NOTE 3: STOCK-BASED COMPENSATION

The Company accounts for its stock-based compensation plans in accordance with the 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, general and administrative expenses) and related income tax benefit is as follows (in thousands):

	Thirteen Weeks Ended				Thirty-Nine Weeks Ended
	November 1,		November 2,		November 1,		November 2,
	2014		2013		2014		2013

Stock option expense	$	201	$	147	$	662	$	464
Restricted stock expense		342		531		1,135		1,324
ESPP expense		55		52		165		156
Total stock-based compensation	$	598	$	730	$	1,962	$	1,944

Income tax benefit on stock-based compensation	$	149	$	218	$	508	$	560

The fair value of each option granted during the thirteen and thirty-nine week periods ended November 1, 2014 and November 2, 2013 is 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
	November 1,			November 2,			November 1,			November 2,
	2014			2013			2014			2013
Stock Options
Expected volatility		35.9	%		38.4	%		36.2	%		38.9	%
Risk-free interest rate		2.0	%		1.2	%		1.9	%		1.0	%
Expected option life (in years)		5.84			5.84			5.84			5.84
Expected dividend yield		1.61	%		1.41	%		1.59	%		1.30	%

Weighted average fair value at grant date	$	4.73		$	4.81		$	4.96		$	4.64

Employee Stock Purchase Plan
Expected volatility		29.1	%		29.5	%		34.2	%		29.4	%
Risk-free interest rate		0.2	%		0.2	%		0.2	%		0.2	%
Expected option life (in years)		0.75			0.75			0.5			0.5
Expected dividend yield		1.35	%		1.35	%		0.90	%		0.90	%

Weighted average fair value at grant date	$	4.35		$	3.42		$	4.30		$	3.15

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 shareholders, 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 41,726 shares issued during the thirty-nine weeks ended November 1, 2014. There are 1,410,928 shares approved to be issued under the 2004 Plan and as of November 1, 2014, there were 816,839 shares available.

Stock Options

The following table summarizes stock option activity during the thirty-nine weeks ended November 1, 2014:

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

Outstanding at February 1, 2014		1,142,429	$	12.63		3.0	$	5,539
Granted		96,500	$	15.81
Forfeited / Cancelled		(25,510)	$	12.78
Exercised		(34,622)	$	11.63
Outstanding at November 1, 2014		1,178,797	$	12.92		2.6	$	3,433

Exercisable at November 1, 2014		483,914	$	10.79		0.9	$	2,380

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 November 1, 2014 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 November 1, 2014, total unrecognized stock-based compensation expense net of estimated forfeitures related to non-vested stock options was approximately $1.3 million, which is expected to be recognized over a weighted average period of approximately 2.8 years. The total fair value of options vested during the thirty-nine weeks ended November 1, 2014 was $268.2 thousand.

Restricted Stock

The following table summarizes restricted stock activity during the thirty-nine weeks ended November 1, 2014:

		Weighted Average
		Grant Date Fair
	Number of Shares	Value

Non-vested Restricted Stock at February 1, 2014	551,013	$	13.53
Granted	136,272	$	17.35
Forfeited / Cancelled	(78,510)	$	13.72
Vested	(32,223)	$	12.94
Non-vested Restricted Stock at November 1, 2014	576,552	$	14.41

The aggregate pre-tax intrinsic value of restricted stock outstanding as of November 1, 2014 is $9.1 million with a weighted average remaining contractual life of 5.8 years. The unrecognized compensation expense net of estimated forfeitures, related to the outstanding stock is approximately $4.9 million, which is expected to be recognized over a weighted average period of approximately 7.1 years. The total fair value of restricted stock awards that vested during the thirty-nine weeks ended November 1, 2014 was $425.8 thousand.