NOTE 3: STOCK-BASED COMPENSATION

The Company accounts for its stock-based compensation plans in accordance with FASB ASC 718 “Compensation – Stock Compensation”. Under FASB ASC 718, stock-based compensation expense is based on awards ultimately expected to vest, and therefore has been reduced for estimated forfeitures. Forfeitures are estimated at the time of grant based on the Company’s historical forfeiture experience and will be revised in subsequent periods if actual forfeitures differ from those estimates.

FASB ASC 718 also requires the benefits of income tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required prior to FASB ASC 718. A summary of the Company’s stock-based compensation (a component of selling and general and administrative expenses) and related income tax benefit is as follows (in thousands):

	Thirteen Weeks Ended				Thirty-Nine Weeks Ended
	October 29, 2011		October 30, 2010		October 29, 2011		October 30, 2010

Stock option expense	$	101	$	111	$	352	$	435
Restricted stock expense		297		301		856		803
ESPP expense		43		36		130		106
Total stock-based compensation	$	441	$	448	$	1,338	$	1,344

Income tax benefit on stock-based compensation	$	121	$	126	$	352	$	361

The fair value of each option granted during the thirteen and thirty-nine week periods ended October 29, 2011 and October 30, 2010, respectively, are estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions:

	Thirteen Weeks Ended						Thirty-Nine Weeks Ended
	October 29, 2011			October 30, 2010			October 29, 2011			October 30, 2010
Stock Options
Expected volatility		40.5	%		42.4	%		41.4	%		42.1	%
Risk-free interest rate		1.5	%		2.7	%		1.9	%		3.0	%
Expected option life (in years)		5.84			5.84			4.96			5.84
Expected dividend yield		0.86	%		0.71	%		0.91	%		0.65	%

Weighted average fair value at grant date	$	4.13		$	5.34		$	4.49		$	4.96

Employee Stock Purchase Plan
Expected volatility		31.5	%		32.0	%		24.8	%		31.9	%
Risk-free interest rate		0.3	%		0.6	%		0.3	%		0.6	%
Expected option life (in years)		0.75			0.75			0.5			0.5
Expected dividend yield		1.02	%		0.69	%		0.68	%		0.46	%

Weighted average fair value at grant date	$	3.59		$	2.64		$	3.07		$	2.42

The following is a summary of the methodology applied to develop each assumption:

Expected Volatility - This is a measure of the amount by which a price has fluctuated or is expected to fluctuate. The Company uses actual historical changes in the market value of our stock to calculate expected price volatility because management believes that this is the best indicator of future volatility. The Company calculates weekly market value changes from the date of grant over a past period representative of the expected life of the options to determine volatility. An increase in the expected volatility will increase compensation expense.

Risk-free Interest Rate - This is the yield of a U.S. Treasury zero-coupon bond issue effective at the grant date with a remaining term equal to the expected life of the option. An increase in the risk-free interest rate will increase compensation expense.

Expected Lives - This is the period of time over which the options granted are expected to remain outstanding and is based on historical experience. Options granted have a maximum term of seven and one-half years. An increase in the expected life will increase compensation expense.

Dividend Yield – This is based on the historical yield for a period equivalent to the expected life of the option. An increase in the dividend yield will decrease compensation expense.

Forfeiture Rate - This is the estimated percentage of options granted that are expected to be forfeited or cancelled before becoming fully vested. This estimate is based on historical experience. An increase in the forfeiture rate will decrease compensation expense.

Employee Stock Purchase Plan

The 2004 Employee Stock Purchase Plan (the “2004 Plan”), which was approved by Fred’s stockholders, permits eligible employees to purchase shares of our common stock through payroll deductions at the lower of 85% of the fair market value of the stock at the time of grant or 85% of the fair market value at the time of exercise. There were 41,154 shares issued during the thirty-nine weeks ended October 29, 2011. There are 1,410,928 shares approved to be issued under the 2004 Plan and as of October 29, 2011, there were 985,679 shares available.

Stock Options

The following table summarizes stock option activity during the thirty-nine weeks ended October 29, 2011:

	Options			Weighted Average Exercise Price		Weighted Average Remaining Contractual Life (Years)		Aggregate Intrinsic Value (Thousands)

Outstanding at January 29, 2011		918,462		$	12.15		3.2	$	1,524
Granted		78,478		$	12.57
Forfeited / Cancelled		(179,583	)	$	14.49
Exercised		(10,217	)	$	11.23
Outstanding at October 29, 2011		807,140		$	11.70		3.1	$	954

Exercisable at October 29, 2011		538,703		$	11.89		2.4	$	575

The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between Fred’s closing stock price on the last trading day of the period ended October 29, 2011 and the exercise price of the option multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on that date. As of October 29, 2011, total unrecognized stock-based compensation expense net of estimated forfeitures related to non-vested stock options was approximately $483.9 thousand, which is expected to be recognized over a weighted average period of approximately 3.13 years. The total fair value of options vested during the thirty-nine weeks ended October 29, 2011 was $625.6 thousand.

Restricted Stock

The following table summarizes restricted stock activity during the thirty-nine weeks ended October 29, 2011:

	Number of Shares			Weighted Average Grant Date Fair Value

Non-vested Restricted Stock at January 29, 2011		472,927		$	12.55
Granted		187,454		$	13.30
Forfeited / Cancelled		(51,868	)	$	12.74
Vested		(59,331	)	$	13.58
Non-vested Restricted Stock at October 29, 2011		549,182		$	12.67

The aggregate pre-tax intrinsic value of restricted stock outstanding as of October 29, 2011 is $6.8 million with a weighted average remaining contractual life of 4.2 years. The unrecognized compensation expense net of estimated forfeitures, related to the outstanding stock is approximately $3.91 million, which is expected to be recognized over a weighted average period of approximately 6.5 years. The total fair value of restricted stock awards that vested during the thirty-nine weeks ended October 29, 2011 was $813.4 thousand.