1. Annual Report for the Year Ended February 3, 2006

2. Dollar General At , the action is non-stop. On the move with 8,000 stores, eight around-the-clock distribution facilities and a bustling sourcing office in Hong Kong, Dollar General is hard at work for our customersliterally 24-7. We are passionate about Serving Others, completely committed to success and doing what it takes to achieve it. 3. The largest small-box value discount retail- sonal items. The Companys 64,500 employ-er in the U.S., Dollar General delivers prod-ees are guided by Dollar Generals mission:ucts that are used and replenished often Serving Others for customers, a betterby consumers, such as food, snacks, health life; for shareholders, a superior return; forand beauty aids and cleaning supplies, asemployees, respect and opportunity.well as basic apparel, housewares and sea-Our Supply Chain Dollar Generanation. To support its prolific growthnetworks in the retail industry. The cin 2005. A ninth facility is expected tOur Stores Dollar General operates neighbor- hood stores in communities often neglected or overlooked by national big-box retailers. Small by choice and convenient by design, Dollar General is the answer for todays busy, value- conscious shopper. In its second full year of operation, the Dollar General Market continues to march forward, growing to 44 stores by the end of 2005. The Dollar General Markets offer one-stop shopping for general merchandise and groceries, including fresh produce. Our Customers Dollar General caters to under-served customers, whose options are limited by time, money and access.Our Merchandise Dollar General deliverseveryday low prices on national brands ourcustomers know and trust, such as Tide, Pepsi,Mattel and Fisher-Price. In fact, Dollar Generalis among the top 10 customers of some of thenations largest consumer products companies. 4. Dollar General issued its initial public stock offering in 1968, and today, its shares trade on the New York Stock Exchange under the symbol DG. The company was added to the S&P 500 in 1998 and was first listed on the Fortune 500 in 1999. al operates more company-owned stores than any retailer in the th, Dollar General invests in one of the most efficient distributioncompany opened its eighth distribution center in Jonesville, S.C.,to open in 2006. ( as of March 3, 2006 )Financial Highlights(In millions, except per share and operating data) February 3,January 28,January 30,January 31, February 1,2006 (a) 2005 2004 20032002SUMMARY OF OPERATIONS:Net sales$ 8,582 $ 7,661 $ 6,872$ 6,100 $ 5,323Net income $ 350 $ 344 $ 299$ 262 $ 204 PER SHARE RESULTS:Basic earnings per share $ 1.09$1.04 $ 0.89 $ 0.79$ 0.61Diluted earnings per share $ 1.08$1.04 $ 0.89 $ 0.78$ 0.61Cash dividends per share of common stock $ 0.175 $ 0.160 $ 0.140$ 0.128 $ 0.128 FINANCIAL POSITION:Total assets $ 2,992 $ 2,841 $ 2,621$ 2,304 $ 2,526Long-term obligations$ 270 $ 258 $ 265$ 330 $ 339Shareholders equity $ 1,721 $ 1,684 $ 1,554$ 1,267 $ 1,024 OPERATING DATA:Retail stores at end of period7,9297,320 6,7006,1135,540 (a) The fiscal year ended February 3, 2006 is comprised of 53 weeks. 5. Fellow Shareholder: For Dollar General, 2005 We produced $350 million of netWe saw our efforts during proved to be a year of significant income, or 4.1 percent of net 2003 and 2004 begin to pay off accomplishments in positioning sales. Earnings per share werenicely during the first three quarters the Company to meet its long-term$1.08, up 3.8 percent over 2004.of 2005. Illustrating that success: objectives. While it was a difficult We generated $251 million inthrough three quarters, the Company year for the Company in some free cash flow.* We increased posted same-store sales growth of respects, we remain on target with our per share dividend by over3.4 percent, which compared very regard to our strategic plan.nine percent and paid cashfavorably with our competitors. In 2005, we saw the organiza-dividends to shareholders ofHowever, in the fourth quarter, our tion grow and become stronger$56 million, or 17.5 cents pereveryday low price model did not and more competitive. We added share. We repurchased approxi-perform well against the height- management expertise, drawingmately 15 million shares of our ened holiday promotional activity both from inside and outside the outstanding common stock. of other retailers. Same-store sales Company. We experienced the ini- Standard and Poors raised thedropped by 1.6 percent in the tial successes of our EZstore effortsCompanys credit rating tofourth quarter. and Project Gold Standard andinvestment grade.I believe that the poor per- learned how to make these projects We opened 734 new stores, formance in the fourth quarter even more effective. In Marchincluding 29 new Dollar General was a short-term misstep resulting 2006, we celebrated the openingMarkets. By fiscal year-end, we from a number of factors rather of our 8,000th store, strengtheningoperated 7,929 stores in 31 than a sign of long-term weakness our claim as the leader in our sectorstates, including 44 Dollar in our basic operating model. First, and the operator of more storesGeneral Markets.we believe the external economic than any other retailer in the US. We opened our eighth distribu-environment, particularly highertion center in South Carolina infuel costs, unemployment and Some of our other accomplish-June 2005 and began construc- consumer debt, negatively impact- ments for the year (a 53-weektion on our ninth distributioned our consumers, forcing trip fiscal year) include:center in Marion, Indiana.consolidation and deferred discre- We added $921 million of new By fiscal year-end, 3,825 storestionary spending. We know the revenue, growing net sales by 12 were operating as EZstores, using period was difficult for all retailers percent to $8.6 billion, while same- our newly engineered processes to serving the lower income customer, store sales increased 2.0 percent. run more effectively and efficiently. and the intensified promotional* Please see Non-GAAP disclosures containedLeft to right: Beryl J. Buley, division president of merchandising, marketing andin Managements Discussion and Analysis ofsupply chain; Challis M. Lowe, executive vice president of human resources;Financial Condition and Results of OperationsKathleen R. Guion, division president of store operations and store development;on page 29.David A. Perdue, chairman and CEO; Susan S. Lanigan, executive vicepresident and general counsel; David M. Tehle, executive vice president and CFO. 6. activity of our competitors seemedhad to strengthen our organiza- work in our stores. These women to be an attempt to combat what tion and prepare it for new chal- and men are absolutely critical to was an overall weakness in thelenges. Third, we had to improveour continued growth and success. sector. our merchandising productivityIn addition to the improvementsSecondly, in addition to exter-and make our practices more con-realized from EZstore, we support nal pressures, we recognized that temporary to compete in a chang-our people by recruiting the right weaknesses in our operations also ing economic environment. managers and by providing com- contributed to our fourth quarter prehensive training to new store results. After much analysis, weStrengthening Store Operationsmanagers on every aspect of run- identified several internal issuesTo address the critical issuesning a Dollar General store. In that negatively impacted ourimpacting the operation of our2005, we made additional progress results, and we moved quickly tostores and, thus, our customerstoward our goal of promoting improve our effectiveness in theseexperiences in the stores, we from within the Company. Of our areas. We firmly believe that westepped back and performed a197 new district managers in 2005, now have the people and plans insoup-to-nuts analysis of how our63 percent were promotions from place to make those improvementsstores worked. In 2004, that com- within the Company. We also and to meet the challenges we face, prehensive evaluation yielded anremain committed to diversity. By in both the short and long term.initiative we call EZstore. While making our workforce an accurate EZstore does not make working inreflection of our customer base, Strategic Efforts a Dollar General store easy, it doeswe more effectively meet diverse Three years ago during my make it less difficult and more pro-customers needs. first year with the Company, work-ductive. EZstore reduces physical ing with your board of directors, labor for our employees, reducesEnhancing the Leadership Team we established a strategic plan labor costs for the Company, To successfully address our that included three major priorities. reduces potential damages,challenges and opportunities, we First, we decided to address thereduces accidents and their costs must have a strong, committed operation of our stores. We want- and, most importantly, improves management team with the right ed to improve how we operated the shopping experience for our talent, skill set and resources. That our stores and address severalcustomers. At the end of 2005,team also must operate with the negative trends. Secondly, we nearly half of our stores werehighest level of integrity. Since knew that to compete in the EZstores. We will continue imple- joining the Company, I have con- changing retail environment, we menting the concept in othertinued to assess our needs in thatstores in 2006.regard and have worked to buildWe employthe right team of people withinapproximatelythe proper organizational structure.64,500 peopleTo help me with this, in 2005, weworldwide, and brought in a seasoned executive tomost of them lead our human resources function. Dollar General began accepting electronic benefits transfer cards in 2003, making shopping hassle-free for customers on government assistance. At the same time, we make shop- ping for all customers more convenient by accepting debit cards and Discover Network cards.Improving the shopability of our stores is oneway Dollar General caters to shoppers. Propermerchandising helps customers find key itemsfaster. Senior Vice President of Store OperationsTom Mitchell shares merchandising tips withDistrict Manager Lisa Buckley.2 7. 3 8. 4 9. In 2005, we added significantmajor national brands, as well asour mix. We are improving our leadership talent in the areas of our own high quality private label sourcing capabilities, as well as our store operations and store devel- products, at everyday low prices.ability to find special purchases opment. All of the new additionsCustomers can find nearly everythat will enhance our treasure have extensive and successful consumable need in our stores in hunt dimension. Our pricing con- retail experience. We also put both addition to a selection of apparel,tinues to be very competitive, and of those areas under the same home and seasonal items. Customers in 2005 we initiated a much more division president, ensuring that can also purchase basic refrigerated rigorous national benchmarking they work closely together to and frozen foods, including dairyeffort to ensure that we remain achieve their complementary goals.products, eggs and packaged con- extremely competitive on price.Near the end of the 2005 venience food items in most of our We also have developed a new fiscal year, we also combined our stores. In nearly all of our stores, store prototype that we plan to merchandising, marketing andwe now have the ability to process test in existing stores and roll out supply chain teams under a newelectronic benefits transfer (EBT) in our new stores in 2006. division president. This move was cards, assisting many customersSpace in our existing stores is the final step in joining all of ourwho rely on government assistance. being reallocated both to high- merchandise-related effortsDuring 2006, we plan to focus light categories that we know are together to support sales growthon long-term improvement ofimportant to our customers and to in our stores. Under the new struc- our merchandising function.add new products. We also are ture, we plan to bring in additionalSpecifically, we are just starting positioning ourselves to respond talent to take our merchandisingour category management effort more quickly to changes in cus- efforts to the next level.and will continue to enhance our tomer needs and product trends segmentation capabilities. We arethroughout the year. Refining Merchandisingalso working to strengthen our We demand quality products Strategiesplanogram, making it morewith the right prices from our ven-The Dollar General model has responsive to trends in the market.dors, and we value our relation- succeeded because we have con- In 2006, we plan to increaseships with vendors who meet that sistently offered merchandise fromour branded assortment and demand. We will continue toensure the proper pres- develop these strong vendor rela-entation of nationaltionships and to build new ones.brands. At the same As part of that effort, we are plan-time, we have the oppor-ning several projects with key ven-tunity to improve our dors in 2006 to enhance the pro-private label assortmentfile of their brands in our stores.and increase its share of Vice President of Global Sourcing Monique Wong leads the Dollar General Hong Kong buying team. Using trend forecasts and sharp negotiating skills, the team secures products customers want at prices they can afford.Stock car racing remains one of the fastest-growing spectator sports in the U.S. and a popular pastime for many of our core customers. Dollar General enters its second year as a NASCAR race team sponsor with rising star Burney Lamar at the wheel. In 2001, we were the first dollar store to introduce coolers, making basic foods, like milk, eggs and cheese, more convenient for our customers.5 10. 6 11. Dollar Generals growing network of stores demands a high efficiency supply chain operation. Senior Vice President/General Merchandise Manager of Consumables Rita F. Branham, Vice President of Distribution Anthony Roden and Vice President of Process Improvement Rod West collaborate to ensure seamless movement of products from shop floor to sales floor.Our Focus in 2006 ing, marketing and store opera-Companys compounded annualIn addition to driving towardtions functions. sales growth rate is in excess of 17 the long-term strategic objectives To meet the expanding needs percent over the past 10 years. Our outlined above, we will pay veryof our customers, as well as the legacy of being customer-centric close attention to the challenges growing number of new cus- is crucial to our future success. ahead in 2006.tomers, we must grow as well. InPast leaders of the Company,One of our highest priorities is 2006, we plan to open approxi- including our founder J.L. Turner, improving same-store sales. Thatmately 800 new traditional Dollarhis son Cal Turner, Sr., and his improvement requires effort in allGeneral stores and 30 Dollar grandson Cal Turner, Jr., under- areas of the business but will be General Markets. We expect tostood the importance of focusing chiefly centered in our merchandis- open our ninth distribution center on the customer. They personal- in 2006 in Marion, Ind., and we will ized the effort to help our cus- consider our expansion strategy as tomers deal with the financial we determine the location of pressures of everyday life. future distribution centers. We Today, we build on that legacy. also will maintain our practice of As we continue to add new cus- investing in technology that sup-tomers, we never forget the needs ports our growth and helps of our low-income core customer. improve performance. Our ability to understand the cir-Since its founding in 1939, cumstances our customers face Dollar General has cultivated aand to give them products they strong and loyal customer base. Itswant, at prices they can afford, is customer-centered efforts have our greatest strength, and our endured and succeeded throughcustomers know it. various economic cycles. The The supply chain team is critical to the success of the EZstore process improvement program, which continues to show promising preliminary results. 7 12. Our customers tell us they are tunity to increase our number ofachieve our objectives, including proud of how far they can stretch stores. In addition, we believe weconsistent financial growth. You their income and that they appre- also can grow by increasing the have a capable team, and I am ciate Dollar Generals efforts to productivity of our existing stores extremely proud of our progress. help them in that regard. We do by adapting to the ever-changing I am very grateful to have the not take that responsibility lightly. economic pressures and needs of opportunity to lead Dollar GeneralAlthough Dollar General is the our customers.at this crucial time in its history. I oldest and largest player in our Your management team, with believe we understand the issues sector, we are still growing rapidly. your board of directors, is working before us and have the people Our business model is as relevant diligently on your behalf to grow who can deal with them. We as ever, and we are focused onshareholder value. We are excited understand the needs of our cus- ensuring that it remains competi- about our future prospects andtomers and our employees, and tive. We have a significant oppor-are motivated and energized towe endeavor to balance those8 13. Senior Vice President ofReal Estate and StoreDevelopment Gayle Aertkerand her store-set teamcelebrate another major mile-stone the grand opening ofDollar Generals 8,000th storeon March 3, 2006. with our responsibility to you, our shareholders. Thank you for your investment in Dollar General Corporation and your continued support. The first Dollar General Market opened in 2003. Perishables fruits, vegetables, and basic cuts of David A. Perdue meat are now a part of our Chairman and Chief Executive Officerstrategy to deliver lifes April 2006necessities at value prices in convenient locations to our customers. 9 14. Financial SectionTable of ContentsSelected Financial Data ....................................................................................... 11Forward-Looking Statements/Risk Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12Managements Discussion and Analysis of Financial Condition and Results of Operations . . . . . . . . . . . . . . . . . . . . . . . 16Quantitative and Qualitative Disclosures About Market Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .29Managements Annual Report on Internal Control Over Financial Reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31Report of Independent Registered Public Accounting Firm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32Consolidated Balance Sheets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33Consolidated Statements of Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34Consolidated Statements of Shareholders Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35Consolidated Statements of Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36Notes to Consolidated Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .37Corporate Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6210 15. SELECTED FINANCIAL DATA The following table sets forth selected consolidated financial information for each of the five most recent fiscal years. This information should be read in conjunction with the Consolidated Financial Statements and the notes thereto and Managements Discussion and Analysis of Financial Condition and Results of Operations.February 3, January 28, January 30,January 31, February 1, 2006(a)20052004 20032002 (In thousands, except per share and operating data)Summary of Operations: Net sales $ 8,582,237 $ 7,660,927$ 6,871,992$ 6,100,404 $ 5,322,895 Gross profit$ 2,464,824 $ 2,263,192$ 2,018,129$ 1,724,266 $ 1,509,412 Penalty expense and litigation settlement (proceeds) $$ $10,000$ (29,541) $ Income before income taxes$ 544,642 $534,757 $ 476,523$ 410,337 $ 322,174 Net income$ 350,155 $344,190 $ 299,002$ 262,351 $ 203,874 Net income as a % of sales 4.1% 4.5%4.4% 4.3%3.8%Per Share Results: Basic earnings per share$ 1.09$1.04$ 0.89 $ 0.79$0.61 Diluted earnings per share$ 1.08$1.04$ 0.89 $ 0.78$0.61 Cash dividends per share of common stock $ 0.175 $0.160 $ 0.140$ 0.128 $ 0.128 Weighted average diluted shares 324,133332,068 337,636335,050 335,017Financial Position: Total assets$ 2,992,187 $ 2,841,004$ 2,621,117$ 2,303,619$ 2,526,481 Long-term obligations $ 269,962 $ 258,462$ 265,337$ 330,337$ 339,470 Shareholders equity$ 1,720,795 $ 1,684,465$ 1,554,299$ 1,267,445$ 1,023,690 Return on average assets (b) 12.1% 12.7%12.3%10.9%8.6% Return on average equity (b) 20.9% 22.1%21.4%23.2%22.2%Operating Data: Retail stores at end of period7,929 7,320 6,7006,113 5,540 Year-end selling square feet 54,753,00050,015,00045,354,000 41,201,00037,421,000 Highly consumable sales65.3% 63.0% 61.2%60.2% 58.0% Seasonal sales 15.7% 16.5% 16.8%16.3% 16.7% Home products sales10.6% 11.5% 12.5%13.3% 14.4% Basic clothing sales 8.4%9.0%9.5% 10.2% 10.9% (a) The fiscal year ended February 3, 2006 is comprised of 53 weeks. (b) Average assets or equity, as applicable, is calculated using the fiscal year-end balance and the four preceding fiscal quarter-end balances. 11 16. FORWARD-LOOKING STATEMENTS/RISK FACTORS Except for specific historical information, many of thesales and net income during the Christmas selling season discussions in this report may express or imply projectionsin the fourth quarter. In anticipation of this holiday, the of revenues or expenditures, plans and objectives forCompany purchases substantial amounts of seasonal future operations, growth or initiatives, expected futureinventory and hires many temporary employees. A sea- economic performance, or the expected outcome or sonal merchandise inventory imbalance could result if for impact of pending or threatened litigation. These and sim- any reason the Companys net sales during the Christmas ilar statements regarding events or results which Dollar selling season were to fall below seasonal norms. If such General Corporation (the Company or Dollar General)an imbalance were to occur, more markdowns than antici- expects will or may occur in the future are forward-lookingpated might be required to minimize the imbalance. The statements concerning matters that involve risks, uncer- Companys profitability and operating results could be tainties and other factors which may cause the actual per- adversely affected by unanticipated markdowns and by formance of the Company to differ materially from thoselower than anticipated sales. Lower than anticipated sales expressed or implied by these statements. All forward- in the Christmas selling season would also negatively looking information should be evaluated in the context ofimpact the Companys ability to leverage the increased these risks, uncertainties and other factors. The wordslabor costs. believe,anticipate,project,plan,expect,estimate, objective,forecast,goal,intend,will likely result, or Competition in the retail industry could limit the will continue and similar expressions generally identify Companys growth opportunities and reduce its profitability. forward-looking statements. The Company believes the The Company operates in the discount retail merchandise assumptions underlying these forward-looking statementsbusiness, which is highly competitive. This competitive are reasonable; however, any of the assumptions could be environment subjects the Company to the risk of reduced inaccurate, and therefore, actual results may differ materi- profitability because of the lower prices, and thus the ally from those projected in or implied by the forward-lower margins, required to maintain the Companys com- looking statements. Factors and risks that may result in petitive position. The Company competes with discount actual results differing from this forward-looking informa-stores and with many other retailers, including mass mer- tion include, but are not limited to, those listed below, as chandise, grocery, drug, convenience, variety and other well as other factors discussed throughout this document,specialty stores. These other retail companies operate including, without limitation, the factors described under stores in many of the areas where the Company operates. Critical Accounting Policies and Estimates inThe Companys direct competitors in the dollar store retail Managements Discussion and Analysis contained herein, category include, without limitation, Family Dollar, Dollar or discussed, from time to time, in the Companys filingsTree, Freds, and various local, independent operators. with the Securities and Exchange Commission (the SEC), Competitors from other retail categories include Wal-Mart press releases and other communications. and Walgreens, among others. Some of the Companys Readers are cautioned not to place undue reliancecompetitors utilize aggressive promotional activities, on forward-looking statements made in this document, advertising programs, and pricing discounts and the since the statements speak only as of the documents Companys results of operations could be adversely date. The Company has no obligation, and does notaffected if the Company does not respond effectively to intend, to publicly update or revise any of these forward- these efforts. looking statements to reflect events or circumstances The discount retail merchandise business is subject to occurring after the date of this document or to reflect theexcess capacity, and some of the Companys competitors occurrence of unanticipated events. Readers areare much larger and have substantially greater resources advised, however, to consult any further disclosures the than the Company. The competition for customers has Company may make on related subjects in its documentsintensified in recent years as larger competitors, such as filed with or furnished to the SEC or in its other publicWal-Mart, have moved into, or increased their presence in, disclosures. the Companys geographic markets. The Companyremains vulnerable to the marketing power and high level The Companys business is moderately seasonal with the of consumer recognition of these major national discount highest portion of sales occurring during the fourth quarter.chains and to the risk that these chains or others could Adverse events during the fourth quarter could, therefore, venture into the dollar store industry in a significant way. materially affect the Companys financial statements as aGenerally, the Company expects an increase in competition. whole. The Company realizes a significant portion of its net 12 17. FORWARD-LOOKING STATEMENTS/RISK FACTORS The Companys financial performance is highly sensitivewith the consequence that its net sales or profit margins to changes in overall economic conditions that may impactwould be reduced. Also, prolonged or repeated price consumer spending and the Companys costs of doing busi- increases of certain raw materials could affect our vendors ness. A general slowdown in the United States economyproduct costs and, ultimately, the Companys profitability. or rising personal debt levels may adversely affect theThe Companys ability to pass on incremental pricing spending of the Companys consumers, which would likelychanges may be limited due to operational and competi- result in lower net sales than expected on a quarterly ortive factors, which could negatively affect the Companys annual basis. Economic conditions affecting disposable profitability and sales. consumer income, such as employment levels, business conditions, fuel and energy costs, inflation, interest rates,The efficient operation of the Companys business is and tax rates, could also adversely affect the Companys heavily dependent on its information systems. The Company business by reducing consumer spending or causingdepends on a variety of information technology systems consumers to shift their spending to other products. The for the efficient functioning of its business. The Company Company might be unable to anticipate these buying relies on certain software vendors to maintain and periodi- patterns and implement appropriate inventory strategies, cally upgrade many of these systems so that they can con- which would adversely affect its sales and gross profittinue to support the Companys business. The software performance. In addition, continued increases in fuel andprograms supporting many of the Companys systems energy costs would increase the Companys transportation were licensed to the Company by independent software costs and overall cost of doing business and could adverse-developers. The inability of these developers or the ly affect the Companys financial statements as a whole. Company to continue to maintain and upgrade theseinformation systems and software programs would disruptNatural disasters or unusually adverse weather condi- or reduce the efficiency of the Companys operations if it tions could adversely affect the Companys net sales and sup-were unable to convert to alternate systems in an efficient ply chain efficiency. Unusually adverse weather conditions,and timely manner. In addition, costs and potential prob- natural disasters or similar disruptions, especially duringlems and interruptions associated with the implementa- the peak Christmas selling season, but also at other times,tion of new or upgraded systems and technology or with could significantly reduce the Companys net sales. In maintenance or adequate support of existing systems addition, these disruptions could also adversely affect thecould also disrupt or reduce the efficiency of the Companys supply chain efficiency and make it more diffi-Companys operations. The Company also relies heavily on cult for the Company to obtain sufficient quantities ofits information technology staff. If the Company cannot merchandise from its suppliers.meet its staffing needs in this area, the Company may notbe able to fulfill its technology initiatives while continuingExisting military efforts and the possibility of war andto provide maintenance on existing systems. acts of terrorism could disrupt the Companys information or distribution systems or increase our costs of doing business. The Company is dependent upon the smooth function- Existing U.S. military efforts, as well as the involvement ofing of its distribution network, the capacity of its distribution the United States in other military engagements, or a sig- centers (DCs), and the timely receipt of inventory. The nificant act of terrorism on U.S. soil or elsewhere, could Company relies upon the ability to replenish depleted have an adverse impact on the Company by, among otherinventory through deliveries to its DCs from vendors and things, disrupting its information or distribution systems;from the DCs to its stores by various means of transporta- causing dramatic increases in fuel prices thereby increas- tion, including shipments by air, sea and truck. Labor short- ing the costs of doing business; or impeding the flow of ages in the transportation industry could negatively affect imports or domestic products to the Company. transportation costs. In addition, long-term disruptions tothe national and international transportation infrastruc-The Companys business is dependent on its ability to ture that lead to delays or interruptions of service would obtain attractive pricing and other terms from its vendors.adversely affect the Companys business. The Company The Company believes that it has generally good relationsalso may face difficulty in obtaining needed inventory with its vendors and that it is generally able to obtain from its vendors because of interruptions in production, attractive pricing and other terms from vendors. However,adverse weather conditions, foreign trade restrictions or if the Company fails to maintain good relations with its government regulations, or for other reasons, which would vendors, it may not be able to obtain attractive pricing adversely affect the Companys sales. Moreover, if the 13 18. FORWARD-LOOKING STATEMENTS/RISK FACTORS Company were unable to achieve functionality of new DCsdifferent geographic areas; general economic conditions; in the time frame expected, the Companys ability to and the availability of sufficient funds for expansion. Many achieve the expected growth could be inhibited.of these factors are beyond the Companys control. In Construction and expansion projects relating to theaddition, the Company may not anticipate all of the Companys DCs entail risks which could cause delays andchallenges imposed by the expansion of its operations cost overruns, such as: shortages of materials; shortages of and, as a result, may not meet its targets for opening new skilled labor or work stoppages; unforeseen construction,stores or expanding profitably. scheduling, engineering, environmental or geological problems; weather interference; fires or other casualtyThe inability to execute operating initiatives could nega- losses; and unanticipated cost increases. The completion tively affect the Companys future operating results. The dates and ultimate costs of these projects could differ sig- Company is involved in a significant number of operating nificantly from initial expectations due to construction-initiatives that have the potential to be disruptive in the related or other reasons. The Company cannot guarantee short term if they are not implemented effectively. that any project will be completed on time or within Ineffective implementation or execution of some or all of established budgets. these initiatives could also negatively impact theCompanys operating results. Please reference the discus-The Companys success depends to a significant extent sion of the initiatives in the Results of Operations upon the abilities of its senior management team and the Executive Overview section included in the Managements performance of its employees. The loss of services of keyDiscussion and Analysis of Financial Condition and Results members of the Companys senior management team or of Operations section of this document. of certain other key employees could negatively affect the Companys business. The risk of key employee turnover The Companys cost of doing business could increase as intensifies as a greater number of public corporations a result of changes in federal, state or local regulations. locate in the vicinity of the Companys headquarters. In Unanticipated changes in the federal or state minimum addition, future performance will depend upon thewage or living wage requirements or changes in other Companys ability to attract, retain and motivate qualifiedwage or workplace regulations could adversely affect the employees to keep pace with its expansion schedule.Companys ability to meet financial targets. In addition, The inability to do so may limit the Companys ability changes in federal, state or local regulations governing the to effectively penetrate new market areas. Also, the sale of the Companys products, particularly over-the- Companys stores are decentralized and are managed counter medications or health products, could increase through a network of geographically dispersedthe Companys cost of doing business and could adversely management personnel. The inability of the Company toaffect the Companys sales results. Also, the Companys effectively and efficiently operate its stores, including theinability to comply with these regulatory changes in a ability to control losses resulting from inventory and cashtimely fashion or to adequately execute a required recall shrinkage, may negatively impact the Companys sales could result in significant fines or penalties that could and/or operating margins.affect the Companys financial statements as a whole. If the Company cannot open new stores on schedule, itsUnanticipated increases in insurance costs or loss experi- growth will be impeded which would adversely affect sales. ence could negatively impact profitability. The costs of some The Companys growth is dependent on both increases in insurance (workers compensation insurance, general liabil- sales in existing stores and the ability to open new stores. ity insurance, health insurance and property insurance) Delays in store openings could adversely affect theand loss experience have risen in recent years. Higher than Companys future operations by slowing new store expected increases in these costs or other insurance costs growth, which may in turn reduce its revenue growth. or unexpected escalations in the Companys loss rates The Companys ability to timely open new stores and to could have an unanticipated negative impact on the expand into additional market areas depends in part on Companys profitability. the following factors: the availability of attractive store locations; the ability to negotiate favorable lease terms;The Company is subject to certain legal proceedings that the ability to hire and train new personnel, especially storemay adversely affect its financial statements as a whole. The managers; the ability to identify customer demand in Company is involved in a number of legal proceedings,14 19. FORWARD-LOOKING STATEMENTS/RISK FACTORS which include, for instance, consumer, employment, tort expectations. The Companys ability to obtain indemnifi- and other litigation. Certain of these lawsuits, if decided cation from the manufacturers of these products may be adversely to the Company or settled by the Company, may hindered by the manufacturers lack of understanding of result in liability material to the Companys financial state-U.S. product liability laws, which may make it more likely ments as a whole or may negatively impact the Companys that the Company may have to respond to claims or com- operating results if changes to the operation of the busi-plaints from its customers as if the Company were the ness are required. Please see Note 7 to the Consolidatedmanufacturer of the products. Any of these circumstances Financial Statements included in this document for furthercould have a material adverse effect on the Companys details regarding certain of these pending matters. business and its financial statements as a whole.The Company may be unable to rely on liability indemni- The Company is subject to interest rate risk which could ties given by foreign vendors which could adversely affect itsimpact profitability. The Company is subject to market risk financial statements as a whole. The Company importsfrom exposure to changes in interest rates based on its approximately 13% of its merchandise globally. Sources of financing, investing and cash management activities. supply may prove to be unreliable, or the quality of theChanges in interest rates could have an unanticipated globally sourced products may vary from the Companys negative impact on the Companys profitability.15 20. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Generalexpenses, but is particularly critical as we compete forretail site locations and for qualified talent to manage andAccounting Periods. The following text contains refer-operate our stores. The fact that many of our stores are ences to years 2006, 2005, 2004 and 2003, which representlocated in towns that many retailers may find too small to fiscal years ending or ended February 2, 2007, February 3, support their business model, however, has allowed Dollar 2006, January 28, 2005, and January 30, 2004, respectively.General to continue to increase its store count faster than Fiscal year 2006 will be, and each of 2004 and 2003 was, most retailers. a 52-week accounting period, while fiscal 2005 was aManagement of the Company continues to focus on 53-week accounting period, which affects the comparabili-making good investment decisions for the long-term ty of certain amounts in the Consolidated Financialgrowth and profitability of the Company. In order to better Statements and financial ratios between 2005 and the support sales efforts in our stores and to enable the other fiscal years reflected herein. The Companys fiscalCompany to continue its rapid growth, the Company has year ends on the Friday closest to January 31. This discus-attempted to strengthen the senior leadership team over sion and analysis should be read with, and is qualified in the last several years. In 2005, changes were made to the its entirety by, the Consolidated Financial Statements and organization structure in order to increase synergies the notes thereto. It also should be read in conjunction between store operations and new store development with the Forward-Looking Statements/Risk Factors disclo- and among merchandising, marketing and the supply sure set forth above.chain. Executives were added to support our efforts inhuman resources, real estate, store operations, supplyPurpose of Discussion. We intend for this discussion to chain and the Dollar General Market concept. Going provide the reader with information that will assist inforward, the Company expects these new leaders to understanding our Company and the critical economichave a positive impact on the overall performance and factors that affect our Company. In addition, we hope to profitability of the Company. help the reader understand our financial statements, theAlong with other retail companies, we are impacted changes in certain key items in those financial statements by a number of factors including, but not limited to: cost from year to year, and the primary factors that accountedof product, consumer debt levels, economic conditions, for those changes, as well as how certain accounting customer preferences, unemployment, labor costs, principles affect our financial statements.inflation, fuel prices, weather patterns, insurance costsand accident costs. Executive Overview Key Items in Fiscal 2005. Despite a difficult economicDollar General Corporation (Dollar General or the environment for our customers in 2005, the Company Company) is the largest dollar store discount retailer ofsuccessfully implemented many of the important operat- consumable basics in the United States, with over 8,000ing initiatives outlined in last years Form 10-K, while also stores. We are committed to serving the needs of low-, increasing sales and earnings per share. The following middle- and fixed-income customers. However, the are some of the more significant accomplishments during Company sells quality private label and national brand the year: Total sales increased by 12.0 percent, including sales products that appeal to a wide range of customers. Our merchandise is priced at competitive everyday low pricesduring the 53rd week, and same-store sales increased that do not change frequently as a result of promotionalby 2.0 percent; We opened 734 new stores, including 29 Dollar activity. We believe many of our customers shop at Dollar General because they trust us to consistently stock quality General Market stores; We implemented EZstore the Companys initiative merchandise at low prices. We also believe convenience,, or the ability to complete a shopping trip in a limited designed to improve inventory flow from distribution amount of time, is critical to many of our customers and is centers to consumers as well as improve other areas a key factor that differentiates us from large-box retailers. of store operations, including labor scheduling, hiringWe operate in the highly competitive retail industry.and training and product presentation, in 3,825 stores We face strong sales competition from other retailers thatas of year-end; We completed construction of and opened the sell general merchandise and food. Because of Dollar Generals low-price strategy, we must strive to keep ourCompanys eighth DC in South Carolina and began operating costs as low as possible. This effort affects all construction of a ninth DC in Indiana to increase over- 16 21. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSall distribution capacity and to decrease stem milesof the asset losses in the future. Significant business inter-between the DCs and the stores; ruption was experienced during the hurricanes. The We increased annual inventory turns to 4.2 times inCompany did not recover any business interruption insur-2005, including the 53rd week, from 4.0 times in 2004 ance proceeds during the year, and will not record anyand reduced inventory levels on a per-store basis bysuch proceeds until the business interruption claims are1% as of year end. The Company has executed end-of- substantially settled.season markdowns over the past two years tominimize seasonal inventory carried forward to the Company Performance Measures. Management usesfollowing year. The Company made substantiala number of metrics, including those indicated on theprogress on this initiative in 2005 and continues totable included in Results of Operations below, to assessaggressively identify, evaluate, merchandise andits performance. The following are the more frequentlymarkdown aged inventory;discussed metrics: We introduced Dollar General gift cards before the Earnings per share (EPS) growth is an indicator ofChristmas holiday season;the increased returns generated for the Companys We introduced Fisher-Price branded childrensshareholders. EPS of $1.08 in 2005 reflected anapparel and Bobbie Brooks apparel for women inincrease of 3.8 percent over EPS of $1.04 reported inour stores;2004. We developed and installed new systems to provide Total net sales growth indicates, among other things,enhanced store operating statements, supplierthe success of the Companys selection of new storecommunications and transportation and claims locations and merchandising strategies. Total net salesmanagement; andincreased 12.0% in 2005, including the impact of the We generated sufficient cash flow to allow the53rd week. Same-store sales growth indicates whether our mer-Company to repurchase approximately 15 millionshares of its common stock for $297.6 million andchandising strategies, store execution and customerto increase our per share dividend to shareholders service in existing stores have been successful inby over 9%.generating increased sales. Same-store sales increasedThe Company believes its 2005 sales (particularly in 2.0 percent in 2005, with stronger same-store sales in more discretionary, higher gross profit categories) werethe first half of the year than the latter half. Sales were negatively impacted by the effect on its typical low- tonegatively impacted for the year by the economic middle-income customer of high gasoline and heating factors discussed above. However, the latter half of the fuel prices as well as higher interest rates and increasing year was increasingly impacted by promotional efforts consumer debt levels. The Companys gross profit rate was of competitors. Same-store sales in 2004 increased by negatively impacted for the year by several factors as3.2 percent. Operating margin rate (operating profit divided by net further discussed in Results of Operations below, but was most notably affected by the decrease, as a percentagesales), which is an indicator of the Companys success of sales, in sales of higher gross profit merchandise in leveraging its fixed costs and managing its variable categories and higher transportation fuel costs.costs, declined to 6.5 percent in 2005 versus 7.3In 2005, Hurricanes Katrina and Rita made landfall inpercent in 2004. The various components impacting the Gulf Coast, impacting our operations, our customers,this metric are fully discussed in Results of and our employees. At the peak, approximately 350 storesOperations below. Free cash flow (the sum of net cash flows from operat- were temporarily closed due to Hurricane Katrina and 330 stores were temporarily closed due to Hurricane Rita. The ing activities, net cash flows from investing activities Company ultimately closed 41 stores as a result of theand net cash flows from financing activities, excluding hurricanes, and suffered the total destruction of inventory share repurchases and changes in debt other than in 29 of those stores due to Hurricane Katrina and 3 of required payments). Although this measure is a non- those stores due to Hurricane Rita. Significant losses of GAAP measure, the Company believes it is useful as an inventory and fixed assets, in the form of store fixtures and indicator of the cash flow generating capacity of the leasehold improvements, were caused by the hurricanes.Companys operations. It is also a useful metric to ana- These losses were offset by insurance proceeds received lyze in conjunction with net income to determine during the year. In addition, the Company expects towhether there is any significant non-cash component record additional insurance proceeds in excess of the costto the Companys net income. The Company generat- 17 22. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ed free cash flow of $250.9 million in 2005 compared improved in-store presentation, and heightened to $96.2 million in 2004, as calculated below underpromotional energy aimed at increasing customer Non-GAAP disclosures.traffic and average customer ticket. The Company Inventory turns (cost of goods sold for the year divid-plans to strengthen its treasure hunt offering and to ed by average inventory balances, at cost, measured at execute a variety of new marketing, promotional the end of the latest five fiscal quarters) is an indicatorand/or advertising strategies. The Company will also of how well the Company is managing the largestimplement a new store floor plan in all new stores, asset on its balance sheet. Inventory turns were 4.2 emphasizing improved merchandising adjacencies, times in 2005, including the 53rd week, compared tooperational efficiencies and customer service, and will 4.0 times in 2004. continue efforts referred to as Project Gold Standard Return on average assets (net income for the yearbegun in 2005 to improve the shopability and finan- divided by average total assets, measured at the end cial performance of existing stores; Further development of the Dollar General Market of the latest five fiscal quarters), is an overall indicator of the Companys effectiveness in deploying itsconcept; Continued investment in EZstore, further reducing resources. Return on assets was 12.1 percent in 2005 and 12.7 percent in 2004.store labor and related costs, with the goal of com-While the Company is particularly pleased with thepleting the rollout by the end of 2006; Increased efforts to control inventory shrink in the improvement in inventory management and free cash flow generation, we did not achieve our overall internal stores, which remains above acceptable levels as a financial goals set out at the beginning of the year.percentage of sales; Opening a minimum of 800 new traditional Dollar This shortfall was partially a result of non-controllable economic and other factors that impacted our customers.General stores, while continuing to pursue further As a result of the Companys inability to achieve itsgeographical expansion, with increased emphasis on financial targets, executives and administrative employees site selection, approval processes, and lowering rent as did not earn a bonus under the Companys Teamshare a percentage of sales in new and existing stores; and Continued investment in the Companys infrastruc- bonus program. The Company has identified the following opportunities aimed at improving financial performance ture, including increasing global sourcing, further in 2006. developing our information technology capabilities,and opening the Companys ninth distribution center Key Items for Fiscal 2006. For 2006, the Company has thereby expanding distribution capacity. established the following priorities and initiatives aimed atThe Company can provide no assurance that it continuing the Companys growth and improving its oper- will be successful in executing these initiatives, nor ating and financial performance while remaining focused can the Company guarantee that the successful on serving its customers: implementation of these initiatives will result in superior Improvement in sales performance of same-stores financial performance. and new stores through new merchandise additions,18 23. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations The following discussion of the Companys financial performance is based on the Consolidated Financial Statements set forth herein. The following table contains results of operations data for the 2005, 2004 and 2003 fiscal years, and the dollar and percentage variances among those years.2005 vs. 20042004 vs. 20032005 (a) 20042003$ change % change$ change % change (amounts in millions, excluding per share amounts) Net sales by category: Highly consumable$ 5,606.5$ 4,825.1$ 4,206.9$ 781.416.2% $ 618.214.7% % of net sales 65.33% 62.98% 61.22% Seasonal 1,348.81,264.01,156.1 84.8 6.7107.9 9.3 % of net sales 15.72% 16.50% 16.82% Home products907.8879.5860.9 28.4 3.2 18.6 2.2 % of net sales 10.58% 11.48% 12.53% Basic clothing 719.2692.4648.1 26.8 3.9 44.3 6.8 % of net sales8.38%9.04%9.43%Net sales$ 8,582.2$ 7,660.9$ 6,872.0$ 921.312.0% $ 788.911.5% Cost of goods sold 6,117.45,397.74,853.9719.713.3543.911.2 % of net sales 71.28% 70.46% 70.63%Gross profit 2,464.82,263.2 2,018.1 201.6 8.9245.112.1 % of net sales 28.72% 29.54%29.37% Selling, general and administrative expenses 1,903.01,706.2 1,500.1 196.711.5206.113.7 % of net sales 22.17% 22.27%21.83% Penalty expense10.0 (10.0) (100.0) % of net sales 0.15%Operating profit 561.9 557.0 508.04.9 0.9 49.0 9.6 % of net sales 6.55% 7.27% 7.39% Interest income(9.0) (6.6) (4.1) (2.4) 36.9 (2.5) 60.2 % of net sales(0.10)% (0.09)% (0.06)% Interest expense 26.228.835.6(2.6) (8.9)(6.8)(19.1) % of net sales 0.31% 0.38% 0.52%Income before income taxes 544.6 534.8 476.59.9 1.8 58.212.2 % of net sales6.35% 6.98% 6.93% Income taxes 194.5 190.6 177.53.9 2.1 13.0 7.3 % of net sales2.27% 2.49% 2.58%Net income $ 350.2$344.2$299.0$ 6.0 1.7% $ 45.2 15.1% % of net sales4.08% 4.49% 4.35%Diluted earnings per share $1.08$ 1.04$ 0.89$ 0.043.8% $ 0.15 16.9% Weighted average diluted shares324.1 332.1 337.6(7.9)(2.4) (5.6)(1.6) (a) The fiscal year ended February 3, 2006 is comprised of 53 weeks. 19 24. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Net Sales. Increases in 2005 net sales resulted primari- The Companys sales increase in 2004 compared to ly from opening additional stores, including 609 net new2003 resulted primarily from opening additional stores, stores in 2005, and a same-store sales increase of 2.0% for including 620 net new stores in 2004, and a same-store 2005 compared to 2004. Same-store sales calculations forsales increase of 3.2% for 2004 compared to 2003. The 2005 and prior include only those stores that were open increase in same-store sales accounted for $204.0 million both at the end of that period and at the beginning of theof the increase in sales while stores opened since the preceding fiscal year. Same-store sales increases are beginning of 2003 were the primary contributors to the calculated based on the comparable calendar weeks remaining $585.0 million sales increase during 2004. The in the prior year. Accordingly, the same store salesCompanys sales increase in 2004 was primarily attributa- percentage for 2005 discussed above excludes sales from ble to the highly consumable category, which increased by the 53rd week as there was no comparable week in 2004.$618.2 million, or 14.7%. The increase in same-store sales accounted for $144.2 million of the increase in sales. Stores opened since the Gross Profit. The gross profit rate declined by 82 basis beginning of 2004, as well as the $162.9 million impact ofpoints in 2005 as compared with 2004 due to a number of the 53rd week of sales in fiscal year 2005 for all stores werefactors, including but not limited to: lower sales (as a per- the primary contributors to the remaining $777.1 millioncentage of total sales) in the Companys seasonal, home sales increase during 2005. The increase in same-storeproducts and basic clothing categories, which have higher sales is primarily attributable to an increase in average than average markups; an increase in markdowns as a customer purchase.percentage of sales primarily as a result of the Companys The Company has recently revised and published itsinitiative to reduce per-store inventory; higher transporta- method for determining the stores that are included in thetion expenses primarily attributable to increased fuel Companys publicly released same-store sales calculations.costs; an increase in the Companys shrink rate; and an Beginning in fiscal 2006, the Company now provides same-estimated $5.2 million reduction resulting from the store sales calculations for those stores that have been open expansion of the number of departments utilized for the at least 13 full fiscal months and remain open at the end ofgross profit calculation from 10 to 23, as further described the reporting period. Using the revised methodology, thebelow under Critical Accounting Policies and Estimates. same-store sales increase in 2005 was 2.2%. These factors were partially offset by higher average The Company monitors its sales internally by the four mark-ups on the Companys beginning inventory in major categories noted in the table above. The Companys2005 as compared with 2004. In 2005 and 2004, the merchandising mix in recent years has shifted to faster-Company experienced inventory shrinkage of 3.22% turning consumable products versus seasonal, home and 3.05%, respectively. products and clothing. This has been driven by customer The gross profit rate increased 17 basis points in 2004 wants and needs in the marketplace. As a result, over the as compared with 2003. Although the Companys gross past three years the highly consumable category has profit rate was pressured by sales mix shifts to more highly become a greater percentage of the Companys overallconsumable items, which typically carry lower gross profit sales mix while the percentages of the seasonal, home rates, the Company was able to more than offset this products and basic clothing categories have declined. through increases in gross markups on all merchandise Accordingly, the Companys sales increase by merchandisecategories in 2004. More specific factors include higher category in 2005 compared to 2004 was primarily attribut- initial mark-ups on merchandise received during 2004 as able to the highly consumable category, which increased compared with 2003, achieved primarily from the positive by $781.4 million, or 16.2%. The Company believes thatimpact of opportunistic purchasing, renegotiating product future sales growth is dependent upon an increase in thecosts with several key suppliers, selective price increases, number of customer transactions as well as an increase in and an increase in various performance-based vendor the dollar value of the average transaction. The Companyrebates; and higher average mark-ups on the Companys continually reviews its merchandise mix and strives tobeginning inventory in 2004 as compared to 2003, which adjust it when deemed necessary as a part of its ongoingrepresents the cumulative impact of higher margin pur- efforts to improve overall sales and gross profit. Thesechases over time. These components of gross profit, which ongoing reviews may result in a shift in the Companyspositively impacted the Companys results, were partially merchandising strategy which could increase permanent offset by an increase in transportation expenses as a per- markdowns in the future.centage of sales, resulting primarily from higher fuel costs 20 25. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS in 2004 as compared to 2003; and a nonrecurring favor- ing from its agreement in principle with the Securities and able inventory adjustment in 2003 of $7.8 million, repre-Exchange Commission (SEC) staff to settle the matters senting a change in the Companys estimated provisionarising out of a restatement of the Companys financial for shrinkage. statements for fiscal years 2001 and prior.Selling, General and Administrative (SG&A) Expense. Interest Income. The increase in interest income in The 10 basis point decrease in SG&A expense as a percent-2005 compared to 2004 is due primarily to higher interest age of sales in 2005 as compared with 2004 was due toearned on short-term investments due to increased a number of factors, including but not limited to theinterest rates on short-term borrowings. The increase in following expense categories that either declined or interest income in 2004 compared to 2003 is due primarily increased less than the 12.0% increase in sales: employeeto interest income on certain notes receivable purchased incentive compensation expense (decreased 37.8%), basedin May 2003 relating to the Companys South Boston upon the Companys fiscal 2005 financial performance;DC, as further discussed below under Liquidity and professional fees (decreased 32.3%), primarily due to theCapital Resources. reduction of consulting fees associated with the EZstore project and 2004 fees associated with the Companys Interest Expense. The decrease in interest expense in initial Sarbanes-Oxley compliance effort; and employee 2005 is primarily attributable to a reduction in tax related health benefits (decreased 10.0%), due in part to a down-interest expense of $1.4 million, principally due to the ward revision in claim lag assumptions based upon review reversal of interest accruals pertaining to certain income and recommendation by the Companys outside actuarytax related contingencies that were resolved during 2005. and decreased claims costs as a percentage of sales. The decrease in interest expense in 2004 compared to Partially offsetting these reductions in SG&A were current 2003 is due primarily to capitalized interest of $3.6 million year increases in store occupancy costs (increased 17.6%), related to the Companys DC construction and expansion primarily due to rising average monthly rentals associated projects in 2004 compared to $0.2 million in 2003 and a with the Companys leased store locations, and store reduction in amortization of debt issuance costs of $2.2 utilities costs (increased 22.7%) primarily related to million due in part to the amendment of the Companys increased electricity and gas expense. revolving credit facility in June 2004. The Company had The increase in SG&A expense as a percentage ofvariable-rate debt of $14.5 million as of February 3, 2006. sales in 2004 as compared with 2003 was due to a numberThe remainder of the Companys outstanding indebted- of factors, including but not limited to increases in theness at February 3, 2006 and all of its outstanding indebt- following expense categories that were in excess of theedness at January 28, 2005 was fixed rate debt. 11.5 percent increase in sales: store occupancy costs (increased 17.4%), primarily due to rising average monthlyIncome Taxes. The effective income tax rates for 2005, rentals associated with the Companys leased store 2004 and 2003 were 35.7%, 35.6% and 37.3%, respectively. locations; purchased services (increased 54.6%), due pri- While the 2005 and 2004 rates were similar overall, marily to fees associated with the increased customerthe rates contained offsetting differences. Non-recurring usage of debit cards; professional fees (increased 119.2%),factors causing the 2005 tax rate to increase when primarily due to consulting fees associated with both thecompared to the 2004 tax rate include a reduction in fed- Companys 2004 EZstore project and compliance with eral jobs credits of approximately $1.0 million, additional certain provisions of the Sarbanes-Oxley Act of 2002; andnet foreign income tax expense of approximately $0.8 inventory services (increased 88.2%), due to both an million and a decrease in the contingent income tax increased number of physical inventories and a higherreserve due to resolution of contingent liabilities that is average cost per physical inventory. Partially offsetting$3.6 million less than the decrease that occurred in 2004. these increases was a reduction in accruals for employee Non-recurring factors causing the 2005 tax rate to bonus expenses (declined 21.3%), primarily related todecrease when compared to the 2004 tax rate include the higher bonus expense in 2003 resulting from therecognition of state tax credits of approximately $2.3 Companys financial performance during 2003. million related to the Companys construction of a DCin Indiana and a non-recurring benefit of approximately Penalty Expense. During 2003, the Company recorded $2.6 million related to an internal restructuring that was a charge of $10.0 million relating to a civil penalty result-completed during 2005. Excluding the non-recurring21 26. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS items, the 2005 effective tax rate would have been explained in more detail below), as compared to changes approximately 36.5%. in inventory balances in 2004 ($219.4 million use of cash).The 2004 rate was lower than the 2003 rate primarilyAs described in Note 7 to the Consolidated Financial due to the reversal of certain contingent income tax liabili-Statements, the Company is involved in a number of legal ties of approximately $6.2 million in 2004, when the actions and claims, some of which could potentially result Company adjusted its tax contingency reserve based uponin material cash payments. Adverse developments in the results of two state income tax examinations. The taxthose actions could materially and adversely affect the rate in 2003 was negatively impacted by the $10.0 millionCompanys liquidity. The Company also has certain penalty expense in 2003, as discussed above, which was income tax-related contingencies as more fully described not deductible for income tax purposes.below under Critical Accounting Policies and Estimates .In 2005, the Company recognized a reduction in itsEstimates of these contingent liabilities are included in the federal income tax expense of approximately $4.5 million Companys Consolidated Financial Statements. However, for federal jobs related tax credits. Of this amount,future negative developments could have a material approximately $3.9 million relates to the Work adverse effect on the Companys liquidity. See Notes 4 and Opportunity Tax Credit (WOTC), the Welfare to Work 7 to the Consolidated Financial Statements. Credit (WtW) and the Native American EmploymentOn September 30, 2005, November 30, 2004 and Credit. The federal law that provided for the WOTC and March 13, 2003, the Board of Directors authorized the WtW credit programs expired on December 31, 2005 for Company to repurchase up to 10 million, 10 million and 12 employees hired after that date. Credits can continue to million shares, respectively, of its outstanding common be earned in 2006 for eligible employees that were hired stock. These authorizations allow or allowed, as applicable, prior to the December 31, 2005 date. The federal law thatfor purchases in the open market or in privately negotiat- provided for the Native American Employment Credit ed transactions from time to time, subject to market con- expired for years beginning after December 31, 2005 (the ditions. The objective of the Companys share repurchase Companys 2006 year) without regard to when theinitiative is to enhance shareholder value by purchasing employee was hired. The Company currently anticipatesshares at a price that produces a return on investment that that Congress will renew these credit programs on ais greater than the Company's cost of capital. Additionally, retroactive basis; however, renewal cannot currently beshare repurchases generally are undertaken only if such assured. Should these credit programs not be renewed,purchases result in an accretive impact on the Company's the Company currently anticipates a reduction in its 2006fully diluted earnings per share calculation. The 2005 credits of approximately $3.1 million. authorization expires September 30, 2006. The 2004and 2003 authorizations were completed prior to their Liquidity and Capital Resourcesexpiration dates. During 2005, the Company purchasedapproximately 15.0 million shares pursuant to the 2005 Current Financial Condition / Recent Developments. and 2004 authorizations at a total cost of $297.6 million. During the past three years, the Company has generated During 2004, the Company purchased approximately 11.0 an aggregate of approximately $1.46 billion in cash flowsmillion shares pursuant to the 2004 and 2003 authoriza- from operating activities. During that period, the Company tions at a total cost of $209.3 million. During 2003, the has expanded the number of stores it operates by approxi-Company purchased approximately 1.5 million shares mately 30% (over 1,800 stores) and has incurred approxi- pursuant to the 2003 authorization at a total cost of $29.7 mately $713 million in capital expenditures, primarily tomillion. Share repurchases in 2005 increased diluted support this growth. Also during this three-year period, the earnings per share by approximately $0.01. Company has expended approximately $537 million for repurchases of its common stock and paid dividends of approximately $156 million. The Companys inventory balance represented approximately 49% of its total assets as of February 3, 2006. The Companys proficiency in managing its inventory balances can have a significant impact on the Companys cash flows from operations during a given fiscal year. For example, in 2005, changes in inventory balances repre- sented a much less significant use of cash ($97.9 million, as 22 27. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe following table summarizes the Companys significant contractual obligations as of February 3, 2006 (in thousands): Payments Due by Period Contractual obligations (a) Total< 1 yr 1-3 yrs 3-5 yrs> 5 yrsLong-term debt $ 214,473 $ $ $ 199,978$ 14,495 Capital lease obligations22,0287,8627,992 1,148 5,026 Financing obligations89,5862,0315,136 4,68477,735 Inventory purchase obligations 85,148 85,148 Interest (b)169,466 25,933 49,89539,77253,866 Operating leases1,368,848281,615424,225 269,466 393,542 Total contractual cash obligations $1,949,549$ 402,589$ 487,248 $ 515,048$544,664(a) The Company has self-insurance liabilities of $154.7 million that are not reflected in the table above due to the absence of scheduled maturities. (b) Represents obligations for interest payments on long-term debt, capital lease and financing obligations. Excludes interest on $14.5 million of vari- able rate long-term debt issued in 2005 which interest, on an annualized basis, would have equaled approximately $0.6 million in 2005. In fiscal year 2005, the Companys South Carolina- DC, the Economic Development Board of Marion approved based wholly owned captive insurance subsidiary, Ashleya tax increment financing in the amount of $14.5 million, River Insurance Company (ARIC), had cash and cashwhich matures February 1, 2035. Pursuant to this financ- equivalents and investments balances held pursuant toing, proceeds from the issuance of certain revenue bonds South Carolina regulatory requirements to maintain 30% were loaned to the Company in connection with the con- of ARICs liability for insurance losses in the form of certainstruction of this DC. The variable interest rate on this loan specified types of assets and as such, these investments is based on the weekly remarketing of the bonds, which are not available for general corporate purposes. At are supported by a bank letter of credit, and ranged from February 3, 2006, these cash and cash equivalents and3.52% to 4.60% in 2005. investments balances totaled $43.4 million. Significant terms of the Companys outstanding debt The Company has a $250 million revolving creditobligations could have an effect on the Companys ability facility (the Credit Facility), which expires in June 2009. As to incur additional debt financing. The Credit Facility con- of February 3, 2006, the Company had no outstanding bor- tains financial covenants, which include limits on certain rowings or standby letters of credit outstanding under the debt to cash flow ratios, a fixed charge coverage test, and Credit Facility. Outstanding standby letters of credit reduceminimum allowable consolidated net worth. The Credit the borrowing capacity of the Credit Facility. The CreditFacility also places certain specified limitations on secured Facility contains certain financial covenants. The Company and unsecured debt. The Companys outstanding notes was in compliance with all these financial covenants atdiscussed above place certain specified limitations on February 3, 2006. See Note 5 to the Consolidated Financial secured debt and place certain limitations on the Statements for further discussion of the Credit Facility.Companys ability to execute sale-leaseback transactions. The Company has $200 million (principal amount) of The Company has generated significant cash flows from 8 5/8% unsecured notes due June 15, 2010. This indebted- its operations during recent years. The Company had peak ness was incurred to assist in funding the Companys borrowings under the Credit Facility of $100.3 million growth. Interest on the notes is payable semi-annually onduring 2005 and $73.1 million during 2004, all of which June 15 and December 15 of each year. The Companywere repaid prior to February 3, 2006 and January 28, may seek, from time to time, to retire the notes through 2005, respectively, and had no borrowings outstanding cash purchases on the open market, in privately negotiat-under the Credit Facility at any time during 2003. ed transactions or otherwise. Such repurchases, if any, will Therefore, the Company does not believe that any existing depend on prevailing market conditions, the Companyslimitations on its ability to incur additional indebtedness liquidity requirements, contractual restrictions and other will have a material impact on its liquidity. Notes 5 and factors. The amounts involved may be material. 7 to the Consolidated Financial Statements contain In July 2005, as an inducement for the Company toadditional disclosures related to the Companys debt select Marion, Indiana as the site for construction of a new and financing obligations. 23 28. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSAt February 3, 2006 and January 28, 2005, thehave already been marked down and some may require Company had commercial letter of credit facilities totaling additional markdowns in future periods. The future rate of $195.0 million and $215.0 million, respectively, of which sales of this merchandise will be a key determinant of the $85.1 million and $98.8 million, respectively, were rate of future markdowns. outstanding for the funding of imported merchandiseCash flows from operating activities for 2004 purchases.compared to 2003 declined by $122.6 million. The mostDuring 2005, the Company incurred significant losses significant component of the change in cash flows from caused by Hurricane Katrina, primarily inventory and fixedoperating activities was an increase in inventory levels in assets, in the form of store fixtures and leasehold improve-2004. Total merchandise inventories at the end of 2004 ments. The Company has received insurance proceeds of were $1.38 billion compared to $1.16 billion at the end of $8.0 million due to these losses, and has utilized a portion2003, a 19 percent increase, or a 9 percent increase on a of these proceeds to replace lost assets. The Company per store basis, with the remainder primarily attributable expects to receive additional insurance proceeds, due into growth in the number of stores. The largest portion of part to significant business interruption experienced the increase in inventories resulted from the Companys during the hurricanes. The Company did not recover anyfocus on improving in-stock levels of core merchandise at business interruption proceeds during 2005, and will notthe stores. New initiatives, including the expansion of the record any such proceeds until the business interruptionperishable food program and the addition of certain core claims are substantially settled. Losses related to inventory apparel items, magazines and Hispanic food items also are included in cash flows provided by operating activities contributed to the inventory increase. In addition, due to while losses related to fixed assets are included in cash an early Easter in 2005, the Company received more flows used in investing activities. The insurance proceedsseasonal merchandise for Spring 2005 before the end of approximated the amount of losses recorded by the fiscal 2004. Cash flows in 2004 increased by $45.3 million Company, resulting in no material impact on reportedover 2003 related to changes in income taxes payable, 2005 net income.primarily due to a large payment of federal income taxesThe Company believes that its existing cash balances for 2002 that was made in 2003. Cash flows in the 2004 ($200.6 million at February 3, 2006), cash flows from opera-period were positively impacted by an increase in net tions ($555.5 million generated in 2005), the Credit Facility income of $45.2 million driven by improved operating results ($250 million available at February 3, 2006) and its antici-(as more fully discussed above under Results of Operations). pated ongoing access to the capital markets, if necessary, will provide sufficient financing to meet the CompanysCash flows used in investing activities. Cash flows used currently foreseeable liquidity and capital resource needs. in investing activities of $264.4 million in 2005 were primarily related to capital expenditures. Significant Cash flows provided by operating activities. Cash flows components of the Companys purchases of property and from operating activities for 2005 compared to 2004 equipment in 2005 included the following approximate increased by $164.0 million. The most significant compo-amounts: $102 million for distribution and transportation- nent of the increase in cash flows from operating activitiesrelated capital expenditures; $96 million for new stores; in the 2005 period as compared to the 2004 period was $47 million related to the EZstore project; $18 million for the changes in inventory balances. Seasonal inventory certain fixtures in existing stores; and $15 million for levels increased by 10% in 2005 as compared to a 22%various systems-related capital projects. During 2005, increase in 2004, home products inventory levelsthe Company opened 734 new stores and relocated or increased by 2% in 2005 as compared to a 16% increase inremodeled 82 stores. Distribution and transportation 2004, while basic clothing inventory levels declined by 5%expenditures in 2005 included costs associated with the in 2005 as compared to a 21% increase in 2004. Totalconstruction of the Companys new DCs in South Carolina merchandise inventories at the end of 2005 were $1.47 and Indiana. billion compared to $1.38 billion at the end of 2004, a 7.1Net sales of short-term investments in 2005 of $34.1 percent increase overall, but a 1% decrease on a per storemillion primarily reflect the Companys investment activities basis, reflecting the Companys focus on lowering its per in tax-exempt auction market securities. Purchases of long- store inventory levels. In connection with this effort, the term investments are related to the Companys captive Company has completed an initiative of identifyinginsurance subsidiary. specific merchandise in its stores that it intends to sell via Cash flows used in investing activities of $259.2 million promotional discounts to customers. Some of these items in 2004 were also primarily related to capital expenditures.24 29. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Significant components of the Companys purchases oftechnology and systems. The Company plans to under- property and equipment in 2004 included the following take these expenditures in order to improve its infrastruc- approximate amounts: $101 million for distribution andture and provide support for its anticipated growth. transportation-related capital expenditures; $82 million for new stores; $26 million for certain fixtures in existing stores;Cash flows used in financing activities. Cash flows used $26 million for various systems-related capital projects; and in financing activities were $323.3 million in 2005. The $23 million for coolers in existing stores, which allow the Company repurchased approximately 15.0 million shares stores to carry refrigerated products. During 2004, the of its common stock at a total cost of $297.6 million, paid Company opened 722 new stores and relocated or remod- cash dividends of $56.2 million, or $0.175 per share, on its eled 80 stores. Distribution and transportation expendituresoutstanding common stock, and expended $14.3 million in 2004 included costs associated with the construction ofto reduce its outstanding capital lease and financing the Companys new DC in South Carolina as well as costs obligations. Also in 2005, the Company received proceeds associated with the expansion of the Ardmore, Oklahomaof $14.5 million from the issuance of a tax increment and South Boston, Virginia DCs. financing in conjunction with the construction of its new Net sales of short-term investments in 2004 of $25.8DC in Indiana. During 2004, the Company repurchased million primarily reflect the Companys investment activi-approximately 11.0 million shares of its common stock at a ties in tax-exempt auction market securities. total cost of $209.3 million, paid cash dividends of $52.7 Cash flows used in investing activities totaled $256.7million, or $0.16 per share, on its outstanding common million in 2003. The Companys purchases of property andstock and expended $16.4 million to reduce its outstand- equipment in 2003 included the following approximateing capital lease and financing obligations. During 2003, amounts: $63 million for new, relocated and remodeled the Company repurchased approximately 1.5 million stores; $22 million for systems-related capital projects; and shares of its common stock at a total cost of $29.7 million, $25 million for distribution and transportation-related paid cash dividends of $46.9 million, or $0.14 per share, on capital expenditures. During 2003, the Company opened its outstanding common stock, and expended $15.9 673 new stores and relocated or remodeled 76 stores.million to reduce its outstanding capital lease and financ- Systems-related projects in 2003 included approximately ing obligations. These uses of cash were partially offset by $6 million for point-of-sale and satellite technology and $3proceeds from the exercise of stock options during 2005, million related to debit/credit/EBT technology. Distribution2004 and 2003 of $29.4 million, $34.1 million and $49.5 and transportation expenditures in 2003 included approxi- million, respectively. The majority of the remaining mately $19 million at the Ardmore, Oklahoma and South borrowings and repayments were a result of activity Boston, Virginia DCs primarily related to the ongoing associated with daily cash needs of the Company. expansion of those facilities. Net purchases of short-term investments in 2003 ofCritical Accounting Policies and Estimates $67.2 million primarily reflect the Companys investment activities in tax-exempt auction market securities. The preparation of financial statements in accordance During 2003, the Company purchased two securedwith GAAP requires management to make estimates and promissory notes totaling $49.6 million which represent assumptions that affect reported amounts and related debt issued by a third party entity from which thedisclosures. In addition to the estimates presented below, Company leases its DC in South Boston, Virginia. See Note there are other items within the Companys financial 7 to the Companys Consolidated Financial Statements. statements that require estimation, but are not deemed Capital expenditures during 2006 are projected to becritical as defined below. The Company believes these approximately $375 million. The Company anticipates estimates are reasonable and appropriate. However, if funding its 2006 capital requirements with cash flows fromactual experience differs from the assumptions and operations and the Credit Facility, if necessary. Significant other considerations used, the resulting changes could components of the 2006 capital plan include the comple- have a material effect on the financial statements taken tion of construction of the new DC in Indiana and antici- as a whole. pated costs related to the Companys planned tenth DC;Management believes the following policies and leasehold improvements and fixtures and equipment for estimates are critical because they involve significant approximately 800 new stores, which includes 30 new judgments, assumptions, and estimates. Management Dollar General Market stores; the continued rollout of thehas discussed the development and selection of its critical Companys EZstore project; and additional investments inaccounting estimates with the Audit Committee of the25 30. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Companys Board of Directors and the Audit Committeepling process and index formulation. Also, on an ongoing has reviewed the disclosures presented below relating basis, the Company reviews and evaluates the salability of to them.its inventory and records LCM reserves, if necessary. The Company calculates its shrink provision based onMerchandise Inventories. Merchandise inventories are actual physical inventory results during the fiscal period stated at the lower of cost or market with cost determinedand an accrual for estimated shrink occurring subsequent using the retail last-in, first-out (LIFO) method. Under theto a physical inventory through the end of the fiscal Companys retail inventory method (RIM), the calculationreporting period. This accrual is calculated as a percentage of gross profit and the resulting valuation of inventories at of sales and is determined by dividing the book-to-physi- cost are computed by applying a calculated cost-to-retail cal inventory adjustments recorded during the previous inventory ratio to the retail value of sales. The RIM is an twelve months by the related sales for the same period for averaging method that has been widely used in the retaileach store. Beginning in 2003, in an effort to improve this industry due to its practicality. Also, it is recognized that estimate, the Company began applying store-specific the use of the RIM will result in valuing inventories at theshrink rates to store-specific sales generated subsequent lower of cost or market if markdowns are currently takento a given stores physical inventory. Prior to 2003, the as a reduction of the retail value of inventories.Company applied a weighted-average shrink rate to allInherent in the RIM calculation are certain significantCompany sales generated subsequent to physical invento- management judgments and estimates including, among ries. During 2005, in an attempt to further refine its shrink others, initial markups, markdowns, and shrinkage, whichaccrual, the Company changed from a store-level shrink significantly impact the gross profit calculation as well asaccrual to a store- and department-level shrink accrual. To the ending inventory valuation at cost. These significant the extent that subsequent physical inventories yield estimates, coupled with the fact that the RIM is an averag- different results than this estimated accrual, the ing process, can, under certain circumstances, produce dis- Companys effective shrink rate for a given reporting torted cost figures. Factors that can lead to distortion in period will include the impact of adjusting the estimated the calculation of the inventory balance include: results to the actual results. Although the Company applying the RIM to a group of pro