service requirements beyond the next 12 months.

Operating Cash Flows

Net cash provided by operating activities was $122.1 million in fiscal 2004, compared to $43.2 million in fiscal 2003 and $202.2 million in fiscal 2002. The change in our operating cash flows was primarily due to

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changes in working capital (defined as current assets less current liabilities). Net changes in assets and liabilities negatively affected our operating cash flows by $7.2 million in fiscal 2004, compared to $83.8 million in fiscal 2003. The net difference of $76.6 million accounted for most of the increase in our operating cash flows in fiscal 2004 versus fiscal 2003. In fiscal 2002, net changes in assets and liabilities positively affected our operating cash flows by $56.2 million.

During fiscal 2004, pharmacy and other receivables increased $28.3 million from the end of fiscal 2003. The increase was primarily due to increased amounts owed to us from vendors as a result of changes in some of our contractual purchase arrangements, the timing of payments from customers in our PBM segment and increased pharmacy receivables arising from higher sales. During fiscal 2003, receivables increased $12.6 million from the end of fiscal 2002, primarily due to increased pharmacy receivables arising from higher sales, as well as changes in payment terms for certain of our PBM customers. The $2.9 million decrease in receivables during fiscal 2002 was primarily due to store closures during the year.

During fiscal 2004, inventories increased $33.7 million from the end of fiscal 2003, primarily due to higher inventory levels in our distribution centers as a result of our efforts to remain in-stock during the grocery strike in Southern California and the system conversion in our Northern California facility, in addition to increasing the amount of merchandise we carry in our distribution centers. The $37.1 million increase in inventory levels during fiscal 2003 was primarily the result of lower than anticipated sell-through of inventory during the third and fourth quarters of the year. The $18.0 million decrease in inventories during fiscal 2002 was primarily due to store closures during the year.

During fiscal 2004, current and other liabilities, excluding the current portion of long-term debt, increased $54.7 million from fiscal 2003. The increase was primarily due to a $25.8 million increase in accounts payable and accrued expenses resulting from higher inventory levels and improved payment terms with many of our vendors; a $17.2 million increase in employee compensation and benefits primarily related to increased workers’ compensation reserves during the year; and a $10.4 million increase in taxes payable due to increased current taxes due, and the effect of income tax credits in fiscal 2003 which had the effect of lowering taxes payable last year. The decrease in current and other liabilities during fiscal 2003 was primarily due to a reduction in accounts payable and accrued expenses of $29.7 million. During fiscal 2003, we resolved a payment dispute with a vendor, resulting in payment of amounts early in the fiscal year that were in outstanding payables as of the end of fiscal 2002. We also accelerated the timing of our payments to certain vendors during fiscal 2003. In addition, taxes payable were lower in fiscal 2003 due to tax credits. The increase in current and other liabilities in fiscal 2002 was a result of higher payables due to a payment dispute with a vendor, offset by decreases in reserves as stores were closed during the year.

Working capital was $173.6 million as of January 29, 2004, $242.6 million as of January 30, 2003 and $236.7 million as of January 31, 2002. As of January 29, 2004, current liabilities included $91.9 million for the current maturities of long-term debt ($50 million on our unsecured revolving line of credit, which expires in October 2004, and $41.9 million of principal payments due during fiscal 2005 on our private placement notes). Excluding debt, our working capital on a per store basis increased to $565 thousand in fiscal 2004 from $538 thousand in fiscal 2003, primarily as a result of higher inventories and receivables, partially offset by increased current liabilities.

We plan to reduce our working capital, excluding debt, by approximately $50 million on an equivalent-store basis during fiscal 2005. Changes in equivalent-store working capital serve as a measure of our working capital management, excluding the effects of changes in the number of stores. We calculate the change in equivalent-store working capital by multiplying the change in average working capital per store by the number of stores open as of the end of the current period. We exclude the current maturities of long-term debt from our calculation of equivalent-store working capital because we intend to renew or replace the line of credit prior to its October 2004 expiration date and refinance all or a portion of the current maturities of the private placement notes.

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Closed stores will continue to impact future operating cash flows negatively as we make payments associated with our noncancelable lease obligations associated with those stores. However, those payments will be partially, and in some cases fully, offset by sublease rental income and the elimination of the operating cash flow losses that were incurred by the closed stores prior to closure. The majority of the payments associated with closed stores will occur over their respective remaining lease terms of up to 21 years, with an average lease term of approximately 12 years. As a result, we do not expect our existing closed store obligations to affect our operating cash flows significantly in any single fiscal year unless we close a significant number of stores in a short period. Our store closure reserves were $9.5 million as of January 29, 2004.

Investing Cash Flows

Net cash used in investing activities was $104.3 million in fiscal 2004, compared to $87.2 million in fiscal 2003 and $94.6 million in fiscal 2002. Investing activities primarily consist of capital expenditures for new stores, store remodels and improvements, equipment, technology and supply chain improvements, partially offset by cash receipts from property dispositions and sale-leaseback transactions. Fiscal 2002 investing cash outflows also included $5.8 million for the acquisition of the remaining 50% of RxAmerica, net of cash acquired. Prior to our acquisition of 100% ownership of RxAmerica in September 2001, it was a joint venture between Longs and Albertson’s, Inc.

Capital expenditures were $114.0 million in fiscal 2004, compared to $93.9 million in fiscal 2003 and $111.4 million in fiscal 2002. The increase from fiscal 2003 to fiscal 2004 was due primarily to investments in store pharmacy robotics and digital photography technologies. Our capital expenditures also included investments in new stores, store remodels and improvements, equipment, technology and supply chain upgrades.

Cash receipts from property dispositions were $9.7 million in fiscal 2004, $6.8 million in fiscal 2003 and $22.6 million in fiscal 2002. In fiscal 2004, we sold two previously closed store properties as well as one of our support facilities that we closed in the first half of the year. Fiscal 2002 receipts included $15.2 million associated with five sale-leaseback transactions. We may enter into additional sale-leaseback transactions in the future to provide funding for a portion of our capital expenditures. We also may sell additional properties, particularly if we close stores on our company-owned properties.

We opened 18 new stores in fiscal 2004, 22 new stores in fiscal 2003 and 24 new stores in fiscal 2002. We also remodeled 20 stores during fiscal 2004. We plan to open approximately 5 to 10 new stores and to remodel up to 40 existing stores in fiscal 2005. We expect net capital expenditures in fiscal 2005 to be between $105 million and $115 million, primarily for new store investments, remodels and improvements to existing stores, technology and supply chain improvements, including expenditures under the supply chain program discussed further below. In addition, in the ordinary course of business we may acquire stores, store-related assets including pharmacy customer lists, or other complementary businesses.

In February 2002, our board of directors approved a program to upgrade our supply chain systems and processes. Over the term of this program (February 2002 through expected completion in fiscal 2006), we expect to invest approximately $63.0 million in capital expenditures for supply chain improvements, largely related to systems changes. Since inception of the program, we have invested approximately $29.0 million in capital expenditures.

Financing Cash Flows

Net cash used in financing activities was $17.8 million in fiscal 2004, compared to $39.1 million in fiscal 2003 and $29.2 million in fiscal 2002. Our financing activities primarily consist of long-term borrowings and repayments, repurchases of common stock and dividend payments.

In fiscal 2004, borrowings under our unsecured revolving line of credit were $25.0 million. We used these borrowings, together with cash flows from operations, to finance capital expenditures, stock repurchases and

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dividend payments. We also repaid $2.3 million of long-term borrowings, consisting of regularly scheduled principal payments on our private placement notes. In fiscal 2003, we repaid $17.6 million of long-term borrowings, including $15.0 million under our revolving line of credit and $2.1 million of regularly scheduled principal payments on our private placement notes. In fiscal 2002, we obtained $50 million in additional privately placed debt financing, offset by $58 million in repayments of long-term and short-term borrowings.

In February and March 2003, we repurchased 853,100 shares of our common stock at a total cost of $12.0 million to complete a share repurchase program authorized by our board of directors in November 1999. In March 2003, our board of directors authorized the repurchase of up to 2,000,000 additional shares of our common stock through January 2008, for a maximum total expenditure of $50 million. We repurchased 509,100 shares under the new authorization in March 2003 at a total cost of $8.0 million. Any future repurchase of our common stock will depend on existing market conditions, our financial position, and other capital requirements.

Our board of directors makes decisions about the declaration of quarterly dividends based on, among other things, our results of operations and financial position. We have paid regular quarterly dividends of $0.14 per share ($0.56 per share annually) for each of the last three fiscal years. Total dividends were $21.0 million in fiscal 2004, $21.4 million in fiscal 2003 and $21.2 million in fiscal 2002.

Contractual Obligations

The following table summarizes our contractual obligations as of January 29, 2004:

See “Debt,” “Leases” and “Commitments and Contingencies” in the accompanying notes to our consolidated financial statements for further information about the above items.

Purchase obligations primarily represent outstanding commitments to purchase pharmaceutical inventories from AmerisourceBergen Corporation under a long-term supply contract for use in the normal course of business. Purchase obligations also include merchandise purchase commitments under other long-term supply contracts, as well as outstanding commitments under purchase orders issued in the normal course of business.

Our other long-term liabilities of $50.7 million as of January 29, 2004 consisted of $20.6 million of deferred rent, $10.7 million of capital lease obligations, $9.9 million of deferred tax liabilities and $9.5 million of store closure reserves. These items either are not of a contractual nature, such as deferred rent and deferred income taxes, or are included elsewhere in the above table, such as capital and closed store lease obligations.

In addition to the above obligations, we incur substantial cash requirements for the payment of interest and income taxes each year. Payments for interest fluctuate based on our borrowings and interest rates. Our cash payments for interest were $13.8 million in fiscal 2004, $13.7 million in fiscal 2003 and $14.8 million in fiscal 2002. Most of our outstanding debt ($156.4 million as of January 29, 2004) bears interest at fixed rates. Borrowings on our unsecured revolving line of credit ($50 million as of January 29, 2004) bear interest at LIBOR-based rates. A substantial portion of our outstanding debt obligations ($91.9 million), including of all the

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$50 million borrowed under our unsecured revolving line of credit, matures in fiscal 2005. We intend to renew or replace the line of credit prior to its expiration. The amount of borrowings and interest rates on the replacement facility will affect the amount of interest we incur in the future.

Our cash payments for income taxes were $8.8 million in fiscal 2004, $26.5 million in fiscal 2003 and $19.9 million in fiscal 2002. Payments for income taxes fluctuate based on our taxable income and the availability of tax deductions and credits.

We also incur obligations for contributions to our Employee Savings and Profit Sharing Plan. We match a portion of our employees’ voluntary contributions and provide profit sharing contributions to the plan in some years. Our contributions to the plan, which may be made in cash or in shares of our common stock, fluctuate based on the level of participation in the plan by our employees as well as our levels of income. We contributed $7.3 million in fiscal 2004, $8.0 million in fiscal 2003 and $9.4 million in fiscal 2002 to this plan, all of which we funded with shares of our common stock.

OFF-BALANCE SHEET ARRANGEMENTS

We do not make use of any off-balance sheet arrangements that currently have or that we expect are reasonably likely to have a material effect on our financial condition, results of operations or cash flows. We utilize operating leases for many of our store locations, and from time to time we engage in sale-leaseback arrangements for financing purposes. We do not use special-purpose entities in any of our leasing arrangements.

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, disclosure of contingent assets and liabilities and the reported amounts of revenues and expenses during the reporting period. Uncertainties regarding such estimates and assumptions are inherent in the preparation of our financial statements, and actual results may differ from those estimates and assumptions. We believe the following critical accounting policies require the most significant judgments and estimates used in the preparation of our consolidated financial statements:

Accounts Receivable and Reserves

Our receivables primarily include amounts due from third party providers (e.g., pharmacy benefit managers, insurance companies and governmental agencies), vendors and our pharmacy benefit management customers. We maintain an allowance for the amount of these receivables that we estimate to be uncollectible. Our estimates of uncollectible amounts are based on our historical collection experience, current economic and credit conditions and any information available to us indicating that specific accounts are unlikely to be collected. We have historically collected a relatively high percentage of our accounts receivable, especially pharmacy receivables, and our credit and collection losses have not materially adversely affected us. However, if the financial condition of our third party providers, vendors or PBM customers deteriorates, we may increase the allowance for uncollectible accounts and our recovery of recorded receivables may be significantly affected.

Merchandise Inventories

We record our inventories at the lower of cost or market value. If we do not sell the merchandise at expected prices or if we make decisions to significantly reduce or eliminate merchandise items or categories, we may increase the allowance for markdowns and our realization of recorded inventories may be significantly affected.

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We use the last-in, first-out (LIFO) method to determine inventory cost. The calculation of LIFO inventory costs depends on a number of factors, including inflation rates, inventory levels and merchandise mix, that require estimates during interim periods. These estimates are subject to substantial variability and may result in significant adjustments, particularly during the fourth quarter, when final inflation rates and inventory levels and mix are determined.

Impairment of Long-Lived Assets

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

We review goodwill and other intangible assets with indefinite useful lives for impairment annually, or more frequently if events or changes in circumstances warrant. We perform our annual impairment testing during the fourth fiscal quarter, when updated financial projections are available. If the carrying values of such assets exceed their estimated fair values, we record an impairment loss to write the assets down to their estimated fair values.

We generally evaluate store-specific long-lived tangible assets and intangible assets with finite useful lives at an individual store level, which is the lowest level at which independent cash flows can be identified. We evaluate corporate assets or other long-lived assets that are not store-specific at a consolidated entity or segment level as appropriate. We evaluate goodwill at a reporting unit level in accordance with SFAS No. 142, Goodwill and Other Intangible Assets. Geographic regional divisions within the retail drug store segment comprise our reporting units.

Since quoted market prices are not typically available for our long-lived tangible and intangible assets, we estimate fair values for most assets based on the expected present value of future cash flows. We estimate future cash flows based on store-level historical results, current trends and operating and cash flow projections. Our estimates are subject to substantial uncertainty and may be affected by a number of factors outside of our control, including general economic conditions, the competitive environment and regulatory changes. If actual results differ from our estimates, we may record significant additional impairment charges in the future. We recorded impairment charges of $3.9 million in fiscal 2004, $10.2 million in fiscal 2003 and $0.8 million in fiscal 2002.

In fiscal 2004, we recorded $1.5 million of system technology assets we abandoned and $5.2 million of accelerated depreciation on a pharmacy system platform that we no longer use. In fiscal 2003, we recorded $5.2 million related to the impairment of system technology assets that we abandoned. We have made substantial investments in technology assets; should their utility not manifest as expected we could incur substantial impairment charges or accelerated depreciation.

Store Closure Reserves

Prior to January 1, 2003, we recorded the estimated costs associated with closing a store during the period in which the store was identified and approved by management under a plan of termination, which included the method of disposition and the expected date of completion. These costs include direct costs to terminate a lease, lease rental payments net of expected sublease income, and the difference between the carrying values and estimated recoverable values of long-lived tangible and intangible assets. We recorded severance and other employee-related costs in the period in which we communicated the closure and related severance packages to the affected employees.

Effective with the adoption of SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, on January 1, 2003, we recognize a liability for costs associated with closing a store when the liability

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is incurred. We record the present value of expected future lease costs, net of estimated sublease future income, when the store is closed. We record severance and other employee-related costs in the period in which we communicate the closure and related severance packages to the affected employees.

Our calculation of store closure costs includes significant estimates about the amounts and timing of future sublease income. These estimates are based on our historical experience, the condition and location of the property, the lease terms and current real estate leasing market conditions. If actual results differ from our estimates, we may significantly adjust our store closure reserves in future periods. We recorded provisions for store closures of $3.5 million in fiscal 2004 and $0.6 million in fiscal 2003, and a benefit of $2.5 million in fiscal 2002.

In addition, periodically we make judgments about which stores we should close and which stores we should continue to operate. During fiscal 2004, we took a series of actions to improve the operating performance of 25 underperforming stores and of stores opened during the last three years. We closed one of these stores during the year, and have presently decided to continue operating the remainder, while continuing to closely monitor their operating performance. If we decide to close a number of these stores, we could incur substantial additional store closure costs.

Insurance Reserves

We maintain insurance coverage for significant exposures as well as those risks required to be insured by law. It is generally our policy to retain a significant portion of certain losses related to workers’ compensation, general liability, property losses, pharmacist liability, business interruptions and employee health care. We record provisions for these items based on claims experience, regulatory changes, an estimate of claims incurred but not yet reported and other relevant factors. We discount reserves for workers’ compensation and general liability claims to their expected present value using an essentially risk-free interest rate. The projections involved in this estimate are subject to substantial uncertainty because of several unpredictable factors, including actual claims experience, regulatory changes, litigation trends and changes in inflation and interest rates. Our workers’ compensation and other insurance-related expenses increased $12.8 million, or 0.3% of sales, in fiscal 2004.

Our self-insurance exposure is concentrated in California, where the majority of our stores are located. California has experienced significant increases in workers’ compensation costs as a result of legislative changes and rising medical costs. The California State Legislature is currently considering changes to the state’s workers’ compensation laws in an effort to reduce costs, and we cannot predict the outcome of such deliberations. Increases in workers’ compensation costs have adversely affected our results of operations and may continue to adversely affect us in the future.

If claims are greater than we estimated, or if costs increase beyond what we anticipated, our recorded reserves may not be sufficient, and we may need to record significant additional expense.

Revenue Recognition

We recognize revenue from the sale of merchandise and services, net of an allowance for estimated returns, at the time the merchandise is sold or services performed. The allowance for sales returns is estimated based on our historical experience. Historically, our sales returns have not been significant, but changes in our experience could result in significant additional reserves.

We recognize revenue from our PBM segment when our RxAmerica subsidiary has completed its service obligations under its contracts, including the approval or denial of the authorization request to the participating pharmacy. RxAmerica does not take title to prescription drug inventories or assume substantial risks and rewards of inventory ownership or receivable collection. Accordingly, under our existing contracts we recognize PBM revenues from third-party health plans net of the reimbursements due to participating pharmacies. We do not

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recognize or otherwise reflect in our financial statements co-payments made to participating pharmacies by health plan members. We estimate certain rebate revenues in our PBM segment based on our historical experience, contractual terms and prescription drug utilization mix. These estimates are subject to uncertainty and actual results could differ significantly.

Vendor Rebates and Allowances

We record merchandise rebates and allowances as a reduction of cost of sales when we sell the related inventory. We recognize advertising rebates and allowances as a reduction of advertising expense, a component of cost of sales, when we incur the related advertising expense or complete the required performance. We defer lump-sum payments received from vendors in connection with a contractual arrangement and recognize them over the contract term as a reduction of cost of sales. Some of our contractual arrangements require estimates of the rebate amounts earned and collectible. If actual rebates and allowances received differ from our estimates, we may be required to record significant adjustments to our rebates and allowances.

Other Significant Accounting Policies

The above policies are not intended to be a comprehensive list of all of our accounting policies. In many cases, generally accepted accounting principles specifically dictate the accounting treatment for a particular transaction. There are also certain areas in which management’s judgment in selecting any available alternative would not produce a materially different result. See the accompanying audited consolidated financial statements and notes thereto for a more complete discussion of our accounting policies and other disclosures required by generally accepted accounting principles.

NEW ACCOUNTING PRONOUNCEMENTS

See Note 1, “The Company and Significant Accounting Policies,” in the accompanying notes to our consolidated financial statements included in Item 8 of this Form 10-K.

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RISK FACTORS

You should carefully read the following risk factors.

Our ability to successfully implement significant organizational changes, including new supply chain systems and processes, is critical to the ongoing success of our business.

We are currently undertaking significant organizational changes, including store workflow and staffing changes, increased centralization, restructured incentive compensation arrangements and other strategic initiatives. In addition, in February 2002 our board of directors approved a program to upgrade our supply chain, primarily through technology systems changes, in an effort to increase efficiency and enhance profitability. Such organizational and technology systems changes are complex and could cause disruptions that would adversely affect our sales, gross profit and operating and administrative expenses. For example, the implementation of new distribution management software in one of our front-end distribution centers caused some disruption in our supply chain, which adversely affected our front-end sales and gross profit during the second half of fiscal 2004. Our ability to successfully implement these organizational, systems and process changes, which are significant to our operations and business, is critical to our future profitability. We cannot assure you that we will be able to execute these changes successfully and without significant disruption to our business. If we are not successful, we may not achieve any of the expected benefits from these initiatives, despite having expended significant capital and human effort. Furthermore, we may encounter difficulties implementing this amount of change in our organization that could have a negative impact on our implementation plans and project budgets. We may also determine that additional investment is required to bring our supply chain and related systems to their desired state; this could result in significant additional investment of time and money and implementation risk.

Continued economic softness could continue to adversely affect consumer-buying practices and reduce our sales and profitability.

A sluggish economy has adversely affected our sales and operating profitability for the past two fiscal years. The economy is very soft in many of the markets we serve, particularly California, where unemployment is high and a state budget crisis has created a climate of political uncertainty. If the economy remains soft or slows further, or if unemployment increases, our pharmacy sales could be adversely affected as consumers may lose their health insurance due to unemployment. Further, if economic conditions, war, terrorism or other global concerns continue to worry consumers, they may continue to decrease their purchases, particularly of products other than pharmaceutical products. We make a higher profit on our sales of front-end products than we do on sales of pharmaceutical products. Therefore, any continued decrease in our sales of front-end products would decrease our profitability.

The retail drug store and pharmacy benefit management industries 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, mail order pharmacies, on-line retailers, supermarket chains and mass merchandisers. In the PBM industry, our competitors include large national and regional PBMs, some of which are owned by our retail drug store competitors. 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 could require us to reduce prices, purchase more effectively and increase customer service 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.

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 wholly or partially reimbursed by third-party health plans for approximately 90% of all the prescription drugs that we sell. Pharmacy sales reimbursed by third parties, including Medicare and Medicaid

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plans, 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, the Medicare Prescription Drug Improvement and Modernization Act of 2003 included new prescription drug benefits for Medicare participants. Also, the proposed California state budget includes a proposed 10% across-the-board reduction in Medi-Cal reimbursements to pharmacies effective July 1, 2004. If the State of California implements these or similar reductions in reimbursement levels, our sales and gross profits could be significantly adversely affected. If third-party health plans continue to reduce their reimbursement levels, or if 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 significant investments we are making in our stores may not increase our sales and profitability, which could adversely affect our results of operations, financial condition and cash flows.

We are currently making significant investments in our stores in an effort to increase our sales and profitability. These investments include the installation of new digital photo equipment, technology, and remodels and other improvements to some existing stores. These investments require significant capital expenditures and human effort and are largely unprecedented at our company. We are uncertain about consumer reaction to these changes and therefore we cannot assure you that they will result in increased sales and profitability. A failure to increase our sales and profitability would adversely affect our results of operations, financial condition and cash flows.

Continued volatility in insurance related expenses and the markets for insurance coverage could have a material adverse affect on us.

The costs of most types of insurance, especially workers’ compensation, employee benefits, director and officer and others have continued to rise, while the amount and availability of coverage have decreased. Claims costs for workers’ compensation and other self-insured exposures have also increased. In fiscal 2004, for example, our insurance-related expenses increased $12.8 million, or 0.3% of sales, over fiscal 2003. These conditions have been exacerbated by rising health care costs, legislative changes, economic conditions and terrorism. If our insurance-related costs continue to increase significantly, or if we are unable to obtain adequate levels of insurance, our financial position and results of operations could be adversely affected.

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 half of our total merchandise, including over 90% of our pharmaceuticals, from a single supplier, AmerisourceBergen, with whom we have a long-term supply contract. Any significant disruptions in our relationship with AmerisourceBergen, or deterioration in AmerisourceBergen’s financial condition, could have a material adverse effect on us. Recent news reports indicate that federal regulatory and law enforcement agencies are investigating certain of AmerisourceBergen’s business practices. If these or other investigations result in significant sanctions or penalties against AmerisourceBergen, or in significant changes to their business practices, they could have an adverse impact on our relationship with AmerisourceBergen and thereby adversely affect our business.

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

Our industry is continuing to experience 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 order to mitigate this risk we entered into a joint venture agreement with AmerisourceBergen to operate a central prescription fill center. The success of this fill center, which cannot be assured, is important to our ability to

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address the shortage of pharmacists, but additional efforts may be necessary to address this business issue. Other options may be costly or unavailable to us. Further, a significant disruption in our fill center’s operations could worsen the effects of the pharmacist shortage and adversely affect our business.

We are subject to governmental regulations, procedures and requirements. Our noncompliance with, or a significant change in, these regulations could have a material adverse effect on us.

Our pharmacy and PBM businesses are subject to numerous federal, state and local regulations, many of which are new and developing. These include, but are not limited to, local registrations of pharmacies in the states where our pharmacies are located and applicable Medicare and Medicaid regulations. In addition, the Health Insurance Portability and Accountability Act, or HIPAA imposes certain requirements regarding the protection of confidential patient medical records and other information. Compliance with these regulations, particularly HIPAA, requires that we implement complex changes to our systems and processes. Failure to adhere to these and other applicable regulations could result in the imposition of civil and criminal penalties. Furthermore, any new federal or state regulations or reforms, including healthcare reform initiatives or pharmacy benefit management regulation, could adversely affect us.

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

Pharmacies are exposed to risks inherent in the packaging and distribution of pharmaceuticals and other healthcare products and are significantly dependent upon suppliers to provide safe, government-approved and non-counterfeit products. Although we maintain professional liability and errors and omissions liability insurance, should a product liability issue arise, we cannot assure you that the coverage limits under our insurance programs will be adequate to protect us against future claims, that we will be able to maintain this insurance on acceptable terms in the future or that the damage to our reputation in the event of a product liability issue will not have a material adverse effect on our business.

Our geographic concentration in the western United States presents certain risks that could adversely affect us.

Our stores, distribution centers and corporate offices are located in the western United States. Risks prevalent in this region include, but are not limited to, major earthquakes, periodic energy shortages and rising energy costs, and shipping and other transportation-related disruptions. Because of our geographic concentration, these risks could result in significant disruptions to our business or increased operating expenses.

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, dividend payments, share repurchases and other general corporate purposes. A portion of our debt ($50 million at January 29, 2004) bears interest at LIBOR-based rates, and therefore an increase in interest rates could increase our interest expense. We do not currently undertake any specific actions to cover our exposure to interest rate risk and we are not currently a party to any interest rate risk management transactions. We have not purchased and do not currently hold any derivative financial instruments. Depending on the interest rate environment and subject to approval by our board of directors, we may make use of derivative financial instruments or other interest rate management vehicles in the future.

A 10% change in interest rates (29 basis points on our floating-rate debt as of January 29, 2004) 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

LONGS DRUG STORES CORPORATION

STATEMENTS OF CONSOLIDATED INCOME