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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 27, 2005

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.    x

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 the registrant’s common stock held by non-affiliates of the registrant as computed by the reported last sale price of the registrant’s common stock on the New York Stock Exchange at the close of business on July 29, 2004 was approximately $761,879,000.

There were 37,487,201 shares of common stock outstanding as of February 24, 2005.

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 2005 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; changes in supply chain practices; workers’ compensation costs; liquidity and cash requirements; working capital reductions; the number of store openings, closures and remodels; the level of capital expenditures; contractual commitments; third-party sales as a percentage of total pharmacy sales; and our effective tax rate 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 limited. 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 brothers, 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 2005 fiscal year contained 52 weeks of operations and ended on January 27, 2005.

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 472 stores in California, Colorado, Hawaii, Nevada, Washington and Oregon and one mail order pharmacy as of January 27, 2005. 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, claims administration and formulary management 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. We submitted our 2004 annual Section 12(a) CEO certification with the New York Stock Exchange (“NYSE”). The certification was not qualified in any respect. Additionally, we filed with the Securities and Exchange Commission as exhibits to our Form 10-K for the year ended January 29, 2004 the CEO and CFO certifications required under Section 302 of the Sarbanes-Oxley Act of 2002.

Initiatives

We are currently undertaking a series of initiatives designed to help us respond to the changing needs of our customers while improving our productivity and profitability. These initiatives fall into the following five broad categories:

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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 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 processing, convenience food and beverage items and greeting cards. In addition, we sell merchandise in non-core front-end categories such as housewares, automotive and sporting goods. 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. We also 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 approximately 5.2 million lives with a network of pharmacies in all 50 states as well as Puerto Rico and the Virgin Islands.

Purchasing and Distribution

We are in the process of centralizing our merchandise procurement and replenishment. Several years ago, store managers had significant control over their product mix and purchased from numerous manufacturers and

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distributors under a decentralized organizational structure. As we upgrade our supply chain to achieve greater efficiencies and economies of scale, we have transitioned 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. We are also in the early stages of identifying a location and designing a new distribution facility that will allow us to increase our self-distribution. Our goal is to double our self-distribution of front-end merchandise from current levels by fiscal 2008.

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

We are upgrading technology throughout our company in an effort to improve our efficiency, productivity and profitability.

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 high-volume pharmacies. The fill centers and robotic technology enable our pharmacists to spend more time with customers while maintaining high quality customer service standards.

Our stores also utilize computer-assisted ordering and replenishment systems for certain goods that track sales and merchandise on hand and plan orders as necessary, and point-of-sale systems that facilitate customer check-out and allow us to process a high volume of transactions efficiently. We also have digital photo technology systems in over 85% of our stores.

We are making extensive system changes as part of our efforts to upgrade our supply chain. We have implemented a new distribution management system in our front-end California distribution centers and a new retail merchandise system in all of our stores. We also have laid the groundwork for later stages of the project, which include the implementation of procurement and allocation systems that will be more integrated with our distribution management and retail merchandise systems, and the implementation of a system for ordering, receiving and inventory management in our stores.

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.

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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 terms and are generally renewable indefinitely.

Employees

As of January 27, 2005, we had approximately 22,000 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 reimbursement, both nationally and at the state level. For example, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 included 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, and the Sarbanes-Oxley Act of 2002. 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.

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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 that is scheduled to expire in fiscal 2007. 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 significant state budget deficits, 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.

Item 2. Properties

Stores

We also remodeled 40 stores during fiscal 2005 and 20 stores during fiscal 2004, and we plan to remodel up to 40 additional stores in fiscal 2006.

Our stores are located in the following states:

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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 size of the stores we opened in fiscal 2005 is approximately 18,000 square feet. We lease 58% of our stores from third parties. Of the remaining stores, 31% are company-owned buildings on company-owned land, and 11% are company-owned buildings on leased land.

Distribution Centers

We operate the following distribution centers:

We also 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 61,000 square feet of office space, also in California. We also lease 38,000 square feet of office space for our PBM segment in Salt Lake City, Utah. Our remaining properties are not material, either individually or in the aggregate.

Item 3. Legal Proceedings

We are subject to various lawsuits and claims arising in the normal course of our businesses. In the opinion of management, after consultation with counsel, the disposition of these matters 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 2005.

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PART II

Item 5. Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

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 2,617 stockholders of record as of February 24, 2005.

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:

In March 2003, our board of directors authorized the repurchase of up to 2,000,000 shares of our common stock through January 2009, for a maximum total purchase price of $50 million. Through the end of fiscal 2005, we repurchased 1,245,360 shares under this authorization at a total cost of $24.9 million.

The following is a summary of our common stock repurchases during the fourth quarter of fiscal 2005:

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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

We continued to face an environment of economic sluggishness and increasing competition during fiscal 2005. U.S. economic growth has improved and unemployment has declined. However, the recovery in California, our primary market, has been more gradual than that of the broader national economy, and the state’s unemployment rate remains above the national average. Significant federal and state budget deficits, record government borrowing and rising gasoline prices also have helped create an environment of economic uncertainty, particularly in 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 environment, we have undertaken 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 more profitable long-term growth. Our changes fall into the following five broad initiative categories:

During the course of fiscal 2005, we made progress on activities 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 2006. We plan to continue to make significant changes to our operations in an effort to further strengthen our competitive position while improving our profitability and long-term growth prospects.

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RESULTS OF OPERATIONS

Sales

Fiscal 2005 versus Fiscal 2004

Sales increased 1.8% in fiscal 2005 over fiscal 2004, with same-store sales increasing 0.6%. Growth in the number of stores accounted for most of the total sales increase. Higher mail order sales and PBM revenues also contributed to total sales growth.

A strike against three major grocery chains in Southern California that began in October 2003 and ended in February 2004 resulted in increased sales in some of our Southern California stores, primarily in the fourth quarter of fiscal 2004. We estimate that the strike favorably impacted our fiscal 2004 same-store sales by 0.8 to 1.0 percentage points.

Pharmacy sales increased 4.1% in fiscal 2005 over fiscal 2004, with same-store pharmacy sales increasing 2.7%. The increase in same-store pharmacy sales was primarily due to an increase in the average retail price per prescription over fiscal 2004, partially offset by a decline in same-store prescription volume. The increase in the average retail price per prescription was lower than in recent years, due in part to the increased utilization of lower-priced, high-volume generic drugs. We expect that average retail prices for prescription drugs will continue to rise due to pharmaceutical cost inflation and the continued introduction and usage of newer and more expensive drugs, partially offset by continuing increases in utilization of generic drugs.

The decrease in our same-store prescription volume was partially due to declines in allergy and anti-ulcer prescriptions following the conversion of Claritin and Prilosec from prescription to over-the-counter status, continued health concerns over women’s hormone replacement therapy drugs, and a mild cold and flu season on the West Coast. While the conversion of prescription drugs to over-the-counter status has a negative impact on our prescription volumes, over the long term we expect several favorable industry trends to positively impact our prescription volumes. These industry trends include an aging U.S. population consuming a greater number of prescription drugs, the growing usage of prescription drugs as preventive therapy by healthcare providers and the introduction of new drugs. Factors that could offset these favorable trends include increasing competition, including competition from the rapidly growing mail-order channel, and rising prescription drug costs, which could cause consumers to reduce their purchases of prescription drugs or third-party health plans to reduce their coverage of prescription drug costs for their members.

Pharmacy sales were 47.4% of total drug store sales in fiscal 2005, compared to 46.3% in fiscal 2004. We expect pharmacy sales to continue to increase as a percentage of total drug store sales as pharmacy sales continue to increase faster than front-end sales.

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Third-party health plans covered 91.9% of our pharmacy sales in fiscal 2005, compared to 91.2% in fiscal 2004. We expect third-party sales to remain over 90% of our total pharmacy sales for the foreseeable future due to significant consumer participation in managed care and other third-party plans. The scheduled addition of a prescription drug benefit to Medicare in 2006 could further increase third-party sales as a percentage of total pharmacy sales.

Front-end sales increased 0.4% in fiscal 2005 from fiscal 2004, with same-store front-end sales decreasing 1.3%. The decline in same-store front-end sales was partially due to the Southern California grocery strike, which favorably affected last year’s front-end sales. In addition, as part of our efforts to improve our merchandise offering, we have shifted our front-end merchandise mix toward our core categories of health, wellness, beauty and convenience, resulting in lower sales in non-core categories. We will continue to make adjustments to our front-end merchandise assortments in an effort to further improve our competitive position and profitability. A continued industry-wide decline in photo processing sales due to consumers’ continued migration to digital photography technology also adversely affected same-store front-end sales in fiscal 2005. We expect this trend to continue.

The economic environment continues to be difficult in our markets. Over the past year, U.S. economic growth has improved and unemployment has declined. However, the recovery in California, our primary market, has been more gradual than that of the broader national economy, and the state’s unemployment rate remains above the national average. Significant federal and state budget deficits, record government borrowing and rising gasoline prices also have helped create an environment of economic uncertainty, particularly in California. We anticipate that the economy in California will continue to be difficult in fiscal 2006.

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 decrease in same-store sales of 0.2%. Mail order sales and higher PBM revenues also contributed to total sales growth. We estimate that the Southern California grocery strike favorably impacted our fiscal 2004 same-store sales by 0.8 to 1.0 percentage points.

Pharmacy sales increased 6.4% in fiscal 2004 over fiscal 2003, with same-store pharmacy sales increasing 3.5%. The increase in same-store pharmacy sales was primarily driven by an increase in the average retail price per prescription over fiscal 2003, partially offset by a decline in same-store prescription volume. The decrease in our same-store prescription volume in fiscal 2004 was partially due to the conversion of the allergy drug Claritin from prescription to over-the-counter status in December 2002, health concerns over women’s hormone replacement therapy drugs and sluggish economic growth.

Pharmacy sales were 46.3% of total retail drug store sales in fiscal 2004, compared to 44.4% in fiscal 2003. Third-party health plans covered 91.2% of our pharmacy sales in fiscal 2004, compared to 90.7% in fiscal 2003.

Front-end sales decreased 1.2% in fiscal 2004, with same-store front-end sales decreasing 3.2%. The decline in front-end sales in fiscal 2004 was primarily due to economic weakness and high unemployment, particularly in California; a decline in sales in our photo category, primarily due to consumers’ continued migration to digital photography technology; supply chain disruptions due to the implementation of a new distribution management system in our Northern California distribution center; and the war in Iraq, which adversely affected consumer spending in our first fiscal quarter. Increased sales in some of our Southern California stores resulting from the grocery strike partially offset these factors.

Gross Profit

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Fiscal 2005 versus Fiscal 2004

Gross profit was 25.7% of sales in fiscal 2005, compared to 25.3% in fiscal 2004. The increase was primarily due to a more profitable sales mix, improved inventory management and the increased utilization of generic drugs, which generally have higher gross profit percentages than name-brand drugs. Better buying practices resulting from our progress in centralizing procurement, advertising and promotional activities also contributed to our improved gross profit percentage.

Continued reductions in prescription drug reimbursement rates from third-party health plans, including government-sponsored plans such as Medi-Cal, partially offset the increase in our gross profit percentage. In addition, pharmacy sales have lower gross profit percentages than front-end sales, and as pharmacy sales continued to grow as a percent of total sales, our overall gross profit as a percent of sales was adversely impacted. Gross profit in fiscal 2004 also included a benefit of $3.6 million related to the resolution of a pricing dispute with a vendor.

Our LIFO provision, which is included in cost of sales, was $5.5 million in fiscal 2005, compared to $1.4 million in fiscal 2004. The increase of $4.1 million, which negatively affected our gross profit, was primarily due to higher net inflation compared to last year, when we experienced a deflationary environment in many of our front-end categories. The LIFO provision fluctuates with inflation rates, inventory levels and merchandise mix.

We will continue to make adjustments to our front-end merchandise assortments in an effort to further improve the profitability of our sales mix. Further, our supply chain initiative includes continuing efforts to improve our buying practices and inventory management and reduce our distribution costs. We also expect that the utilization of generic drugs will continue to increase. We expect that continuing reductions in third-party reimbursement levels and increasing pharmacy sales as a percent of total sales will at least partially offset these favorable effects on our gross profit percentage.

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. We classify store occupancy costs as a component of operating and administrative expenses. Our gross profit percentages may not be comparable to those of some other retailers who include distribution and advertising costs in their operating expenses, or store occupancy costs in their cost of sales.

Fiscal 2004 versus Fiscal 2003

Gross profit was 25.3% of sales in fiscal 2004, compared to 25.7% in fiscal 2003. The decrease was primarily due to increased markdowns to reduce merchandise inventories in our non-core categories and higher distribution and merchandise costs as a result of the implementation of a new distribution management system in our Northern California distribution center and higher than anticipated volume in our Southern California distribution center due to the grocery strike.

Continued reductions in prescription drug reimbursement rates from third-party health plans, including government-sponsored plans such as Medi-Cal, increased pharmacy sales as a percent of total sales, increased promotional sales as a percent of total front-end sales, and price reductions on more than 2,000 high-volume items in our core categories also contributed to the decline in our gross profit percentage in fiscal 2004.

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. Gross profit in fiscal 2004 also included a benefit of $3.6 million related to the resolution of a pricing dispute with a vendor.

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In addition, our LIFO provision was $1.4 million in fiscal 2004, compared to $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, was primarily due to lower overall net inflation on our front-end merchandise costs during the year.

Operating and Administrative Expenses

Fiscal 2005 versus Fiscal 2004

Operating and administrative expenses were 22.1% of sales in fiscal 2005 and in fiscal 2004. In fiscal 2004 we took a series of steps 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, store labor savings through workflow and staffing changes, modifications to many of our incentive compensation arrangements and the closure of certain support facilities. These actions, combined with other ongoing cost reduction efforts, resulted in lower operating and administrative expenses as a percent of sales beginning in the second half of fiscal 2004 and continuing through the first half of fiscal 2005. Our operating and administrative expense rate began to increase in the second half of fiscal 2005, primarily due to a lack of leverage on labor and related benefit costs, which increased primarily due to normal annual wage adjustments, against lower than expected sales. Expenses related to our supply chain improvement efforts and development of our PBM segment and mail-order services to support potential future growth also increased our operating and administrative expense rate.

Workers’ compensation and other insurance-related expenses decreased $9.2 million, or 0.2% of sales, in fiscal 2005 compared to fiscal 2004. We are self-insured for a substantial portion of our workers’ compensation and general liability costs. Our insurance-related expenses during fiscal 2005 included a $4.7 million net decrease in our self-insurance reserves, versus a $5.5 million net increase in those reserves in fiscal 2004, based on third-party actuarial valuations of our self-insured programs and reserves. The decrease in our insurance-related expenses, including the actuarial reserve adjustments, partially reflected a decline in workers’ compensation claims and lower costs per claim.

Insurance costs across industries have fluctuated significantly over the last several years as a result of rising health care costs, legislative and regulatory changes, economic conditions and terrorism. Last year the California State Legislature adopted changes to the state’s workers’ compensation laws in an effort to reduce costs, but the effects of those changes have not yet been fully realized. We are continuing to develop our company’s safety culture in an effort to reduce the number of work related injuries. Our workers’ compensation claims decreased 22% in fiscal 2005 from the previous year, and 36% over two years.

Operating and administrative expenses in fiscal 2004 included net charges of $4.1 million, or 0.1% of sales, for employee termination and other costs associated with the reduction of our administrative workforce and closure of certain support facilities and a voluntary separation program for store managers announced in July 2003, partially offset by gains on the disposition of certain properties.

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

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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 a voluntary separation program for store managers announced in July 2003.

Workers’ compensation and other insurance-related expenses increased $12.8 million, or 0.3% of sales, in fiscal 2004 over fiscal 2003. This increase 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.

Operating and administrative expenses in fiscal 2004 included net expenses of $4.1 million, or 0.1% of sales, for employee termination and other costs associated with the reduction of our administrative workforce and closure of certain support facilities and the voluntary separation program for store managers, partially offset by gains on the disposition of certain properties.

Depreciation and Amortization

Depreciation and amortization expenses were $85.3 million in fiscal 2005, compared to $83.6 million in fiscal 2004 and $77.7 million in fiscal 2003. The increase in fiscal 2005 over 2004 was primarily due to increased depreciation expense resulting from capital expenditures for new stores investments, remodels and improvements to existing stores, supply chain improvements and technology; as well as accelerated depreciation of assets to be removed or replaced in our remodeled stores. The increase in fiscal 2004 over fiscal 2003 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.

Our depreciation and amortization expenses include accelerated depreciation for assets to be retired before the completion of their originally estimated useful lives, including assets to be removed or replaced in our remodeled stores. The amount of accelerated depreciation expenses related to store remodels will vary based on the level and timing of our remodel activities.

Provision for Store Closures and Asset Impairments

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

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Store Closures

The following is a summary of the provision 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 incurred.

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 February 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. We have also recorded asset impairment charges for the write-off of abandoned store and information technology assets.

In fiscal 2005, we recorded $1.2 million of impairment charges for underperforming stores to write the related assets down to their estimated fair values.

In fiscal 2004, we recorded $1.3 million of impairment charges for underperforming stores to write the related assets down to their estimated fair values. Also during fiscal 2004, we recorded asset impairments of $1.5 million related to the write-off of abandoned information technology assets and $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 the related assets down 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.

Legal Settlements and Other Disputes

In June 2004, we reached an agreement to settle two purported class action lawsuits relating to the calculation of earned overtime wages for certain of our former and current store managers and assistant store

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managers in California. The lawsuits alleged that we improperly classified such employees as exempt under California’s wage and hour laws. We denied all liability in these cases, but agreed to the settlement in order to resolve the plaintiffs’ claims while avoiding protracted litigation. Under the settlement, we made cash payments of $11 million to cover claims by eligible plaintiffs, plaintiff attorneys’ fees and costs, payments to the named plaintiffs and costs of a third-party administrator. We recorded a charge of $11.6 million for the total cost of this settlement, including applicable employer payroll taxes, in the second quarter of fiscal 2005. We paid these settlement costs in the second half of fiscal 2005.

We also recorded a gain of $0.8 million from the favorable settlement of a separate, unrelated class action lawsuit, for which we had filed a claim as a member of the plaintiff class, which alleged unlawful price fixing and market allocation by certain vitamin manufacturers. We received the settlement payment in the second quarter of fiscal 2005. The combined net charge resulting from these two fiscal 2005 settlements was $10.8 million.

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.

Net Interest Expense

Net interest expense was $13.4 million in both fiscal 2005 and fiscal 2004 and $13.0 million in fiscal 2003. Lower average borrowings in fiscal 2005 offset higher interest rates and lower interest capitalization on construction and systems projects compared to fiscal 2004. The increase in fiscal 2004 over fiscal 2003 was due to higher average borrowings, partially offset by increased interest capitalization on construction and systems projects.

Income Taxes

Our effective income tax rate varies based on the level of our pre-tax income and the amount and timing of certain tax deductions and credits. Our effective income tax rates were 36.0% in fiscal 2005, 35.3% in fiscal 2004 and 29.8% in 2003. 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 5.9 percentage points. We expect that our effective income tax rate will be approximately 37% in fiscal 2006.

Cumulative Effect of Accounting Change

In fiscal 2003, 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) 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.

On August 6, 2004, we replaced our $195 million unsecured revolving line of credit with a secured $280 million revolving line of credit with a syndication of banks. As of January 27, 2005, borrowings of $40 million, with a weighted average interest rate of 3.46%, were outstanding on the new secured line of credit. The new agreement, which expires in August 2009, accrues interest at LIBOR-based rates and is secured with inventory, accounts receivable and certain intangible assets. The new agreement contains customary restrictions but no

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financial covenants and no limitations on capital expenditures or share repurchases if availability of credit remains above a minimum level. The agreement also includes an option to increase the credit facility’s borrowing and letter-of-credit capacity from $280 million to $345 million, subject to certain conditions. Borrowings on the line of credit do not require repayment until the expiration date but may be prepaid by the Company without penalty. Letters of credit totaling $30 million were outstanding under the agreement as of January 27, 2005. We pay a monthly commitment fee of 0.25% per annum on the unused portion of the line of credit.

Additionally, as of January 27, 2005 we had $114.6 million in outstanding privately placed promissory notes. These notes, which mature at various dates through 2014, bear interest at fixed rates ranging from 5.85% to 7.85%. As required by the note agreements, in August 2004 we secured our private placement notes on the same basis as the new secured revolving line of credit. The private placement notes may be redeemed at the Company’s option prior to their scheduled maturities subject to an early payment premium. Current maturities of $8.9 million as of January 27, 2005 constitute regularly scheduled principal payments due in fiscal 2006.

The privately placed promissory notes contain various customary financial covenants and restrictions. Failure to comply with these covenants and restrictions, or with the restrictions included in our secured revolving line of credit, could adversely affect our ability to manage our cash requirements, and could result in higher interest costs and potentially accelerated repayment requirements. As of January 27, 2005, we were in compliance with the restrictions and limitations included in these provisions.

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 $181.3 million in fiscal 2005, compared to $122.1 million in fiscal 2004 and $43.2 million in fiscal 2003. The changes in our operating cash flows were primarily due to changes in working capital (defined as current assets less current liabilities) and a higher percentage of deferred income taxes versus taxes currently payable. Net changes in assets and liabilities and deferred taxes favorably affected our operating cash flows by $49.9 million in fiscal 2005, and unfavorably affected our operating cash flows by $6.8 million in fiscal 2004 and $86.2 million in fiscal 2003.

Merchandise inventories decreased $43.8 million in fiscal 2005, after increases of $33.7 million in fiscal 2004 and $37.1 million in fiscal 2003. The decrease in fiscal 2005 reflects improved inventory management in our stores and distribution centers. Inventory levels were higher in fiscal 2004 as a result of our efforts last year to remain in-stock during the system conversion in our Northern California distribution center and the Southern California grocery strike. The increase in fiscal 2003 over fiscal 2002 was primarily due to lower than anticipated sell-through of inventory during the third and fourth quarter of the year.

Pharmacy and other receivables decreased $5.6 million in fiscal 2005, and increased $28.3 million in fiscal 2004 and $12.6 million in fiscal 2003. The decrease in fiscal 2005 was primarily due to the timing of payments from customers in our PBM segment; lease-related receivables; third-party health plans; and vendors, for amounts associated with our contractual purchase arrangements. The increase in fiscal 2004 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. The $12.6 million increase in receivables during fiscal 2003 was primarily due to increased pharmacy receivables arising from higher sales, as well as changes in payment terms for certain of our PBM customers.

Changes in current liabilities (excluding the current maturities of debt) deferred income taxes and other assets and liabilities unfavorably affected our operating cash flows by $0.8 million in fiscal 2005, versus a

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favorable impact of $55.1 million in fiscal 2004 and an unfavorable impact of $29.8 million in fiscal 2003. The unfavorable impact in fiscal 2005 was due to decreased accounts payable resulting from lower merchandise inventory levels, partially offset by increased accruals for workers’ compensation and employee compensation and benefits. The fiscal 2005 results also reflect the reclassification of certain income tax amounts from taxes payable to deferred income taxes as a result of the acceleration of certain income tax deductions resulting from tax planning and optimization efforts. The favorable impact in fiscal 2004 was primarily due to increased accounts payable and accrued expenses resulting from higher inventory levels and improved payment terms with many of our vendors; increased employee compensation and benefits primarily related to increased workers’ compensation reserves during the year; and increased 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 in fiscal 2003. The $29.8 million decrease during fiscal 2003 was primarily due to a reduction in accounts payable and accrued expenses as a result of the resolution of a payment dispute with a vendor for amounts owed as of the end of the previous year, the acceleration of the timing of our payments to certain vendors, and lower taxes payable due to tax credits.

Closed stores will continue to impact future operating cash flows negatively as we make payments associated with our non-cancelable 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 $7.0 million as of January 27, 2005.

Investing Cash Flows

Net cash used in investing activities was $84.2 million in fiscal 2005, compared to $104.3 million in fiscal 2004 and $87.2 million in fiscal 2003. 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.

Capital expenditures were $91.2 million in fiscal 2005, compared to $114.0 million in fiscal 2004 and $93.9 million in fiscal 2003. The decrease in fiscal 2005 from fiscal 2004 was partially due to the timing of expenditures for certain approved projects in fiscal 2005, which will carry over into fiscal 2006. The increased level of capital expenditures in fiscal 2004 also included investments in store pharmacy robotics and digital photography technology.

Cash receipts from property dispositions were $7.0 million in fiscal 2005, compared to $9.7 million in fiscal 2004 and $6.8 million in fiscal 2003, and primarily include the sale of company-owned locations as a result of store closures or sale-leaseback transactions. In the future, we may sell additional properties, particularly if we close stores on our company-owned properties. We also may enter into additional sale-leaseback transactions to provide funding for a portion of our capital expenditures.

We opened 4 new stores and relocated 2 stores in fiscal 2005, opened 18 new stores and relocated one store in fiscal 2004 and opened 22 new stores and relocated 3 stores in fiscal 2003. We also remodeled 40 stores during fiscal 2005 and 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 2006. We expect net capital expenditures in fiscal 2006 to be between $120 million and $130 million, primarily for remodels and improvements to existing stores, new store investments, technology and supply chain improvements. In addition, in the ordinary course of business we may acquire stores, store-related assets including pharmacy customer lists, or other complementary businesses.

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Financing Cash Flows

Net cash used in financing activities was $83.5 million in fiscal 2005, compared to $17.8 million in fiscal 2004 and $39.1 million in fiscal 2003. Our financing activities primarily consist of long-term borrowings and repayments, repurchases of common stock, dividend payments and proceeds from the exercise of stock options.

In fiscal 2005, we repaid $51.9 million of long-term borrowings, including $41.9 million of regularly scheduled principal payments on our private placement notes and $10.0 million under our revolving line of credit. In fiscal 2004, we increased our revolving line of credit borrowings by $25.0 million, and made $2.3 million 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. Our borrowing levels on our revolving line of credit fluctuate based largely on the levels of our cash flows from operations, capital expenditures and stock repurchases.

In fiscal 2005, we repurchased 736,260 shares of our common stock at a total cost of $16.9 million under a share repurchase program authorized by the Board of Directors in March 2003. In fiscal 2004, we repurchased 509,100 shares at a total cost of $8.0 million under this authorization, in addition to 853,100 shares at a total cost of $12.0 million to complete a previously authorized share repurchase program. Under the repurchase program authorized in March 2003, we are authorized to repurchase up to 754,640 additional shares of our common stock through January 2009, for a maximum additional purchase price of $25.2 million. We did not repurchase any of our common stock in fiscal 2003. 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 $20.9 million in fiscal 2005, $21.0 million in fiscal 2004 and $21.4 million in fiscal 2003.

Proceeds from employee stock option exercises were $6.2 million in fiscal 2005, compared to $0.5 million in fiscal 2004. The increased level of stock option exercises reflects an increasing number of vested options and a higher average stock price.

Contractual Obligations

The following table summarizes our contractual obligations as of January 27, 2005:

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

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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 $73.3 million as of January 27, 2005 consisted of deferred tax liabilities, deferred rent, capital lease obligations, and 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, net of amounts capitalized, were $13.7 million in fiscal 2005, $13.8 million in fiscal 2004 and $13.7 million in fiscal 2003. Most of our outstanding debt ($114.6 million as of January 27, 2005) bears interest at fixed rates. Borrowings on our unsecured revolving line of credit ($40 million as of January 27, 2005) bear interest at LIBOR-based rates.

Our cash payments for income taxes were $15.7 million in fiscal 2005, $8.8 million in fiscal 2004 and $26.5 million in fiscal 2003. Payments for income taxes fluctuate based on our taxable income and the availability and timing 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. Our contributions to this plan were $7.7 million for fiscal 2005, $7.3 million for fiscal 2004 and $8.0 million for fiscal 2003, 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

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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.

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 annual inflation rates and year-end 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 $1.2 million in fiscal 2005, $3.9 million in fiscal 2004 and $10.2 million in fiscal 2003.

Store Closure Reserves

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 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.

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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 $0.3 million in fiscal 2005, $3.5 million in fiscal 2004 and $0.6 million in fiscal 2003.

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. An independent actuary periodically evaluates our most significant insurance reserves. 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. 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 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 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 the cost of inventory and recognize the benefit through 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

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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 a series of initiatives designed to help us respond to the changing needs of our customers while improving our productivity and profitability. These initiatives include a program to upgrade our supply chain, primarily through technology systems changes. 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 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 a significant additional investment of time and money and increased implementation risk.

Changes in economic conditions could adversely affect consumer buying practices and reduce our sales and profitability.

Over the past year, the U.S. economic growth has improved and unemployment has declined. However, the recovery in California, our primary market, has been slower, and the state’s unemployment rate remains above the national average. Significant federal and state budget deficits, record government borrowing and rising gasoline prices also have helped create an environment of economic uncertainty, particularly in California. Deterioration in economic conditions, particularly in California, could adversely affect our sales and profitability. For example, an increase in unemployment could cause consumers to lose their health insurance, which could in turn adversely affect our pharmacy sales, or a significant increase in prescription co-payments could cause consumers not to buy medications. Further, a decrease in overall consumer spending as a result of changes in economic conditions could adversely affect our front-end sales. For example, the significant increase in gasoline prices may cause consumers to reduce their spending on consumable products. Our profit margins are higher on our front-end sales than our pharmacy sales and therefore any decrease in our sales of front-end products would have a disproportionate negative impact on 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, on-line retailers, supermarket chains and mass merchandisers, many of whom are aggressively expanding in markets we serve. In addition, competition from mail order pharmacies is rapidly intensifying, and some third-party health plans require mail-order fulfillment of certain medications. 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. For example, in fiscal 2004 we reduced prices on over 2,000 items in core categories in order to better align our prices and improve our competitive position. 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.

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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 more than 90% of all the prescription drugs that we sell. Pharmacy sales reimbursed by third parties have lower gross margins than non third-party pharmacy sales, and 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, government-sponsored health plans such as Medicare and Medicaid are making continuing efforts to reduce their costs, including prescription drug reimbursements. For example, last year the State of California adopted a budget that reduced Medi-Cal reimbursements to health care providers including pharmacies effective September 1, 2004. If third-party health plans, including government-sponsored plans, continue to reduce their reimbursement levels, our sales and gross profits could be significantly adversely affected. In addition, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 included new prescription drug benefits and discounts for Medicare participants. If these changes result in lower reimbursement levels for Medicare participants, our sales and gross profits could be adversely affected.

Structural changes in the retail pharmacy and related industries could adversely affect our operations.

The pharmacy industry is undergoing significant structural changes, including declining third-party reimbursement levels, significant changes to government-sponsored health plans such as Medicare and Medicaid, legislative and other initiatives to permit re-importation of prescription drugs from foreign countries, and mandatory mail-order fulfillment of prescriptions by certain health plans. These changes could adversely affect our sales and profitability by reducing prescription drug reimbursement levels or by causing consumers to purchase their prescription drugs from other sources.

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 have recently made and are continuing to make significant investments in our stores in an effort to increase our sales and profitability. These investments include the installation of new digital photo equipment, pharmacy and other 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 effect on us.

The costs of many types of insurance, especially workers’ compensation, employee medical and others have been highly volatile in recent years. 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 over fiscal 2003. These conditions have been exacerbated by rising health care costs, legislative changes, economic conditions, terrorism and heightened scrutiny of insurance brokers and insurance providers. 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 that is scheduled to expire

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in fiscal 2007. Any significant disruptions in our relationship with AmerisourceBergen, deterioration in AmerisourceBergen’s financial condition, or industry-wide changes in wholesaler business practices, including those of AmerisourceBergen, could have a material adverse effect on us. Failure to renew or replace our supply contract with AmerisourceBergen or another supplier upon its expiration under similar terms and conditions, or to increase our self-distribution capabilities relative to the products we currently purchase under this contract, could significantly disrupt our operations and adversely affect our sales and profitability.

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. If we are unable to attract and retain pharmacists, our business could be adversely affected. In order to mitigate this risk we have established centralized prescription fill centers, including one that we operate under a joint venture with AmerisourceBergen, and have also installed robotic prescription fill equipment in many of our pharmacies. The success of these efforts, which cannot be assured, is important to our ability to address the shortage of pharmacists, but additional efforts may be necessary to address this business issue. Other options may be costly, and could adversely affect our results of operations, financial condition and cash flows.

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.

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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 ($40 million at January 27, 2005) 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 (35 basis points on our floating-rate debt as of January 27, 2005) 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