Management s Report Management s Responsibility for Financial Statements Management is responsible for the preparation and presentation of the accompanying consolidated financial statements and all other information in the Annual Report. This responsibility includes the selection and consistent application of appropriate accounting principles and methods in addition to making the estimates, judgements and assumptions necessary to prepare the consolidated financial statements in accordance with Canadian generally accepted accounting principles. It also includes ensuring that the financial information presented elsewhere in the Annual Report is consistent with the consolidated financial statements. In fulfilling its responsibilities, management has established and maintains systems of internal controls. Although no cost-effective system of internal controls will prevent or detect all errors and irregularities, these systems are designed to provide reasonable assurance regarding the reliability of the Company s financial reporting and preparation of the financial statements in accordance with Canadian generally accepted accounting principles. These systems include controls to provide reasonable assurance that resources are safeguarded from material loss or inappropriate use, that transactions are authorized, recorded and reported properly and that financial records are reliable for preparing the consolidated financial statements. Internal auditors, who are employees of the Company, review and evaluate internal controls on management s behalf. The consolidated financial statements have been audited by the independent auditors, Deloitte & Touche LLP, in accordance with generally accepted auditing standards. Their report follows. The Board of Directors, acting through an Audit Committee which is comprised solely of directors who are not employees of the Company, is responsible for determining that management fulfils its responsibility for financial reporting and internal control. This responsibility is carried out through periodic meetings with senior officers, financial management, internal audit and the independent auditors to discuss audit activities, the adequacy of internal financial controls and financial reporting matters. The Audit Committee has reviewed these consolidated financial statements and the Management s Discussion and Analysis and has recommended their approval by the Board of Directors prior to their inclusion in this Annual Report. Jürgen Schreiber PRESIDENT AND CHIEF EXECUTIVE OFFICER George Halatsis EXECUTIVE VICE-PRESIDENT AND CHIEF FINANCIAL OFFICER Auditors Report To the Shareholders of Shoppers Drug Mart Corporation We have audited the consolidated balance sheets of Shoppers Drug Mart Corporation as at December 29, 2007 and December 30, 2006 and the consolidated statements of earnings, retained earnings, comprehensive income and accumulated other comprehensive income and cash flows for the 52 week periods then ended. These financial statements are the responsibility of the Company s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with Canadian generally accepted auditing standards. Those standards require that we plan and perform an audit to obtain reasonable assurance whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. In our opinion, these consolidated financial statements present fairly, in all material respects, the financial position of Shoppers Drug Mart Corporation as at December 29, 2007 and December 30, 2006 and the results of its operations and its cash flows for the 52 week periods then ended in accordance with Canadian generally accepted accounting principles. Chartered Accountants, Licensed Public Accountants TORONTO, ONTARIO FEBRUARY 5, 2008 37
Consolidated Statements of Earnings 52 weeks ended December 29, 2007 and December 30, 2006 (in thousands of dollars, except per share amounts) Sales $ 8,478,382 $ 7,786,436 Operating expenses Cost of goods sold and other operating expenses 7,516,291 6,958,361 Amortization 172,075 144,549 Operating income 790,016 683,526 Interest expense (Note 4) 52,873 49,872 Earnings before income taxes 737,143 633,654 Income taxes (Note 5) Current 249,948 220,398 Future (6,433) (9,235) 243,515 211,163 Net earnings $ 493,628 $ 422,491 Net earnings per common share (Note 11) Basic $ 2.28 $ 1.97 Diluted $ 2.27 $ 1.95 The accompanying notes are an integral part of these consolidated financial statements. Consolidated Statements of Retained Earnings 52 weeks ended December 29, 2007 and December 30, 2006 (in thousands of dollars) Retained earnings, beginning of period $ 1,225,616 $ 941,672 Impact of the adoption of new accounting standards, Handbook Sections 3855, Financial Instruments Recognition and Measurement; 3865, Hedges; and 1530, Comprehensive Income (Note 2) 66 Net earnings 493,628 422,491 Dividends (138,398) (102,952) Premium on share capital purchased for cancellation (Note 11) (24) (35,595) Retained earnings, end of period $ 1,580,888 $ 1,225,616 The accompanying notes are an integral part of these consolidated financial statements. 38
Consolidated Statements of Comprehensive Income and Accumulated Other Comprehensive Income 52 weeks ended December 29, 2007 and December 30, 2006 (in thousands of dollars) Net earnings $ 493,628 $ Other comprehensive income, net of tax Change in unrealized gain on interest rate derivatives (net of tax of $65) 24 Change in unrealized gain on equity forward derivatives (net of tax of $12) (23) Amount of previously unrealized gain on equity forward derivatives recognized in earnings during the period (net of tax of $82) (160) _ Other comprehensive loss (159) Comprehensive income $ 493,469 $ Accumulated other comprehensive income, upon adoption of new accounting standards (Note 2) $ 406 $ Other comprehensive loss (net of tax of $29) (159) Accumulated other comprehensive income, end of period $ 247 $ The accompanying notes are an integral part of these consolidated financial statements. 39
Consolidated Balance Sheets As at December 29, 2007 and December 30, 2006 (in thousands of dollars) Assets Current Cash $ 27,588 $ 62,865 Accounts receivable 372,306 307,779 Inventory 1,577,524 1,372,124 Future income taxes (Note 5) 60,089 46,407 Prepaid expenses and deposits (Note 3) 134,692 32,248 2,172,199 1,821,423 Property and equipment (Note 6) 1,126,513 907,728 Deferred costs (Note 7) 32,966 25,936 Goodwill 2,245,441 2,122,162 Other intangible assets (Note 8) 57,930 45,249 Other assets 8,990 6,516 Total assets $ 5,644,039 $ 4,929,014 Liabilities Current Bank indebtedness $ 225,152 $ 134,487 Commercial paper (Notes 4 and 14) 543,847 503,550 Accounts payable and accrued liabilities 990,545 843,278 Income taxes payable 65,825 70,672 Dividends payable 34,686 25,797 Current portion of long-term debt (Note 9) 298,990 2,159,045 1,577,784 Long-term debt (Note 9) 300,000 Other long-term liabilities (Note 10) 244,657 188,938 Future income taxes (Note 5) 30,171 21,689 2,433,873 2,088,411 Associate interest 113,119 116,649 Shareholders equity Share capital (Note 11) 1,506,020 1,491,264 Contributed surplus (Note 12) 9,892 7,074 Accumulated other comprehensive income 247 Retained earnings 1,580,888 1,225,616 1,581,135 1,225,616 3,097,047 2,723,954 Total liabilities and shareholders equity $ 5,644,039 $ 4,929,014 The accompanying notes are an integral part of these consolidated financial statements. On behalf of the Board of Directors: Jürgen Schreiber DIRECTOR David M. Williams DIRECTOR 40
Consolidated Statements of Cash Flows 52 weeks ended December 29, 2007 and December 30, 2006 (in thousands of dollars) Operating activities Net earnings $ 493,628 $ 422,491 Items not affecting cash Amortization 181,418 150,088 Future income taxes (6,433) (9,235) Loss on disposal of property and equipment 4,165 7,185 Stock-based compensation (Note 12) 3,544 3,492 676,322 574,021 Net change in non-cash working capital balances (Note 13) (137,697) (26,551) Increase in other long-term liabilities 48,464 38,990 Store opening costs (22,031) (16,644) Cash flows from operating activities 565,058 569,816 Investing activities Purchase of property and equipment (395,526) (287,216) Proceeds from disposition of property and equipment 18,014 3,269 Business acquisitions (Note 3) (139,833) (93,866) Deposits (Note 3) (93,688) Other assets (1,714) (3,570) Cash flows used in investing activities (612,747) (381,383) Financing activities Bank indebtedness, net 90,665 (29,359) Commercial paper, net 40,800 33,700 Repayment of long-term debt (Note 9) (27,025) Deferred financing costs (20) (454) Associate interest (3,530) 148 Proceeds from shares issued for stock options exercised 13,710 10,898 Repayment of share purchase loans 325 2,287 Repurchase of share capital (29) (41,789) Dividends paid (129,509) (98,498) Cash flows from (used in) financing activities 12,412 (150,092) (Decrease) increase in cash (35,277) 38,341 Cash, beginning of period 62,865 24,524 Cash, end of period $ 27,588 $ 62,865 Supplemental cash flow information Interest paid $ 50,596 $ 48,075 Income taxes paid $ 280,393 $ 188,270 The accompanying notes are an integral part of these consolidated financial statements. 41
Notes to the Consolidated Financial Statements December 29, 2007 and December 30, 2006 (in thousands of dollars, except per share data) 1. Significant Accounting Policies These financial statements have been prepared in accordance with Canadian generally accepted accounting principles. Description of the Business Shoppers Drug Mart Corporation (the Company ) is a licensor of approximately 1,057 Shoppers Drug Mart/Pharmaprix full-service retail drug stores across Canada. The Shoppers Drug Mart/Pharmaprix stores are licensed to Associate-owners ( Associates ). In addition, the Company owns and operates 64 Shoppers Home Health Care stores. Under the Canadian Institute of Chartered Accountants ( CICA ) Accounting Guideline 15, Consolidation of Variable Interest Entities, the Company consolidates the Associate-owned stores and an independent trust. The individual Associate-owned stores that comprise the Company s store network are variable interest entities ( VIE ) and the Company is the primary beneficiary. As such, the Associate-owned stores are subject to consolidation by the Company. The Associate-owned stores remain separate legal entities and consolidation of the Associate-owned stores has no impact on the underlying risks facing the Company. The Company has an arrangement with an independent trust (the Trust ) to provide loans to Associates to facilitate their purchase of inventory and fund their working capital requirements. The Trust s activities are financed through the issuance of short-term, assetbacked notes to third-party investors. The Trust is a VIE and the Company is the primary beneficiary. As such, the Trust is subject to consolidation by the Company. Fiscal Year The fiscal year of the Company consists of a 52 or 53 week period ending on the Saturday closest to December 31. The Company s 2007 and 2006 fiscal years consisted of 52 week periods. Basis of Consolidation The consolidated financial statements include the accounts of Shoppers Drug Mart Corporation, its subsidiaries, the Associateowned stores that comprise the Company s store network and the Trust. All intercompany balances and transactions are eliminated on consolidation. Estimates The preparation of the consolidated financial statements in conformity with Canadian generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Estimates are used when accounting for items such as inventory provisions, Shoppers Optimum loyalty card program costs, assumptions underlying the actuarial determination of employee future benefits, income and other taxes and when testing goodwill, other intangible assets and long-lived assets for impairment. Actual results could differ from these estimates. Comparative Amounts Certain comparative amounts have been reclassified to conform with the current period s financial statement presentation. Revenue Recognition The Company recognizes revenue at the time goods are sold, net of returns. 42
Bank Indebtedness Bank indebtedness is comprised of corporate bank overdraft balances and bank lines of credit used by the Associate-owned stores to meet their operating needs and outstanding cheques. Inventory Inventory is valued at the lower of cost and estimated net realizable value, with cost being determined on the first-in, first-out basis. Property and Equipment Property and equipment are recorded at cost. Amortization is recorded on a straight-line basis over the estimated useful lives of the assets at the rates indicated below. Buildings Equipment and fixtures Computer software and equipment Leasehold improvements 20 years 3 to 10 years 2 to 10 years Lesser of term of the lease and useful life Long-lived assets are tested for impairment when events or circumstances indicate their carrying value exceeds the sum of the undiscounted cash flows expected from their use and eventual disposal. An impairment loss is measured as the amount by which the long-lived assets carrying value exceeds the fair value. The Company reviews long-lived assets for impairment annually. Deferred Costs Store Opening Costs Certain costs associated with the opening of new and relocated stores are deferred and amortized into cost of goods sold and other operating expenses on a straight-line basis over a period of three years. Goodwill and Other Intangible Assets The Company records as goodwill the excess amount of the purchase price of an acquired business over the fair value of the underlying net assets, including intangible assets, at the date of acquisition. Goodwill is not amortized but is tested for impairment on an annual basis. In the event of an impairment, the excess of the carrying amount over the fair value of goodwill would be charged to earnings. Intangible assets are amortized on a straight-line basis over the estimated useful lives of the assets at the rates indicated below. Intangible assets are tested for impairment when an indication of impairment exists. In the event of an impairment, the excess of the carrying amount over the fair value of intangible assets would be charged to earnings. Prescription files Developed technology Customer relationships Other 7 years 3 years 5 to 25 years Indefinite Leases The Company leases most of its store locations and office space. Terms vary in length and typically permit renewal for additional periods. Minimum rent, including scheduled escalations, is expensed on a straight-line basis over the term of the lease, including any rent-free periods. Landlord inducements are deferred and amortized as reductions to rent expense on a straight-line basis over the same period. The Company capitalizes rent expense during a store s fixturing period to leasehold improvements. 43
Notes to the Consolidated Financial Statements (continued) December 29, 2007 and December 30, 2006 (in thousands of dollars, except per share data) 1. Significant Accounting Policies (continued) Leases may include additional payments for real estate taxes, maintenance and insurance. These amounts are expensed in the period to which they relate. Shoppers Optimum Loyalty Program The Shoppers Optimum loyalty card program (the Program ) allows members to earn points on their purchases in Shoppers Drug Mart, Pharmaprix and Shoppers Home Health Care stores at a rate of 10 points for each dollar spent on eligible products and services, plus any applicable bonus points. Members can then redeem points, in accordance with the Program rewards schedule or other offers, for discounts on front store merchandise at the time of a future purchase transaction. When points are earned by Program members, the Company records an expense and establishes a liability for future redemptions by multiplying the number of points issued by the estimated cost per point. The Program liability is included in accounts payable and accrued liabilities on the Company s consolidated balance sheets. The actual cost of Program redemptions is charged against the liability account. The estimated cost per point is determined based on many factors, including the historical behaviour of Program members, expected future redemption patterns and associated costs. The Company monitors, on an ongoing basis, trends in redemption rates (points redeemed as a percentage of points issued) and net cost per point redeemed and adjusts the estimated cost per point based upon expected future activity. To the extent that estimates differ from actual experience, the Program costs could be higher or lower. Employee Future Benefits The Company maintains registered defined benefit pension plans under which benefits are available to certain employee groups. The Company also makes supplementary retirement benefits available to certain employees under a non-registered defined benefit pension plan. The Company accrues its obligations for employee benefit plans under the following policies: The cost of pensions and other retirement benefits earned by employees is actuarially determined using the projected benefit method pro-rated on service and management s best estimate of expected plan investment performance, salary escalation, retirement ages of employees and expected health care costs. For the purpose of calculating the expected return on plan assets, those assets are valued at fair value. The excess of the net actuarial gain (loss) over 10% of the greater of the benefit obligation and the fair value of plan assets is amortized over the average remaining service period of active employees. The average remaining service period of the active employees covered by the pension plans and other retirement benefit plan is 14 and 10 years, respectively. Stock-based Compensation The Company has stock option compensation plans which are described in Note 12. Compensation expense is recognized for these plans for stock options granted to employees and directors after December 28, 2002 using the fair value method. Any consideration paid by employees and directors on exercise of stock options is credited to share capital. Income Taxes The Company accounts for income taxes using the liability method of accounting. Under the liability method, future income tax assets and liabilities are determined based on differences between the carrying amounts of balance sheet items and their corresponding tax values. The liability method requires the computation of future income taxes using the substantively enacted corporate income tax rates for the years in which the differences are expected to reverse. 44
Derivative Financial Instruments The Company uses interest rate derivatives to manage its exposure to fluctuations in interest rates related to the Company s commercial paper and long-term debt. The income or expense arising from the use of these instruments is included in interest expense for the year. The Company uses cash-settled equity forward agreements to limit its exposure to future price changes in the Company s share price for share unit awards under the Company s long-term incentive plan ( LTIP ). The income and expense arising from the use of these instruments are included in cost of goods sold and other operating expenses for the year. See Note 12 for further discussion of the LTIP. The Company formally identifies, designates and documents all relationships between hedging instruments and hedged items, as well as its risk assessment objective and strategy for undertaking various hedge transactions. The Company assesses, both at the hedge s inception and on an ongoing basis, whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items. When such derivative instruments cease to exist or be effective as hedges, or when designation of a hedging relationship is terminated, any associated deferred gains or losses are recognized in net earnings in the same period as the corresponding gains or losses associated with the hedged item. When a hedged item ceases to exist, any associated deferred gains or losses are recognized in net earnings in the period the hedged item ceases to exist. Associate Interest Associate interest reflects the investment the Associates have in the net assets of their corporations. 2. Changes in Accounting Policies Financial Instruments In 2006, the CICA issued new accounting standards concerning financial instruments: Financial Instruments Recognition and Measurement ( Section 3855 ); Financial Instruments Disclosure and Presentation ( Section 3861 ), Hedges ( Section 3865 ); and Comprehensive Income ( Section 1530 ). The standards require prospective application and were effective for the Company s first quarter of fiscal 2007. The Company applied the new accounting standards at the beginning of its current fiscal year. Financial Assets and Liabilities Section 3855 establishes standards for recognizing and measuring financial instruments. Under the new standards, all financial instruments are classified into one of the following five categories: held for trading, held-to-maturity investments, loans and receivables, available-for-sale financial assets or other financial liabilities. The Company s financial assets and financial liabilities are classified and measured as follows: Asset/Liability Category Measurement Cash Held for trading Fair value Accounts receivable Loans and receivables Amortized cost Long-term receivables* Loans and receivables Amortized cost Bank indebtedness Held for trading Fair value Commercial paper Other financial liabilities Amortized cost Accounts payable Other financial liabilities Amortized cost Long-term debt Other financial liabilities Amortized cost Other long-term liabilities Other financial liabilities Amortized cost *Included in other assets in the consolidated balance sheets. 45
Notes to the Consolidated Financial Statements (continued) December 29, 2007 and December 30, 2006 (in thousands of dollars, except per share data) 2. Changes in Accounting Policies (continued) Derivative and Hedge Accounting The Company s interest rate derivatives have been designated as cash flow hedges and reported at fair value, in accordance with the new standards, as a component of other assets. A percentage of the equity forward derivatives, related to unearned units under the LTIP, have been designated as a hedge. The fair value of the percentage of the equity derivatives designated as a hedge has been reflected in the opening balance of accumulated other comprehensive income, net of tax. The following table summarizes the impact on the Company s opening balance sheet for fiscal 2007 as a result of the adjustments relating to interest rate and equity forward derivatives: Long-term December 30, Incentive Plan and December 31, 2006 Balance, Interest Rate Equity Forward 2006 Opening as Reported Derivatives Derivatives Balance Other assets $ 6,516 $ 338 $ 610 $ 7,464 Other long-term liabilities $ 188,938 $ $ 234 $ 189,172 Future income taxes (within liabilities) $ 21,689 $ 115 $ 128 $ 21,932 Retained earnings $ 1,225,616 $ $ 66 $ 1,225,682 Accumulated other comprehensive income $ $ 223 $ 183 $ 406 In addition to the above adjustments, the Company has adopted the policy of adding transaction costs to financial assets and liabilities classified as other than held for trading. As a result, the Company s deferred financing costs were reclassified to the debt balances to which they relate. As at December 31, 2006, the commercial paper balance was reduced by $707 of deferred financing costs and the long-term debt balance was reduced by $1,518 of deferred financing costs. As at December 29, 2007, the commercial paper balance was reduced by $503 of deferred financing costs and the long-term debt balance was reduced by $1,010 of deferred financing costs. The Company does not have any significant embedded features in contractual arrangements that required separate presentation from the related host contract. As a result of the implementation of these standards, the Consolidated Financial Statements include Consolidated Statements of Comprehensive Income and Accumulated Other Comprehensive Income, with the cumulative amount of other comprehensive income presented as a new category of shareholders equity in the Consolidated Balance Sheets. The components of accumulated other comprehensive income as at December 29, 2007 are comprised as follows: Accumulated other comprehensive income Unrealized gain on interest rate derivatives (net of tax of $180) $ 247 Unrealized gain on equity forward derivatives (net of tax of $nil) Accumulated other comprehensive income $ 247 Equity As a result of the issuance of guidance on financial instruments accounting, the CICA issued an amended accounting standard regarding Equity ( Section 3251 ), which replaces Section 3250, Equity. The standard requires companies to disclose the impact of the new financial instruments accounting standards on equity within the Consolidated Balance Sheets and the Consolidated Statements of Retained Earnings. The standard requires prospective application and was effective for the Company s first quarter of fiscal 2007. The Company applied the new accounting standard at the beginning of its current fiscal year. 46
Future Accounting Standards Capital Disclosures In 2006, the CICA issued a new accounting standard concerning Capital Disclosures ( Section 1535 ), which requires the disclosure of both quantitative and qualitative information that enables users of financial statements to evaluate the entity s objectives, policies and processes for managing capital. The standard also requires an entity to disclose if it has complied with any capital requirements, and, if it has not complied, the consequences of such non-compliance. The standard is effective for interim and annual financial statements for fiscal years beginning on or after October 1, 2007. The Company will apply the new accounting standard at the beginning of its 2008 fiscal year with the impact being limited to the Company s disclosures, with no impact on the Company s results of operations or financial position. Financial Instruments Disclosure and Presentation The Company will be required to adopt two new accounting standards concerning financial instruments: Financial Instruments Disclosures ( Section 3862 ) and Financial Instruments Presentation ( Section 3863 ). These standards were issued in December 2006 and will replace Section 3861, Financial Instruments, Disclosure and Presentation. The new disclosure standard increases the emphasis on the risk associated with financial instruments and how those risks are managed. The new presentation standard carries forward the former presentation requirements under the existing Section 3861. The standards are effective for interim and annual financial statements for fiscal years beginning on or after October 1, 2007. The Company will apply the new accounting standards at the beginning of its 2008 fiscal year with the impact being limited to the Company s disclosures, with no impact on the Company s results of operations or financial position. Inventories The CICA issued a new accounting standard concerning Inventories ( Section 3031 ), in June 2007, which is based on the International Accounting Standards Board s International Accounting Standard 2. The new section replaced the existing guidance on inventories. The new section provides additional guidance on measuring the cost of inventory and the measurement and presentation of cost of goods sold as well as requiring additional associated disclosures. The new standard also allows for the reversal of any write-downs previously recognized. The standard is effective for interim and annual financial statements for fiscal years beginning on or after January 1, 2008. The Company will apply the new accounting standard at the beginning of its 2008 fiscal year. The Company is currently assessing the impact of the new standard on the Company s results of operations, financial position and disclosures. Going Concern In June 2007, the CICA issued amendments to Section 1400, General Standards of Financial Statement Presentation to include requirements to assess and disclose an entity s ability to continue as a going concern. The amendments are effective for interim and annual financial statements beginning on or after January 1, 2008. The Company will apply the new amendments at the beginning of its 2008 fiscal year and does not expect the implementation to have a significant impact on the Company s results of operations, financial position or disclosures. 3. Acquisitions Centre d Escomptes Racine On September 25, 2007, the Company purchased the assets of the seven stores of Centre d Escomptes Racine, a pharmacy chain in Québec. The total cost of the acquisition, including costs incurred in connection with the acquisition, was $77,077 and will be allocated among inventory, other assets, goodwill and other intangible assets. The purchase price allocation has not been completed and the full purchase price has been recorded in goodwill. 47
Notes to the Consolidated Financial Statements (continued) December 29, 2007 and December 30, 2006 (in thousands of dollars, except per share data) 3. Acquisitions (continued) The operations of the acquired stores have been included in the Company s results of operations from the date of acquisition. Other Business Acquisitions During the year, the Company acquired the assets or shares of a number of pharmacies, each of which is individually immaterial to the Company s total acquisitions. The total cost of the acquisitions of $62,756, including costs incurred in connection with the acquisitions, is allocated primarily to goodwill and other intangible assets based on their fair values. The operations of the acquired pharmacies have been included in the Company s results of operations from the date of acquisition. Funds Held in Escrow The Company had amounts held in escrow of $93,688 (2006 $nil) with respect to a number of offers to acquire certain pharmacies. These amounts are included in the balance of prepaid expenses and deposits as at December 29, 2007. 4. Interest Expense The significant components of the Company s interest expense are as follows: Interest on bank indebtedness $ 10,887 $ 7,629 Interest on commercial paper 27,593 24,902 Interest on long-term debt 13,679 15,719 Amortization of deferred financing costs 714 1,622 $ 52,873 $ 49,872 Commercial paper is issued with maturities from overnight to 90 days at floating interest rates based on Bankers Acceptance rates. In December 2005, the Company entered into interest rate derivative agreements converting an aggregate notional principal amount of $250,000 of floating rate commercial paper debt issued by the Trust into fixed rate debt. The fixed rates payable by the Company under these agreements range from 4.03% to 4.18%. See Note 15 for further discussion of the derivative agreements. 5. Income Taxes The effective income tax rate is comprised of the following: Combined Canadian federal and provincial statutory tax rate 33.0% 33.1% Adjusted for: Future income tax benefit resulting from the recognition of net capital loss carryforwards (1.1%) Increase (decrease) in future income taxes resulting from statutory tax rate changes 0.3% (0.2%) Non-deductible charges and other (0.3%) 1.5% Effective income tax rate 33.0% 33.3% 48
The components of the Company s future income tax assets and liabilities are as follows: Current Deferred income $ 46,183 $ 36,449 Accrued liabilities 14,053 11,132 Other (147) (1,174) $ 60,089 $ 46,407 Long-term Depreciable assets $ (60,803) $ (51,719) Other long-term liabilities 33,854 31,894 Deferred costs (7,916) (6,323) Net capital loss carryforwards 6,696 6,974 Other (2,002) (2,515) $ (30,171) $ (21,689) 6. Property and Equipment Accumulated Net Book Accumulated Net Book Cost Amortization Value Cost Amortization Value Properties held for development $ 38,155 $ $ 38,155 $ 10,386 $ $ 10,386 Properties under development 26,218 26,218 14,525 14,525 Land 34,778 34,778 32,686 32,686 Buildings 118,064 25,731 92,333 94,939 23,708 71,231 Equipment, fixtures, computer software and equipment 863,636 433,127 430,509 728,078 355,931 372,147 Leasehold improvements 691,460 186,940 504,520 554,780 148,027 406,753 $ 1,772,311 $ 645,798 $ 1,126,513 $ 1,435,394 $ 527,666 $ 907,728 The Company amortized $161,584 (2006 $133,845) of property and equipment into amortization during the year. 7. Deferred Costs Accumulated Net Book Accumulated Net Book Cost Amortization Value Cost Amortization Value Financing costs $ $ $ $ 15,041 $ 12,816 $ 2,225 Store opening costs 81,416 48,450 32,966 58,653 34,942 23,711 $ 81,416 $ 48,450 $ 32,966 $ 73,694 $ 47,758 $ 25,936 The Company amortized $13,508 (2006 $11,102) of store opening costs into cost of goods sold and other operating expenses during the year. In conjunction with the adoption of Section 3855, the Company adopted the policy of adding transaction costs to the financial assets and liabilities classified as other than held for trading. As a result, the Company s deferred financing costs were reclassified to the debt balances to which they relate. 49
Notes to the Consolidated Financial Statements (continued) December 29, 2007 and December 30, 2006 (in thousands of dollars, except per share data) 8. Other Intangible Assets Accumulated Net Book Accumulated Net Book Cost Amortization Value Cost Amortization Value Prescription files $ 40,529 $ 11,472 $ 29,057 $ 26,703 $ 7,192 $ 19,511 Developed technology 1,486 516 970 1,305 95 1,210 Customer relationships 29,600 1,897 27,703 24,600 272 24,328 Other 200 200 200 200 $ 71,815 $ 13,885 $ 57,930 $ 52,808 $ 7,559 $ 45,249 The Company amortized $4,280 (2006 $3,152) of prescription files, $421 (2006 $95) of developed technology and $1,625 (2006 $272) of customer relationships into amortization during the year. 9. Long-term Debt Maturity Series 1 notes 4.97% October 2008 $ 298,990 $ 300,000 Less: current portion 298,990 $ $ 300,000 $550,000 Revolving term facility June 2011 Long-term debt $ $ 300,000 As at December 29, 2007, $61,212 (2006 $50,931) of the $550,000 revolving term facility was utilized, all in respect of letters of credit and trade finance guarantees, of which $50,000 (2006 $45,500) relates to a letter of credit for the benefit of the Trust (Note 14). In conjunction with the adoption of Section 3855, the Company adopted the policy of adding transaction costs to the financial assets and liabilities classified as other than held for trading. As a result, the Company s deferred financing costs were reclassified to the debt balances to which they relate. Minimum Repayments Future minimum required repayments of long-term debt are as follows: Series 1 notes 2008 $ 300,000 10. Other Long-term Liabilities Other long-term liabilities are comprised as follows: Deferred rent obligation $ 206,611 $ 163,532 Employee future benefits 15,247 13,648 Long-term incentive plan (Note 12) 6,742 3,592 Other 16,057 8,166 $ 244,657 $ 188,938 50
Deferred Rent Obligation The deferred rent obligation represents the difference between rent expense and cash rent payments and the deferral of landlord inducements. Employee Future Benefits The Company maintains registered defined benefit pension plans under which benefits are available to certain employee groups. The Company also makes supplementary retirement benefits available to certain employees under a non-registered defined benefit pension plan. The pension plans are funded through contributions based on actuarial cost methods as permitted by pension regulatory bodies as applicable. Earnings are charged with the cost of benefits earned by employees as services are rendered. Benefits under these plans are based on the employee s years of service and final average earnings. The most recent actuarial valuations of the registered plans for funding purposes were performed as at December 31, 2006 and the next valuations will be required as at December 31, 2009. The most recent actuarial valuation of the non-registered plan for funding purposes was as at December 31, 2007 and the next valuation will be required as at December 31, 2008. The Company also maintains post-retirement benefit plans, other than pensions, covering benefits such as health and life insurance benefits for retirees. The cost of these plans is charged to earnings as benefits are earned by employees on the basis of service rendered. Information about the Company s pension and other post-retirement benefit plans, measured at November 30, 2007 and 2006, respectively, is as follows: Pension Other Benefit Pension Other Benefit Plans Plans Plans Plans Fair value of plan assets Fair value of plan assets, beginning of period $ 75,825 $ $ 67,718 $ Actual return on plan assets 3,164 7,043 Company contribution 4,735 491 4,237 344 Participant contributions 1,042 958 Benefits paid (4,256) (491) (4,131) (344) Fair value of plan assets, end of period $ 80,510 $ $ 75,825 $ Accrued benefit obligation Benefit obligation, beginning of period $ 101,024 $ 4,595 $ 94,393 $ 4,302 Service cost 6,230 415 5,967 392 Interest cost 4,198 256 3,722 245 Participant contributions 1,042 958 Plan amendments (248) Actuarial (gain) loss (7,366) 115 Benefits paid (4,256) (491) (4,131) (344) Accrued benefit obligation, end of period $ 100,624 $ 4,775 $ 101,024 $ 4,595 Funded status plan deficit $ (20,114) $ (4,775) $ (25,199) $ (4,595) Unrecognized plan amendments (1,507) (1,708) Unrecognized losses 11,149 17,854 Accrued benefit liability $ (10,472) $ (4,775) $ (9,053) $ (4,595) 51
Notes to the Consolidated Financial Statements (continued) December 29, 2007 and December 30, 2006 (in thousands of dollars, except per share data) 10. Other Long-term Liabilities (continued) The significant actuarial assumptions adopted are as follows: Registered Non-registered Other Registered Non-registered Other Pension Plans Pension Plan Benefit Plans Pension Plans Pension Plan Benefit Plans Accrued benefit obligation, end of period Discount rate 5.25% 2.63% 5.25% 5.00% 2.50% 5.00% Compensation increase 4.00% 4.00% 4.00% 4.00% 4.00% 4.00% Benefit expense for the period Discount rate 5.00% 2.50% 5.00% 5.00% 2.50% 5.00% Expected return on assets 7.50% 3.75% N/A 7.50% 3.75% N/A Compensation increase 4.00% 4.00% 4.00% 4.00% 4.00% 4.00% The health care cost trend rates used were 5.5% for 2007 and 2006, with 5.5% being the ultimate trend rate for later years. A 1% change in the assumed health care cost trend rate would not have a significant effect on the amounts reported for other benefit plans. The components of the Company s pension and other post-retirement benefit plans expense are as follows: Pension Other Benefit Pension Other Benefit Plans Plans Plans Plans Service costs $ 6,230 $ 415 $ 5,967 $ 392 Interest cost 4,198 256 3,722 245 Actual return on plan assets (3,164) (7,043) Actuarial (gain) loss (7,366) 115 Plan amendments (248) Costs arising from events of the period (350) 671 2,761 637 Difference between: Actual and expected return on plan assets (1,225) 3,295 Actuarial gain or loss recognized for the year and actual actuarial gain or loss on accrued benefit obligation 7,930 749 Amortization of plan amendment and actual plan amendments (201) (201) Net expense $ 6,154 $ 671 $ 6,604 $ 637 Total cash payments for employee future benefits consist of the Company s contributions to the pension plans and cash payments made directly to beneficiaries of the other benefit plans and totalled $5,226 (2006 $4,581). The assets of the registered pension plans consist of cash, contributions receivable and a proportionate share of a Master Trust. The assets held by the Master Trust are invested in a limited number of pooled funds, based on market values as at November 30, 2007 and 2006, respectively, as follows: Equity 58% 59% Fixed income 41% 40% Cash and cash equivalents 1% 1% The assets of the non-registered plan consist of cash and investments. The investments are in pooled funds with an allocation of 60% equities and 40% bonds based on market values as at November 30, 2007 and 2006, respectively. 52
11. Share Capital Authorized Unlimited number of common shares Unlimited number of preferred shares, issuable in series without nominal or par value Outstanding Number of Number of Common Stated Common Stated Shares Value Shares Value Beginning balance 214,975,945 $ 1,491,264 213,430,744 $ 1,441,254 Shares issued 1,813,199 13,710 2,459,012 53,915 Shares repurchased (682) (5) (913,811) (6,192) Repayment of share purchase loans 325 2,287 Exercised options 726 Ending balance 216,788,462 $ 1,506,020 214,975,945 $ 1,491,264 Weighted Average Shares Outstanding December 29, 2007 Basic 216,062,811 Diluted 217,220,846 December 30, 2006 Basic 213,931,722 Diluted 216,668,141 The common shares that may be issued under the Company s stock option plans, including contingently returnable shares issued as part of those plans, have a dilutive impact on the weighted average number of shares of 1,158,035 (2006 2,736,420). Individual shareholder agreements address matters related to the transfer of certain shares issued to the Company s management and Associates, including shares issued under options granted to management. In particular, each provides, subject to certain exceptions, for a general prohibition on any transfer of a member of management s or Associate s shares for a period of five years from the date that the individual entered into the shareholder agreement. The Company has issued loans to certain key employees under a stock purchase plan to acquire common shares of the Company. The share purchase loans receivable are non-interest bearing, mature in 2008 to 2010, are subject to certain terms of repayment pursuant to a shareholders agreement and are secured by the shares to which the loans relate. Share purchase loans are presented as a reduction in share capital and the related shares are deducted in the determination of the weighted average shares outstanding for purposes of the basic net earnings per common share calculation. 53
Notes to the Consolidated Financial Statements (continued) December 29, 2007 and December 30, 2006 (in thousands of dollars, except per share data) 11. Share Capital (continued) Normal Course Issuer Bid During 2007, the Company did not repurchase any common shares for cancellation under its normal course issuer bid. In 2006, the Company repurchased 913,600 common shares at a cost of $41,780. Repurchases were made at market prices through the Toronto Stock Exchange. The Company s current normal course issuer bid, which became effective September 10, 2007 and expires September 9, 2008, allows for the repurchase for cancellation of up to 5,400,000 common shares, representing 2.5% of the Company s outstanding common shares. No common shares have been repurchased under the current normal course issuer bid. 12. Stock-based Compensation The Company established stock option plans for certain employees and its Board of Directors as described below and has reserved 20,000,000 common shares for issuance under the plans. Effective February 2007, directors are no longer eligible to participate in the stock option plan. The Company established a deferred share unit plan for non-employee directors, which plan is also described below. In 2003, the Company adopted the guidance of accounting standard 3870, Stock-based Compensation and Other Stock-based Payments on a prospective basis. The guidance requires the use of the fair value method to account for stock options issued under employee and director stock option programs. The Company expensed $3,544 in 2007 (2006 $3,492) associated with stock options issued under the employee and director plans. If compensation expense under the fair value method of accounting had been recognized on stock options issued in 2002, the Company s net earnings for the periods ended December 29, 2007 and December 30, 2006 would have been reduced by $176 and $582, respectively. Basic and diluted earnings per share would have been unchanged for both periods. The fair value of each option was estimated on the date of the grant using the Black-Scholes option-pricing model. Employee Stock Option Plan Options issued to certain employees have an exercise price per share of no less than the fair market value on the date of the option grant. These options include awards for shares that vest based on the passage of time, performance criteria, or both. Time-based options are exercisable 20% per year on the anniversary of the grant date in each of the five subsequent years. Performance-based options are exercisable 20% per year on the anniversary of the grant date in each of the five subsequent years provided that the Company achieves specified earnings-based performance targets. Performance targets not achieved are considered to be met if the performance is achieved on a cumulative basis in subsequent years. The performance-based options become fully exercisable on the ninth anniversary of the date of grant, provided that they have not otherwise been terminated, whether or not the performance targets are achieved. Upon the termination of an optionee s employment, all unexercisable options expire immediately and exercisable options expire within 180 days of the date of termination. The plan provides that the Company may pay, in cash, certain terminated option holders the appreciated value of the options to cancel exercisable options. Subject to certain prior events of expiry, such as the termination of the employee s employment for cause, all exercisable options expire on the tenth anniversary of the date of grant. 54
A summary of the status of the employee stock option plan and changes during the period is presented below: Weighted Weighted Options on Average Options on Average Common Exercise Price Common Exercise Price Shares Per Share Shares Per Share Outstanding, beginning of period 2,916,450 $ 15.30 4,015,825 $ 9.65 Granted 350,000 46.32 Exercised (1,773,199) 7.82 (1,412,277) 6.71 Forfeited/Cancelled including repurchased (14,191) 29.64 (37,098) 22.83 Outstanding, end of period 1,129,060 $ 26.88 2,916,450 $ 15.30 Options exercisable, end of period 753,125 $ 19.25 2,206,468 $ 9.37 2007 Outstanding Options 2007 Exercisable Options Weighted Weighted Weighted Number of Average Average Number of Average Options Contractual Life Exercise Price Exercisable Exercise Price Range of Exercise Price Outstanding (Years) Per Share Options Per Share $ 5.00 $ 5.60 298,900 3.6 $ 5.44 298,900 $ 5.44 $17.13 $24.84 253,600 4.4 22.17 240,885 22.09 $25.86 $26.57 59,334 5.7 26.04 44,501 26.04 $29.30 $36.41 167,226 6.4 31.90 98,839 31.87 $46.32 350,000 8.7 46.32 70,000 46.32 1,129,060 5.9 $ 26.88 753,125 $ 19.25 Director Stock Option Plan Prior to February 2007, under the Company s director stock option plan, participating directors were issued time-based options to purchase 60,000 common shares. The options have an exercise price per share at fair market value on the date of the option grant, which is normally the date the optionee becomes a director. One-third of the options become exercisable in each of the following three years on the anniversary of the date of grant. Unexercisable options expire upon the optionee ceasing to be a director. Exercisable options expire on the earlier of 180 days of the optionee ceasing to be a director or the expiry date of the options, which is on the tenth anniversary of the date of grant. A summary of the status of the director stock option plan and changes during the period is presented below: Weighted Weighted Options on Average Options on Average Common Exercise Price Common Exercise Price Shares Per Share Shares Per Share Outstanding, beginning of period 460,000 $ 37.66 420,000 $ 29.93 Granted 180,000 44.02 Exercised (40,000) 34.14 (120,000) 20.74 Cancelled (20,000) 34.14 Outstanding, end of period 420,000 $ 37.99 460,000 $ 37.66 Options exercisable, end of period 260,000 $ 34.63 200,000 $ 30.28 55
Notes to the Consolidated Financial Statements (continued) December 29, 2007 and December 30, 2006 (in thousands of dollars, except per share data) 12. Stock-based Compensation (continued) 2007 Outstanding Options 2007 Exercisable Options Weighted Weighted Weighted Number of Average Average Number of Average Options Contractual Life Exercise Price Exercisable Exercise Price Range of Exercise Price Outstanding (Years) Per Share Options Per Share $23.35 $26.95 120,000 5.2 $ 25.15 120,000 $ 25.15 $41.80 120,000 7.6 41.80 80,000 41.80 $44.02 180,000 8.1 44.02 60,000 44.02 420,000 7.1 $ 37.99 260,000 $ 34.63 Deferred Share Unit Plan for Non-employee Directors The Company maintains a deferred share unit ( DSU ) plan to provide directors with the option to elect to receive DSUs in lieu of cash payment for all or a portion of their director fees. When such an election is made, the Company credits to the account of each director a number of DSUs (each equivalent in value to a common share) equal to the amount of fees divided by the fair market value of the common shares. The directors accounts shall be credited with dividend equivalents in the form of additional DSUs if and when the Company pays dividends on the common shares. Upon the director ceasing to be a member of the Board of Directors, the director shall receive a cash amount equal to the number of DSUs in his or her account multiplied by the fair market value of the common shares on the date the director ceases to be a member of the Board of Directors or on a later date selected by the director, which shall in any event be a date prior to the end of the following calendar year. During 2007, the Company issued an aggregate of 15,635 DSUs (2006 9,689) and recorded $788 (2006 $464) in director fee compensation. Long-term Incentive Plan The Company maintains a long-term incentive plan ( LTIP ) for certain employees, which was initiated in 2006. Under the LTIP, the employees are eligible to receive an award of share units equivalent in value to common shares of the Company. During 2007, the Company awarded 100,172 share units (2006 147,403), cumulatively totalling 247,575 share units, which vest one-third each year. 194,837 units were outstanding as at December 29, 2007 and 138,564 units were outstanding at December 30, 2006; the difference between share units awarded and outstanding was due to forfeitures of units by employees leaving the program before share units were vested. During 2007, the Company recognized compensation expense of $3,669 (2006 $3,308) associated with the share units. The liability associated with the share units earned by the employees under the LTIP is recorded in other long-term liabilities and is carried at the market value of the Company s shares at the end of the period. The Company has entered into cash-settled equity forward agreements to limit its exposure to future price changes in the Company s share price for share unit awards. These agreements mature in December 2008 and December 2009. A percentage of the equity forward derivatives, related to unearned units under the LTIP, have been designated as a hedge. 13. Net Change in Non-cash Working Capital Balances Accounts receivable $ (64,527) $ (38,227) Inventory (205,400) (146,515) Prepaid expenses (8,756) (2,904) Accounts payable and accrued liabilities 147,267 130,795 Income taxes payable (6,281) 30,300 $ (137,697) $ (26,551) 56