SUMMARY. Risk Level *

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1 January 09, 2015 Fred s Inc (FRED-NASDAQ) Current Recommendation SUMMARY DATA NEUTRAL Prior Recommendation Underperform Date of Last Change 07/17/2014 Current Price (01/08/15) $17.13 Target Price $ Week High $ Week Low $13.18 One-Year Return (%) Beta 1.00 Average Daily Volume (sh) 175,195 Shares Outstanding (mil) 37 Market Capitalization ($mil) $632 Short Interest Ratio (days) Institutional Ownership (%) 91 Insider Ownership (%) 7 Annual Cash Dividend $0.24 Dividend Yield (%) Yr. Historical Growth Rates Sales (%) 2.1 Earnings Per Share (%) -2.7 Dividend (%) 12.9 using TTM EPS using 2015 Estimate N/A N/A using 2016 Estimate 29.6 Zacks Rank *: Short Term 1 3 months outlook 3 - Hold * Definition / Disclosure on last page SUMMARY Fred s third-quarter fiscal 2014 loss of $0.16 per share was wider than the Zacks Consensus Estimate of a loss of $0.14 and compared unfavorably with earnings of $0.20 reported a year ago. Sales increased 3% year over year. Comps remained almost flat versus a 1.4% increase in the year-ago period. Overall, we remain concerned by slowing traffic at Fred s stores and intensifying competitive environment. In fiscal 2014, the company undertook a new plan to reposition its merchandise assortment and focus on convenience and consumables instead of discretionary categories where the brand has little competitive advantage. Fred s undertook several initiatives to drive profits. Management s shift of focus to high-margin products is also encouraging. Management is optimistic about the near future and is taking aggressive steps to keep its inventory at manageable levels. Although the company s new marketing initiative started yielding results, we remain cautious. Risk Level * Average Type of Stock Small-Value Industry Retail-Discount Zacks Industry Rank * 105 out of 267 ZACKS CONSENSUS ESTIMATES Revenue Estimates (In millions of $) Q1 Q2 Q3 Q4 Year (Apr) (Jul) (Oct) (Jan) (Jan) A 471 A 451 A 533 A 1,955 A A 482 A 461 A 495 A 1,939 A A 491 A 476 A 504 E 1,969 E E 477 E 466 E 509 E 1,934 E Earnings Per Share Estimates (EPS is operating earnings before non-recurring items, but including employee stock options expenses) Q1 Q2 Q3 Q4 Year (Apr) (Jul) (Oct) (Jan) (Jan) 2012 $0.28 A $0.06 A $0.18 A $0.18 A $0.93 A 2013 $0.31 A $0.09 A $0.20 A $0.17 A $0.77 A 2014 $0.17 A -$0.19 A -$0.16 A $0.01 E -$0.18 E 2015 $0.26 E $0.02 E $0.08 E $0.70 E $0.58 E Projected EPS Growth - Next 5 Years % Zacks Investment Research, All Rights reserved S. Riverside Plaza, Chicago IL 60606

2 OVERVIEW Memphis, TN-based Fred's Inc., founded in 1947, sells its products through company-owned discount general merchandise stores and franchised Fred's stores. The company serves low, middle and fixed income families located in small- to medium-sized towns and full service pharmacies, which are included in company-owned and express stores. The company s merchandise mix includes frequently purchased items such as household goods, apparel, food, tobacco, healthcare and paper products. Some of its retail outlets also feature pharmacies offering prescription drugs. Fred s sources a sizeable portion of its merchandise from two major suppliers AmerisourceBergen Corp. and Proctor & Gamble. REASON TO BUY Loyalty Program May Drive Higher Sales: Fred s pursues a strong digital card and mobile application program. The company effectively uses social/digital media to drive customer awareness and thereby, improve traffic. A significant portion of customers is opting for Fred s loyalty card as the preferred mode of payment. The company noted that usually smartcard members purchase 35% higher than ordinary customers and visit the stores twice as often. Top-Line Boosting Initiative Undertaken: The company is remodeling and refreshing the store layouts and allocating more space to key revenue-generating categories. Fred s increased capital deployment for infrastructure and stock at its stores throughout fiscal Moreover, Fred s revamped its marketing strategies, including a circular ad featuring items which are expected to appeal to customers. Moreover, the company undertook a new plan to reposition its merchandise assortment and focus on convenience and consumables instead of discretionary categories where the brand has little competitive advantage. Fred s undertook several initiatives to drive profits. Management s shift of focus to high-margin products is also encouraging.. Focus on High-Margin Products: As part of its 3-year reconfiguration plan started in fiscal 2013, Fred s is increasing its focus on higher-margin categories and moving away from the lower-margin consumable categories. The company expects to increase its operating income in this process. Moreover, Fred s has decided to shut down underperforming assets in order to reduce cost. REASONS TO SELL Declining Comps over the Past Few Months: Fred s witnessed soft comps in September, October and November 2014 amid tough retail conditions. Despite the repositioning efforts, we remain concerned by the slowing traffic and intensifying competition, and are unsure whether management s efforts to reposition the brand will prove successful. Fred s expects the industrial headwinds that affected comps in the first half of fiscal 2014 to continue in the second half as well. Tough retail environment and low comps are expected to hurt its top line. Lack of International Exposure: Absence of international exposure deprives Fred s of the benefits of high growth opportunities in the developing nations like China, Brazil, India, Mexico, Russia and Equity Research FRED Page 2

3 Southeast Asia. However, peers like Costco Wholesale Corporation and Limited Brands that operate in these markets are insulated from the macroeconomic headwinds in the U.S. and Europe. High Dependence on Pharmacy Department: Fred s turnaround initiative, the 3-year reconfiguration plan started in fiscal 2013, focuses heavily on the pharmacy department. The company is increasing its pharmacy department by more than 60% at its stores. However, the initiative will suffer a setback, if the department fails to drive comps. RECENT NEWS Fred's Posts Wider-than-Expected Q3 Loss on Weak Comps Nov 26, 2014 Fred's third-quarter fiscal 2014 loss of $0.16 was wider than the Zacks Consensus Estimate of a loss of $0.14. The results compared unfavorably with earnings of $0.20 reported a year ago as well as the company s expectation of incurring loss in the range of $0.05 to $0.11. Softer comps and weak margins led to the disappointing results. The third-quarter results exclude provisions to reserve impacts and non-operational charges. In the second quarter, Fred s planned to shut down stores which did not meet its operational targets under its 3- year reconfiguration plan. Per this strategy, the company closed five stores in the third quarter. The reported results also exclude provisions to establish reserves for closed-store inventory and additional above-cost markdowns on low-productive inventory. Fred s embarked on a 3-year reconfiguration plan in fiscal 2013 to enhance its focus on higher-margin categories and move away from the lower-margin consumable categories. The company is remodeling and refreshing its store layouts and allocating space to highlight key revenue-generating categories. Soft Revenues and Margin Total third-quarter sales increased 3% to $476.2 million from $460.5 million in the year-ago quarter. Sales, however, beat the Zacks Consensus Estimate of $469.0 million by 1.5%. Comparable store sales increased 0.3% lower than an increase of 1.4% in the year-ago period. Sales in segments like Household goods, Apparel and linen, Paper and chemical and Food and tobacco declined from the last year. However, Pharmaceuticals sales improved driven by Fred s goal to increase pharmacy penetration at its stores. Gross margin shrank 250 basis points (bps) to 27.1% of sales, excluding the impact of the inventory provision. Margins were affected by persistent pressure on pharmacy initial markups following generic inflation and markdowns on general merchandise due to promotional discounts offered by the company to reduce inventory. As a result, selling, general and administrative (SG&A) expenses increased to 29.4% of sales, up 120 bps year over year. Disciplined expense management was offset by higher occupancy-related costs and transitional expenses associated with the restructuring of Fred s store models. The company incurred an operating loss of $16.6 million compared to an income of $10.6 million a year ago. During the quarter, Fred's opened six Xpress pharmacy locations while closing two in addition to five fullservice stores. Equity Research FRED Page 3

4 Fourth-Quarter Fiscal 2014 Outlook Fred s provided a conservative outlook for fourth-quarter fiscal The company expects total sales to increase 4% to 6% on a year-over-year basis. Comparable store sales are expected to remain within the range of flat to up 2% from the year-ago level. Loss per share is forecasted in the range of $0.08 to $0.12 as against earnings of $0.11 in the same quarter last year. The loss per share guidance fell short the Zacks Consensus Estimate of a loss of $0.02. VALUATION Over the last five years, Fred s shares have traded in the range of 13.5x to 45.2x trailing 12-month earnings. Based on fiscal 2016 earnings estimate of $0.58 per share, the stock is trading at 29.6x, which is a 38.0% premium to the industry average of 21.5x. At the end of the third quarter of fiscal 2014, the P/B multiple of the stock was approximately 1.4x, a 77.4% discount to the industry average of 6.2x. On a P/B basis, the price target is based on a P/B multiple of approximately 1.4x. Fred s holds a Zacks Rank #3 (Hold). Key Indicators F1 F2 Est. 5-Yr EPS Gr% P/CF 5-Yr High 5-Yr Low FREDS INC (FRED) Industry Average S&P PRICESMART INC (PSMT) BURLINGTON STRS (BURL) TUESDAY MORNING (TUES) GORDMANS STORES (GMAN) TTM is trailing 12 months; F1 is 2015 and F2 is 2016, CF is operating cash flow P/B Last Qtr. P/B 5-Yr High P/B 5-Yr Low ROE D/E Last Qtr. Div Yield Last Qtr. EV/EBITDA FREDS INC (FRED) Industry Average S&P Equity Research FRED Page 4

5 Earnings Surprise and Estimate Revision History Equity Research FRED Page 5

6 DISCLOSURES & DEFINITIONS The analysts contributing to this report do not hold any shares of FRED. The EPS and revenue forecasts are the Zacks Consensus estimates. Additionally, the analysts contributing to this report certify that the views expressed herein accurately reflect the analysts personal views as to the subject securities and issuers. Zacks certifies that no part of the analysts compensation was, is, or will be, directly or indirectly, related to the specific recommendation or views expressed by the analyst in the report. Additional information on the securities mentioned in this report is available upon request. This report is based on data obtained from sources we believe to be reliable, but is not guaranteed as to accuracy and does not purport to be complete. Because of individual objectives, the report should not be construed as advice designed to meet the particular investment needs of any investor. Any opinions expressed herein are subject to change. This report is not to be construed as an offer or the solicitation of an offer to buy or sell the securities herein mentioned. Zacks or its officers, employees or customers may have a position long or short in the securities mentioned and buy or sell the securities from time to time. Zacks uses the following rating system for the securities it covers. Outperform- Zacks expects that the subject company will outperform the broader U.S. equity market over the next six to twelve months. Neutral- Zacks expects that the company will perform in line with the broader U.S. equity market over the next six to twelve months. Underperform- Zacks expects the company will under perform the broader U.S. Equity market over the next six to twelve months. The current distribution of Zacks Ratings is as follows on the 1105 companies covered: Outperform %, Neutral %, Underperform 5.7%. Data is as of midnight on the business day immediately prior to this publication. Our recommendation for each stock is closely linked to the Zacks Rank, which results from a proprietary quantitative model using trends in earnings estimate revisions. This model is proven most effective for judging the timeliness of a stock over the next 1 to 3 months. The model assigns each stock a rank from 1 through 5. Zacks Rank 1 = Strong Buy. Zacks Rank 2 = Buy. Zacks Rank 3 = Hold. Zacks Rank 4 = Sell. Zacks Rank 5 = Strong Sell. We also provide a Zacks Industry Rank for each company which provides an idea of the near-term attractiveness of a company s industry group. We have 264 industry groups in total. Thus, the Zacks Industry Rank is a number between 1 and 264. In terms of investment attractiveness, the higher the rank the better. Historically, the top half of the industries has outperformed the general market. In determining Risk Level, we rely on a proprietary quantitative model that divides the entire universe of stocks into five groups, based on each stock s historical price volatility. The first group has stocks with the lowest values and are deemed Low Risk, while the 5 th group has the highest values and are designated High Risk. Designations of Below-Average Risk, Average Risk, and Above-Average Risk correspond to the second, third, and fourth groups of stocks, respectively. Equity Research FRED Page 6