Introduction

We strongly recommend that you read our accompanying audited consolidated financial statements and footnotes along with this important discussion and analysis.

Results of Operations

Fiscal 2000, which ended on December 30, 2000 and fiscal 1998, which ended on December 26, 1998, each included 52 weeks. Fiscal 1999, which ended on January 1, 2000, included 53 weeks.

Net sales increased 11.0% in 2000 to $20.1 billion. This compares to increases of 18.5% in 1999 and 11.1% in 1998. Same store sales, consisting of sales from stores that have been open for more than one year, rose 10.9% in 2000, 12.5% in 1999 and 10.8% in 1998. Pharmacy same store sales increased 17.7% in 2000, 19.4% in 1999 and 16.5% in 1998. Our pharmacy sales as a percentage of total net sales were 63% in 2000, 59% in 1999 and 58% in 1998. Our third party prescription sales as a percentage of total pharmacy sales were 89% in 2000, 87% in 1999 and 84% in 1998.

As you review our sales performance, we believe you should consider the following important information:

• Our pharmacy sales growth continued to benefit from our ability to attract and retain managed care customers and favorable industry trends. These trends include an aging American population; many "baby boomers" are now in their fifties and are consuming a greater number of prescription drugs. The increased use of pharmaceuticals as the first line of defense for healthcare and the introduction of a number of successful new prescription drugs also contributed to the growing demand for pharmacy services.
  
  
• Our front store sales growth was driven by strong performance in the general merchandise, health and beauty, convenience foods and film and photofinishing categories.
  
  
• The increase in net sales in 2000 was negatively affected by the 53rd week in 1999. Excluding the impact of the 53rd week in 1999, comparable net sales increased 13.4% in 2000 when compared to 1999.
  
  
• The increase in net sales in 1999 was positively affected by the 53rd week in 1999. Excluding the impact of the 53rd week in 1999, comparable net sales increased 16.0% in 1999 when compared to 1998.
  
  
• The increase in net sales in 1998 was positively affected by our efforts to improve the performance of the Revco stores, which we acquired in 1997. To do this, we converted the retained Revco stores to the CVS store format and relocated certain stores. Our performance during the conversion period was positively affected by temporary promotional events.
  
  
• We continued to relocate our existing shopping center stores to larger, more convenient, freestanding locations. Historically, we have achieved significant improvements in customer count and net sales when we do this. The resulting increase in net sales has typically been driven by an increase in front store sales, which normally have a higher gross margin. We believe that our relocation program offers a significant opportunity for future growth, as only 39% of our existing stores are freestanding. We currently expect to have approximately 44% of our stores in freestanding locations by the end of 2001. Our long-term goal is to have 80% of our stores located in freestanding sites. We cannot, however, guarantee that future store relocations will deliver the same results as those historically achieved. Please read the "Cautionary Statement Concerning Forward-Looking Statements" section below.

Gross margin as a percentage of net sales was 26.7% in 2000. This compares to 26.9% in 1999 and 27.0% in 1998. As you review our gross margin performance, please remember to consider the impact of the following nonrecurring charge:

• During 1998, we recorded a $10.0 million charge to cost of goods sold to reflect markdowns on noncompatible Arbor merchandise, which resulted from the CVS/Arbor merger transaction. Please read Note 10 to the consolidated financial statements for other important information about the CVS/Arbor merger.

If you exclude the effect of this nonrecurring charge, our comparable gross margin as a percentage of net sales was 26.7% in 2000, 26.9% in 1999 and 27.1% in 1998.

Why has our comparable gross margin rate been declining?

• Pharmacy sales are growing at a faster pace than front store sales. On average, our gross margin on pharmacy sales is lower than our gross margin on front store sales.
  
  
• Sales to customers covered by third party insurance programs have continued to increase and, thus, have become a larger part of our total pharmacy business. On average, our gross margin on third party pharmacy sales is lower than our gross margin on cash pharmacy sales.
  
  
• Our third party gross margin rates have historically reflected varying degrees of pressure due to the efforts of managed care organizations and other pharmacy benefit managers to reduce prescription drug costs. To address this trend, we have dropped and/or renegotiated a number of third party programs that fell below our minimum profitability standards. These continuing efforts have resulted in a stabilization of third party rates. However, in the event this trend were to continue and we elect to drop additional programs and/or decide not to participate in future programs that fall below our minimum profitability standards, we may not be able to sustain our current rate of sales growth.

Total operating expenses were 20.1% of net sales in 2000. This compares to 20.6% of net sales in 1999 and 22.1% in 1998. As you review our performance in this area, please remember to consider the impact of the following nonrecurring gain and charge:

• During 2000, we recorded a $19.2 million pre-tax ($11.5 million after-tax) nonrecurring gain in total operating expenses, which represented a partial payment of our share of the settlement proceeds from a class action lawsuit against certain manufacturers of brand name prescription drugs. The timing and amount of any future payments have yet to be determined.
  
  
• During 1998, we recorded a $147.3 million pre-tax ($101.3 million after-tax) charge in total operating expenses for direct and other merger-related costs pertaining to the CVS/Arbor merger transaction and related restructuring activities. In addition, we incurred $31.3 million of nonrecurring costs ($18.4 million after-tax) in connection with eliminating Arbor's information technology systems and Revco's noncompatible store merchandise fixtures. Please read Note 10 to the consolidated financial statements for other important information about the CVS/Arbor merger.

If you exclude the effect of the nonrecurring gain and charges we recorded in 2000 and 1998, respectively, comparable total operating expenses as a percentage of net sales were 20.2% in 2000, 20.6% in 1999 and 20.9% in 1998.

What have we done to improve our comparable total operating expenses as a percentage of net sales?

• Our strong sales performance has consistently allowed our net sales to grow at a faster pace than total operating expenses.
  
  
• Our information technology initiatives have led to greater productivity, which has resulted in lower operating costs, particularly at the store level.

Operating profit increased $187.2 million in 2000 to $1.3 billion. This compares to $1.1 billion in 1999 and $751.9 million in 1998. If you exclude the effect of the nonrecurring gain we recorded in total operating expenses in 2000 and the nonrecurring charges we recorded in gross margin and in total operating expenses in 1998, our comparable operating profit increased $168.0 million in 2000 to $1.3 billion (or 14.8%). This compares to $1.1 billion in 1999 and $940.5 million in 1998. Comparable operating profit as a percentage of net sales was 6.5% in 2000, 6.3% in 1999 and 6.2% in 1998.

Interest expense, net consisted of the following:

	Fiscal Year
In millions	2000	1999	1998
Interest expense	$ 84.1	$ 66.1	$ 69.7
Interest income	(4.8)	(7.0)	(8.8)
Interest expense, net	$ 79.3	$ 59.1	$ 60.9

The increase in interest expense in 2000 was primarily due to higher average interest rates and higher average borrowing levels during the year.

Income tax provision ~ Our effective income tax rate was 40.0% in 2000, 41.0% in 1999 and 44.4% in 1998. The decrease in our effective income tax rate in 2000 and 1999 was primarily due to lower state income taxes. Our effective income tax rate was higher in 1998 because certain components of the nonrecurring charges we recorded in conjunction with the CVS/Arbor merger transaction were not deductible for income tax purposes.

Net earnings increased $110.9 million to $746.0 million (or $1.83 per diluted share) in 2000. This compares to $635.1 million (or $1.55 per diluted share) in 1999 and $384.5 million (or $0.95 per diluted share) in 1998. If you exclude the effect of the nonrecurring gain we recorded in total operating expenses in 2000 and the nonrecurring charges we recorded in gross margin and in total operating expenses in 1998, our comparable net earnings increased $99.4 million to $734.5 million (or $1.80 per diluted share) in 2000. This compares to $635.1 million (or $1.55 per diluted share) in 1999 and $510.1 million (or $1.26 per diluted share) in 1998.

Liquidity & Capital Resources

Liquidity ~ We generally finance our working capital and capital expenditure requirements with internally generated funds and our commercial paper program. In addition, we may elect to use additional long-term borrowings and/or other financing sources in the future to support our continued growth.

Our commercial paper program is supported by a $670 million, five-year unsecured revolving credit facility, which expires on May 30, 2002 and a $995 million unsecured revolving credit facility, which expires on May 25, 2001. We can also obtain short-term financing through various uncommitted lines of credit. As of December 30, 2000, we had $589.6 million of commercial paper outstanding at a weighted average interest rate of 6.9%.

Our credit facilities and unsecured senior notes contain customary restrictive financial and operating covenants. We do not believe that the restrictions contained in these covenants materially affect our financial or operating flexibility.

On March 6, 2000, the Board of Directors approved a common stock repurchase program, which allows the Company to acquire up to $1 billion of its common stock. During 2000, we repurchased 4.7 million shares of common stock at an aggregate cost of $163.2 million.

On September 18, 2000, the Company completed the acquisition of certain assets of Stadtlander Pharmacy of Pittsburgh, Pennsylvania, a subsidiary of Bergen Brunswig Corporation, for $124 million in cash plus the assumption of certain liabilities. The results of operations of Stadtlander have been included in the consolidated financial statements since this date.

Capital Resources ~ Although there can be no assurance and assuming market interest rates remain favorable, we currently believe that we will continue to have access to capital at attractive interest rates in 2001. We further believe that our cash on hand and cash provided by operations, together with our ability to obtain additional short-term and long-term financing, will be sufficient to cover our future working capital needs, capital expenditures and debt service requirements for at least the next 12 months.

Net Cash Provided by Operations ~ Net cash provided by operations increased to $780.2 million in 2000. This compares to $726.3 million in 1999 and $292.4 million in 1998. The improvement in net cash provided by operations was primarily the result of higher net earnings. As of December 30, 2000, the future cash payments associated with various restructuring programs totaled $105.2 million, which primarily consists of continuing lease obligations extending through 2020.

Capital Expenditures ~ Our capital expenditures, before the effect of the sale-leaseback transactions discussed below, totaled $695.3 million in 2000. This compared to $722.7 million, in 1999 and $502.3 million in 1998. During 2000, we opened 158 new stores, relocated 230 existing stores and closed 123 stores. This includes 34 new ProCare stores and 1 relocation. We also entered three new major markets in 2000 including Chicago, Illinois, Tampa and Orlando, Florida. As of December 30, 2000, we operated 4,133 retail and specialty pharmacy stores in 31 states and the District of Columbia. This compares to 4,098 stores as of January 1, 2000. The Company finances a portion of its store development program through sale-leaseback transactions. Proceeds from sale-leaseback transactions totaled $299.3 million in 2000 and $229.2 million in 1999. The properties were sold at net book value and the resulting leases are being accounted for as operating leases.

Recent Accounting Pronouncements

Effective fiscal 2001, we adopted Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities," as amended by SFAS 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities—an amendment to FASB Statement No. 133." These statements, which established the accounting and financial reporting requirements for derivative instruments, require companies to recognize derivatives as either assets or liabilities on the balance sheet and measure those instruments at fair value. The adoption of this standard did not have a material effect on our consolidated financial statements.

During the fourth quarter of 2000, we adopted the Staff Accounting Bulletin 101, "Revenue Recognition in Financial Statements." This bulletin summarizes the application of generally accepted accounting principles to revenue recognition in financial statements. The adoption of this standard did not have a material effect on our consolidated financial statements.

Cautionary Statement Concerning Forward-Looking Statements

We have made forward-looking statements in this Annual Report that are subject to risks and uncertainties that could cause actual results to differ materially. For these statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. We strongly recommend that you become familiar with the specific risks and uncertainties that we have outlined for you under the caption "Cautionary Statement Concerning Forward-Looking Statements" in our Annual Report on Form 10-K for the fiscal year ended December 30, 2000.