NOTE 8 – EQUITY INCENTIVE PLANS

Incentive stock option plan. The Company has a long-term incentive plan, which was reapproved by Fred's stockholders at the 2012 annual shareholders meeting. The 2012 plan is substantially identical to the prior plan. The 2012 plan increases the number of shares of the Company’s common stock authorized for issuance by 600,000 shares, from the 2,400,000 which was available under the prior plan to 3,000,000 shares. The plan expires March 18, 2022, and Section 10 of the 2002 plan, which provides for supplemental cash payments or loans to individuals in connection with all or any part of an award under the plan, has been removed and is not part of the 2012 plan. Shares available to be granted under the long-term incentive plan were 1,273,395 as of February 1, 2014 (1,343,795 shares as of February 2, 2013). Options issued under the 2002 and 2012 plans expire five to eight years from the date of grant. Options outstanding at February 1, 2014 expire in fiscal 2014 through fiscal 2021.

The Company grants stock options to key employees including executive officers, as well as other employees, as prescribed by the Compensation Committee (the “Committee”) of the Board of Directors. The number of options granted is directly linked to the employee’s job classification. Options, which include non-qualified stock options and incentive stock options, are rights to purchase a specified number of shares of Fred's common stock at a price fixed by the Committee. Stock options granted have an exercise price equal to the market price of Fred's common stock on the date of grant. The exercise price for stock options issued under the plan that qualify as incentive stock options within the meaning of Section 422(b) of the Code shall not be less than 100% of the fair value as of the date of grant. The option exercise price may be satisfied in cash or by exchanging shares of Fred's common stock owned by the optionee for at least six months, or a combination of cash and shares. Options have a maximum term of five to eight years from the date of grant. Options granted under the plan generally become exercisable ratably over five years or ten percent during each of the first four years on the anniversary date and sixty percent on the fifth anniversary date. The rest vest ratably over the requisite service period. Stock option expense is generally recognized using the graded vesting attribution method. The plan contains a non-compete provision and a provision that if the Company meets or exceeds a specified operating income margin during the most recently completed fiscal year that the annual vesting percentage will accelerate from ten to twenty percent during that vesting period. The plan also provides for annual stock grants at the market price of the common stock on the grant date to non-employee directors according to a non-discretionary formula. The number of shares granted is dependent upon current director compensation levels.

Employee Stock Purchase Plan. The 2004 Employee Stock Purchase Plan ("ESSP") (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 market price at the time of exercise. There were 60,912, 54,830 and 52,526 shares issued during fiscal years 2013, 2012 and 2011, respectively. There are 1,410,928 shares approved to be issued under the 2004 Plan and as of February 1, 2014 there were 858,565 shares available.

The following represents total stock based compensation expense (a component of selling, general and administrative expenses) recognized in the consolidated financial statements (in thousands):

(in thousands)	2013		2012		2011
Stock option expense	$	610	$	600	$	455
Restricted stock expense		984		1,258		1,446
ESPP expense		197		197		174
Total stock-based compensation	$	1,791	$	2,055	$	2,075

Income tax benefit on stock-based compensation	$	473	$	565	$	573

The Company uses the Modified Black-Scholes Option Valuation Model (“BSM”) to measure the fair value of stock options granted to employees. The BSM option valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock volatility and option life. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.

The fair value of each option granted is estimated on the date of grant using the BSM with the following weighted average assumptions:

Stock Options	2013			2012			2011
Expected volatility		32.1	%		39.7	%		41.2	%
Risk-free interest rate		1.2	%		0.5	%		1.8	%
Expected option life (in years)		4.73			4.16			5.13
Expected dividend yield		1.7	%		1.3	%		0.9	%

Weighted average fair value at grant date	$	3.81		$	3.95		$	4.35

Employee Stock Purchase Plan
Expected volatility		22.7	%		33.2	%		27.6	%
Risk-free interest rate		0.2	%		0.1	%		0.3	%
Expected option life (in years)		0.63			0.63			0.63
Expected dividend yield		1.1	%		1.0	%		0.9	%

Weighted average fair value at grant date	$	3.02		$	3.60		$	3.32

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.

Stock Options. The following table summarizes stock option activity from January 29, 2011 through February 1, 2014:

	Options	Weighted- Average Exercise Price		Weighted- Averaged Contractual Life (years)	Aggregate Intrinsic Value (000s)
Outstanding at January 29, 2011	918,462	$	12.15	3.2	$	1,524
Granted	113,821		11.96
Forfeited / Cancelled	(218,844)		14.39
Exercised	(18,063)		12.12
Outstanding at January 28, 2012	795,376	$	11.52	3	$	2,831
Granted	441,791		13.65
Forfeited / Cancelled	(24,600)		14.54
Exercised	(66,912)		13.14
Outstanding at February 2, 2013	1,145,655	$	12.18	3.2	$	1,467
Granted	213,859		15.26
Forfeited / Cancelled	(135,716)		13.18
Exercised	(81,369)		12.26
Outstanding at February 1, 2014	1,142,429	$	12.63	3.0	$	5,539

Exercisable at February 1, 2014	458,056	$	10.74	1.4	$	3,089

The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the excess of Fred's closing stock price on the last trading day of the fiscal year end 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. This amount changes based on changes in the market value of Fred's stock. As of February 1, 2014, total unrecognized stock-based compensation expense net of estimated forfeitures related to non-vested stock options was approximately $1.5 million, which is expected to be recognized over a weighted average period of approximately 3.1 years.

Other information relative to option activity during 2013, 2012 and 2011 is as follows:

(dollars in thousands)	2013		2012		2011
Total fair value of stock options vested	$	353	$	543	$	642
Total pretax intrinsic value of stock options exercised	$	266	$	76	$	42

The following table summarizes information about stock options outstanding at February 1, 2014:

	Options Outstanding				Options Exercisable
Range of Exercise Prices	Shares	Weighted- Averaged Contractual Life (years)		Weighted- Average Exercise Price	Shares		Weighted- Average Exercise Price
$ 8.66 - $12.75	455,769	1.4	$	10.35	403,762	$	10.36
$13.00 - $13.64	470,207	3.6	$	13.57	34,924	$	13.11
$13.72 - $18.03	216,453	5.2	$	15.41	19,370	$	14.30
	1,142,429				458,056

Restricted Stock. The Company’s equity incentive plans also allow for granting of restricted stock having a fixed number of shares at a purchase price that is set by the Compensation Committee of the Company’s Board of Directors, which purchase price may be set at zero, to certain executive officers, directors and key employees. The Company calculates compensation expense as the difference between the market price of the underlying stock on the date of grant and the purchase price if any. Restricted shares granted under the plan have various vesting types, which include cliff vesting and graded vesting with a requisite service period of three to ten years. Restricted stock has a maximum term of five to ten years from grant date. Compensation expense is recorded on a straight-line basis for shares that cliff vest and under the graded vesting attribution method for those that have graded vesting. If certain performance metrics are met, vesting may be accelerated and is recognized once achievement of the performance metric is considered probable.

The following table summarizes restricted stock from January 29, 2011 through February 1, 2014:

	Shares		Weighted-Average Grant Date Fair Value
Non-vested Restricted Stock at January 29, 2011	472,927	$	12.55
Granted	396,830		12.59
Forfeited / Cancelled	(91,375)		12.12
Exercised	(66,782)		12.29
Non-vested Restricted Stock at January 28, 2012	711,600	$	12.56
Granted	133,979		14.45
Forfeited / Cancelled	(94,796)		12.16
Exercised	(129,774)		12.26
Non-vested Restricted Stock at February 2, 2013	621,009	$	13.09
Granted	113,943		14.72
Forfeited / Cancelled	(125,686)		13.22
Exercised	(58,253)		11.83
Non-vested Restricted Stock at February 1, 2014	551,013	$	13.53

The aggregate pre-tax intrinsic value of restricted stock outstanding as of February 1, 2014 is $9.6 million with a weighted average remaining contractual life of 5.2 years. The unrecognized compensation expense net of estimated forfeitures, related to the outstanding restricted stock is approximately $4.1 million, which is expected to be recognized over a weighted average period of approximately 6.2 years. The total fair value of restricted stock awards that vested for the years ended February 1, 2014, February 2, 2013 and January 28, 2012 was $0.7 million, $1.5 million and $0.9 million, respectively.

There were no significant modifications to the Company’s share-based compensation plans during fiscal 2013, 2012 or 2011.