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Article by DailyStocks_admin    (03-16-08 01:27 PM)

Filed with the SEC from Feb 28 to Mar 05:

Duckwall-ALCO Stores (DUCK)
Investor Strongbow Capital wants Duckwall-ALCO to change leadership, and criticized the Midwest retailer's 2008 earnings estimate. Strongbow said that Duckwall's 2008 earnings guidance shows "that the company's operating performance is deteriorating at an alarming rate." Strongbow suggested that its managing director, Raymond A.D. French, be put on Duckwall's board. Strongbow currently holds 543,517 shares (14.3%).

BUSINESS OVERVIEW

History

Duckwall-ALCO Stores, Inc., (the “Company” or “Registrant”), was founded as a general merchandising operation in 1901 in Abilene, Kansas by A. L. Duckwall. From its founding until 1968, the Company conducted its retail operations as small variety or “dime” stores. In 1968, the Company followed an emerging trend to discount retailing when it opened its first ALCO discount store. The Company's overall business strategy involves identifying and opening stores in towns that will provide the Company with the highest return on investment. Although the Company prefers markets that don’t have direct competition from national or regional full-line discount stores, its strategy does not preclude it from entering competitive markets. This strategy includes opening ALCO discount stores. As of January 28, 2007, the Company operates 256 retail stores located in the central United States, consisting of 189 ALCO retail discount stores and 67 Duckwall variety stores.

The Company was incorporated on July 2, 1915 under the laws of Kansas. The Company's executive offices are located at 401 Cottage Street, Abilene, Kansas 67410-2832, and its telephone number is (785) 263-3350.

General

The Company is a regional retailer operating 256 stores in 21 states in the central United States. The Company's strategy is to target smaller markets not served by other regional or national full-line retail discount chains and to provide the most convenient access to retail shopping within each market. The Company's ALCO discount stores offer a full line of merchandise consisting of approximately 35,000 items, including automotive, candy, crafts, domestics, electronics, fabrics, furniture, hardware, health and beauty aids, housewares, jewelry, ladies', men's and children's apparel and shoes, pre-recorded music and video, sporting goods, seasonal items, stationery and toys. The Company's smaller Duckwall variety stores offer a more limited selection of similar merchandise.

Of the Company's 189 ALCO discount stores, 155 stores are located in communities that do not have another full-line discounter. The ALCO discount stores account for 94% of the Company's net sales. The current ALCO store averages 20,300 square feet of selling space. However, the Company's store expansion program is primarily directed toward opening stores with a design prototype of approximately 21,500 square feet of selling space. Based on the Company’s experience, the design of the Class 20 Stores produces the greatest return on investment for newly opened stores.

All of the Company's discount and variety stores are serviced by the Company's 352,000 square foot distribution center in Abilene, Kansas.

Business Strategy

The Company intends to focus on executing a business strategy that includes the following key components:

Markets: The Company intends to open ALCO stores primarily in towns with populations of typically less than 5,000 that are in trade areas with populations of less than 16,000 where: (1) there is no direct competition from national or regional full-line discount retailers; (2) economic and demographic criteria indicate the market is able to commercially support a discount retailer; and (3) the opening of an ALCO store would significantly reduce the likelihood of the entry into such market by another full-line discount retailer. This key component of the Company's strategy has guided the Company in both its opening of new stores and in its closing of existing stores.

Market Selection: The Company utilizes a detailed process to analyze under-served markets which includes examining factors such as distance from competition, trade area, demographics, retail sales levels, existence and stability of major employers, location of county government, disposable income, and distance from the Company’s distribution center. Markets that are determined to be sizable enough to support an ALCO and that have no direct competition from another full-line discount retailer are examined closely and eventually selected or passed over by the Company's experienced management team.

Store Expansion: The Company's expansion program is designed primarily around the prototype Class 20 Store. This prototype details shelf space, merchandise presentation, store items to be offered, parking, storage requirements, as well as other store design considerations. The 21,500 square feet of selling space is large enough to permit a full line of the Company's merchandise, while minimizing capital expenditures, labor costs and general overhead costs. The Company will also consider opportunities in acceptable markets to open ALCO stores in available space in buildings already constructed.

Technology : The Company went live on the human resources/payroll and financial systems during fiscal 2006. The Company went live on the Point-of-Sale (POS) system in the third quarter of fiscal 2007. Financial Planning, Performance Analysis, and Merchandise Allocation systems went live in the second quarter of fiscal 2007. The Company is conducting a review of its logistics. This could result in the determination that the Company will need to consider a new integrated Warehouse Management System.

Advertising and Promotion: The Company utilizes full-color photography advertising circulars of eight to 24 pages distributed through newspaper insertion or, in the case of inadequate newspaper coverage, through direct mail. During fiscal 2007, these circulars were distributed 40 times in ALCO markets. In its Duckwall markets, the Company distributed a full-color, four page insert 11 times during fiscal 2007. The Company’s marketing program is designed to create awareness and recognition of its competitive pricing on a comprehensive merchandise selection for the whole family. During fiscal 2008, the Company will distribute approximately 42 circulars in ALCO markets and will discontinue advertising in Duckwall markets.

Store Environment: The Company's stores are open, clean, bright and offer a pleasant atmosphere with disciplined product presentation, attractive displays and efficient check-out procedures. The Company endeavors to staff its stores with courteous, highly motivated, knowledgeable store associates in order to provide a convenient, friendly and enjoyable shopping experience.

Store Development

The Company expects to open approximately 25 ALCO stores during fiscal year 2008. The Company's strategy regarding store development is to increase sales and profitability at existing stores by continually refining the merchandising mix and improving operating efficiencies, and through new store openings in the Company's targeted base of under-served markets in the central United States.

As of January 28, 2007, the Company owned three ALCO and one Duckwall location, and leased 186 ALCO and 66 Duckwall locations. The Company's present intention is to lease all new stores; however, the company may own some of the ALCO locations. The estimated investment to open a new prototype ALCO store that is leased is approximately $800,000 for the equipment and inventory.

Store Environment and Merchandising

The Company manages its stores to attractively and conveniently display a full line of merchandise within the confines of the stores' available square footage. Corporate merchandising direction is provided to each store to ensure a consistent company-wide store presentation. To facilitate long-term merchandising planning, the Company divides its merchandise into three core categories driven by the Company's customer profile: primary, secondary, and convenience. The primary core receives management's primary focus, with a wide assortment of merchandise being placed in the most accessible locations within the stores and receiving significant promotional consideration. The secondary core consists of categories of merchandise for which the Company maintains a strong assortment that is easily and readily identifiable by its customers. The convenience core consists of categories of merchandise for which ALCO will maintain convenient (but limited) assortments, focusing on key items that are in keeping with customers' expectations for a discount store. Secondary and convenience cores include merchandise that the Company feels is important to carry, as the target customer expects to find them within a discount store and they ensure a high level of customer traffic. The Company continually evaluates and ranks all product lines, shifting product classifications when necessary to reflect the changing demand for products.

Purchasing

Procurement and merchandising of products is directed by a staff of two Vice President - Divisional Merchandise Managers and one Assistant Vice President Divisional Merchandise Manager who are each responsible for specific product categories. The Company employs twenty merchandise buyers and two assistant buyers who each report to a Divisional Merchandise Manager. Buyers are assisted by a management information system that provides them with current price and volume information by SKU, thus allowing them to react quickly with buying and pricing adjustments dictated by customer buying patterns.

The Company purchases its merchandise from approximately 2,200 suppliers. The Company generally does not utilize long-term supply contracts. Only one supplier accounted for more than 5% of the Company's total purchases in fiscal 2007 and competing brand name and private label products are available from other suppliers at competitive prices. The Company believes that its relationships with its suppliers are good and that the loss of any one or more of its suppliers would not have a material adverse effect on the Company.

Pricing

Merchandise pricing is done at the corporate level with the impact significantly different depending upon the level of competition in the market. This pricing strategy, with its promotional activities, is designed to bring consistent value to the customer. In fiscal 2008, promotions on various items will be offered approximately 42 times through advertising circulars.

Distribution and Transportation

The Company operates a 352,000 square foot distribution center in Abilene, Kansas, from which it services all stores. The distribution center is responsible for distributing approximately 80% of the Company's merchandise, with the balance being delivered directly to the Company's stores by its vendors. The distribution center maintains an integrated management information system, allowing the Company to utilize such cost cutting efficiencies as perpetual inventories, safety programs, and employee productivity software. As stated previously, the Company is considering an upgrade to the system.

Effective January 1, 2006, the Company contracted with Werner Enterprises, Inc. to be its dedicated transportation provider. Werner will sublease the Subsidiary’s equipment which includes five tractors and 23 trailers until such equipment leases expire.

Management Information Systems

The Company has committed significant resources to the purchase and application of available computer hardware and software to its discount retailing operations with the intent to lower costs, improve customer service and enhance general business planning. In general, the Company's merchandising systems are designed to integrate the key retailing functions of seasonal merchandise planning, purchase order management, merchandise distribution, sales information and inventory maintenance and replenishment. All of the Company's ALCO discount stores have POS computer terminals that record certain sales data in a format that can be transmitted nightly to the Company's data processing facility where it is used to produce daily and weekly management reports. During the last four fiscal years, the Company has devoted resources to development of systems that have improved information available to management and improved specific operational efficiencies.

Approximately 2,000 of the Company's merchandise suppliers currently participate in the Company's electronic data interchange (“EDI”) system, which makes it possible for the Company to place purchase orders electronically. A number of these suppliers are able to utilize additional EDI functions, including transmitting invoices and advance shipment notices to the Company and receiving sales history from the Company. Refer to the section above: Business Strategy: Technology, for additional discussion on the Company’s planned technology upgrades.

Store Locations

As of January 28, 2007, the Company operated 189 ALCO stores in 21 states located in smaller communities in the central United States. The ALCO stores average approximately 20,800 square feet of selling space, with an additional 5,000 square feet utilized for merchandise processing, temporary storage and administration. The Company also operates 67 Duckwall stores in 10 states.

Competition

While the discount retail business in general is highly competitive, the Company's business strategy is to locate its ALCO discount stores in smaller markets where there is no direct competition with larger national or regional full-line discount chains, and where it is believed no such competition is likely to develop. Accordingly, the Company's primary method of competing is to offer its customers a conveniently located store with a wide range of merchandise at discount prices in a primary trade area population under 16,000 that does not have a large national or regional full-line discount store. The Company believes that trade area size is a significant deterrent to larger national and regional full-line discount chains. Duckwall variety stores are located in very small markets, and like the ALCO stores, emphasize the convenience of location to the primary customer base.

In the discount retail business in general, price, merchandise selection, merchandise quality, advertising and customer service are all important aspects of competing. The Company encounters direct competition with national full-line discount stores in 26 of its ALCO markets, and another eight ALCO stores are in direct competition with regional full-line discount stores. The competing regional and national full-line discount retailers are generally larger than the Company and the stores of such competitors in the Company's markets are substantially larger, have a somewhat wider selection of merchandise and are very price competitive in some lines of merchandise. Where there are no national or regional full-line discount retail stores directly competing with the Company's ALCO stores, the Company's customers nevertheless shop at retail discount stores and other retailers located in regional trade centers, and to that extent the Company competes with such discount stores and retailers. The Company also competes for retail sales with mail order companies, specialty retailers, mass merchandisers, dollar stores, manufacturer’s outlets, and the internet. In the 123 markets in which the Company operates a Class 18 Store, only 12 markets have direct competition from a national or regional full-line discount retailer. The Company competes with dollar stores in 87 percent of its ALCO stores and approximately 40 percent of its Duckwall stores.

Employees

As of January 28, 2007, the Company employed approximately 4,800 people. Of these employees, approximately 490 were employed in the general office and distribution center in Abilene Kansas, 4,310 in the store locations. Additional employees are hired on a seasonal basis, most of whom are sales personnel. We offer a broad range of company-paid benefits to our employees, including a 401(k) plan, medical and dental plans, short-term and long-term disability insurance, paid vacation and merchandise discounts. Eligibility for and the level of these benefits varies depending on the employees' full-time or part-time status and/or length of service. There is no collective bargaining agent for any of the Company's employees. The Company considers its relations with its employees to be excellent.

CEO BACKGROUND

Warren H. Gfeller has been the owner of Stranger Valley Land Co., LLC, a land development company, and Clayton-Hamilton Equities, LLC, a private investment company, since 1991. He also serves as a director of Inergy Partners, LLC, Inergy Holdings LP, Zapata, Inc., and Gardner Bankshares, Inc.

Dennis A. Mullin has served in various capacities with Steel & Pipe Supply Co., Inc., since 1972 and has served as its President since 1995 and Chief Executive Officer since 1999. Prior thereto he served as its Executive Vice President. He also serves as a director of Commerce Bank, Kansas City.

Lolan C. Mackey has been a partner of Diversified Retail Solutions LLC, a retail senior management advisory firm, since 1997. For 25 years prior thereto, Mr. Mackey was employed in various capacities by Wal-Mart Stores, Inc. From 1990 to 1994, he was Vice President of Store Planning. From 1994 to 1997, he was Vice President of International Operations.

Jeffrey J. Macke has been President of Macke Asset Management, an investment advisory firm, since 1997. Since January 2007, Mr. Macke has been a panelist on “Fast Money”, a market commentary program airing nightly on cable news network CNBC

Robert L. Ring has been a business process and strategic development consultant since 1994. For the 32 years prior thereto, Mr. Ring was employed in various capacities by The Coleman Company. From 1990 to 1994, he was President and Chief Operating Officer. He also serves as a director of Bass Pro Shops, Cobalt Boats, SKT Ventures Inc., and SLS International, Inc.

Dennis E. Logue has served as Chairman of the Board of Ledyard National Bank since 2005. From 2001 to 2005, he was Dean of the Michael F. Price College of Business at the University of Oklahoma. Prior thereto, Mr. Logue held numerous business-oriented professorships, most recently at the Amos Tuck School, Dartmouth College from 1974 to 2001. He is the author or co-author of more than eighty professional papers on a wide variety of financial topics. He has authored or co-authored six books on pension plans. He also serves as a director of Waddell & Reed Financial, Inc. and Abraxas Petroleum Corp.

COMPENSATION

Base Salary. In the course of negotiating base salaries with our executive officers, we strive to take into account each individual’s levels of experience and anticipated skills and contribution to us, our geographic location and informal market surveys indicating what competitive salaries might be. In setting base salaries of executive officers other than Mr. Dale, the Compensation Committee also takes into account recommendations made by Mr. Dale. When considering adjustments to the base salary of Mr. Dale, the Compensation Committee typically takes into account the Company’s performance and the Committee’s assessment of his effectiveness in the performance of his duties. In 2006, even though the Company did not meet goals necessary for executive officers to receive bonuses, the Compensation Committee felt that significant improvements to the Company’s operations had been made and concluded that it would enter a new contract with Mr. Dale, extending the term of his employment and increasing his base salary and bonuses opportunities while increasing the Company Return on Equity goal required to earn that bonus. When considering adjustments to the base salaries of named executive officers other than Mr. Dale, the Compensation Committee typically reviews each executive officer’s existing base salary and, in determining whether to adjust base salary levels, takes into account the Company’s performance, Mr. Dale’s recommendations and assessments of each executive’s growth, effectiveness in the performance of his or her duties and contributions to the Company’s business and length of service. Such adjustments generally are considered

annually but may result from promotions that occur at other times.

Annual Incentives. We believe that a portion of an executive officer’s total annual compensation should be at risk, and that the amount at risk should vary depending upon the level of his or her responsibilities. Accordingly, the Compensation Committee has approved contractual bonus opportunities, based on Return on Equity, of 30% for vice-presidents, 35% for senior vice presidents and 75% for Mr. Dale.

The Committee selected Return on Equity as the performance measure based on negotiations with Mr. Dale when he was initially employed by the Company. Both parties agreed it was a fair measure which, if achieved, would promote long term stockholder value. The initial goal for Return on Equity set for Mr. Dale and other executives for Fiscal 2006 was 6%. For Fiscal 2007 the Committee increased the goal for Return on Equity to 7.15%. The Fiscal 2006 and 2007 goals were not met, and no bonuses have been paid to the named executive officers in either year except Mr. Sturdivant, who negotiated an guaranteed bonus of $10,000 for Fiscal 2007 when he joined us, as stated above.

Our employment agreements provide that bonuses must be repaid to the extent they are paid based on financial information which is later determined to be materially overstated and results in a financial restatement which would have lessened the amount of bonus paid the employee.

Prior to Fiscal 2006, we awarded bonuses on a discretionary basis. The employment agreements with our named executives permit us to make such bonuses but to date we have elected not to do so.

Long Term Incentives. We use stock options as a long term incentive to focus our employee’s efforts on activities which will promote our long term success. In June of 2006, at the first Compensation Committee meeting following our annual meeting, the Committee approved the grant of 231,000 stock options Company-wide, of which 105,000 were granted to our named executive officers. The awards to the named executive officers ranged from 50,000 options in the case of Mr. Dale to 5,000 options in the case of Mr. Marcus. Mr. Dale’s award resulted from negotiations between Mr. Dale and the Compensation Committee. The levels of awards to the other named executive officers were based on recommendations of Mr. Dale, which were based generally upon performance. We do not anticipate making similar awards annually. However, we do make awards at other times. For example, Mr. Marcus and Mr. Canfield each received awards of 10,000 options in April and December of 2006, respectively, following their promotions, and Mr. Sturdivant received an award in February of 2006 pursuant to his employment agreement. These awards were recommend by Mr. Dale and approved by the Compensation Committee. In all cases, in accordance with our 2003 Stock Option Plan, the exercise price of each award is market price on the date the Compensation Committee approved the award.

Historically, we have not timed the grant of stock options to coincide with, precede or follow the release of material non-public information

Other Annual Arrangements. Mr. Canfield and Mr. Schoenbeck are each provided a $100,000 life insurance policy. We agreed to provide this coverage several years ago. We generally try to avoid providing this benefit to new executives. We also make an annual matching contribution to the accounts of named executive officers under our 401k plan. The contribution level is the same as for all employees, which is 50% of the amount contributed by the employee (which may not exceed $15,000) up to 4% of his base pay. Employees become fully vested in the Company’s contributions after seven years.

Severance Pay Arrangements. We compete in a market place where severance and change in control protections are commonplace and have negotiated severance arrangements with our named executive officers to facilitate our ability to attract and retain them. The arrangements that we have agreed to are described fully under Narrative Disclosure to Summary Compensation Table and Grants of Plan-Based Awards Table — Employment Contracts , but generally provide for one year’s base salary and benefits continuation for all named executive officers following termination after a change in control and one year’s base salary and benefits continuation for each named executive officer other than Mr. Dale in the event we do not renew his agreement or terminate him without cause or if he terminates for good reason. If we terminate Mr. Dale without cause or he terminates for good reason, he is entitled to base salary and benefits continuation to the end of the term of his contract, which expires in 2012.

Tax, Accounting and Other Considerations. Tax Considerations . Section 162(m) of the U.S. Internal Revenue Code places a limit of $1,000,000 on the amount of compensation that we may deduct in any one year with respect to any one of our named executive officers. However, qualifying performance-based compensation will not be subject to the deduction limit if certain requirements are met. Certain components of our executive compensation program (stock options) are designed to be qualifying performance-based compensation under Section 162(m). Our other programs are not. However, we do not anticipate that non-qualifying compensation of any named executive officer will approach the $1,000,000 limit.

Accounting Considerations . With the adoption of FAS 123R, we do not expect accounting treatment of differing forms of equity awards to vary significantly and, therefore, accounting treatment is not expected to have a material effect on the selection of forms of compensation.

MANAGEMENT DISCUSSION FROM LATEST 10K

Overview

Operations . The Company is a regional discount retailer operating in 21 states in the central United States.

The Company’s fiscal year ends on the Sunday closest to January 31. Fiscal 2007, 2006 and 2005 each consisted of 52 weeks. For purposes of this management's discussion and analysis of financial condition and results of operations, the financial numbers are presented in thousands.

Strategy. The Company's overall business strategy involves identifying and opening stores in towns that will provide the Company with the highest return on investment. Although the Company prefers markets that don’t have direct competition from national or regional full-line discount stores, its strategy does not preclude it from entering competitive markets. Even in non-competitive markets, competition still exists, as the Company's customers still shop at retail discount stores and other retailers located in regional trade centers. The Company also competes for retail sales with other entities, such as mail order companies, specialty retailers, mass merchandisers, dollar stores, manufacturer's outlets, and the internet.

The Company is constantly evaluating the appropriate mix of merchandise to improve sales and gross margin performance. The Company uses centralized purchasing, merchandising, pricing and warehousing to obtain volume discounts, improve efficiencies and achieve consistency among stores and the best overall results. The Company utilizes information obtained from its POS system and regular input from its store associates to determine its merchandise offerings.

The Company, when appropriate, implements new merchandising and marketing initiatives in an effort to increase customer traffic and same-store sales. The Company is changing its focus from consumable products that carry a lower margin to higher margin soft goods. This includes more fashion apparel that will appeal to a broad base of customers. The Company is also adding new items to its assortments and has made changes to its advertising program that reduces the number of items advertised, but increases the frequency of the advertising.

Recent Events. During fiscal 2007, the Company purchased and retired 3,337 shares of the Company’s Common Stock for an average price of $30.46. All shares repurchased were retired. On March 23, 2006, the Board of Directors approved a plan to repurchase 200,000 shares of the Company’s common stock. There are 196,663 shares remaining under this plan.

The Company completed the rollout of its new POS system in the fourth quarter of fiscal 2007.

The Company entered into an agreement with Radio Shack to carry Radio Shack branded products. This merchandise was incorporated into the product mix in nine stores locations during fiscal 2007.

On September 26, 2006, the Company announced its first store that would carry Bass Pro Shops® branded products. An additional store carrying these items was added in the first quarter of fiscal 2008.

Items Impacting Specific Periods. The Company had items impacting specific periods. The Company analyzed its income tax liability account based on current information, and determined it was over-accrued with respect to certain tax matters arising in prior years. During the fourth quarter of fiscal 2006 the Company reversed this over-accrual of approximately $371. The Company completes an actuarial analysis of its self-insurance liabilities twice a year. In the third quarter of fiscal 2005, the Company increased its self-insurance reserves by $463 as a result of the actuarial analysis indicating higher than previously estimated claim activity. In the second quarter of fiscal 2006, the Company decreased its self-insurance reserves by $901 as a result of lower than estimated claim activity. In fiscal 2007 there was not a significant change in the self-insurance reserves. In the fourth quarter of fiscal 2007, the Company recorded $795 in income due to a decrease in its LIFO reserve. During the fourth quarter of fiscal 2007 the Company experienced store physical inventory shrinkage $795 higher than expected.

Key Items in Fiscal 2007. The Company measures itself against a number of financial metrics to assess its performance. Some of the important financial items during fiscal 2007 were:


•

Net sales increased 9.7% to $475,255. Same store sales increased 6.0% compared to the prior year.

•

Gross margin decreased to 31.6% of sales, compared to 31.8% in the prior year.

•

Selling, general and administrative expenses were 27.8% of sales, compared to 28.7% in the prior year.

•

Earnings per share was $1.49, compared to earnings of $0.47 per share in the prior year.

•

Return on average equity was 5.5%, compared to 1.8% in the prior year.

Same store sales growth is a measure which may indicate whether existing stores are maintaining their market share. Other factors, such as the overall economy, may also affect same store sales. The Company defines same stores as those stores that were open as of the first day of the prior fiscal year and remain open at the end of the reporting period (this may also be referred to as comparable stores).

Gross margin percentage is a key measure of the Company's ability to maximize profit on the purchase and subsequent sale of merchandise, while minimizing promotional and clearance markdowns, shrinkage, damage, and returns. Gross margin percentage is defined as sales less cost of sales, expressed as a percentage of sales.

Selling, general and administrative expenses are a measure of the Company’s ability to manage and control its expenses to purchase, distribute and sell merchandise.

Earnings per share ("EPS") growth is an indicator of the returns generated for the Company's stockholders. EPS from continuing operations was $1.48 per diluted share for fiscal 2007, compared to $1.13 per diluted share for the prior fiscal year. Return on average equity is a measure of how much income was produced on the average equity of the Company.

Results of Operations.

Critical Accounting Policies

Our analysis of operations and financial condition is based on our consolidated financial statements, prepared in accordance with U.S. generally accepted accounting principles (GAAP). Preparation of these consolidated financial statements requires us to make estimates and assumptions affecting the reported amounts of assets and liabilities at the date of the financial statements, reported amounts of revenues and expenses during the reporting period and related disclosures of contingent assets and liabilities. In the Notes to Consolidated Financial Statements, we describe our significant accounting policies used in preparing the consolidated financial statements. Our estimates are evaluated on an ongoing basis and are drawn from historical experience and other assumptions that we believe to be reasonable under the circumstances. Actual results could differ under different assumptions or conditions. The following items in our consolidated financial statements require significant estimation or judgment:

Inventory : As discussed in Note 1(d) to the Consolidated Financial Statements, inventories are stated at the lower of cost or net realizable value with cost determined using the last-in, first-out (LIFO) method. The retail inventory method (“RIM”) used by the Company is an averaging method that has been widely used in the retail industry. This method calculates a cost to retail ratio that is applied to the retail value of inventory to calculate cost inventory and the resulting gross margin. Use of the RIM does not eliminate the use of management judgments and estimates, including markdowns and shrinkage, which significantly impact the ending inventory valuation at cost and the resulting gross margins. The Company continually evaluates product categories to determine if markdown action is appropriate, or if a markdown reserve should be established. The Company recognizes that the use of the RIM will result in valuing inventories at lower of cost or market if markdowns are currently taken as a reduction of the retail value of inventories. As of January 28, 2007 and January 29, 2006, the Company had recorded markdowns that had not been taken and which served to reduce inventories to lower of cost or market by approximately $354 and $597, respectively. Management believes that the RIM provides an inventory valuation which reasonably approximates cost and results in carrying inventory at the lower of cost or market. For LIFO, the Company determines lower of cost or market by pool. The Company has historically accrued its shrink reserve based on a three-year average shrink percentage at each of its store locations. Historically the three-year average has appropriately recorded estimated shrinkage on a monthly basis. At the end of fiscal 2007, the Company determined that this reserve was not sufficient due to the shrink results for the last month of fiscal 2007. The stores inventoried in January 2007 experienced $795 more shrink at cost, than had previously been reserved. A 0.5% increase in this percentage would increase the recorded reserve by $257.

Insurance : The Company retains significant deductibles on its insurance policies for workers compensation, general liability and medical claims. Due to the fact that it takes more than one year to determine the actual costs, these costs are estimated based on the Company’s historical loss experience and estimates from the insurance carriers and consultants. The Company completes an actuarial evaluation of its loss experience twice each year. In between actuarial evaluations, management monitors the cost and number of claims and compares those results to historical amounts. The Company’s actuarial method is the fully developed method. This method includes a loss conversion factor that includes administrative, legal and claims handling expenses. The Company records its reserves on an undiscounted basis. The Company’s prior estimates have varied based on changes in assumptions related to actual claims versus estimated ultimate loss calculations. Current and future estimates could be affected by changes in those same assumptions and are reasonably likely to occur. A 1% increase in the loss development factor would increase the recorded liability by $75.

Income Taxes: The Company’s tax provision and establishment of reserves for potential tax liabilities involves the use of estimates and judgment. The Company has identified exposures for which they have established a reserve, such as differences in interpretation of tax laws at the federal, state, and local units of government. In the ordinary course of business, the Company analyzes its income accounts. During fiscal 2006, the Company determined that it was overaccrued with respect to certain matters arising in prior years. The Company reversed such overaccrual of approximately $371 during fiscal 2006.

Share-Based Payments: Effective January 30, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 " Share-Based Payment " ("SFAS 123(R)") and began recognizing compensation expense for its share-based payments based on the fair value of the awards. Share-based payments consist of stock option grants. SFAS 123(R) requires share-based compensation expense recognized since January 30, 2006 to be based on the following: a) grant date fair value estimated in accordance with the original provisions of SFAS 123 for unvested options granted prior to the adoption date and b) grant date fair value estimated in accordance with the provisions of SFAS 123(R) for all share-based payments granted subsequent to the adoption date. For Executives and Directors, the Company estimates forfeitures will not occur. This is due to the fact that, historically, the Company does not experience material turnover of these two classes. Any turnover in these classes could have a significant impact on the stock option expense for the Company. For non-Executives, the Company estimates a higher forfeiture rate. An actual turnover rate, lower or higher than historical trends, and changes in estimated forfeiture rates would impact the stock option expense recorded by the Company.

Fiscal 2007 Compared to Fiscal 2006

Net sales for fiscal 2007 increased $42.0 million or 9.7% to $475.3 million compared to $433.3 million for fiscal 2006. During fiscal 2007, the Company opened seven ALCO stores. One ALCO was closed and one Duckwall store was closed and replaced by an ALCO store, resulting in a year end total of 256 stores. Net sales for all stores open the full year in both fiscal 2007 and 2006 (same stores), increased by $25.6 million or 6.0% in fiscal 2007 compared to fiscal 2006. The average sale for fiscal 2007 increased 7.2% compared to fiscal 2006. The Company had four of its merchandise departments experience greater than 15% increase in sales for fiscal 2007 when compared to fiscal 2006.

Gross margin for fiscal 2007 increased $12.6 million, or 9.1%, to $150.4 million compared to $137.8 million in fiscal 2006. As a percentage of net sales, gross margin decreased to 31.6% in fiscal 2007 compared to 31.8% in fiscal 2006. Fiscal 2007 gross margin was positively impacted by a LIFO reserve reductions and increased vendor participation support, offset by a reduction in warehouse swell, additional shrinkage reserve and increased transportation costs.

Selling, general and administrative expenses increased $8.0 million or 6.4% to $132.2 million in fiscal 2007 compared to $124.2 million in fiscal 2006. As a percentage of net sales, selling, general and administrative expenses were 27.8% in fiscal 2007 and 28.7% in fiscal 2006. The decrease in selling, general and administrative expenses as a percentage of net sales was due in part to an increase in vendor participation in CO-OP advertising, offset by increased payroll, increase in expenses related to stock options, increase in credit card fees, increase in advertising, professional services and software maintenance fees associated with rollout of IT initiative and increase in utilities and new store rents.

Depreciation and amortization expense increased $860 or 14.5% to $6.8 million in fiscal 2007 compared to $5.9 million in fiscal 2006. The increase in depreciation and amortization expense was attributable to a full year’s depreciation on capitalized software which was purchased in the fourth quarter of fiscal 2006.

Income from continuing operations increased $3.7 million, or 48.1%, to $11.4 million in fiscal 2007 compared to $7.7 million in fiscal 2006. Income from continuing operations as a percentage of net sales was 2.4% in fiscal 2007 compared to 1.8% in fiscal 2006. The increase in gross margin, as described above, had the largest impact on the increased income from continuing operations.

Interest expense increased $1.4 million or 107.7%, to $2.7 million in fiscal 2007 compared to $1.3 million in fiscal 2006. The increase in interest expense was attributable to increased borrowings by the Company during fiscal 2007 compared to fiscal 2006. Interest expense may increase if interest rates continue to rise or if the Company expands its borrowing to fund capital expenditures or other programs.

Income taxes on continuing operations were $3.0 million in fiscal 2007 compared to $1.8 million in fiscal 2006. The Company's effective tax rate was 35.1% in fiscal 2007 and 27.4% in fiscal 2006. The effective tax rate is higher due to permanent tax differences relating to stock compensation expense and reversal of over-accrual of approximately $371 during the fourth quarter of 2006.

Income from discontinued operations, net of income taxes was $70 in fiscal 2007, compared to a loss of $2.7 million in fiscal 2006.

MANAGEMENT DISCUSSION FOR LATEST QUARTER

RESULTS OF OPERATIONS

Thirteen Weeks Ended October 28, 2007 Compared to Thirteen Weeks Ended October 29, 2006.

Net Sales

Net sales for the third quarter of fiscal 2008 increased $5,484, or 5.0%, to $114,314 compared to $108,830 for the third quarter of fiscal 2007. Same store sales increased 2.2% when compared with the prior year same quarter. The sales were favorably impacted by customer acceptance of the current merchandise strategy and an average transaction increase of $0.61 to $18.85 or 3.3%.

Gross Margin

Gross margin for the third quarter of fiscal 2008 increased $2,965, or 8.8%, to $36,810 compared to $33,845 in the third quarter of fiscal 2007. Gross margin as a percentage of sales was 32.2% for the third quarter of fiscal 2008, which increased when compared to 31.1% for the third quarter of fiscal 2007. The increase in the gross margin percentage was primarily due to lower freight costs (58 basis points), increased vendor support (174 basis points) and significantly improved initial markon percentages (44 basis points); offset by increased markdowns (103 basis points) and shrinkage (63 basis points). The increase in vendor support is due to new store allowances for six new stores opened in the third quarter of fiscal 2008 compared to no new stores opened in the third quarter of fiscal 2007.

SG&A

Selling, general and administrative expense increased $4,394 or 13.5%, to $37,002 in the third quarter of fiscal 2008 compared to $32,608 in the third quarter of fiscal 2007. As a percentage of net sales, selling, general and administrative expenses for fiscal 2008 were 32.4%, compared to 30.0% for fiscal 2007.

As a percentage of comparable store sales, selling, general and administrative expenses, excluding significant fluctuations for fiscal 2008 were 27.8%, compared to 28.5% for fiscal 2007. The Company opened six new stores in the third quarter of fiscal 2008 compared to no new stores opened in the third quarter of fiscal 2007. Inventory service fees decreased in the third quarter of fiscal 2008 and are expected to be consistent with fiscal 2007. Fiscal 2008 CO-OP income is expected to be consistent with fiscal 2007.

Depreciation and Amortization Expense

Depreciation and amortization expense increased $269, or 16.4%, to $1,905 in the third quarter of fiscal 2008 compared to $1,636 in the third quarter of fiscal 2007. The increase is primarily due to new stores opened in the third quarter of fiscal 2007 and the first quarter of fiscal 2008 and items related to the IT initiative.

Interest Expense

Interest expense increased $120, or 14.8%, to $929 in the third quarter of fiscal 2008 compared to $809 in the third quarter of fiscal 2007. The increase in interest expense was due to higher levels of borrowing due to opening six new stores in the third quarter of fiscal 2008 compared to zero for fiscal 2007.

Income Taxes

The Company’s effective tax rate on earnings from continuing operations before income taxes in the third quarter of fiscal 2008 was 41.4%, compared to 49.4% in the third quarter of fiscal 2007. The effective tax rate is lower due to work opportunity tax credits not being effective in the third quarter of fiscal 2007.

Earnings (Loss) from Discontinued Operations

Earnings from discontinued operations, net of income tax, was $137 in the third quarter of fiscal 2008, compared to loss of $37 in the third quarter of fiscal 2007. In the third quarter of fiscal 2008, one ALCO store and four Duckwall stores were closed. The gain for the third quarter of fiscal 2008 was due the sale of property from the ALCO store closed in the third quarter of fiscal 2008. Stores closed where the Company has exited the market are reflected in discontinued operations in all periods presented.

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