INGLES MARKETS INC - Quarter Report: 2006 March (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

For the quarterly period ended March 25, 2006

For the transition period from              to             

Commission file number 0-14706.

INGLES MARKETS, INCORPORATED

(Exact name of registrant as specified in its charter)

(828) 669-2941

Registrant’s telephone number, including area code

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨.

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  ¨    Accelerated filer  x    Non-accelerated filer  ¨.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x.

As of April 26, 2006, the Registrant had 12,165,687 shares of Class A Common Stock, $0.05 par value per share, outstanding and 12,325,524 shares of Class B Common Stock, $0.05 par value per share, outstanding.

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INGLES MARKETS, INCORPORATED

INDEX

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Part I. Financial Information

Item 1. Financial Statements

INGLES MARKETS, INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)

See notes to unaudited interim financial statements.

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INGLES MARKETS, INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

See notes to unaudited interim financial statements.

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INGLES MARKETS, INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

See notes to unaudited interim financial statements.

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INGLES MARKETS, INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (UNAUDITED)

SIX MONTHS ENDED MARCH 25, 2006 AND MARCH 26, 2005

See notes to unaudited interim financial statements.

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INGLES MARKETS, INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

See notes to unaudited interim financial statements.

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INGLES MARKETS, INCORPORATED AND SUBSIDIARIES

NOTES TO UNAUDITED INTERIM FINANCIAL STATEMENTS

Six Months Ended March 25, 2006 and March 26, 2005

A. BASIS OF PREPARATION

In the opinion of management, the accompanying unaudited interim financial statements contain all adjustments necessary to present fairly the Company’s financial position as of March 25, 2006, the results of operations for the three-month and six-month periods ended March 25, 2006 and March 26, 2005, and the changes in stockholders’ equity and cash flows for the six-month periods ended March 25, 2006 and March 26, 2005. The adjustments made are of a normal recurring nature. Certain information and footnote disclosures normally included in the annual financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission for Form 10-Q. It is suggested that these unaudited interim financial statements be read in conjunction with the audited financial statements and the notes thereto included in the Annual Report on Form 10-K for the year ended September 24, 2005 and the Form 10-Q for the fiscal quarter ended March 26, 2005, filed by the Company under the Securities Exchange Act of 1934 on December 8, 2005 and May 5, 2005, respectively.

The results of operations for the three-month and six-month periods ended March 25, 2006 are not necessarily indicative of the results to be expected for the full fiscal year.

B. ACCOUNTING FOR STOCK-BASED COMPENSATION

Prior to September 25, 2005 the Company accounted for its stock-based compensation plans under the fair value recognition provisions of FASB Statement No. 123, “Accounting for Stock-Based Compensation,” (“FAS 123”). Under the fair value recognition provisions of FAS 123, stock-based compensation cost was measured at the grant date based on the value of the award and was recognized as expense over the vesting period. Under the transition method selected by the Company as allowed by FASB Statement No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure” (“FAS 148”), the Company elected to apply the change in accounting principle using the prospective method. As no options were granted, modified or settled during the six months ended March 26, 2005, there was no stock-based employee compensation expense included in net income. The effect on net income for the six months ended March 26, 2005 would have been approximately $28,000 if the Company had applied the fair value recognition provisions to awards granted prior to the adoption of Statement 123. This expense would not have affected the Company’s reported basic and diluted earnings per share.

On December 16, 2004, the FASB issued FASB Statement No. 123 (revised 2004), “Share-Based Payment,” which is a revision of FASB Statement No. 123, “Accounting for Stock-Based Compensation.” Statement 123(R) supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and amends FASB Statement No. 95, “Statement of Cash Flows.” Generally, the approach in Statement 123(R) is similar to the approach described in Statement 123. The Company adopted Statement 123(R) as of September 25, 2005 using the “modified prospective” method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of Statement 123(R) for all share-based payments granted after the effective date and (b) based on the requirements of Statement 123 for all awards granted to employees prior to the effective date of Statement 123(R) that remain unvested on the effective date. There was no compensation cost associated with outstanding awards and therefore no effect on earnings per share for the six months ended March 25, 2006.

C. ALLOWANCE FOR DOUBTFUL ACCOUNTS

Receivables are presented net of an allowance for doubtful accounts of $820,000 and $818,000 at March 25, 2006 and September 24, 2005, respectively.

D. ACCRUED EXPENSES AND CURRENT PORTION OF OTHER LONG-TERM LIABILITIES

Accrued expenses and current portion of other long-term liabilities consist of the following:

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Self-insurance reserves are established for workers’ compensation and employee group medical and dental benefits based on claims filed and estimates of claims incurred but not reported. The Company is insured for covered costs in excess of $500,000 per occurrence for workers’ compensation and $250,000 per covered person for medical care benefits for a policy year. Employee insurance expense, including workers’ compensation and medical care benefits, net of employee contributions, totaled $5.0 million and $5.3 million for the three-month periods ended March 25, 2006 and March 26, 2005, respectively. For the six-month periods ended March 25, 2006 and March 26, 2005, employee insurance expense, net of employee contributions, totaled $11.3 million and $9.9 million, respectively.

E. LONG-TERM DEBT

At March 25, 2006, the Company had lines of credit with five banks totaling $135 million, all of which were unused. The lines of credit mature in October and November 2006. At March 25, 2006, the Company had $15.6 million in unused letters of credit that reduced the amounts available to be drawn under its lines of credit. The letters of credit mature from May 2006 to February 2007. The lines provide the Company with various interest rate options generally at rates less than prime. The Company is not required to maintain compensating balances in connection with these lines of credit. The lines of credit contain provisions that under certain circumstances would permit lending institutions to terminate or withdraw their respective extensions of credit to the Company. Included among the triggering factors permitting the termination or withdrawal of lines of credit to the Company are certain events of default, including both monetary and non-monetary defaults, the initiation of bankruptcy or insolvency proceedings, and the failure of the Company to meet certain financial covenants designated in its respective loan documents. The Company was in compliance with all financial covenants related to these lines of credit at March 25, 2006.

In addition, line of credit agreements and other long-term debt contain various restrictive covenants requiring, among other things, minimum levels of net worth and maintenance of certain financial ratios. One of the covenants has the effect of restricting funds available for dividends to approximately $77.5 million, based on tangible net worth at March 25, 2006. As of March 25, 2006, the Company was in compliance with these covenants.

F. DIVIDENDS

The Company paid cash dividends of $0.165 for each share of Class A Common Stock and $0.15 for each share of Class B Common Stock on January 19, 2006 and October 18, 2005 to stockholders of record on January 6, 2006 and October 6, 2005, respectively.

G. SETTLEMENT OF SECURITIES AND EXCHANGE COMMISSION INVESTIGATION

In April 2006 the Company reached a settlement agreement with the Securities and Exchange Commission (“the SEC”) resolving a civil complaint against the Company in connection with the previously disclosed private investigation regarding certain vendor contracts entered into in fiscal years 2002 and 2003 and certain internal control accounting issues.

The settlement does not require the Company to pay a monetary penalty. The Company settled the SEC’s charges without admitting or denying the SEC’s allegations. Under the settlement, the Company has consented to the entry of injunctions against future violations of certain provisions of Federal securities laws. See Part II Item 1. Legal Proceedings.

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H. CALCULATON OF EARNINGS PER COMMON SHARE

The Company has two classes of common stock: Class A, which is publicly traded, and Class B, which has no public market. The Class B Common Stock has restrictions on transfer; however, each share is convertible into one share of Class A Common Stock at any time. Each share of Class A Common Stock has one vote per share and each share of Class B Common Stock has ten votes per share. Each share of Class A Common Stock is entitled to receive cash dividends equal to 110% of any cash dividend on Class B Common Stock.

The Company has determined that, under Emerging Issues Task Force (EITF) Issue 03-6, “Participating Securities and the Two-Class Method under FASB Statement No. 128, Earnings per Share,” the two-class method of computing earnings per share is required. Prior periods have been restated to reflect this change.

The two-class method of computing basic earnings per share for each period reflects the cash dividends paid per share for each class of stock, plus the amount of allocated undistributed earnings per share computed using the participation percentage which reflects the dividend rights of each class of stock. Diluted earnings per share is calculated assuming the exercise of dilutive stock options outstanding and the conversion of all shares of Class B Common Stock to shares of Class A Common Stock on a share-for-share basis. The tables below reconcile the numerators and denominators of basic and diluted earnings per share for current and restated periods.

The restated per share amounts for the second quarter of fiscal 2005 and the six months ended March 26, 2005 are based on the following amounts:

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I. LINES OF BUSINESS

The Company operates three lines of business: retail grocery sales, shopping center rentals, and a fluid dairy processing plant. All of the Company’s operations are domestic. Information about the Company’s operations by lines of business (in thousands) is as follows:

Revenue from shopping center rentals is reported on the rental income, net line of the income statements. The other revenues comprise the net sales reported.

For the three-month periods ended March 25, 2006 and March 26, 2005, respectively, the fluid dairy segment had $12.2 million and $12.1 million in sales to the grocery sales segment. The fluid dairy segment had $24.5 million and $23.5 million in sales to the grocery sales segment for the six-month periods ended March 25, 2006 and March 26, 2005, respectively. These sales have been eliminated in consolidation and are excluded from the amounts in the table above.

Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

Ingles, a leading supermarket chain in the Southeast, operates 197 supermarkets in Georgia (76), North Carolina (63), South Carolina (35), Tennessee (20), Virginia (2) and Alabama (1). The Company locates its supermarkets primarily in suburban areas, small towns and rural communities. Ingles supermarkets offer customers a wide variety of nationally advertised food products, including grocery, meat and dairy products, produce, frozen foods and other perishables and non-food products, including health and beauty care products and general merchandise, as well as quality private label items. In addition, the Company focuses on selling high-growth, high-margin products to its customers through the development of book sections, media centers, floral departments, bakery departments and prepared foods including delicatessen sections. During fiscal 2000, the Company began adding fuel centers and pharmacies at select store locations. As of March 25, 2006, the Company operated 41 in-store pharmacies and 31 fuel centers. During the second quarter of fiscal 2006, the Company opened its first convenience store and automated car wash.

Ingles also operates two other lines of business, fluid dairy processing and shopping center rentals. The fluid dairy processing segment sells approximately 31% of its products to the retail grocery segment and approximately 69% of its products to third parties. Real estate ownership (including the shopping center rental segment) is an important component of the Company’s operations, providing both operational and economic benefit.

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Critical Accounting Policies

Critical accounting policies are those accounting policies that management believes are important to the portrayal of Ingles’ financial condition and results of operations, and require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.

Self-Insurance

The Company is self-insured for workers’ compensation and group medical and dental benefits. Risks and uncertainties are associated with self-insurance; however, the Company has limited its exposure by maintaining excess liability coverage. Self-insurance reserves are established based on claims filed and estimates of claims incurred but not reported. The estimates are based on data provided by the respective claims administrators. These estimates can fluctuate if historical trends are not predictive of the future. The majority of the Company’s properties are self-insured for casualty losses and business interruption; however, liability coverage is maintained.

Asset Impairments

The Company accounts for the impairment of long-lived assets annually unless events and changes in circumstances indicate that additional testing is necessary. The Company accounts for impairment in accordance with Statement of Financial Accounting Standards No. 144. For assets to be held and used, the Company tests for impairment using undiscounted cash flows and calculates the amount of impairment using discounted cash flows. For assets held for sale, impairment is recognized based on the excess of remaining book value over expected recovery value. The recovery value is the fair value as determined by independent quotes or expected sales prices developed by internal specialists. Estimates of future cash flows and expected sales prices are judgments based upon the Company’s experience and knowledge of local operations and cash flows that are projected for several years into the future. These estimates can fluctuate significantly due to changes in real estate market conditions, the economic environment, capital spending decisions and inflation.

Closed Store Accrual

For properties closed prior to December 31, 2002 that were under long-term lease agreements, the present value of any remaining liability under the lease, discounted using risk-free rates and net of expected sublease recovery, is recognized as a liability and expensed. For all store closures subsequent to the adoption of Statement of Financial Accounting Standards No. 146, effective December 31, 2002, the liability is recognized and expensed based on the difference between the present value of any remaining liability under the lease and the present value of the estimated market rate at which the Company expects to be able to sublease the properties. The Company’s estimates of market rates are based on its experience, knowledge and third-party advice or market data. If the real estate and leasing markets change, sublease recovery could vary significantly from the recoveries originally assumed, resulting in a material change in the Company’s recorded liability.

Vendor Allowances

The Company receives funds for a variety of merchandising activities from the many vendors whose products the Company buys for resale in its stores. These incentives and allowances include volume or purchase based incentives, advertising allowances, slotting fees, and promotional discounts. The purpose of these incentives and allowances is generally to help defray the costs incurred by the Company for stocking, advertising, promoting and selling the vendor’s products. Whenever possible, vendor discounts and allowances that relate to buying and merchandising activities are recorded as a component of item cost in inventory and recognized in merchandise costs when the item is sold. Due to system constraints and the nature of certain allowances, it is sometimes not practicable to apply allowances to the item cost of inventory. In those instances, the allowances are applied as a reduction of merchandise costs using a rational and systematic methodology, which results in the recognition of these incentives when the inventory related to the initial purchase is sold. Amounts that represent a reimbursement of specific identifiable incremental costs, such as advertising, are recorded as a reduction to the related expense in the period that the related expense is incurred.

Tax Contingencies

Despite the Company’s belief that its tax positions are consistent with applicable tax laws, the Company believes that certain positions are likely to be challenged by taxing authorities. Settlement of any challenge can result in no change, a complete disallowance, or some partial adjustment reached through negotiations or litigation. Significant judgment is required in evaluating the Company’s tax contingencies. The Company’s contingencies are adjusted in light of changing facts and circumstances, such as the progress of its tax audits as well as evolving case law. Income tax expense includes the impact of contingency provisions and changes to contingencies that the Company considers appropriate. Unfavorable settlement of any particular issue would require use of cash. Favorable resolution would be recognized as a reduction to income tax expense at the time of resolution.

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Results of Operations

Ingles operates on a 52 or 53-week fiscal year ending on the last Saturday in September. There are 13 and 26 weeks of operations included in the unaudited condensed consolidated statements of income for the three and six-month periods ended March 25, 2006 and March 26, 2005. Comparable store sales are defined as sales by grocery stores in operation for the entire duration of the previous and current fiscal years. Replacement stores and major and minor remodels are included in the comparable store sales calculation. A replacement store is a new store that is opened to replace an existing nearby store that is closed. A major remodel entails substantial remodeling of an existing store and may include additional retail square footage. A minor remodel includes repainting, remodeling and updating the lighting and equipment throughout an existing store. For the three and six-month periods ended March 25, 2006 and March 26, 2005, comparable store sales include 193 stores.

The following table sets forth, for the periods indicated, selected financial information as a percentage of net sales. For information regarding the various segments of the business, see Note I “Lines of Business” to the Unaudited Consolidated Financial Statements.

Three Months Ended March 25, 2006 Compared to the Three Months Ended March 26, 2005

Net Sales. Net sales increased 8.9% to $606.6 million for the three months ended March 25, 2006 from $557.3 million for the three months ended March 26, 2005. Ingles operated 197 stores at March 25, 2006, compared to 195 stores at March 26, 2005. Retail square footage was approximately 9.5 million at March 25, 2006 and 9.3 million at March 26, 2005. Comparable store sales for the same period grew $41.5 million or 8.0%. Sales improved in each department except video, with the largest percentage increases in the gasoline, pharmacy, deli and produce departments. The Company operated 4 additional pharmacy departments and 7 additional gasoline departments at March 25, 2006 compared to March 26, 2005. Fuel price inflation of approximately 23.0% as well as growth in total gallons sold increased gasoline department sales in the March 2006 three-month period. Pharmacy sales increased both in the number of prescriptions filled and the average revenue per prescription. Increases in the deli and produce departments reflect our customers’ desire for convenience as well as for fresh and organic products.

Net sales to outside parties for the Company’s milk processing subsidiary decreased $0.6 million or 2.3% in the March 2006 quarter compared to the March 2005 quarter. The sales decrease is primarily attributable to a decrease in raw milk costs in the March 2006 quarter compared to the March 2005 quarter, which is passed on to the subsidiary’s customers in the pricing of milk products. Measured in gallons of product sold, volume was higher in the March 2006 quarter compared to the prior year quarter.

Sales comparisons for the three and six-month periods were affected by the timing of the Easter holiday. In fiscal 2006, Easter falls in the Company’s third fiscal quarter. In fiscal 2005, Easter related sales were included in the three and six-month periods ended March 26, 2005. The Company estimates that comparable store sales increases are slightly higher, at 8.7% for the March 2006 quarter adjusted for the effect of Easter 2005 sales. Sales growth for the remainder of fiscal year 2006 will be influenced to some extent by market fluctuations in the per gallon price of gasoline, Easter related sales discussed above, and by the success of promotional efforts to retain and grow its customer base.

Gross Profit. Gross profit for the three-month period ended March 25, 2006 increased $12.5 million or 8.8% to $154.5 million, or 25.5% of sales, compared to $142.0 million, also 25.5% of sales, for the three-month period ended March 26, 2005. Gross profit dollars increased due to the higher sales volume in the grocery segment. Gross profit as a percentage of sales remained level, as sales growth in lower margin gasoline and pharmacy departments was offset by sales and margin growth in high volume grocery and meat departments.

Gross profit for the Company’s milk processing subsidiary for the March 2006 quarter increased $0.2 million or 2.9% to $5.2 million, or 13.0% of sales, compared to $5.0 million, or 12.5% of sales for the March 2005 quarter. Although sales decreased, gross profit as a percentage of sales increased due to increased gallons sold, and relatively level per-gallon margins.

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In addition to the direct product cost, the cost of goods sold line item for the grocery segment includes inbound freight charges. Purchasing and receiving costs, inspection costs, warehousing costs, internal transfer costs and other costs of the Company’s distribution network are included in operating and administrative expenses. The milk processing segment is a manufacturing process. Therefore, all of the costs mentioned above incurred by the milk processing segment are included in the cost of sales line item.

The Company’s gross margins may not be comparable to those of other retailers, since some retailers include all of the costs related to their distribution network in cost of goods sold and others, like the Company, exclude a portion of the costs from gross profit, including the costs instead in a line item such as operating and administrative expenses.

Operating and Administrative Expenses. Operating and administrative expenses increased $6.4 million or 5.3% to $128.0 million for the three months ended March 25, 2006, from $121.6 million for the three months ended March 26, 2005. As a percentage of sales, operating and administrative expenses decreased to 21.1% for the three months ended March 25, 2006 compared to 21.8% for the three months ended March 26, 2005. A variety of factors contributed to the dollar increase.

A breakdown of the major increases (decreases) in operating and administrative expenses is as follows:

Salaries and wages increased in dollars due to additional labor hours required for the increased sales volume, but decreased as a percentage of sales due to the allocation of management salaries over higher sales dollars and sales growth in less labor-intensive departments such as gasoline.

Taxes and licenses increased due to higher estimated expected tax payments.

Utility and fuel expenses increased due to increases in market energy prices.

Bank charges rose primarily due to increased fees for processing debit and credit cards. The increase is a result of both increased usage of cards and increased transaction fees related to the usage.

Insurance expense decreased as increased employee health insurance costs were offset by favorable claims experience in workers compensation and liability insurance. This favorable experience resulted in decreases to self-insurance liability reserves.

Equipment rent expense decreased due to the expiration of operating leases on equipment used in the Company’s distribution facility and in its stores. Much of this equipment was purchased by the Company at the expiration of the lease term.

Rental Income, Net. Rental income, net increased $0.2 million to $1.3 million for the March 2006 quarter from $1.1 million for the March 2005 quarter. Gross rental income increased $0.1 million, while shopping center expenses decreased $0.1 million. Tenant activity has been relatively quiet over the past twelve months, following a period in which the Company sold certain income-producing properties and during which several tenants relocated from shopping centers to stand-alone sites.

Other Income, Net. Other income, net decreased $0.2 million to $0.1 million for the three-month period ended March 25, 2006 from $0.3 million for the three-month period ended March 26, 2005. There were no significant asset sales in either quarter. Lower excess cash balances in fiscal 2006 resulted in decreased interest income.

Interest Expense. Interest expense decreased $0.7 million for the three-month period ended March 25, 2006 to $12.2 million from $12.9 million for the three-month period ended March 26, 2005. Total debt at March 25, 2006 was $560.6 million compared to $586.5 million at March 26, 2005.

Income Taxes. Income tax expense as a percentage of pre-tax income increased to 39.7% in the March 2006 quarter compared to 38.2% in the March 2005 quarter due to increased state income taxes.

Net Income. Net income increased $3.9 million or 72.5% for the three-month period ended March 25, 2006 to $9.4 million compared to $5.5 million for the three-month period ended March 26, 2005. Net income, as a percentage of sales, was 1.6% for the March 2006 quarter and 1.0% for the March 2005 quarter. The increase in net income is attributed to increased sales, stable gross margin and a decrease in expenses as a percentage of sales. Basic and diluted earnings per share for Class A Common Stock were $0.41 and $0.38 for the March 2006 quarter compared to $0.24 and $0.23, respectively, for the March 2005 quarter. Basic and diluted earnings per share for Class B Common Stock were each $0.37 for the March 2006 quarter compared to $0.22 of basic and diluted earnings per share for the March 2005 quarter.

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Six Months Ended March 25, 2006 Compared to the Six Months Ended March 26, 2005

Net Sales. Net sales for the six months ended March 25, 2006 increased 10.2% to $1.23 billion, compared to $1.12 billion for the six months ended March 26, 2005. Comparable store sales increased $93.1 million or 8.9% for the same period. Sales improved in each department except video, with the largest percentage increases in the gasoline, pharmacy, deli and produce departments, as noted above in the three-month discussion.

Net sales to outside parties for the Company’s milk processing subsidiary increased $0.4 million or 0.7% in the March 2006 six-month period compared to the March 2005 six-month period due to the increased raw milk costs and slightly higher volume of gallons sold.

Sales comparisons for the three and six-month periods were affected by the timing of the Easter holiday, as described in the three-month discussion. The Company estimates that comparable store sales increases are slightly higher, at 9.2% for the March 2006 six month period adjusted for the effect of Easter 2005 sales.

In addition to the factors discussed above in the three-month discussion, the Company recently completed or expects to complete four new, remodeled or replacement stores during the last six months of fiscal 2006. The Company expects that both the maturation of new and expanded stores and successful promotional efforts will continue to drive sales growth.

Gross Profit. Gross profit for the six months ended March 25, 2006 increased $24.1 million or 8.5% to $308.1 million compared to $284.0 million, for the six months ended March 26, 2005. As a percent of sales, gross profit decreased to 25.0% for the six months ended March 25, 2006 from 25.4% for the six months ended March 26, 2005. Lower margins in gasoline and frozen foods during the first six months of fiscal 2006, attributable to competitive and promotional factors, accounted for much of the overall margin decrease. Sales of lower margin gasoline increased substantially both in sales dollars and gallons sold. Following heavy holiday promotional activity during the Company’s first fiscal quarter ended December 24, 2005 gross profit as a percentage of sales increased during the second fiscal quarter of 2006.

Gross profit for the Company’s milk processing subsidiary for the March 2006 six-month period decreased $0.3 million or 2.8% to $9.8 million, or 12.4% of sales compared to $10.1 million or 12.9% of sales for the March 2005 six-month period. Higher cream prices during the first quarter of fiscal 2005 contributed to the higher gross profit as a percentage of sales during last fiscal year. Excess cream is produced in the processing of milk and is sold in bulk to producers of ice cream and cheese.

Operating and Administrative Expenses. Operating and administrative expenses increased $14.2 million or 5.8% to $258.5 million for the six months ended March 25, 2006, from $244.3 million for the six months ended March 26, 2005. As a percentage of sales, operating and administrative expenses decreased to 21.0% for the March 2006 six-month period from 21.8% for the March 2005 six-month period. A variety of factors contributed to the dollar increase.

A breakdown of the major increases (decreases) in operating and administrative expenses is as follows:

Salaries and wages increased in dollars due to additional labor hours required for the increased sales volume but decreased to 8.9% of sales for the March 2006 six-month period compared to 9.1% for the comparable 2005 period. Increased sales over the same number of store properties allows the Company to better leverage store and management personnel costs.

Utility and fuel expenses increased due to increases in market energy prices.

Bank charges rose primarily due to increased fees for processing debit and credit cards. The increase is a result of both increased usage of cards and increased transaction fees related to the usage.

Store supplies increased due to upgraded packaging used in perishables departments and the higher cost of plastic used in bags and wrapping materials.

Taxes and licenses increased due to higher estimated expected tax payments.

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Equipment rent expense decreased due to the expiration of operating leases on equipment used in the Company’s distribution facility and in its stores. Much of this equipment was purchased by the Company at the expiration of the lease term.

Rental Income, Net. Rental income, net was $2.6 million for each of the six month periods. Tenant activity has been relatively quiet over the past eighteen months, following a period in which the Company sold certain income-producing properties and in which several tenants relocated from shopping centers to stand alone sites.

Other Income, Net. Other income, net increased $0.1 million for the March 2006 six-month period over the comparable period in fiscal 2005. During the March 2005 six-month period, the Company disposed of certain equipment and leasehold improvements from recently closed stores. During the March 2006 six-month period, the Company received proceeds from land compensation settlements with state or local governments.

Interest Expense. Interest expense decreased $1.4 million to $24.6 million for the six months ended March 25, 2006 from $26.0 million for the six months ended March 26, 2005. Total debt at March 25, 2006 was $560.6 million compared to $586.5 million at March 26, 2005.

Income Taxes. Income tax expense as a percentage of pre-tax income increased to 39.5% in the March 2006 six-month period from 37.9% in the March 2005 six-month period due to increased state income taxes.

Net Income. Net income increased $6.7 million or 63.3% for the March 2006 six-month period to $17.2 million, compared to $10.5 million, for the March 2005 six-month period. The increase in net income is attributed to increased sales, stable gross margin and a decrease in expenses as a percent of sales. Basic and diluted earnings per share for Class A Common Stock were $0.74 and $0.70 for the March 2006 six-month period compared to $0.46 and $0.44, respectively, for the March 2005 six-month period. Basic and diluted earnings per share for Class B Common Stock were each $0.67 for the March 2006 six month period compared to $0.42 of basic and diluted earnings per share for the March 2005 six month period.

Liquidity and Capital Resources

Capital Expenditures

The Company believes that a key to its ability to continue to develop a loyal customer base is providing conveniently located, clean and modern stores which provide customers with good service and a broad selection of competitively priced products. As such, the Company has invested and will continue to invest significant amounts of capital toward the modernization of its store base. The Company’s modernization program includes the opening of new stores, the completion of major remodels and expansion of selected existing stores, the relocation of selected existing stores to larger, more convenient locations and the completion of minor remodeling of its remaining existing stores.

Capital expenditures totaled $43.7 million for the six-month period ended March 25, 2006 including the completion of one new convenience store/car wash, one replacement store, one fuel center at an existing store and the purchase of four future store sites. Shortly after quarter end, the Company opened one new store, one replacement store, closed one store and added three fuel centers. Capital expenditures also included the costs of upgrading and replacing store equipment, technology investments, capital expenditures related to the Company’s distribution operation and its milk processing plant, and expenditures for stores to open later in fiscal 2006 and in fiscal 2007.

Ingles’ capital expenditure plans for all of fiscal 2006 include investments of approximately $80 million. For the balance of fiscal 2006, the Company plans to open one remodeled and one replacement store, both of which will be owned, and add approximately four new fuel stations. Expenditure plans will also include investments in stores expected to open in fiscal 2007 as well as technology improvements, upgrading and replacing existing store equipment, warehouse and transportation equipment, and improvements to the Company’s milk processing plant.

The Company expects that its net annual capital expenditures will remain in the range of approximately $65 to $75 million going forward in order to maintain a modern store base. The number of projects may also fluctuate due to the varying costs of the types of projects pursued including new stores, major remodel/expansions or minor remodels. The Company makes decisions on the allocation of capital expenditure dollars based on many factors including the competitive environment, other Company capital initiatives and its financial condition.

The Company does not generally enter into commitments for capital expenditures other than on a store-by-store basis at the time it begins construction on a new store or begins a major or minor remodeling project. Construction commitments at March 25, 2006 totaled $8.5 million.

Liquidity

The Company generated net cash from operations of $30.6 million for the six months ended March 25, 2006 compared to $21.6 million for the comparable 2005 period. Inventory and receivables increased by a total of $6.0 million to support increased growth. Accounts payable decreased $2.7 million for the six months ended March 2006 following the normal holiday season inventory increase.

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Cash used by investing activities for the March 2006 six-month period totaled $43.1 million comprised primarily of $43.7 million of capital expenditures during the period, partially offset by $0.6 million of proceeds from the sale of assets.

Cash used by financing activities during the March 2006 six-month period totaled $16.0 million including principal payments on long-term debt of $8.8 million and dividend payments of $7.7 million offset in part by cash received from the exercise of stock options of $0.5 million.

At March 25, 2006, the Company had committed lines of credit with five banks totaling $135 million. No amounts were borrowed under the lines of credit at March 25, 2006; however unused letters of credit totaling $15.6 million reduced the amount available to be drawn under these lines to $119.4 million at March 25, 2006. The lines of credit mature in October and November 2006. The lines provide the Company with various interest rate options generally at rates less than prime. The Company is not required to maintain compensating balances in connection with these lines of credit. The Company was in compliance with all financial covenants related to these lines of credit at March 25, 2006. At the present time, the Company believes existing line of credit agreements could be renewed at approximately current terms.

The Company has outstanding $349.8 million principal amount of 8 ⁷/8% Senior Unsubordinated Notes (“the Notes”) maturing in December 2011. The indenture governing the Notes contains certain restrictive covenants relating to, among other things, the issuance of indebtedness and the payment of dividends. The Company was in compliance with all financial covenants related to the Notes at March 25, 2006.

The Company’s principal sources of liquidity are expected to be cash flow from operations, borrowings under its lines of credit and long-term financing. As of March 25, 2006, the Company had unencumbered real property and equipment with a net book value of approximately $441 million. The Company believes, based on its current results of operations and financial condition, that its financial resources, including existing bank lines of credit, short- and long-term financing expected to be available to it and internally generated funds, will be sufficient to meet planned capital expenditures and working capital requirements for the foreseeable future, including any debt service requirements of additional borrowings. However, there can be no assurance that any such sources of financing will be available to the Company on acceptable terms, or at all.

As noted above, all of the Company’s line of credit agreements mature in October and November 2006. The Company’s $349.8 million principal amount of the Notes can be redeemed at a declining premium rate beginning at 104.438% after December 1, 2006. The Company is currently evaluating financing options for the line of credit agreements, the Notes, and for future capital needs.

It is possible that, in the future, the Company’s results of operations and financial condition will be different from that described in this report based on a number of intangible factors. These factors may include, among others, increased competition, changing regional and national economic conditions, adverse climatic conditions affecting food production and delivery and changing demographics as well as the additional factors discussed below under “Forward Looking Statements”. It is also possible, for such reasons, that the results of operations from the new, expanded, remodeled and/or replacement stores will not meet or exceed the results of operations from existing stores that are described in this report.

Contractual Obligations and Commercial Commitments

There have been no material changes in contractual obligations and commercial commitments subsequent to September 24, 2005.

Off Balance Sheet Arrangements

The Company is not a party to any off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on the Company’s financial condition, revenues, expenses, results of operations, liquidity, capital expenditures or capital resources.

Quarterly Cash Dividends

Since December 27, 1993, the Company has paid regular quarterly cash dividends of $0.165 (sixteen and one-half cents) per share on its Class A Common Stock and $0.15 (fifteen cents) per share on its Class B Common Stock for an annual rate of $0.66 and $0.60 per share, respectively.

The Company expects to continue paying regular cash dividends on a quarterly basis. However, the Board of Directors periodically reconsiders the declaration of dividends. The Company pays these dividends at the discretion of the Board of Directors and the continuation of these payments, the amount of such dividends, and the form in which the dividends are paid (cash or stock) depends upon the results of operations, the financial condition of the Company and other factors which the Board of Directors deems relevant. In addition, certain loan agreements containing provisions outlining minimum tangible net worth requirements restrict the ability of the Company to pay additional dividends to approximately $77.5 million based on tangible net worth at March 25, 2006. Further, the

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Company is prevented from declaring dividends at any time that it is in default under the indenture governing the Company’s senior subordinated debt. In addition, the terms of the indenture may restrict the ability of the Company to pay additional dividends based on certain financial parameters.

Seasonality

Sales in the grocery segment of the Company’s business are subject to a slight seasonal variance due to holiday related sales and due to sales in areas where seasonal homes are located. Sales are traditionally higher in the Company’s first fiscal quarter due to the inclusion of sales related to Thanksgiving and Christmas. The Company’s second fiscal quarter traditionally has the lowest sales of the year. In the third and fourth quarter, sales are affected by the return of customers to seasonal homes in our market area. The fluid dairy segment of the Company’s business has slight seasonal variation to the extent of its sales into the grocery industry. The Company’s real estate segment is not subject to seasonal variations.

Impact of Inflation

The following table from the United States Bureau of Labor Statistics lists changes in the Consumer Price Index that could have an effect on the Company’s operations. One of the Company’s significant costs is labor, which increases with general inflation. Inflation in energy costs affects both the Company’s gasoline sales and distribution expenses.

Forward Looking Statements

This Quarterly Report contains certain forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934. The words “expect,” “anticipate,” “intend,” “plan,” “believe,” “seek” and similar expressions are intended to identify forward-looking statements. While these forward-looking statements and the related assumptions are made in good faith and reflect the Company’s current judgment regarding the direction of the Company’s business, actual results will almost always vary, sometimes materially, from any estimates, predictions, projections, assumptions or other future performance suggested herein. Such statements are based upon a number of assumptions and estimates which are inherently subject to significant risks and uncertainties many of which are beyond the Company’s control. Some of these assumptions inevitably will not materialize, and unanticipated events will occur which will affect the Company’s results. Some important factors (but not necessarily all factors) that affect the Company’s revenues, growth strategies, future profitability and operating results, or that otherwise could cause actual results to differ materially from those expressed in or implied by any forward-looking statement, include business and economic conditions generally in the Company’s operating area; the Company’s ability to successfully implement its expansion and operating strategies and to manage rapid expansion; pricing pressures and other competitive factors; the Company’s ability to reduce costs and achieve improvements in operating results; the availability and terms of financing; increases in labor and utility costs; success or failure in the ownership and development of real estate; changes in the laws and government regulations applicable to the Company; and changes in accounting policies, standards, guidelines or principles as may be adopted by regulatory agencies as well as the Financial Accounting Standards Board.

Consequently, actual events affecting the Company and the impact of such events on the Company’s operations may vary significantly from those described in this report or contemplated or implied by statements in this report.

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

There have been no material changes in market interest rates subsequent to September 24, 2005.

Item 4. CONTROLS AND PROCEDURES

(a) Evaluation of Disclosure Controls and Procedures

The Company maintains disclosure controls and procedures designed to provide reasonable assurance of achieving the objective that information in its Exchange Act reports is recorded, processed, summarized and reported within the time periods specified and pursuant to the regulations of the Securities and Exchange Commission. Disclosure controls and procedures, as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act, include controls and procedures designed to ensure the information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. It should be noted that the Company’s system of controls, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system are met.

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As required by SEC Rule 13a-15(b), the Company carried out an evaluation, under the supervision and with participation of its management including its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of its disclosure controls and procedures as of March 25, 2006, the end of the period covered by this report. In making this evaluation, it considered matters previously identified and disclosed in connection with the filing of its Form 10-K for fiscal 2005. After consideration of the matters discussed above, the Company has concluded that its controls and procedures were not effective in all respects as of the end of the period covered by this report.

The Company disclosed in its Form 10-K for fiscal 2005 the following material weaknesses identified by management.

Segregation of Duties

Management identified two different areas where the lack of appropriate segregation of duties constituted a material weakness.

Information Technology General Controls

Vendor Income

During previous fiscal years, the Company attempted to implement additional controls and procedures designed to ensure vendor income was recorded completely, accurately and timely. The changes were not sufficient to correct all weaknesses in the design of such controls. As such, the controls and procedures for vendor income are not sufficient to ensure that all vendor income is properly recorded. In addition, there has been a lack of compliance with these procedures by certain Company associates.

Subsequent to the filing of the Company’s Form 10-Q for the first quarter of fiscal 2006, management has undertaken the following remediation efforts:

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Part II. Other Information

Item 1. LEGAL PROCEEDINGS

Settlement of Securities and Exchange Commission Investigation

In April 2006 the Company reached a settlement agreement with the Securities and Exchange Commission (“the SEC”) resolving a civil complaint against the Company in connection with the previously disclosed private investigation regarding certain vendor contracts entered into in fiscal years 2002 and 2003 and certain internal control accounting issues.

The settlement does not require the Company to pay a monetary penalty. The Company settled the SEC’s charges without admitting or denying the SEC’s allegations. Under the settlement, the Company has consented to the entry of injunctions against future violations of certain provisions of Federal securities laws.

Shareholder Derivative Claim

On June 15, 2005, a purported shareholder of the Company filed a shareholder derivative suit on behalf of the Company against certain current and former individual members of the Company’s Board of Directors and against the Company as a nominal defendant in the U.S. District Court for the Western District of North Carolina. The suit alleges that the defendant Directors breached their fiduciary duties by failing to implement appropriate internal controls. The suit seeks from the Directors damages in an unspecified amount allegedly sustained by the Company, as well as disgorgement by certain Directors to the Company of salaries and bonuses received by those Directors between 2002 and 2005. The Company’s Board of Directors appointed an independent committee, which retained independent counsel, to review the suit and evaluate whether maintenance of the derivative proceeding was in the best interest of the Company. After an investigation, the independent committee concluded that the maintenance of the derivative proceeding was not in the best interest of the Company. On October 10, 2005, the Company filed a motion to dismiss the derivative proceeding and expects a ruling on that motion later this fiscal year. No amount is currently recorded as the outcome of the case is not known and any potential loss is not estimable.

Various legal proceedings and claims arising in the ordinary course of business are pending against the Company. In the opinion of management, the ultimate liability, if any, from all pending legal proceedings and claims would not materially affect the Company’s financial position or the results of its operations.

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

The Annual Meeting of Stockholders of Ingles Markets, Incorporated was held Tuesday, February 14, 2006. One matter was submitted to a vote of the stockholders at this meeting, the election of nine directors to serve until the 2007 Annual Meeting of Stockholders. At the meeting,

John O. Pollard, and Fred D. Ayers were elected by the holders of Class A Common Stock by the following votes: (a) Mr. Pollard: 8,711,166 votes for and 2,509,044 votes withheld; (b) Mr. Ayers: 10,935,702 votes for and 284,508 votes withheld. Ronald B. Freeman, Charles L. Gaither, Jr., Robert P. Ingle, Robert P. Ingle, II, James W. Lanning, Charles E. Russell and Laura Ingle Sharp were each elected by the holders of Class B Common Stock by the following vote: 10,388,568 votes for and 0 votes withheld.

Item 6. EXHIBITS

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Form 10-Q to be signed on its behalf by the undersigned thereunto duly authorized.

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