ITEM 1. BUSINESS - ------- --------
INTRODUCTION
In 1977, the first Drug Emporium store was opened in Columbus, Ohio. Today, the Company operates 136 company-owned stores, franchises 88 stores, and has license agreements with 2 stores, with combined revenues in excess of $1.3 billion. The accompanying financial statements include only amounts related to company-owned stores.
Drug Emporium is a category-dominant, value-added retailer selling health and beauty care, over-the-counter medication, prescription drugs, greeting cards, cosmetics and highly-consumable products at everyday low prices. Product lines include a vast array of health items, cosmetics, designer fragrances and seasonal lines. Pharmacy sales contributed 25%, 25% and 24% of total revenue for fiscal 1996, 1995 and 1994.
The Company's common stock trades on the Nasdaq National Market under the symbol DEMP. As of March 2, 1996, there were 13,184,085 shares outstanding. Drug Emporium's 7-3/4% convertible subordinated debentures, due October 1, 2014, are traded on the Nasdaq National Market under the symbol DEMPG.
In January 1993, the Company developed and began executing a plan to improve the operating results of the stores. As a result of these efforts the Company reported seven consecutive profitable quarters. The profitable results were achieved despite continued and consistent losses from the stores in the Washington, D.C. market. Because the stores in the Washington, D.C. market did not sufficiently respond to turnaround efforts and in order to free up capital for investment in better performing markets, the Company sold seven stores in the Washington, D.C. market and announced the closing of fourteen additional stores. The cost associated with disposing of these 21 stores resulted in a pretax charge of $11,850,000 recorded in November 1994. In the fourth quarter of Fiscal 1996, an additional pretax charge of $3,000,000 was taken to cover rent and related charges at several properties which have taken longer than expected to sublease.
Management's goal is to sublease or through other means remove all significant closed-store obligations by the end of Fiscal 1997. Since January 1993, the Company has closed 38 stores of which obligations continue at March 3, 1996 on eight stores. Of the remaining obligations, management intends to open two stores under a close-out format and continues to seek ways to relieve obligations on the remaining six stores.
Late in the third quarter the Company acquired 26 stores from F&M Distributors, Inc. ("F&M") in two separate transactions. The acquired stores were located in Milwaukee, Baltimore and Detroit, with Detroit representing a new market for the Company. Three of the stores were subsequently closed or merged with existing Drug Emporium operations. None of the closed stores carried any future lease obligations to the Company.
The Company reviewed all of the F&M stores for possible acquisition and selected these stores, approximately one-fourth of the available stores, based on historical sales results, an evaluation of competition and an analysis that showed that the acquisition would produce return-on-investment results stronger and more quickly than building new stores in these markets.
Since the F&M stores were acquired, management has installed new pharmacy, labor management and point-of-sale (POS) systems. The goals for Fiscal 1997 for the acquired stores include increasing pharmacy sales, re-introducing a discount image to the customers, improving labor productivity, bringing the inventory mix into balance and having the stores contribute to earnings.
Management believes that the acquired stores may put some pressure on earnings in the first two quarters as operational investments are made to position the stores for the future.
STORE OPERATIONS
Company stores range in size from 18,000 to 33,000 square feet, with a typical store having approximately 25,000 square feet, including retail selling space and storage space in the rear of each store.
Each store has a manager, one or two assistant managers, a head pharmacist, and approximately 8 to 12 additional full-time employees. The stores are grouped into six operational regions, each overseen by a regional vice president. The regional vice presidents' responsibilities include visiting all Company stores and assuring that Company standards for buying, merchandising, customer service and store appearance are maintained.
The Company's stores are located primarily in shopping centers on major commercial thoroughfares. The capital expenditures required to fixture and equip a store averages $200,000. Pre-opening expenses, including salaries and promotional expenses, average $50,000 per store, and each store requires approximately $1,000,000 in initial inventory.
The typical trade area for a Drug Emporium store encompasses 200,000 people in 75,000 households within a defined area, usually five miles. The customer profile: 80 percent middle-to-upper income women between the ages of 25 and 54 who shop on a two-and-a-half week cycle.
Drug Emporium stores accommodate 8,000 to 12,000 shoppers per week and provide an environment for shoppers seeking a pleasant and social shopping experience. Drug Emporium fills a unique tenant category in a shopping center's merchandising mix. Preferably placed adjacent to a supermarket chain store, Drug Emporium stores are well received by both hard and soft goods national retailers.
Most stores are open seven days and 80 hours a week. Each store has a similar layout, with the pharmacy located in the rear of the store. Company stores accept payment in cash, check or credit card and from third-party providers.
The table set forth below lists the 226 Drug Emporium stores by market as of March 2, 1996:
Subsequent to March 2, 1996, the Company acquired six stores in the Philadelphia market.
The Company considers various geographic and demographic factors, including population around the site, income level within that area, proximity to major shopping malls, traffic count, accessibility of site, proximity of competitors and available
parking spaces. Extensive market research is utilized through an outside market research firm which identifies, among other things, trade area, trade area potential, demographic factors, competitors and competitors' sales/strengths/weaknesses, and projects three-year anticipated sales volumes.
Company and, to a limited extent, franchisee pharmacy matters are supervised by the Director of Pharmacy who directs compliance with state and federal pharmacy regulations and training. The Company has implemented a computerized pharmacy system across its network of Company stores. Most franchisees have installed similar systems. The system simplifies the preparation of labels and maintenance of patient profiles.
Drug Emporium continues to have a strong franchise network consisting of 88 stores. In 1993, Drug Emporium, Inc. established a Franchise Advisory Board designed to provide a forum to investigate and discuss issues and concerns of the Company and its franchisees. One of the major accomplishments of the Franchise Advisory Board was the formation of a program called DESIRE, which stands for Drug Emporium Shares in Research and Education.
Under its franchise system, the Company permits franchisees to operate Drug Emporium stores in a specific geographic area based on ADIs (areas of dominant influence of television signals). Prospective franchisees must make a minimum equity investment of $1,000,000 per store and establish an acceptable line of credit in the amount of $500,000 per store. The Company assists franchisees in site selection, store layout, and establishing purchasing and advertising policies.
The Company selects its franchisees carefully and works closely with them to increase the likelihood of success for each franchisee. Prospective franchisees sign confidentiality agreements in addition to a non-compete clause contained within the executed franchise agreement. Upon execution of a franchise agreement, the franchisee must pay a nonrefundable $25,000 fee for the first store and a $10,000 commitment fee for each additional store designated for that market. The balance of the $25,000 store fee ($15,000) is payable upon the opening of each subsequent designated store in the market.
The current franchise agreement provides for franchise royalties at a minimum rate of $6,000 per store for the second year and $25,000 per year per store for stores open three years or more against the following percentage royalties: 1% on gross sales from $3.5 million to $6 million, 2% from $6 million to $8 million, 3% from $8 million to $10 million, and 1.25% on gross sales over $10 million.
In addition, each franchisee must pay .1% of gross sales to the Company to offset the cost of developing advertising. Each franchisee must also spend at least 1% of gross sales for advertising. The current franchise agreement permits the Company to require that .6% of the 1% advertising expenditure be contributed to a national advertising program if such program is established by the Company.
The Company may either open its own stores or allow other franchisees to open stores in a franchisee's territory outside a defined area for each existing store if the franchisee fails to comply with the development schedule agreed upon by the Company and the franchisee.
During fiscal 1996, the Company had one new franchise market open and two stores open under a license agreement.
The license agreement allows the Drug Emporium retail concept to be operated within a grocery store with the Drug Emporium portion of sales generating a royalty fee. During fiscal 1996, licensees were charged a flat royalty fee of 1.25% of sales.
ACQUISITION OF FRANCHISEES
The Company, from time to time, has acquired or sought to acquire certain of its franchise operations. The Company's decision to pursue the acquisition of a franchisee is based on the Company's evaluation of the growth opportunities in a particular market, the impact the acquisition would have on earnings per share and the quality of the franchisee's existing management. Since 1983, the Company has acquired franchisees located in Los Angeles, Washington, D.C., Atlanta, Cincinnati, Milwaukee, Minneapolis, St. Louis, Charleston, S.C., Indianapolis, Orlando, Baton Rouge, Louisville, and Oklahoma City. The Company plans to evaluate future opportunities to acquire appropriate franchisees from time to time and may use cash or securities to pay for such acquisitions.
MERCHANDISING AND MARKETING
The Company's merchandising goal is to provide customers with the widest available selection of health and beauty aids, cosmetics, prescription drugs and general merchandise at everyday low prices. The Company estimates that approximately 67% of a typical store's sales mix is health and beauty aids and general merchandise, 25% pharmacy items and 8% cosmetics.
The Company is continuing to aggressively oversee strategies designed to lower the total cost of acquiring merchandise in order to continue to be competitive with other national and regional chain discounters. The Company completed implementation of POS scanning during fiscal 1996. POS has provided information to better manage gross margins by electronically capturing transactions at the store level.
During fiscal 1996, the Company's primary pharmacy supplier, McKesson Drug, accounted for approximately 20% of the Company's purchases. No other single vendor accounted for more than 10% of the Company's purchases. The Company purchases from over 500 vendors, although the great majority of the business is conducted with approximately 100 vendors. The Company believes it is a significant customer for each of these 100 vendors.
The Company advertises through the use of television, radio, newspaper and direct mail. Point of sale advertising is also used. The Company's strategy of clustering stores within ADI markets is an important factor in maximizing the effect of its advertising expenditures. The Company works with an advertising agency that coordinates advertising for the entire chain. Benefits of centralization include efficiencies of buys with media, coordination of chain-wide promotional activities, and ability to negotiate better prices with vendors.
CUSTOMER SERVICE
The Company believes that its commitment to customer service is an important ingredient of its success. The Company encourages its managers and other employees to be responsible to customers. The stores are designed to make products easily accessible. Store employees are trained to be friendly and helpful to customers. Each store has numerous cashiers to speed up and facilitate customer check-out.
COMPETITION
The sale of deep discount health and beauty aids, cosmetics and prescription drugs is highly competitive. The Company believes that the principal bases of competition in this market are price, product variety, service, site location and customer recognition. The Company also believes there exist only a few similar companies, the major one being Phar-Mor Inc. The Company's stores compete not only with those similar companies but with numerous other drug stores with national or regional images, and also with supermarkets, combination stores and discount stores. Many of the Company's supermarket, combination store and discount and retail drug store competitors have more outlets and substantially greater financial resources than the Company or have more convenient locations than Company stores. The Company believes that its prices are competitive and that it offers greater product variety and better service than its competitors. The Company also believes that the smaller size of its stores compared to the major discount competitors provides a better shopping experience and allows a better selection of sites in tight real estate markets that exist in some major cities. The Company's ability to expand successfully into new markets is especially sensitive to the competitive factors in those markets.
EMPLOYEES AND TRAINING
At March 2, 1996, the Company had a total of approximately 5,600 employees, both full-time and part-time, of which 160 were corporate staff personnel. None of the employees are covered by a collective bargaining agreement. The Company considers its relations with its employees to be good.
Drug Emporium believes that the training of store employees and franchisees is one of the most important elements of its business. The Company conducts training classes at its headquarters, and senior management works closely with regional and district managers in this regard.
REGULATION
The sale of franchises by the Company is subject to regulation by the Federal Trade Commission and various states in which it does, or may in the future do, business. Such regulations generally require the prior registration or an exemption from registration for the sale of franchises and delivery to prospective franchisees of a franchise disclosure document. No assurances can be given that any future changes in the existing laws or the promulgation of new laws will not adversely affect the Company.
The Company is also subject to the Fair Labor Standards Act, which governs such matters as minimum wages, overtime and other working conditions. A portion of the Company's personnel are paid at rates related to the federal minimum wage, and
accordingly, further increases in the minimum wage increase the Company's labor costs.
The prescription drug business is subject to the federal Food, Drug and Cosmetic Act, Drug Abuse Prevention and Control Act and Fair Packaging and Labeling Act relating to the content and labeling of drug products, comparable state statutes and state regulation regarding recordkeeping and licensing matters with civil and criminal penalties for violations.
SERVICE MARKS
The Company has obtained federal registrations of the servicemark "Drug Emporium" and "Savings So Big You Need A Shopping Cart" for retail drug store services "Drug Emporium" for technical aid and assistance in the establishment and operation of retail drug stores and "Drug Emporium", plus design, for retail drug store services. Federal registration of the servicemarks "Food and Drug Emporium," "Drug Emporium RX," and "Drug Emporium Express" are currently pending.
The mark "Drug Emporium" has been registered in the states of Alabama, Arizona, Arkansas, California, Colorado, Florida, Georgia, Indiana, Kansas, Kentucky, Louisiana, Maryland, Minnesota, Missouri, Nebraska, Nevada, New Jersey, New Mexico, New York, North Carolina, Ohio, Oklahoma, Pennsylvania, South Carolina, Tennessee, Texas, Virginia, Washington, West Virginia and Wisconsin, as well as Mexico and Puerto Rico. The mark "Savings So Big You Need A Shopping Cart" has been filed and is pending in Canada and Mexico. The mark "Drug Emporium," plus design, and the shopping cart design have been filed in Mexico, Japan and France, and the shopping cart design is registered in Canada. The Company believes that these marks are of material importance to its business.
Federal registration of a mark does not create new substantive rights to use the mark or to assert rights based on ownership, but it does provide additional remedies for the protection of the mark.
EXECUTIVE OFFICERS OF THE COMPANY
The Company's executive officers are:
DAVID L. KRIEGEL ----------------
Since December 1992, Mr. Kriegel has been the Chairman and Chief Executive Officer of the Company. Mr. Kriegel is Chairman and Chief Executive Officer of Kriegel Holding Company, Inc., a privately-owned corporation dealing with consumer products, real estate and distribution. Until January 1993, Mr. Kriegel was Vice President of Cardinal Health and Marketing Group, a division of Cardinal Distribution, Inc., a publicly owned company. From September 1988 to December 1990, Mr. Kriegel was Corporate Vice President of Roundy's Inc., a cooperative food distributor. Mr. Kriegel is a director of Bank One, Lima, N.A.
ROBERT E. LYONS, III --------------------
Mr. Lyons assumed a new position with the Company in January 1993 as Senior Vice President with key marketing and merchandising responsibilities. From January 1990 to December 1992, Mr. Lyons was President and Chief Operating Officer of the Company. Mr. Lyons has been with the Company and/or associated with a franchise since 1983.
TIMOTHY S. McCORD - -----------------
Since June 1994, Mr. McCord, a Certified Public Accountant, has served as Chief Financial Officer. From June 1993 to June 1994, Mr. McCord was Controller of the Company. Previous to joining the Company, Mr. McCord was employed by Ernst & Young, LLP, the external auditors to the Company, for ten years.
JANE H. LAGUSCH - ---------------
Mrs. Lagusch has been associated with the Company in various capacities since 1980 and she was appointed a Vice President of the Company January 30, 1993. Mrs. Lagusch has responsibility for corporate administrative functions.
KEITH E. ALESSI - ---------------
Mr. Alessi is a member of the board of directors and Treasurer of the Company. He served as Chief Financial Officer from January to June of 1994. Since 1988, Mr. Alessi has been associated with Farm Fresh, Inc., a privately-held grocery chain, in various capacities, and currently as Vice Chairman and director. Mr. Alessi is also Chairman and Chief Executive Officer of Virginia Supermarkets, Inc. and is a director of New Cort Holding, Inc.
A. JOEL ARNOLD - --------------
Mr. Arnold was appointed to the office of Senior Vice President on June 15, 1995. He formerly held the position of Director of Merchandising and Operations in which he served for two years. A registered pharmacist, Mr. Arnold has 37 years' experience in the retail drug industry in positions ranging from store manager to senior vice president and general manager.
ITEM 2.

ITEM 2. PROPERTIES - ------------------
Most of the Company's stores are occupied pursuant to long-term leases that vary as to rental provisions, expiration dates, renewal options, and rental amounts and payment provisions. The Company does not deem any individual stores lease to be significant in relation to its overall operations. For information as to the amount of the Company's rental obligations for retail store leases, see Note 5 of Notes to Consolidated Financial Statements.
The Company also owns a 20,000 square foot executive office building for its use as its principal office. The site includes five acres of property and is located in Powell, Ohio, just north of Columbus.
ITEM 3.

ITEM 3. LEGAL PROCEEDINGS - -------------------------
Nortex Drug Distributors, Inc v. Drug Emporium, Inc., Case No. C2-93-767, filed August 6, 1993 which is pending in the United States District Court, Southern District of Ohio, Eastern Division. The plaintiff is a franchisee of the Company. The plaintiff is seeking treble damages and a declaration that the noncompetition clause in the franchise agreements is unenforceable. The plantiff is charging breach of contract on the franchise agreement, Antitrust violations, conversion, fraud, interference with contract and deceptive trade practices. Plaintiff also seeks a declaration that the noncompete provision in the franchise agreement is unenforcable. No specific amount of damages is claimed. The Company is aggressively defending this suit.
Texas Drug Distributors Inc. v. Drug Emporium, Inc. was settled and dismissed with no material effect on the Company.
ITEM 4.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS -----------------------------------------------------------------------------
The Company's common stock is traded on the Nasdaq National Market under the symbol DEMP. The following table sets forth, for the quarterly periods shown, the high and low sale price per share as reported on Nasdaq National Market:
The Company paid no dividends in fiscal 1996 or 1995.
The Company's bank credit agreement prohibits payment of dividends, stock repurchases and acquisition of the Company's convertible subordinated debt.
At April 29, 1996, the number of holders of record of the Company's common stock, without determination of the number of individual participants in security positions, was approximately 5,191.
ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA ------- -----------------------
The information required by this Item 6 is incorporated by reference from page 10 of the Drug Emporium, Inc. Annual Report to Stockholders for the year ended March 2, 1996.
ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND ------- --------------------------------------------------------------- RESULTS OF OPERATIONS ---------------------
The information required by this Item 7 is incorporated by reference from pages 11 and 12 of the Drug Emporium, Inc. Annual Report to Stockholders for the year ended March 2, 1996.
ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ------- -------------------------------------------
The information required by this Item 8 is incorporated by reference from pages 13 through 22 of the Drug Emporium, Inc. Annual Report to Stockholders for the year ended March 2, 1996.
ITEM 9.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT -------- --------------------------------------------------
Certain of the information required by this Item 10 is set forth under Item 1. "Executive Officers of the Company."
*
ITEM 11.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS -------- ----------------------------------------------
*
* Reference is made to information under the captions "Election of Directors," "Executive Compensation," "Security Ownership of Certain Beneficial Owners and Management," and "Certain Relationships and Related Transactions," in the Company's Proxy Statement for the Annual Meeting of Stockholders to be held June 26, 1996. The Company mailed its definitive proxy statement to stockholders on or about May 20, 1996.
ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K -------- ---------------------------------------------------------------
(a)(1) Financial Statements --------------------
The following Consolidated Financial Statements of Drug Emporium, Inc. are incorporated by reference in Item 8 from the pages set forth below of the Drug Emporium, Inc. Annual Report to Stockholders for the year ended March 2, 1996.
(2) Financial Statement Schedules -----------------------------
Schedules for which provision is made in Regulation S-X are not required under the instructions contained therein, are inapplicable, or the information is included in the footnotes to the Consolidated Financial Statements.
(3) Exhibits List -------------
(3) Articles of Incorporation and By-Laws -------------------------------------
3.3 Restated Certificate of Incorporation (Incorporated by reference to Exhibit 3.3 to the Company's S-1 Registration Statement No. 33-21755)
(10) Material Contracts ------------------
10.1 Drug Emporium, Inc. 1983 Incentive Stock Option Plan (incorporated by reference to Exhibit 10.2 to the Company's S-1 Registration Statement Registration No. 33-21755) **
10.2 Drug Emporium, Inc. 1984 Incentive Stock Option Plan (incorporated by reference to Exhibit 10.3 to the Company's S-1 Registration Statement Registration No. 33-21755) **
10.3 Drug Emporium, Inc. 1987 Incentive Stock Option Plan (incorporated by reference to Exhibit 10.4 to the Company's S-1 Registration Statement Registration No. 33-21755) **
10.4 Drug Emporium, Inc. 1990 Incentive Stock Option Plan (incorporated by reference to Exhibit 10.41 to the Company's Annual Report on Form 10-K for the fiscal year ended February 28, 1990) **
10.5 Drug Emporium, Inc. Non-Qualified Stock Option Plan (incorporated by reference to Exhibit 10.5 to the Company's S-1 Registration Statement Registration No. 33-21755) **
10.7 Form of License and Franchise Agreement (incorporated by reference to Exhibit 10.7 to the Company's S-1 Registration Statement Registration No. 33-21755)
10.8 Form of Option Agreement (incorporated by reference to
Exhibit 10.8 to the Company's S-1 Registration Statement Registration No. 33-21755)
10.10 Third Amended and Restated Revolving Credit and Team Loan Agreement dated as of November 13, 1995, between Drug Emporium, Inc. and Bank One, Columbus, N.A. (incorporated by reference to Exhibit 10.1 of the Company's Form 10-Q for the period ended November 25, 1995)
10.11 Employment contract dated March 11, 1993 between David L. Kriegel and Drug Emporium, Inc. (incorporated by reference to the Company's Annual Report on Form 10-K for the fiscal year ended February 27, 1993) **
10.12 Drug Emporium, Inc. 1993 Incentive Stock Option Plan (incorporated by reference to Exhibit 10.12 to the Company's Annual Report on Form 10-K for the fiscal year ended February 27, 1993) **
10.13 Drug Emporium, Inc. 1993 Non-Qualified Stock Option Plan (incorporated by reference to Exhibit 10.13 to the Company's Annual Report on Form 10-K for the fiscal year ended February 27, 1993) **
*(11) Statement re Computation of Per Share Earnings ----------------------------------------------
11.1 Computation of Per Share Earnings is readily computable from information disclosed in the financial statements and therefore is not included as a separate exhibit.
*(13) Annual Report to Security Holders, Form 10Q or Quarterly Report to ------------------------------------------------------------------ Security Holders ----------------
13.1 Annual Report to Stockholders for Fiscal Year Ended March 2, 1996 (limited to those portions incorporated herein)
*(22) Subsidiaries of Registrant -------------------------- 22.1 The Company has the following wholly-owned subsidiaries:
*(24) Consent of Experts ------------------
24.1 Consent of Ernst & Young LLP
(27) Financial Data Schedule -----------------------
27.1 Financial Data Schedule of the Company
*Included with this Annual Report on Form 10-K **Compensatory plans, contracts or agreements
(b) Reports on Form 8-K -------------------
No reports on Form 8-K were filed during the fourth quarter of fiscal 1996.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
DRUG EMPORIUM, INC. (Registrant)
Date: May 30, 1996 By: /s/ David L. Kriegel ----------------------------------- David L. Kriegel Chairman and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated:
Date: May 30, 1996
/s/ Timothy S. McCord /s/ David L. Kriegel ---------------------------------- ----------------------------------- Timothy S. McCord David L. Kriegel Chief Financial Officer Chairman and Chief Executive Officer
/s/ Michael P. Leach /s/ John B. Gerlach ---------------------------------- ----------------------------------- Michael P. Leach John B. Gerlach Controller Director
/s/ Thomas D. Igoe ----------------------------------- Thomas D. Igoe Director
/s/ Robert S. Meeder, Sr. ----------------------------------- Robert S. Meeder, Sr. Director
/s/ William L. Sweet, Jr. ----------------------------------- William L. Sweet, Jr. Director
/s/ V. J. Wiechart, Sr. ----------------------------------- V. J. Wiechart, Sr. Director