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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
X QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES
- - EXCHANGE ACT OF 1934
For the quarterly period ended July 31, 2002
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OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
- - EXCHANGE ACT OF 1934
For the transition period from to
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Commission File No. 1-327
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KMART CORPORATION
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(Exact name of registrant as specified in its charter)
Michigan 38-0729500
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
3100 West Big Beaver Road - Troy, Michigan 48084
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(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code (248) 463-1000
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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
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As of August 28, 2002, 502,471,545 shares of Common Stock of Kmart Corporation
were outstanding.
INDEX
PART I FINANCIAL INFORMATION PAGE
- ------ --------------------- ----
Item 1. Financial Statements
Condensed Consolidated Statements of Operations-- 3
(Unaudited) 13 and 26 weeks ended July 31, 2002 and
August 1, 2001
Condensed Consolidated Balance Sheets-- 4
July 31, 2002 (Unaudited), August 1, 2001 (Unaudited) and
January 30, 2002
Condensed Consolidated Statements of Cash Flows-- 5
(Unaudited) 26 weeks ended July 31, 2002 and
August 1, 2001
Notes to Condensed Consolidated Financial 6-20
Statements (Unaudited)
Item 2. Management's Discussion and Analysis of Results of 21-34
Operations and Financial Condition
Item 3. Quantitative and Qualitative Disclosures about Market Risk 35
Item 4. Controls and Procedures 36
PART II OTHER INFORMATION
- ------- -----------------
Item 3. Defaults Upon Senior Securities 37
Item 5. Other Information 37
Item 6. Exhibits and Reports on Form 8-K 37
Signatures 38
Certifications 39-40
2
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
(UNAUDITED)
13 WEEKS ENDED 26 WEEKS ENDED
--------------------- ---------------------
JULY 31, AUGUST 1, JULY 31, AUGUST 1,
2002 2001 2002 2001
-------- --------- -------- ---------
Sales $ 7,519 $ 8,917 $ 15,158 $ 17,254
Cost of sales, buying and occupancy 6,226 7,253 13,242 14,087
-------- --------- -------- ---------
Gross margin 1,293 1,664 1,916 3,167
Selling, general and administrative expenses 1,644 2,004 3,435 3,716
Equity income (loss) in unconsolidated subsidiaries 14 (8) 19 (24)
Charges for BlueLight.com and other 15 92 15 115
-------- --------- -------- ---------
Loss before interest, income taxes, reorganization items and dividends
on convertible preferred securities of subsidiary trust (352) (440) (1,515) (688)
Interest expense, net (contractual interest for 13 and 26 weeks
ended July 31, 2002 was $100 and $202, respectively) 32 88 65 171
Income tax benefit - (163) (12) (272)
Reorganization items, net 13 - 278 -
Dividends on convertible preferred securities of subsidiary trust, net of
income taxes of $0, $6, $0 and $12, respectively (contractual dividend for 13
and 26 weeks ended July 31, 2002 was $18 and $35 net of tax, respectively) - 12 - 23
-------- --------- -------- ---------
Net loss from continuing operations (397) (377) (1,846) (610)
Gain from discontinued operations 20 - 20 -
-------- --------- -------- ---------
Net loss $ (377) $ (377) $ (1,826) $ (610)
======== ========= ======== =========
Basic/Diluted loss per common share from continuing operations $ (0.79) $ (0.77) $ (3.67) $ (1.25)
Basic/Diluted gain per common share from discontinued operations 0.04 - 0.04 -
-------- --------- -------- ---------
Basic/Diluted loss per common share $ (0.75) $ (0.77) $ (3.63) $ (1.25)
======== ========= ======== =========
Basic/Diluted weighted average shares (millions) 502.7 490.6 502.8 489.6
See accompanying Notes to Condensed Consolidated Financial Statements.
3
CONDENSED CONSOLIDATED BALANCE SHEETS
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
(UNAUDITED)
----------------------
JULY 31, AUGUST 1, JANUARY 30,
2002 2001 2002
-------- --------- ----------
ASSETS
CURRENT ASSETS
Cash and cash equivalents $ 1,003 $ 420 $ 1,245
Merchandise inventories 5,281 6,869 5,822
Other current assets 650 746 817
-------- --------- ----------
TOTAL CURRENT ASSETS 6,934 8,035 7,884
Property and equipment, net 5,872 6,836 6,161
Other assets and deferred charges 251 447 253
-------- --------- ----------
TOTAL ASSETS $ 13,057 $ 15,318 $ 14,298
======== ========= ==========
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES
Long-term debt due within one year $ - $ 116 $ -
Accounts payable 1,466 2,458 103
Accrued payroll and other liabilities 641 1,219 378
Taxes other than income taxes 244 261 143
-------- --------- ----------
TOTAL CURRENT LIABILITIES 2,351 4,054 624
Long-term debt and notes payable - 2,980 330
Capital lease obligations 682 902 857
Other long-term liabilities 127 920 79
-------- --------- ----------
TOTAL LIABILITIES NOT SUBJECT TO COMPROMISE 3,160 8,856 1,890
LIABILITIES SUBJECT TO COMPROMISE 7,376 - 8,060
Company obligated mandatorily redeemable convertible preferred securities of a
subsidiary trust holding solely 7 3/4% convertible junior subordinated
debentures of Kmart (redemption value
$898, $898 and $898, respectively) 889 887 889
Common stock, $1 par value, 1,500,000,000 shares authorized;
502,659,192, 496,962,413 and 503,294,515 shares outstanding,
respectively 503 497 503
Capital in excess of par value 1,694 1,670 1,695
(Accumulated deficit) retained earnings (565) 3,408 1,261
-------- --------- ----------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 13,057 $ 15,318 $ 14,298
======== ========= ==========
See accompanying Notes to Condensed Consolidated Financial Statements.
4
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN MILLIONS)
(UNAUDITED)
26 WEEKS ENDED
--------------------
JULY 31, AUGUST 1,
2002 2001
-------- ---------
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss $ (1,826) $ (610)
Adjustments to reconcile net loss to net cash provided by
(used for) operating activities:
Gain from discontinued operations (20) -
Restructuring, impairments and other charges 827 115
Reorganization items, net 278 -
Depreciation and amortization 375 413
Equity (income) loss in unconsolidated subsidiaries (19) 24
Dividends received from Meldisco 45 51
Changes in Operating Assets and Liabilities:
Increase in inventories (127) (452)
Increase in accounts payable 716 292
Deferred income taxes and taxes payable (10) (225)
Other assets 104 158
Other liabilities 107 185
Cash used for store closings and other charges (131) (105)
-------- ---------
NET CASH PROVIDED BY (USED FOR) OPERATING ACTIVITIES 319 (154)
-------- ---------
NET CASH USED FOR REORGANIZATION ITEMS (50) -
-------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES
Capital expenditures (126) (651)
Investment in BlueLight.com - (45)
-------- ---------
NET CASH USED FOR INVESTING ACTIVITIES (126) (696)
-------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from issuance of debt - 1,194
Debt issuance costs - (3)
Issuance of common shares - 28
Payments on debt (349) (273)
Payments on capital lease obligations (36) (41)
Payments of dividends on preferred securities of subsidiary trust - (36)
-------- ---------
NET CASH (USED FOR) PROVIDED BY FINANCING ACTIVITIES (385) 869
-------- ---------
NET CHANGE IN CASH AND CASH EQUIVALENTS (242) 19
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 1,245 401
-------- ---------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 1,003 $ 420
======== =========
See accompanying Notes to Condensed Consolidated Financial Statements.
5
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
(UNAUDITED)
1. BASIS OF PRESENTATION
General
These interim unaudited Condensed Consolidated Financial
Statements have been prepared on a going concern basis, which assumes
continuity of operations and realization of assets and satisfaction of
liabilities in the ordinary course of business, and in accordance with
Statement of Position 90-7 ("SOP 90-7"), "Financial Reporting by Entities
in Reorganization under the Bankruptcy Code." Accordingly, all pre-petition
liabilities subject to compromise have been segregated in the unaudited
Condensed Consolidated Balance Sheets and classified as Liabilities subject
to compromise, at the estimated amount of allowable claims. Liabilities not
subject to compromise are separately classified as current and non-current.
Revenues, expenses, realized gains and losses, and provisions for losses
resulting from the reorganization are reported separately as Reorganization
items, net, except for those required to be reported as discontinued
operations in conformity with Statement of Financial Accounting Standards
("SFAS") No. 144 "Accounting for the Impairment or Disposal of Long-Lived
Assets" ("SFAS No. 144") in the unaudited Condensed Consolidated Statements
of Operations. Cash used for reorganization items is disclosed separately
in the unaudited Condensed Consolidated Statements of Cash Flows.
These interim unaudited Condensed Consolidated Financial
Statements have been prepared in accordance with the rules and regulations
of the Securities and Exchange Commission ("SEC"). Accordingly, they do not
include all of the information and footnotes required by accounting
principles generally accepted in the United States of America for complete
financial statements. In the opinion of management, all adjustments (which
include normal recurring adjustments) considered necessary for a fair
presentation have been included. Operating results for the 26 week period
ended July 31, 2002 are not necessarily indicative of the results that may
be expected for the 2002 fiscal year ending January 29, 2003. These
unaudited Condensed Consolidated Financial Statements should be read in
conjunction with the audited Consolidated Financial Statements and the
notes thereto included in our Annual Report on Form 10-K for the fiscal
year ended January 30, 2002, filed with the SEC on May 15, 2002.
Reclassifications
Certain reclassifications of prior period financial statements
have been made to conform to the current interim period presentation.
2. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In June 2001, the Financial Accounting Standards Board ("FASB")
issued SFAS No. 143, "Accounting for Asset Retirement Obligations," which
requires that the fair value of a liability for an asset retirement
obligation be recognized in the period in which it is incurred if a
reasonable estimate of fair value can be made. The associated asset
retirement costs would be capitalized as part of the carrying amount of the
long-lived asset and depreciated over the life of the asset. The liability
is accreted at the end of each period through charges to operating expense.
If the obligation is settled for other than the carrying amount of the
liability, a company will recognize a gain or loss on settlement. The
provisions of SFAS No. 143 will be effective for our fiscal year beginning
January 30, 2003. We have not yet determined the impact, if any, of the
adoption of SFAS No. 143.
We are currently reviewing SFAS No. 145, "Rescission of FASB
Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and
Technical Corrections," which was issued in May 2002. The statement
rescinds FASB No. 4, "Reporting Gains and Losses from Extinguishment of
Debt," and an amendment of that statement, FASB No. 64, "Extinguishments of
Debt Made to Satisfy Sinking-Fund Requirements." As a result, gains and
losses from extinguishment of debt will no longer be aggregated and
classified as an extraordinary item, net of related income tax effect, in
the statement of operations. Instead, such gains and losses will be
classified as extraordinary items only if they meet the criteria of unusual
or infrequently occurring items. SFAS No. 145 also requires that gains and
losses from debt extinguishments, which were classified as extraordinary
items in prior periods, be reclassified to continuing operations if they do
not meet the criteria for extraordinary items. The provisions related to
this portion of the statement are required to be applied in fiscal years
beginning after May 15, 2002, with earlier application encouraged.
6
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
(UNAUDITED)
In June 2002, the FASB issued SFAS No. 146, "Accounting for Exit
or Disposal Activities." SFAS No. 146 addresses significant issues
regarding the recognition, measurement, and reporting of costs associated
with exit and disposal activities, including restructuring activities that
are currently accounted for pursuant to the guidance that the Emerging
Issues Task Force ("EITF") set forth in EITF Issue 94-3, "Liability
Recognition for Certain Employee Termination Benefits and Other Costs to
Exit an Activity (including Certain Costs Incurred in a Restructuring)"
("EITF 94-3"). The scope of SFAS No. 146 also includes (1) costs related to
terminating a contract that is not a capital lease and (2) termination
benefits that employees who are involuntarily terminated receive under the
terms of a one-time benefit arrangement that is not an ongoing benefit
arrangement, or an individual deferred compensation contract. SFAS No. 146
will be effective for exit or disposal activities that are initiated after
December 31, 2002.
3. PROCEEDINGS UNDER CHAPTER 11 OF THE BANKRUPTCY CODE
On January 22, 2002 ("Petition Date"), Kmart and 37 of its U.S.
subsidiaries (collectively, the "Debtors") filed voluntary petitions for
reorganization under Chapter 11 of the federal bankruptcy laws ("Bankruptcy
Code" or "Chapter 11") in the United States Bankruptcy Court for the
Northern District of Illinois ("Court") under case numbers 02 B 02462
through 02 B 02499. The reorganization is being jointly administered under
the caption "In re Kmart Corporation, et al. Case No. 02 B 02474." The
Debtors are currently operating their business as debtors-in-possession
pursuant to the Bankruptcy Code.
We decided to seek judicial reorganization based upon a rapid
decline in our liquidity resulting from our below-plan sales and earnings
performance in the fourth quarter of the 2001 fiscal year, the evaporation
of the surety bond market and erosion of supplier confidence. Other factors
included intense competition in the discount retailing industry,
unsuccessful sales and marketing initiatives, the continuing recession, and
recent capital market volatility. As a debtor-in-possession, Kmart is
authorized to continue to operate as an ongoing business, but may not
engage in transactions outside the ordinary course of business without the
approval of the Court, after notice and an opportunity for a hearing.
At first day hearings held on January 22 and 25, 2002, the Court
entered orders granting authority to Kmart to, among other things, pay
pre-petition and post-petition employee wages, salaries, benefits and other
employee obligations and to honor customer service programs, including
warranty returns, layaways and gift certificates. On January 25, 2002, the
Court also gave interim approval for $1.15 billion of a $2 billion senior
secured debtor-in-possession financing facility ("DIP Credit Facility") for
the payment of permitted pre-petition claims, working capital needs,
letters of credit and other general corporate purposes. On March 6, 2002,
the Court approved the entire $2 billion DIP Credit Facility underwritten
by JP Morgan Chase Bank, Fleet Retail Finance, Inc., General Electric
Capital Corporation and Credit Suisse First Boston to supplement our cash
flow from operations during the reorganization process. The DIP Credit
Facility was amended and approved by the Court on August 29, 2002, to
provide additional flexibility under the financial covenant contained
therein that requires certain minimum levels of cumulative earnings before
interest, taxes, depreciation, amortization and other charges ("EBITDA").
The DIP Credit Facility requires that we maintain certain other financial
covenants and restrict liens, indebtedness, capital expenditures, dividend
payments and sales of assets.
Under the Bankruptcy Code, actions to collect pre-petition
indebtedness, as well as most other pending litigation, are stayed and
other contractual obligations against Kmart generally may not be enforced.
Absent an order of the Court, substantially all pre-petition liabilities
are subject to settlement under a plan of reorganization to be voted upon
by creditors and equity holders and approved by the Court. Although the
Debtors expect to file a reorganization plan or plans that provide for
emergence from bankruptcy in 2003 or 2004, there can be no assurance that a
reorganization plan or plans will be proposed by the Debtors or confirmed
by the Court, or that any such plan(s) will be consummated. As provided by
the Bankruptcy Code, the Debtors initially have the exclusive right to
solicit a plan of reorganization for 120 days. On July 24, 2002, the Court
approved our request to extend the period during which we have the
exclusive right to file a plan of reorganization and the period in which we
have the exclusive right to solicit acceptances with respect to any plan we
may timely file until February 28, 2003 and April 22, 2003, respectively.
If the Debtors fail to file a plan of reorganization during such period (as
such period may be extended) or if such plan is not accepted by the
required number of creditors and equity holders, any party in interest may
subsequently file its own plan of reorganization. A plan of reorganization
must be confirmed by the Court, upon certain findings being made by the
Court which are
7
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
(UNAUDITED)
required by the Bankruptcy Code. The Court may confirm a plan
notwithstanding the non-acceptance of the plan by an impaired class of
creditors or equity security holders if certain requirements of the
Bankruptcy Code are met.
Under the Bankruptcy Code, we may assume or reject executory
contracts and unexpired leases, including our store leases, subject to the
approval of the Court and our satisfaction of certain other requirements.
In the event we choose to reject an executory contract or unexpired lease,
parties affected by these rejections may file claims with the
court-appointed claims agent as proscribed by the Bankruptcy Code and/or
orders of the Court. Unless otherwise agreed, the assumption of an
executory contract or unexpired lease will require Kmart to cure all prior
defaults under such executory contract or lease, including all pre-petition
liabilities. In this regard, we expect that liabilities that will be
subject to compromise through the Chapter 11 process will arise in the
future as a result of the rejection of additional executory contracts
and/or unexpired leases, and from the determination of the Court (or
agreement by parties in interest) of allowed claims for items that we now
claim as contingent or disputed. Conversely, we would expect that the
assumption of additional executory contracts may convert liabilities shown
on our financial statements as subject to compromise to post-petition
liabilities. Due to the uncertain nature of many of the potential claims,
we are unable to project the magnitude of such claims with any degree of
certainty. Kmart has incurred, and will continue to incur, significant
costs associated with the reorganization.
On April 15, 2002, we filed with the Court schedules of assets
and liabilities and statements of financial affairs setting forth, among
other things, the assets and liabilities of the Debtors as shown by our
books and records, subject to the assumptions contained in certain notes
filed in connection therewith. All of the schedules and the statements of
financial affairs are subject to further amendment or modification. The
deadline for creditors to file proofs of claim with the court-appointed
claims agent was July 31, 2002, with certain limited exceptions for
extensions granted by the Court. Differences between amounts scheduled by
Kmart and claims by creditors will be investigated and resolved in
connection with our claims resolution process. That process has commenced
and, in light of the number of creditors of the Debtors, may take
considerable time to complete. Accordingly, the ultimate number and amount
of allowed claims is not presently known and, because the settlement terms
of such allowed claims are subject to a confirmed plan of reorganization,
the ultimate distribution with respect to allowed claims is not presently
ascertainable.
The United States Trustee has appointed an unsecured creditors
committee, a financial institutions committee and an equity holders
committee. These official committees and their legal representatives often
take positions on matters that come before the Court, and are the most
likely entities with which Kmart will negotiate the terms of a plan of
reorganization. There can be no assurance that these committees will
support Kmart's positions in the bankruptcy proceedings or the plan of
reorganization once proposed, and disagreements between Kmart and these
committees could protract the bankruptcy proceedings, could negatively
impact Kmart's ability to operate during bankruptcy and could delay Kmart's
emergence from bankruptcy.
We have filed numerous motions in the Chapter 11 case whereby we
were granted authority or approval with respect to various items required
by the Bankruptcy Code and/or necessary for our reorganization efforts. In
addition to motions pertaining to store closure and real estate disposition
matters, we have obtained orders providing for, among other things, (i)
implementation of a key employee retention and incentive program, (ii)
authorization of a second lien for vendors in connection with our secured
inventory trade credit program, (iii) authorization of a settlement
agreement with our sureties who support our self-insurance program and
state licensing requirements, (iv) the extension of time to assume or
reject leases, (v) implementation of uniform procedures for resolving or
otherwise liquidating our numerous pre-petition personal injury actions,
(vi) implementation of uniform procedures for resolving or otherwise
liquidating numerous mechanics and materialmen's liens, (vii) approval of
standing bidding procedures to be utilized in connection with asset sales,
(viii) authority to compromise or settle certain classes of deminimis
controversy and allow claims without further court approval, (ix) approval
of procedures to sell certain deminimis assets free and clear of liens,
claims and encumbrances and to pay market rate broker commissions in
connection with such sales without further court approval and (x)
assumption of agreements with our key brand partners.
At this time, it is not possible to predict the effect of the
Chapter 11 reorganization on our business, various creditors and security
holders or when we will be able to exit Chapter 11.
8
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
(UNAUDITED)
Under the priority scheme established by the Bankruptcy Code,
certain post-petition liabilities and pre-petition liabilities need to be
satisfied before shareholders are entitled to receive any distribution. The
ultimate recovery to creditors, trust convertible preferred securities
holders and/or common shareholders, if any, will not be determined until
confirmation of a plan or plans of reorganization. No assurance can be
given as to what values, if any, will be ascribed in the bankruptcy
proceedings to each of these constituencies. A plan of reorganization could
also result in holders of Kmart common stock receiving no value for their
interests. Because of such possibilities, the value of the common stock is
highly speculative. Accordingly, Kmart urges that appropriate caution be
exercised with respect to existing and future investments in any of these
liabilities and/or securities.
The ability of Kmart to continue as a going concern is predicated
upon numerous issues, including our ability to achieve the following:
- developing a long-term strategy and/or market niche to revitalize
our business and return Kmart to profitability;
- taking appropriate action to offset the negative effects that the
Chapter 11 filing has had on our business, including the loss in
customer traffic and the impairment of vendor relations;
- operating within the framework of our DIP Credit Facility,
including its limitations on capital expenditures, our ability to
generate cash flows from operations or seek other sources of
financing and the availability of projected vendor credit terms;
- attracting, motivating and/or retaining key executives and
associates; and
- developing and, thereafter, having confirmed by the Court, a
plan of reorganization.
These challenges are in addition to those operational and
competitive challenges faced by Kmart in connection with our business as a
discount retailer.
A plan of reorganization could materially change the amounts
reported in the financial statements, which do not give effect to all
adjustments of the carrying value of assets or liabilities that might be
necessary as a consequence of a plan of reorganization.
4. 2002 COST REDUCTION INITIATIVE
On August 19, 2002, we announced a cost reduction initiative
aimed at realigning our organization to reflect our current business needs
following the completion of the 283 store closures. We eliminated
approximately 400 positions at our corporate headquarters and approximately
50 positions nationally that provide corporate support. As a result of the
job eliminations we recorded a charge of $15 in accordance with SFAS No.
112, "Employers' Accounting for Postemployment Benefits." The charge
includes severance, outplacement services and continuation of healthcare
benefits in accordance with the severance plan provisions of our Key
Employee Retention Plan ("KERP"), which was approved by the Court in March
2002. This charge is included in Charges for BlueLight.com and other in our
unaudited Condensed Consolidated Statements of Operations.
5. DISCONTINUED OPERATIONS
During the second quarter of fiscal year 2002, we recorded a
non-cash credit of $20 to reduce reserves for our remaining lease
obligations for the Builder's Square, Inc., Hechinger Company, Pace
Membership Warehouse, Inc. and Furr's Restaurants locations. The $20 credit
primarily relates to adjustments to our estimated allowable claims for the
lease obligations.
6. REORGANIZATION ITEMS, NET
Reorganization items, net represent amounts we incurred as a
direct result of our Chapter 11 filing and are presented separately in the
unaudited Condensed Consolidated Statements of Operations. For the 13 and
26 weeks ended July 31, 2002, respectively, the following amounts have been
recorded:
9
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
(UNAUDITED)
13 Weeks 26 Weeks
Ended Ended
--------- -------
2002 store closings $ (10) $ 218
Professional fees 29 67
Employee costs 37 63
Settlement of pre-petition liabilities (20) (34)
Sale of pharmacy lists (1) (18)
Interest income (5) (9)
Lease auction (2) (2)
Other (15) (7)
--------- -------
Reorganization items, net $ 13 $278
========= =======
The following paragraphs provide additional information relating
to costs that were recorded in the line Reorganization items, net in our
unaudited Condensed Consolidated Statement of Operations for the 13 and 26
week periods ended July 31, 2002:
2002 store closings
On March 20, 2002, the Court approved the closure of 283 stores.
Stores were selected by evaluating the market and financial performance of
every store and the terms of every lease. Candidates for closure were
stores that did not meet our financial requirements for ongoing operations.
All of the stores were closed as of June 2, 2002.
The results of operations of stores that have been closed are
reported in discontinued operations in accordance with SFAS No. 144 when a)
the operations and cash flows of the stores have been (or will be)
eliminated from our ongoing operations and b) we will not have any
significant continuing involvement in the operations of the stores after
the closure.
We have evaluated the 283 stores closed during the second quarter
and determined that in substantially all the cases, the operations and cash
flows of the store will not be eliminated from our ongoing operations. The
results of operations of the limited number of stores that were considered
to be discontinued operations, based upon both quantitative and qualitative
factors, were not considered to be material for separate presentation in
the unaudited Condensed Consolidated Statement of Operations.
As a result of our conclusion that the 283 stores should be
reported in continuing operations, for the 13 and 26 week periods ending
July 31, 2002, we recorded ($10) and $218, respectively, for expenses
related to store closings in fiscal year 2002 to our Reorganization items,
net. We charged $228 to our closed store reserve for allowable claims
related to lease terminations and other costs and reclassified $144 of
capital lease obligations to the closed store reserve during the first
quarter of fiscal 2002. During the second quarter of fiscal 2002, we
recorded a credit of $10 to adjust our estimated allowable claims. The
closed store reserve is included in the line Liabilities subject to
compromise in our unaudited Condensed Consolidated Balance Sheet as of July
31, 2002. The reserve for estimated costs was recorded in accordance with
EITF 94-3. See Note 15 for a summary of reserve activity.
Professional fees
For the 13 and 26 week periods ended July 31, 2002, we recorded
$29 and $67, respectively, for professional fees. Professional fees include
financial, legal, real estate and valuation services directly associated
with our reorganization process.
Employee costs
In March 2002, we received Court approval to implement the KERP
which provides cash incentives and certain benefits to key members of our
salaried management team. The retention program provisions of the KERP are
expected to encourage employees to continue
10
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
(UNAUDITED)
their employment with Kmart through the reorganization process. For the 13
and 26 week periods ended July 31, 2002, we recorded charges of $37 and
$63, respectively, for the KERP bonuses and retention bonuses for
associates in our 283 stores that were closed.
Settlement of pre-petition liabilities
For the 13 and 26 week periods ended July 31, 2002, we recorded
gains of $20 and $34, respectively, representing the difference between the
settlement value of certain pre-petition obligations and the amounts
recorded for allowable claims, primarily related to lease termination
agreements between Kmart and its landlords.
Lease auction
Kmart and certain subsidiaries entered into several Asset
Purchase and Designation Rights Agreements ("Agreements") with Kimco Realty
Corporation, Schottenstein Stores Corporation and Klaff Realty, LP and
other purchasers ("Purchasers"), in accordance with the bidding procedures
order entered on May 10, 2002. Under the terms of the Agreements we have
agreed to sell to the Purchasers either the designation rights with respect
to, or our interest in, 57 leaseholds for closed stores. During the
designation period, as defined under the Agreements, the Purchasers of
designation rights shall have the sole, exclusive and continuing right to
select, identify and designate (i) which leases shall be assumed and
assigned or subleased, and to whom and (ii) which properties shall be
excluded from the transaction.
In consideration for the leasehold and designation rights
acquisitions, the Purchasers are obligated to pay $46, of which $12 was
paid in cash during the second quarter of fiscal 2002. The remaining $34 is
to be paid as the Purchaser receives net proceeds from the sale or
assignment of the properties, but not later than December 31, 2002. The
Purchasers, are responsible for paying all carrying costs related to such
properties during the designation period in accordance with the Agreements.
In addition, we may be entitled to additional proceeds in the event that
designation rights transactions exceed a specified level of proceeds.
A pro-rata portion of the guaranteed proceeds of $46 will be
recognized into income at either the date of the closing on the property
assignment, when we are informed by the Purchasers of their intention to
exclude certain leaseholds from future assignments, upon termination of the
lease or upon expiration of the designation rights period. At the time we
are legally released as the primary obligor under the lease agreement, the
allowed claim amount established in connection with the Court's approval of
our plan to close and reject the lease shall be reversed. Both the income
from the sale of the designation rights and the reversal of the allowed
claim amount are reported in the unaudited Condensed Consolidated Statement
of Operations as reorganization items.
During the second quarter of fiscal 2002, two leases have been
terminated and one has been excluded, resulting in the recognition of $2 of
proceeds from the sale of designation rights. The remaining funds received
have been deferred and will be recognized in our unaudited Condensed
Consolidated Statement of Operations as the performance criteria associated
with these funds are completed.
Other reorganization items
For the 13 and 26 week periods ended July 31, 2002, we recorded
gains of $1 and $18 for the sale of pharmacy lists and $5 and $9 for
interest income earned on excess cash balances, respectively. We also
recorded credits of $15 and $7 for the 13 and 26 week periods ended July
31, 2002, respectively, primarily to adjust our estimated allowable lease
obligation claims.
7. MARKDOWNS FOR INVENTORY LIQUIDATION
For the 13 and 26 week periods ended July 31, 2002, we recorded
charges of $27 and $785, respectively, to write-down inventory liquidated
at our 283 closing stores to net realizable value, given the accelerated
liquidation
11
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
(UNAUDITED)
strategy. This charge is included in Cost of sales, buying and occupancy in
the unaudited Condensed Consolidated Statements of Operations.
For the year, $348 of the charge was recorded relating to the
write-down of inventory initially existing at the closing stores to its
estimated selling value in connection with liquidation sales in the 283
stores. During the liquidation sale the actual markdowns required to
liquidate the inventory were lower than expected. As a result, in the
second quarter, we recorded a credit of $36 to adjust our estimate. In
addition, $117 of the charge related to liquidation fees and expenses
associated with the disposition of inventory through the liquidation sales
at the 283 closing stores, of which $9 was recorded in the second quarter.
The remaining $320 was recorded relating to the acceleration of
markdowns on approximately 107,000 stock keeping units ("SKUs"), the
majority of which were transferred from our remaining open stores to the
283 closing stores and included in the liquidation sales. The liquidation
of these SKUs required higher markdowns than anticipated, accordingly,
an adjustment of $54 was recorded in the second quarter of 2002. The SKUs
that were not transferred from our remaining open stores to the closing
stores as part of the liquidation sales are no longer carried as part of
our product assortment in our remaining open stores and have been further
reduced to their adjusted net realizable value.
The following table summarizes the components of the charge for
markdowns for inventory liquidation during the 26 week period ended July
31, 2002:
Writedown Accelerated
of Inventory Markdown
in the 283 Liquidator of
Closing Fees and Discontinued
Stores Expenses SKUs Total
---------- ---------- ----------- -----
First Quarter $ 384 $ 108 $ 266 $ 758
Second Quarter
Adjustments for actual selling values (36) - 54 18
Additional fees and expenses - 9 - 9
---------- --------- ----------- -----
Total $ 348 $ 117 $ 320 $ 785
========== ========= =========== =====
8. ADJUSTMENTS RELATED TO PRIOR PERIODS
Included in the current period operating results are charges
totaling $90, primarily relating to prior fiscal years. Such adjustments
include the write-off of $57 of costs formerly capitalized into inventory.
Inventory included amounts added for internal purposes to comparably
analyze gross margin across all business units and to optimize purchasing
decisions. These amounts are commonly referred to in the retail industry as
"inventory loads." Largely, they represent costs of sales accrued at the
time of purchase (e.g. royalties and internal buying commissions) or
amounts loaded to add consistency to business practices (e.g. defective
import merchandise which cannot be returned and advertising costs not
supported by vendors). These inventory loads should have been
fully-eliminated for external reporting purposes. The current period
adjustment establishes a reserve to fully offset the current level of
inventory loads remaining in our inventory balance at July 31, 2002. The
remaining $33 relates to other miscellaneous adjustments.
Due to their classification as SG&A, advertising cost loads not
directly related to third party contracts have had the impact of increasing
cost of sales, buying and occupancy expenses and reducing SG&A expenses by
$16 and $33 for the 13 and 26 weeks ended July 31, 2002. Similarly, such
amounts in prior years totaled $14 and $27 for the 13 and 26 weeks ended
August 1, 2001.
12
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
(UNAUDITED)
9. COMPREHENSIVE LOSS
Comprehensive loss represents net loss, adjusted for the effect
of other items that are recorded directly to shareholders' equity. Net loss
and comprehensive loss are equivalent for all periods presented.
10. INTEREST EXPENSE, NET
Interest income of $1 and $2 is included in the line Interest
expense, net in the unaudited Condensed Consolidated Statements of
Operations for each of the 13 and 26 week periods ended July 31, 2002,
respectively. Interest income of $2 and $3 is included in the line Interest
expense, net in the unaudited Condensed Consolidated Statements of
Operations for each of the 13 and 26 week periods ended August 1, 2001,
respectively. Interest income earned as a result of excess cash balances
due to the Chapter 11 filing are recorded in the line Reorganization items,
net in the unaudited Condensed Consolidated Statements of Operations, see
Note 6.
As of the Petition Date, we ceased accruing interest on unsecured
pre-petition debt classified as Liabilities subject to compromise in our
unaudited Condensed Consolidated Balance Sheets in accordance with SOP
90-7. Interest at the stated contractual amount on unsecured debt that was
not charged to results of operations for the 13 and 26 week periods ended
July 31, 2002 was approximately $68 and $137, respectively.
11. RELATED PARTY DISCLOSURE
Commencing March 2002, Kmart engaged various services of JA&A
Services, a consulting firm, whose Chairman and another Principal hold
executive officer positions within Kmart. Specifically, their Chairman, Al
Koch, currently serves as our Chief Financial Officer, and another
Principal, Ted Stenger, currently serves as our Treasurer. For the 13 and
26 week periods ended July 31, 2002, we recorded expenses for such services
totaling $7 and $9, respectively. Fees paid to the firm aggregated
approximately $1 and $2 for the 13 and 26 week periods ended July 31, 2002,
respectively, for services rendered under the consulting agreement. In
addition to hourly fees and expenses, JA&A Services will also receive an
annual performance fee of 0.75% of EBITDA for each year services are
rendered under terms of the agreement.
12. LIABILITIES SUBJECT TO COMPROMISE
Under bankruptcy law, actions by creditors to collect
indebtedness we owe prior to the Petition Date are stayed and certain other
pre-petition contractual obligations may not be enforced against Kmart and
37 of its U.S. subsidiaries. We have received approval from the Court to
pay certain pre-petition liabilities including employee salaries and wages,
benefits and other employee obligations. Except for secured debt and
capital lease obligations, all pre-petition liabilities have been
classified as Liabilities subject to compromise in the unaudited Condensed
Consolidated Balance Sheets. Adjustments to the claims may result from
negotiations, payments authorized by Court order, additional rejection of
executory contracts including leases, or other events.
Pursuant to an order of the Court, we mailed notices to all known
creditors that the deadline for filing proofs of claim with the Court was
July 31, 2002. Amounts that we have recorded may be different than amounts
filed by our creditors. The number and amount of allowable claims cannot be
presently ascertained. An estimated 45,000 claims were filed as of July 31,
2002 of an estimated 1.1 million notices sent to constituents. The claims
reconciliation process may result in adjustments to allowable claims.
The following table summarizes the components of Liabilities
subject to compromise in our unaudited Condensed Consolidated Balance
Sheets as of July 31, 2002 and as of January 30, 2002:
13
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
(UNAUDITED)
July 31, January 30,
2002 2002
-------- -----------
Debt and notes payable $3,327 $3,346
Accounts payable 2,398 3,058
Closed store reserves 747 484
General liability and workers compensation 288 312
Pension obligation 185 195
Taxes payable 160 149
Other liabilities 271 516
-------- -----------
Total liabilities subject to compromise $7,376 $8,060
======== ===========
Following is a reconciliation of the changes in Liabilities
subject to compromise for the period from the Petition Date through July
31, 2002:
Cumulative
since Petition
Date
--------------
Balance, Petition Date $8,551
First day court orders authorizing payment of employee wages, benefits and other
employee obligations, sales and use taxes and payments to critical vendors (833)
Adjustment to general liability and workers compensation accruals (174)
Adjustments to closed store reserves 97
Revisions to estimated allowed claim amounts (108)
Court order authorizing payment of additional trade accounts payable (59)
Gain on settlement of pre-petition liabilities (34)
Other (64)
--------------
Balance, end of period $7,376
==============
13. EMPLOYEE SEVERANCE AND VERP
During the first quarter of 2001, our workforce was reduced by
350 employees through a voluntary early retirement program ("VERP") and
other employee separations. The total cost of the realignment aggregated
$23 ($15, net of tax), which is included in our unaudited Condensed
Consolidated Statement of Operations for the quarter ended August 1, 2001
in the line item Charges for BlueLight.com and other. The charge related to
130 employees that accepted the VERP offer, with costs aggregating $6. The
remaining 220 employees were severed and given post-employment benefits
including severance, outplacement services, continuation of healthcare
benefits and other benefits totaling $17. Of the charge, $19 was reserved
for and paid out of our general corporate assets, including benefits for
highly-compensated employees accepting the VERP offer, and the remaining $4
was paid out of the Kmart Employee Pension Plan. See Note 15 for a summary
of reserve activity.
14. RESTRUCTURING OF BLUELIGHT.COM
We recorded a $92 charge ($73, net of tax) related to our
e-commerce site, BlueLight.com, in the second quarter of fiscal 2001,
comprised of $41 for the impairment of our investment in BlueLight.com and
$51 for the restructuring of our e-commerce business. These charges are
included in the line Charges for BlueLight.com and other in our unaudited
Condensed Consolidated Statements of Operations.
Based upon the changing environment for the internet businesses,
in which the ability for internet businesses to raise capital was
restricted, management's revised future cash flow projections and the
potential need for significant additional cash advances, we adopted a
multi-step plan to substantially restructure the operations of
BlueLight.com.
The initial step was executed by acquiring the remaining 40%
interest in BlueLight.com, LLC, principally through the purchase of all
outstanding common and preferred stock of BlueLight.com, Inc., a holding
company. BlueLight.com, Inc. and BlueLight.com LLC (hereinafter together or
individually, "BlueLight.com") then became wholly-owned subsidiaries of
Kmart, which allowed us to execute our restructuring plan. The purchase
price of the
14
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
(UNAUDITED)
additional interest was $85, with $69 being satisfied through the issuance
of 6.1 million unregistered shares of Kmart common stock and $16 paid in
cash. Based upon the revised cash flow projections for the business, we
recorded in the second quarter of fiscal 2001 a $41 charge to write-down
our investment in BlueLight.com to fair value in accordance SFAS No. 144.
Fair value was determined using the present value of estimated future cash
flows. In connection with the acquisition the return of capital put rights
were terminated, the related $62.5 liability was relieved, and the 4.4
million warrants for Kmart common stock issued to SOFTBANK and other
investors were cancelled.
Of the $51 restructuring charge, $29 related to assets impaired
as a result of the restructuring. These assets represent furniture and
fixtures, leasehold improvements, and computer software and hardware, the
majority of which were located in the headquarters of BlueLight.com, and
were not utilized in the restructured operations. These assets were reduced
to the lower of carrying amount or fair value less cost to sell in
accordance with SFAS No. 144. Fair value was determined using the present
value of estimated future cash flows. Liabilities for lease terminations,
contract terminations and other costs totaling $22 were established as a
result of the decision to exit the BlueLight.com headquarters building and
outsource certain aspects of our overall e-commerce business, including
fulfillment, technology and customer service. See Note 15 for a summary of
reserve activity.
The results of BlueLight.com's operations were fully consolidated
in our financial statements commencing July 31, 2001.
15. RESTRUCTURING RESERVE ACTIVITY
The following table provides information regarding reserve
activity during the 26 week periods ended July 31, 2002 and August 1, 2001,
respectively, for the fiscal year 2000 strategic actions charge, the fiscal
year 2001 employee severance and VERP charge, the fiscal year 2001
BlueLight.com restructuring charge, the fiscal year 2001 supply chain
restructuring charge and the fiscal year 2002 store closings charge.
Reserves established in connection with the fiscal 2002 store closings
charge are composed of $228 relating to lease rejections. Please refer to
our 2001 Annual Report on Form 10-K for the fiscal year ended January 30,
2002, which was filed with the SEC on May 15, 2002, for a discussion of the
2001 supply chain and 2000 strategic actions charges. The liabilities
aggregated $437 and $185 at July 31, 2002 and August 1, 2001, respectively.
15
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
(UNAUDITED)
26 Weeks Ended
------------------------------------------------------------------------------------------
July 31, August 1,
2002 2001
------------------------------------------------- -------------------------------------
2001 2001 2000 2001 2001 2000
2002 Store BlueLight Supply Strategic VERP/ BlueLight Strategic
Closings .com Chain Actions Severance .com Actions
------------ ---------- ---------- ----------- ------------- ---------- -----------
Balance, beginning of year $ - $ 18 $ 11 $ 98 $ - $ - $177
Additions charged to operations 228 - 2 - 19 22 -
Reclassifications 144 - - - - - -
---- ---- ---- ---- ---- ---- ----
Total additions 372 - 2 - 19 92 -
Reductions:
Cash payments:
Lease obligations 17 - - 5 - - 19
Employee costs - - 5 - 14 - -
Contractual obligations - 1 - - - - -
Other costs - - - - - - -
Non-cash reductions:
Adjustments 14 - - 2 - - -
Pre-petition liability settlements 15 - 5 - - - -
---- ---- ---- ---- ---- ---- ----
Balance, end of period $326 $ 17 $ 3 $ 91 $ 5 $ 22 $158
==== ==== ==== ==== ==== ==== ====
16. INVENTORIES AND COST OF MERCHANDISE SOLD
A substantial portion of our inventory is accounted for using the
last-in, first-out ("LIFO") method. Since LIFO costs can only be determined
at the end of each fiscal year when inflation rates and inventory levels are
finalized, estimates are used for LIFO purposes in the interim unaudited
Condensed Consolidated Financial Statements. Inventories valued on LIFO at
July 31, 2002, August 1, 2001 and January 30, 2002 were $269, $194 and $269
lower, respectively, than the amounts that would have been reported under
the first-in, first-out method.
17. INVESTMENTS IN AFFILIATED RETAIL COMPANIES
Meldisco
All Kmart footwear departments are operated under a license agreement
with the Meldisco subsidiaries of Footstar, Inc. ("FTS"), substantially all
of which are 49% owned by Kmart and 51% owned by FTS.
The following table summarizes net sales, gross margin and net income
for the 13 and 26 week periods ended July 31, 2002 and August 31, 2001.
13 Weeks Ended 26 Weeks Ended
------------------------------------ --------------------------------------
July 31, August 1, July 31, August 1,
2002 2001 2002 2001
---------------- ------------------ ------------------ ------------------
Net sales $290 $323 $596 $611
Gross margin 142 160 280 296
Net income 23 29 39 47
BlueLight.com
16
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (continued)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
(UNAUDITED)
On July 31, 2001, we acquired the remaining 40% interest in
BlueLight.com, and BlueLight.com's operations were fully consolidated into
our financial statements. The following table summarizes net sales, gross
margin and net loss for the 13 and 26 week periods ended August 1, 2001. See
Note 14.
August 1, 2001
13 Weeks 26 Weeks
Ended Ended
------------------- ------------------
Net sales $ 4 $ 8
Gross margin - 1
Net loss (25) (55)
Penske
On April 9, 2002, we reached an agreement with Penske Corporation,
Penske Auto Centers, Inc., and Penske Auto Centers, LLC (collectively
"Penske") whereby Penske and Kmart worked together to wind-down operations
at auto service centers at more than 563 Kmart stores in 44 states following
Penske's unilateral decision to close the business as of April 6, 2002. This
matter did not have a material adverse affect on our liquidity, financial
position or results of operations for the 26 weeks ended July 31, 2002.
18. LOSS PER SHARE
Net loss per common share is computed as follows:
13 Weeks Ended 26 Weeks Ended
-------------------------------- ---------------------------------
July 31, 2002 August 1, 2001 July 31, 2002 August 1, 2001
------------- --------------- ------------- --------------
Basic/Diluted loss per common share:
Net loss from continuing operations $ (397) $ (377) $ (1,846) $ (610)
Discontinued operations 20 - 20 -
--------- --------- --------- ---------
Net loss $ (377) $ (377) $ (1,826) $ (610)
========= ========= ========= =========
Basic/Diluted weighted average shares outstanding 502.7 490.6 502.8 489.6
Basic/Diluted loss per common share:
Net loss from continuing operations: $ (0.79) $ (0.77) $ (3.67) $ (1.25)
Discontinued operations 0.04 - 0.04 -
--------- --------- --------- ---------
Net loss $ (0.75) $ (0.77) $ (3.63) $ (1.25)
========= ========= ========= =========
We calculate loss per share in accordance with SFAS No. 128, "Earnings
Per Share." In all periods presented net losses were incurred, therefore
dilutive common stock equivalents were not used in the calculation of
earnings per share as they would have an anti-dilutive effect. Options to
purchase 51.4 million and 60.0 million shares of common stock at prices
ranging from $4.86 to $26.03 and $5.34 to $26.03 were excluded from the
calculations for the 13 and 26 week periods ended July 31, 2002 and August
1, 2001, respectively. The calculations also exclude the effect of trust
convertible preferred securities. For the 13 and 26 week periods ended July
31, 2002 and August 1, 2001, respectively, diluted shares outstanding
exclude approximately 59.9 million common shares from potential conversion
of certain trust convertible preferred securities due to their anti-dilutive
effect.
19. INCOME TAXES
In the fourth quarter of fiscal 2001, we recorded a valuation allowance
against our net deferred tax assets, in accordance with SFAS No. 109,
"Accounting for Income Taxes," as realization of such assets in future years
is uncertain.
We have continued to maintain a valuation allowance against our net
deferred tax assets, and accordingly, we have not recognized any tax benefit
from our losses in fiscal 2002. The $12 tax benefit recorded in the first
quarter of fiscal 2002 relates primarily to amounts now refundable to Kmart
as a result of the Job Creation and Worker Assistance Act of 2002 which was
enacted in the first quarter of fiscal 2002.
17
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
(UNAUDITED)
20. OTHER COMMITMENTS AND CONTINGENCIES
Guarantees
As of July 31, 2002, we had outstanding guarantees for real property
leases of certain former subsidiaries as follows:
Present Value of
Future Lease Gross Future
Obligations @ 7% Lease Obligations
------------------- -------------------
The Sports Authority, Inc. $ 176 $ 298
Borders Group, Inc. 85 144
OfficeMax, Inc. 62 90
-------- --------
Total $ 323 $ 532
======== ========
Our rights and obligations with respect to our guarantee of The Sports
Authority, Inc., OfficeMax, Inc. and Borders Group, Inc. leases are governed
by Lease Guaranty, Indemnification and Reimbursement Agreements dated as of
November 23, 1994, November 9, 1994 and May 24, 1995, respectively, as
amended from time to time. Should a reserve be required, it would be
recorded at the time the obligation was determined to be both probable and
estimable. Kmart's contingent obligation is dependent on the future
operating results of these former subsidiaries and is subject to settlement
under a plan of reorganization to be voted upon by creditors and equity
holders and approved by the Court.
In addition, as of July 31, 2002, we had guaranteed $72 of indebtedness
of other parties related to certain of our leased properties financed by
industrial revenue bonds. These agreements expire from 2004 through 2009.
Our contingent obligation is dependent on the future operating results of
the parties whose debt we guarantee and is subject to settlement under a
plan of reorganization to be voted upon by creditors and equity holders and
approved by the Court.
Bankruptcy Proceedings
On the Petition Date, Kmart and 37 of its U.S. subsidiaries filed
voluntary petitions for reorganization under Chapter 11 of the Bankruptcy
Code in the Court. The reorganization is being jointly administered under
the caption "In re Kmart Corporation, et al., case No. 02 B 02474."
Included in the unaudited Condensed Consolidated Financial Statements are
subsidiaries operating outside of the United States, which have not
commenced Chapter 11 cases or other similar proceedings elsewhere, and are
not debtors. The assets and liabilities and results of operations of such
non-filing subsidiaries are not considered material to the unaudited
Condensed Consolidated Financial Statements. We retain control of our
assets and are authorized to operate the business as a debtor-in-possession
while being subject to the jurisdiction of the Court. As of the Petition
Date, most pending litigation is stayed, and absent further order of the
Court, substantially all pre-petition liabilities are subject to settlement
under a plan of reorganization. At this time, it is not possible to predict
the outcome of the Chapter 11 cases or their effect on our business. If it
is determined that the liabilities subject to compromise in the Chapter 11
cases exceed the fair value of the assets, unsecured claims may be
satisfied at less than 100% of their fair value and the equity interests of
our shareholders may have no value. See Note 3. Proceedings Under Chapter
11 of the Bankruptcy Code.
Legal Proceedings
Since February 21, 2002, five separate purported class actions have
been filed on behalf of purchasers of Kmart common stock between May 17,
2001 and January 22, 2002, inclusive, naming Charles Conaway as CEO and
Chairman of the Board of Kmart as the sole defendant. The complaints filed
in the United States District Court for the Eastern District of Michigan
allege that Mr. Conaway made material misstatements or omissions during the
alleged class period that inflated the trading prices of Kmart's common
stock and seek, among other things, damages under Section 10b-5 of the
Securities and Exchange Act of 1934. Kmart is not a defendant. On August 15,
2002, an amended consolidated
18
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
(UNAUDITED)
complaint was filed that enlarged the class of persons on whose behalf the
action was brought to include purchasers of Kmart securities between March
13, 2001 and May 15, 2002, and added Jeffrey N. Boyer, Mark S. Schwartz,
Matthew F. Hilzinger, Martin E. Welch III and PricewaterhouseCoopers LLP as
defendants.
Kmart is involved in discussions with the United States Attorney
for the District of Puerto Rico regarding a criminal investigation arising
out of the alleged actions of certain of our employees following the 1998
Hurricane Georges.
On March 18, 2002, a purported class action was filed in the
United States District Court for the Eastern District of Michigan on behalf
of participants or beneficiaries of the Kmart Corporation Retirement
Savings Plan against various officers and directors of Kmart alleging
breach of fiduciary duty under ERISA for excessive investment in company
stock; failure to provide complete and accurate information about Kmart
common stock and failure to provide accurate information regarding our
financial condition. Class action allegations are also made for current and
former employees who participate in the Kmart Corporation Retirement
Savings Plan. Kmart is not a defendant.
On April 26, 2002, a lawsuit was filed in the United States
District Court for the Eastern District of Michigan on behalf of three
limited partnerships that purchased stock of Bluelight.com, a subsidiary of
Kmart, naming Charles C. Conaway, as CEO and Chairman of the Board of
Kmart, as the sole defendant. The Complaint alleges that Mr. Conaway
breached his fiduciary duty, took certain actions and made certain
misrepresentations that induced plaintiffs to exchange their Bluelight.com
stock for Kmart stock and prevented plaintiffs from realizing the market
value of their stock. The complaint also alleges violations of Section
10b-5 of the Securities and Exchange Act of 1934 and Section 410 of the
Michigan Uniform Securities Act. Kmart is not a defendant to this
litigation.
Kmart is a defendant in six putative class actions and one
multi-plaintiff case pending in California, all relating to our
classification of assistant managers and various other employees as
"exempt" employees under the federal Fair Labor Standards Act and the
California Labor Code and our alleged failure to pay overtime wages as
required by these laws. These seven wage-and-hour cases were all filed
during 2001 and are currently pending in the U.S. District Court for the
Eastern District of California (Henderson v. Kmart), the U.S. District
Court for the Central District of California (Gulley v. Kmart, the
multi-plaintiff case, which was originally brought in state court) and the
Superior Courts of the State of California for the Counties of Alameda, Los
Angeles and Riverside (Panossian v. Kmart, Wallace v. Kmart, Pierce v.
Kmart, Hancock v. Kmart, Pryor v. Kmart). If all of these cases were
determined adversely to Kmart, the resulting damages would have a material
adverse impact on our results of operations and financial condition.
However, there have been no class certifications, all of the cases are
stayed as a result of Kmart's bankruptcy and, based on our initial
investigations, we believe that we have numerous defenses to each of these
claims. As a result, we are currently unable to quantify the financial
exposure of these cases.
We are a party to a substantial number of other claims, lawsuits,
and pending actions, most of which are routine and all of which are
incidental to our business. Some matters involve claims for large amounts
of damages as well as other relief. The Company assesses the likelihood of
potential losses on an ongoing basis and when they are considered probable
and reasonably estimable, records an estimate of the ultimate outcome. If
there is no single point estimate of loss that is considered more likely
than others, an amount representing the low end of the range of possible
outcomes is recorded. Although the final consequences of these proceedings
are not presently determinable, in the opinion of management, they are not
expected to have a material adverse effect on our liquidity, financial
position or results of operations.
In addition to the foregoing, there are numerous matters filed
with the Court in our reorganization proceedings by creditors, landlords or
other third parties related to our business operations or the conduct of
our reorganization activities. Although none of these individual matters
which have been filed to date have had or are expected to have a material
adverse effect on Kmart, our ability to successfully manage the
reorganization process and develop an acceptable reorganization plan could
be negatively impacted by adverse determinations by the Court on certain of
these matters.
Investigative Matters
Kmart has been provided with copies of anonymous letters sent to
the SEC, our auditors, directors and legal counsel expressing concern with
respect to various matters. The letters purport to be sent by certain of
our employees. The letters have been referred to the Audit Committee, which
has engaged outside counsel to review and investigate the matters set forth
in the letters. We are cooperating with the SEC and the U. S. Attorney's
office for the Eastern District of Michigan with respect to their
investigations of these matters. In that regard, the staff of the SEC has
expressed concerns with respect to the manner in which we recorded vendor
allowances prior to the change in accounting principle at the end of fiscal
2001, as well as the Staff's intention to continue to pursue its
investigation of these matters. The bar date with respect to the filing of
claims by the SEC has been extended to October 29, 2002, with our consent.
In addition, in July of 2002 The United States House
19
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
(UNAUDITED)
Energy and Commerce Committee (the "House Committee") requested that
numerous public companies, including Kmart, provide documentation regarding
certain governance matters. We are cooperating with the House Committee
with respect to their inquiry.
Key Brand Partners
On March 20, 2002, the Court authorized our business
relationships with several key brand partners. Motions were approved
allowing Kmart to assume our license agreements with Martha Stewart Living
Omnimedia, Inc. for Martha Stewart Everyday home, garden, colors, baby,
kitchen, keeping and decorating products, along with candles and
accessories; Jaclyn Smith G.H. Production, Inc. for Jaclyn Smith women's
apparel, jewelry and accessories; Kathy Ireland World Wide, Inc. for Kathy
Ireland women's apparel, accessories and exercise equipment; Disney
Enterprises, Inc. for Disney apparel for infants and children; and Joe
Boxer Licensing, LLC. for JOE BOXER apparel, accessories and home
furnishings.
On May 29, 2002, the Court authorized our business relationship
with Sesame Workshop. Motions were approved allowing Kmart to assume our
license agreement with Sesame Workshop for Sesame Street infants and
children's apparel.
On July 24, 2002 the Court approved our motion allowing Kmart to
assume our license agreement for our proprietary Route 66 apparel line.
21. SUBSEQUENT EVENTS
On August 29, 2002, we received approval from our lenders and the
Court for an amendment to the agreement governing our $2 billion DIP Credit
Facility. The amendment, which received consents from all of the
participants in our DIP syndicate, adjusts the covenant requiring a minimum
cumulative level of EBITDA over specified periods to provide Kmart with
additional flexibility and to better reflect our sales performance since
the commencement of our Chapter 11 reorganization case.
20
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND
FINANCIAL CONDITION
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION
This Form 10-Q, as well as other statements or reports made by or
on behalf of Kmart, may contain or may incorporate by reference material which
includes forward-looking statements within the meaning of the Private Securities
Litigation Reform Act of 1995 that reflect, when made, Kmart's current views
with respect to current events and financial performance. Statements, other than
those based on historical facts, which address activities, events or
developments that we expect or anticipate may occur in the future are
forward-looking statements, which are based upon a number of assumptions
concerning future conditions that may ultimately prove to be inaccurate. Such
forward-looking statements are and will be, as the case may be, subject to many
risks, uncertainties and factors relating to Kmart's operations and business
environment which may cause the actual results of Kmart to be materially
different from any future results, express or implied, by such forward-looking
statements. Factors that could cause actual results to differ materially from
these forward-looking statements include, but are not limited to, the following:
General Factors
- - general economic conditions,
- - weather conditions, including those which affect buying patterns of our
customers,
- - marketplace demand for the products of our key brand partners, as well as
the engagement of appropriate new brand partners,
- - changes in consumer spending and our ability to anticipate buying patterns
and implement appropriate inventory strategies,
- - competitive pressures and other third party actions, including pressures
from pricing and other promotional activities of competitors,
- - our ability to timely acquire desired goods in appropriate quantities
and/or fulfill labor needs at planned costs,
- - our ability to monitor properly our inventory needs and remain in-stock,
- - our ability to successfully implement business strategies and otherwise
execute planned changes in various aspects of the business,
- - regulatory and legal developments,
- - our ability to attract, motivate and/or retain key executives and
associates,
- - our ability to attract and retain customers,
- - other factors affecting business beyond our control,
Bankruptcy Related Factors
- - our ability to continue as a going concern,
- - our ability to operate pursuant to the terms of the DIP Credit Facility,
- - our ability to obtain Court approval with respect to motions in the Chapter
11 proceeding from time to time,
- - our ability to develop, confirm and consummate one or more plans of
reorganization with respect to the Chapter 11 cases,
- - risks associated with third parties seeking and obtaining court approval to
terminate or shorten the exclusivity period that we have to propose and
confirm one or more plans of reorganization, for the appointment of a
Chapter 11 trustee or to convert the cases to Chapter 7 cases,
- - our ability to offset the negative effects that the filing for
reorganization under Chapter 11 has had on our business, including the loss
in customer traffic and the constraints placed on available capital,
- - our ability to obtain and maintain normal terms with vendors and service
providers,
- - our ability to maintain contracts, including leases, that are critical to
our operations,
- - the potential adverse impact of the Chapter 11 cases on our liquidity or
results of operations,
- - our ability to develop a long-term strategy and/or market niche, and
- - our ability to fund and execute our business plan.
Consequently, all of the forward-looking statements are qualified
by these cautionary statements and there can be no assurance that the results or
developments anticipated will be realized or that they will have the expected
effects on our business or operations. The forward-looking statements contained
herein or otherwise that we make or are made on our behalf speak only as of the
date of this report, or if not contained herein, as of the date when made, and
we do not undertake to update these risk factors or such forward-looking
statements.
21
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND
FINANCIAL CONDITION - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
Similarly, these and other factors, including the terms of any
reorganization plan ultimately confirmed, can affect the value of our various
pre-petition liabilities, common stock and/or other equity securities. No
assurance can be given as to what values, if any, will be ascribed in the
bankruptcy proceedings to each of these constituencies. A plan of reorganization
could result in holders of Kmart common stock receiving no value for their
interests. Because of such possibilities, the value of the common stock is
highly speculative. Accordingly, we urge that appropriate caution be exercised
with respect to existing and future investments in any of these liabilities
and/or securities.
The following discussion and analysis should be read in
conjunction with the audited Consolidated Financial Statements and Notes to
Consolidated Financial Statements in Item 8. Financial Statements and
Supplementary Data, of our Annual Report on Form 10-K filed with the SEC for the
fiscal year ended January 30, 2002.
OVERVIEW
On January 22, 2002 ("Petition Date"), Kmart ("Kmart," "we" or
"our") and 37 of its U.S. subsidiaries (collectively, the "Debtors") filed
voluntary petitions for reorganization under Chapter 11 of the federal
bankruptcy laws ("Bankruptcy Code" or "Chapter 11") in the United States
Bankruptcy Court for the Northern District of Illinois ("Court") under case
numbers 02 B 02462 through 02 B 02499. The reorganization is being jointly
administered under the caption "In re Kmart Corporation, et al. Case No. 02 B
02474."
Under Chapter 11, we are operating our business as a
debtor-in-possession. As of the Petition Date, actions to collect pre-petition
indebtedness as well as most other pending litigation, are stayed and other
contractual obligations against Kmart generally may not be enforced. In
addition, under the Bankruptcy Code we may assume or reject executory contracts
and unexpired leases, subject to approval of the Court and our satisfaction of
certain other requirements. Parties affected by these rejections may file claims
against the debtor in accordance with the reorganization process. Absent an
order of the Court, substantially all pre-petition liabilities are subject to
settlement under a plan of reorganization to be voted upon by creditors and
equity holders and approved by the Court.
On March 20, 2002, the Court approved the closure of 283 stores,
or approximately 13% of our 2,114 stores. Stores were selected by evaluating the
market and financial performance of every store and the terms of every lease.
Candidates for closure were stores that did not meet our financial requirements
for ongoing operations. Renegotiation of lease terms was also explored to
improve store profitability and to avoid the need for closure. Shortly after
receiving Court approval we commenced store closing sales, which were completed
by June 2, 2002. Approximately 22,000 associates were impacted by the closures.
On April 4, 2002, we announced that we had contracted with a firm
to assist in the disposition of the leases for the 283 stores. Under the
agreement, the firm assisted our internal real estate staff in identifying
retailers and investors interested in an assignment and landlords interested in
a termination of the leases for the closing stores.
On June 18, 2002, we completed an auction, in which 57 out of the
283 store leases for the closed stores were sold. On June 28, 2002, the Court
approved the auction and we were authorized to sell one lease and designation
rights on 56 leases for consideration totaling $46. We may be entitled to
additional proceeds in the event that our designation rights purchasers of 54
leases achieve a certain level of proceeds on their sale of these leases.
Designation rights allow the purchasers to put the leases back to Kmart prior to
any assignment of such lease. If a lease is put back to Kmart, we retain the
option of rejecting the lease in Court with no obligation to return the
proceeds. Of the 56 leases that we were authorized to sell designation rights,
one has been assigned, two have been terminated and transactions on 4 have been
excluded. In addition, pursuant to the auction and bidding procedures, we
entered into lease termination agreements for 10 of the 283 leases for the
aggregate amount of $2 and the waiver of certain leasehold and rejection damages
claims. There was no successful bidder on the remaining leases.
Our common stock is quoted on the New York, Pacific and Chicago
Stock Exchanges. There are a number of continuing requirements that must be
satisfied in order for a company's stock to remain eligible for quotation on the
New York Stock Exchange ("NYSE"). These requirements include maintaining a
minimum bid price of one dollar. On July 10, 2002, we received notification
from the NYSE that we were not in compliance with this requirement over the
previous 30 consecutive trading days as required for continued listing. To
regain compliance with the listing
22
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND
FINANCIAL CONDITION - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
requirements, our common stock must maintain a minimum bid price of one dollar
for ten consecutive trading days at anytime within six months following such
notice. The NYSE has informed Kmart that if we have not demonstrated compliance
with this requirement we could be subject to trading suspension and delisting.
We cannot give assurances that we will regain compliance in a timely fashion or
at all. If we fail to satisfy the continued listing requirements of the NYSE, we
anticipate that our common stock would be eligible to trade on the Over the
Counter Bulletin Board or in the "pink sheets" maintained by the National
Quotation Bureau, Inc.
The ability of Kmart to continue as a going concern is predicated
upon numerous issues, including our ability to achieve the following:
- developing a long-term strategy and/or market niche to revitalize
our business and return Kmart to profitability;
- taking appropriate action to offset the negative effects that the
Chapter 11 filing has had on our business, including the loss in
customer traffic and the impairment of vendor relations;
- operating within the framework of our DIP Credit Facility,
including its limitations on capital expenditures, our ability to
generate cash flows from operations or seek other sources of
financing and the availability of projected vendor credit terms;
- attracting, motivating and/or retaining key executives and
associates; and
- developing and, thereafter, having confirmed by the Court, a plan
of reorganization.
These challenges are in addition to those operational and
competitive challenges faced by Kmart in connection with our business as a
discount retailer. See "Cautionary Statement Regarding Forward-Looking
Information" above.
ANALYSIS OF OPERATIONS EXCLUDING NON-COMPARABLE ITEMS DESCRIBED BELOW
The following tables segregate non-comparable items from
operating income as reported in the unaudited Condensed Consolidated Statements
of Operations:
13 Weeks Ended 26 Weeks Ended
---------------------- ----------------------
July 31, August 1, July 31, August 1,
2002 2001 2002 2001
-------- --------- -------- ---------
Sales $ 7,519 $ 8,917 $ 15,158 $ 17,254
Cost of sales, buying and occupancy 6,192 7,253 12,432 14,087
-------- --------- -------- ---------
Gross margin 1,327 1,664 2,726 3,167
Selling, general and administrative expenses 1,642 2,004 3,433 3,716
Equity income (loss) in unconsolidated subsidiaries 14 (8) 19 (24)
-------- --------- -------- ---------
Operating loss before non-comparable items (301) (348) (688) (573)
Non-comparable items:
2002 cost reduction initiative 15 - 15 -
2002 inventory markdowns 27 - 785 -
Accelerated depreciation 9 - 27 -
Charge for BlueLight.com - 92 - 92
Charge for employee severance and VERP - - - 23
-------- --------- -------- ---------
Operating loss before reorganization items, net $ (352) $ (440) $ (1,515) $ (688)
======== ========= ======== =========
Same-store sales % (11.0%) 1.0% (11.4%) 1.3%
23
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND
FINANCIAL CONDITION - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
Management uses operating loss before non-comparable items, among
other metrics, to measure operating performance. It supplements and is not
intended to represent a measure of performance in accordance with disclosures
required by accounting principles generally accepted in the United States. The
following discussion excludes non-comparable items. See the table above for a
reconciliation to reported amounts and the section titled Description of
non-comparable items described below:
SAME-STORE SALES AND TOTAL SALES decreased (11.0%) and (15.7%),
respectively, for the 13 weeks ended July 31, 2002 and (11.4%) and (12.1%),
respectively, for the 26 weeks ended July 31, 2002, as compared to the
comparable periods in the prior year. The decrease in same-store sales is
primarily due to, among other factors, lower sales transactions brought on by
negative customer experiences due to poor in-stock levels worsened by our
filing for reorganization under Chapter 11. Same-store sales include sales of
all stores open, that have been open for greater than 13 full months. The
decrease in total sales is attributable to the decrease in same-store sales and
the closure of 283 stores during the second quarter of fiscal 2002.
GROSS MARGIN decreased $337 to $1,327, for the 13 weeks ended
July 31, 2002, from $1,664 for the 13 weeks ended August 1, 2001 and decreased
$441 to $2,726, for the 26 weeks ended July 31, 2002, from $3,167 for the 26
weeks ended August 1, 2001. The decrease in gross margin for the 13 and 26 week
periods ended July 31, 2002, is primarily attributable to the decrease in sales.
Gross margin, as a percent of sales, decreased to 17.6% from 18.7% for the 13
weeks ended July 31, 2002 as compared to the same period from the previous year.
The decrease in gross margin, as a percent of sales for the 13 week period ended
July 31, 2002, is primarily attributable to an increase in clearance markdowns,
shrinkage and store rent, partially offset by a decrease in sales of food and
consumables, which carry lower margins, increased markon on regular sales as a
result of the reduction in the BlueLight Always program and a decrease in
promotional markdowns. For the 26 week period ended July 31, 2002, gross margin,
as a percent of sales, decreased to 18.0% from 18.4%. The decrease in gross
margin, as a percent of sales is primarily attributable to an increase in
shrinkage, a reduction in vendor allowances due to decreased inventory purchases
and an increase in store rent as a percentage of sales, partially offset by a
decrease in sales of food and consumables, which carry lower margins.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES ("SG&A") includes
advertising costs (net of co-op recoveries of $73 in fiscal 2002 and $71 in
fiscal 2001) and decreased $362 for the 13 week period ended July 31, 2002
compared to the same period from the previous year. For the 13 weeks ended July
31, 2002, SG&A was $1,642, or 21.8% of sales, as compared to $2,004, or 22.5% of
sales, for the 13 weeks ended August 1, 2001. SG&A, including advertising costs
(net of co-op recoveries of $143 in fiscal 2002 and $162 in fiscal 2001)
decreased $283 for the 26 weeks ended July 31, 2002 compared to the same period
from the previous year. For the 26 week period ended July 31, 2002, SG&A was
$3,433, or 22.6% of sales, as compared to $3,716, or 21.5% of sales, for the 26
week period ended August 1, 2001. The decrease in SG&A for the 13 and 26 week
periods ended July 31, 2002, as compared to the previous year is primarily
attributable to decreases in expenses for general liability claims due to a
second quarter 2001 adjustment of $167 for general liability reserves to
actuarial findings, lower payroll and benefits due to the closure of 283 stores
in the second quarter of fiscal 2002, lower employee bonus accruals, lower
utilities expense due to the closure of 283 stores and a decrease in rates, and
lower depreciation expense due to the SFAS No. 144 "Accounting for the
Impairment or Disposal of Long-Lived Assets", ("SFAS NO. 144"), impairment
charge recorded in the fourth quarter of fiscal 2001. In addition, the decrease
in SG&A for the 26 week period ended July 31, 2002, was partially offset by an
increase in advertising expense due to lower co-op recoveries. The increase in
SG&A, as a percent of sales, for the 26 week periods ended July 31, 2002 is
primarily attributable to the decrease in total sales compared to the same
period from the previous year.
OPERATING LOSS for the 13 weeks ended July 31, 2002 was ($301),
or (4.0%) of sales, as compared to operating loss of ($348), or (3.9%) of sales,
for the same period of the prior year. Operating loss for the 26 weeks ended
July 31, 2002 was ($688), or (4.5%) of sales, as compared to operating loss of
($573), or (3.3%) of sales, for the same period of the previous year. The
increase in operating loss for the 26 week period ended July 31, 2002, is
attributable to lower sales and a lower gross margin rate, partially offset by a
decrease in SG&A expenses as discussed above. Conversely, operating results for
the 13 week period ended July 31, 2002, improved by $47 primarily related to a
decrease in general liability discussed above, partially offset by prior period
adjustments totalling $90. See Adjustments Related to Prior Periods below.
NET INTEREST EXPENSE for the 13 weeks ended July 31, 2002 and
August 1, 2001 was $32 and $88, respectively. Included in net interest expense
for the 13 weeks ended July 31, 2002 and August 1, 2001, is interest income of
$1 and
24
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND
FINANCIAL CONDITION - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
$2, respectively. Net interest expense for the 26 weeks ended July 31, 2002 and
August 1, 2001 was $65 and $171, respectively. Included in net interest expense
for the 26 weeks ended July 31, 2002 and August 1, 2001 is interest income of $2
and $3, respectively.
EFFECTIVE INCOME TAX rate was (0.0%) and (30.9%) for the 13 weeks
ended July 31, 2002 and August 1, 2001, respectively. For the 26 week periods
ending July 31, 2002 and August 1, 2001, the effective income tax rate was
(0.8%) and (31.7%), respectively. In the fourth quarter of fiscal 2001, we
recorded a valuation allowance against our net deferred tax assets, in
accordance with SFAS No. 109, "Accounting for Income Taxes," as realization of
such assets in future years is uncertain. We have continued to maintain a
valuation allowance against our net deferred tax assets, and accordingly, we
have not recognized any tax benefit from our losses in fiscal 2002. The $12 tax
benefit recorded in the first quarter of fiscal 2002 relates primarily to
amounts now refundable to Kmart as a result of the Job Creation and Worker
Assistance Act of 2002 which was enacted in the first quarter of fiscal 2002.
LIQUIDITY AND FINANCIAL CONDITION
Shortly after the Petition Date, in conjunction with our filing
under Chapter 11, we entered into a $2 billion debtor-in-possession financing
facility ("DIP Credit Facility"). On the Petition Date, the Court gave interim
approval authorizing borrowings up to $1.15 billion of the DIP Credit Facility
for the payment of certain pre-petition claims and the funding of working
capital and other general operating needs. On March 6, 2002, the Court approved
the entire $2 billion DIP Credit Facility. The DIP Credit Facility is a
revolving credit facility under which Kmart is the borrower and the rest of the
Debtors are guarantors. The DIP Credit Facility has been afforded superpriority
claim status in the Chapter 11 case and is collateralized by first liens on
substantially all of the Debtors' assets (subject to valid and unavoidable
prepetition liens and certain other permitted liens) and provides that proceeds
be used for working capital needs and other general corporate purposes. The DIP
Credit Facility requires that we maintain certain financial covenants and
restrict liens, indebtedness, capital expenditures, dividend payments and sale
of assets. On August 29, 2002 we received approval from our lenders and the
Court for an amendment to certain covenants in the agreement governing our DIP
Credit Facility. We are currently in compliance with the amended DIP Credit
Facility financial covenants. Following the Petition Date, we have utilized cash
flows from operations and the DIP Credit Facility as our primary sources of
working capital. As of July 31, 2002 we had utilized $400 of the DIP Credit
Facility for letters of credit issued for ongoing import purchasing operations,
contractual and regulatory purposes. Total availability under the DIP Credit
Facility as of July 31, 2002 is $1.50 billion.
As of July 31, 2002, there were $393 and $652 borrowings
outstanding under our $400 credit facility and $1.1 billion credit facility,
respectively. These borrowings are included in Liabilities subject to compromise
in our unaudited Condensed Consolidated Balance Sheet as of July 31, 2002.
Net cash provided by operating activities for the 26 weeks ended
July 31, 2002 was $319 as compared to net cash used for operating activities of
$154 for the same period in 2001. The increase in cash provided by operating
activities as compared to the same period of the prior year was primarily the
result of an increase in accounts payable, partially offset by lower net
earnings, excluding non-comparable items. The increase in accounts payable is
attributable to the bankruptcy filing as pre-petition indebtedness was stayed.
Net cash used for investing activities was $126 for the 26 weeks
ended July 31, 2002 compared to $696 for the same period in 2001. The decrease
in cash used for investing activities was primarily due to restrictions on
capital expenditures mandated by our DIP Credit Facility.
Net cash used for financing activities was $385 for the 26 weeks
ended July 31, 2002 compared to net cash provided by financing activities of
$869 for the comparable period in 2001. The decrease in cash provided by
financing activities in fiscal 2002 as compared to fiscal 2001 is primarily
attributable to our bankruptcy filing for reorganization under Chapter 11. As of
the Petition Date, pre-petition indebtedness was stayed resulting in substantial
increases in cash balances during fiscal 2002. During the first two quarters of
fiscal 2002, we have paid off $349 of borrowings outstanding at fiscal year end
2001 relating to our DIP Credit Facility and certain other pre-petition
liabilities. In contrast, during the first 26 weeks of fiscal 2001, we borrowed
$764 under our $1.6 billion credit facility and issued $430
25
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND
FINANCIAL CONDITION - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
of 9 7/8% Notes due June 2008 to finance our operations, and to paydown certain
Collateralized Mortgage Backed Securities in July 2001.
Due to the seasonal nature of the retail industry, where
merchandise sales and cash flows from operations are historically higher in the
fourth quarter than any other period, a disproportionate amount of operating
income and cash flows from operations is earned in the fourth quarter. Our
results of operations and cash flows are primarily dependent upon the large
sales volume generated during the fourth quarter of our fiscal year. Fourth
quarter sales represented over 30% of total net sales in fiscal 2001. As a
result, operating performance for the interim periods is not necessarily
indicative of operating performance for the entire year. To support the higher
seasonal sales volume we experience a seasonal inventory build in October and
November and, as a result, our usage of credit lines is higher for this period
of the year. We believe that our DIP credit facility will be adequate to support
our forecasted seasonal borrowing needs.
Our cash needs are satisfied through working capital generated by
our business and funds available under our DIP Credit Facility. The level of
cash generated by our business is dependent, in significant part, on our level
of sales and the credit extended by our vendors. Since our filing for
reorganization under Chapter 11, most of our vendors have resumed normal trade
terms. As of July 24, 2002, we had, on average, 24 days of payables outstanding.
In addition, while we have experienced since the filing negative same-store
sales, our plans for the remainder of the year, in light of our efforts to
stabilize and revitalize the business, contemplate, at a minimum, a modest
improvement in our same-store sales comparison, which should have a favorable
impact on our cash resources. Should, however, we experience a significant
disruption of terms with our vendors, and/or the DIP Credit Facility for any
reason becomes unavailable and/or actual results differ materially from those
projected, our cash resources could be adversely affected.
DESCRIPTION OF NON-COMPARABLE ITEMS
During the 26 week periods ended July 31, 2002 and August 1,
2001, respectively, we have instituted certain restructuring actions to improve
our operations. A more detailed description of these non-comparable items is as
follows:
2002 Cost Reduction Initiative
On August 19, 2002, we announced a cost reduction initiative
aimed at realigning our organization to reflect our current business needs
following the completion of the 283 store closures. We eliminated approximately
400 positions at our corporate headquarters and approximately 50 positions
nationally that provided corporate support. As a result of the job eliminations
we recorded a charge of $15 in accordance with FAS No. 112, "Employers'
Accounting for Postemployment Benefits." The charge includes severance,
outplacement services and continuation of healthcare benefits in accordance with
our Key Employee Retention Plan ("KERP"), which was approved by the Court in
March 2002. This charge is included in Charges for BlueLight.com and other in
our unaudited Condensed Consolidated Statements of Operations.
Markdowns for inventory liquidation
For the 13 and 26 week periods ended July 31, 2002, we recorded
charges of $27 and $785, respectively, to write-down inventory liquidated at our
283 closing stores to net realizable value, given the accelerated liquidation
strategy. This charge is included in Cost of sales, buying and occupancy in the
unaudited Condensed Consolidated Statements of Operations.
For the year, $348 of the charge was recorded relating to the
write-down of inventory initially existing at the closing stores to its
estimated selling value in connection with liquidation sales in the 283 stores.
During the liquidation sale the actual markdowns required to liquidate the
inventory were lower than expected. As a result, in the second quarter, we
recorded a credit of $36 to adjust our estimate. In addition, $117 of the charge
related to liquidation fees and expenses associated with the disposition of
inventory through the liquidation sales at the 283 closing stores, of which $9
was recorded in the second quarter.
26
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND
FINANCIAL CONDITION - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
The remaining $320 was recorded relating to the acceleration of
markdowns on approximately 107,000 stock keeping units ("SKUs"), the majority of
which were transferred from our remaining open stores to the 283 closing stores
and included in the liquidation sales. The liquidation of these SKUs required
higher markdowns than anticipated, accordingly, an adjustment of $54 was
recorded in the second quarter of 2002. The SKUs that were not transferred from
our remaining open stores to the closing stores as part of the liquidation sales
are no longer carried as part of our product assortment in our remaining open
stores and have been further reduced to their adjusted net realizable value.
The following table summarizes the components of the charge for
markdowns for inventory liquidation during the 26 week period ended July 31,
2002:
Writedown Accelerated
of Inventory Markdown
in the 283 Liquidator of
Closing Fees and Discontinued
Stores Expenses SKUs Total
----------------------------------------------------
First Quarter $ 384 $ 108 $ 266 $ 758
Second Quarter
Adjustments for actual selling values (36) - 54 18
Additional fees and expenses - 9 - 9
----------- --------- ------------- ------
Total $ 348 $ 117 $ 320 $ 785
=========== ========= ============= ======
Accelerated depreciation
On September 6, 2001, we announced that we would restructure
certain aspects of our supply chain operations. Part of the restructuring
included implementing new real-time distribution software across our supply
chain improving product flow and efficiency. Completion of the implementation is
expected by mid 2004. The existing supply chain software will continue to be
utilized until replaced in 2004. Depreciation has been accelerated to reflect
the revised remaining useful lives. We recorded a charge of $5 and $9 for the 13
and 26 week periods ended July 31, 2002, respectively, related to the
accelerated depreciation for these assets. For the 13 and 26 week periods ended
July 31, 2002, $2 of the charge is included in SG&A and $3 and $7 of the charge
is included in Cost of sales, buying and occupancy, respectively, in the
unaudited Condensed Consolidated Statements of Operations.
In the fourth quarter of fiscal 2001 we recorded a non-cash
charge for the impairment of long-lived assets in accordance with SFAS No. 144.
Included in the charge was the write-down to fair value of long-lived assets at
our 283 stores for which we received Court approval to close. Depreciation on
the remaining asset values were accelerated to reflect the revised useful lives
and the assets were fully-depreciated by the end of the second quarter of fiscal
2002. We recorded charges of $4 and $18 for the 13 and 26 week periods ended
July 31, 2002, respectively, related to the accelerated depreciation on these
assets. The charges are included in Cost of sales, buying and occupancy in the
unaudited Condensed Consolidated Statements of Operations.
BlueLight.com
We recorded a $92 charge ($73, net of tax) related to our
e-commerce site, BlueLight.com, in the second quarter of fiscal 2001, comprised
of $41 for the impairment of our investment in BlueLight.com and $51 for the
restructuring of our e-commerce business. These charges are included in the line
Charges for BlueLight.com and other in our unaudited Condensed Consolidated
Statements of Operations.
Based upon the changing environment for internet businesses, in
which the ability for such businesses to raise capital was restricted,
management's revised future cash flow projections and the potential need for
significant additional cash advances, we adopted a multi-step plan to
substantially restructure the operations of BlueLight.com.
The initial step was executed by acquiring the remaining 40%
interest in BlueLight.com, LLC, through the purchase of all outstanding common
and preferred stock of BlueLight.com, Inc., a holding company. BlueLight.com,
Inc. and BlueLight.com LLC (hereinafter together or individually,
"BlueLight.com") then became wholly-owned
27
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND
FINANCIAL CONDITION - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
subsidiaries of Kmart, which allowed us to execute our restructuring plan. The
purchase price of the additional interest was $85, with $69 being satisfied
through the issuance of 6.1 million unregistered shares of Kmart common stock
and $16 paid in cash. Based upon the revised cash flow projections for the
business, we recorded a $41 charge to write-down our investment in BlueLight.com
to fair value in accordance SFAS No. 144. Fair value was determined using the
present value of estimated future cash flows. In connection with the
acquisition, the return of capital put rights were terminated, the $62.5
liability was relieved, and the 4.4 million warrants for Kmart common stock
issued to SOFTBANK and other investors were cancelled.
Of the $51 restructuring charge, $29 related to assets impaired
as a result of the restructuring. These assets represent furniture and fixtures,
leasehold improvements, and computer software and hardware, the majority of
which were located in the headquarters of BlueLight.com, and were not utilized
in the restructured operations. These assets were reduced to the lower of
carrying amount or fair value less cost to sell in accordance with SFAS No. 144.
Fair value was determined using the present value of estimated future cash
flows. Liabilities for lease terminations, contract terminations and other costs
totaling $22 were established as a result of the decision to exit the
BlueLight.com headquarters building and outsource certain aspects of our overall
e-commerce business, including fulfillment, technology and customer service. See
Note 15 of the unaudited Condensed Consolidated Financial Statements presented
herein for a summary of reserve activity.
The results of BlueLight.com's operations were fully consolidated
in our financial statements commencing July 31, 2001.
Employee severance and VERP
During the first quarter of 2001, our workforce was reduced by
350 employees through a voluntary early retirement program ("VERP") and other
employee separations. The total cost of the realignment aggregated $23 ($15, net
of tax), which is included in our unaudited Condensed Consolidated Statement of
Operations for the quarter ended August 1, 2001 in the line item Charges for
BlueLight.com and other. The charge relates to 130 employees that accepted the
VERP offer, with costs aggregating $6. The remaining 220 employees were severed
and given post-employment benefits including severance, outplacement services,
continuation of healthcare benefits and other benefits totaling $17. Of the
charge, $19 was reserved for and was paid out of our general corporate assets,
including benefits for highly-compensated employees accepting the VERP offer,
and the remaining $4 was paid out of the Kmart Employee Pension Plan.
REORGANIZATION ITEMS, NET
Reorganization items, net represent amounts we incurred as a
direct result of Chapter 11 and are presented separately in the unaudited
Condensed Consolidated Statements of Operations. For the 13 and 26 week periods
ended July 31, 2002, respectively, the following have been recorded:
13 26
Weeks Weeks
Ended Ended
------ ------
2002 store closings $ (10) $ 218
Professional fees 29 67
Employee costs 37 63
Settlement of pre-petition liabilities (20) (34)
Sale of pharmacy lists (1) (18)
Interest income (5) (9)
Lease auction (2) (2)
Other (15) (7)
----- -----
Total $ 13 $278
===== =====
28
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND
FINANCIAL CONDITION - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
The following paragraphs provide additional information
to costs that were recorded in the line Reorganization items, net in our
unaudited Condensed Consolidated Statement of Operations for the 13 and 26 week
periods ended July 31, 2002:
2002 store closings
On March 20, 2002, the Court approved the closure of 283 stores.
Stores were selected by evaluating the market and financial performance of every
store and the terms of every lease. Candidates for closure were stores that did
not meet our financial requirements for ongoing operations. All of the stores
were closed as of June 2, 2002.
The results of operations of stores that have been closed are
reported in discontinued operations in accordance with SFAS No. 144 when a) the
operations and cash flows of the stores have been (or will be) eliminated from
our ongoing operations and b) we will not have any significant continuing
involvement in the operations of the stores after the closure.
We have evaluated the 283 stores closed during the second quarter
and determined that in substantially all the cases, the operations and cash
flows of the store will not be eliminated from our ongoing operations. The
results of operations of the limited number of stores that were considered to be
discontinued operations, based upon both quantitative and qualitative factors,
were not considered to be material for separate presentation in the unaudited
Condensed Consolidated Statement of Operations.
As a result of our conclusion that the 283 stores should be
reported in continuing operations, for the 13 and 26 week periods ending July
31, 2002, we recorded ($10) and $218, respectively, for expenses related to
store closings in fiscal year 2002 to our Reorganization items, net. We charged
$228 to our closed store reserve for allowable claims related to lease
terminations and other costs and reclassified $144 of capital lease obligations
to the closed store reserve during the first quarter of fiscal 2002. During the
second quarter of fiscal 2002, we recorded a credit of $10 to adjust our
estimated allowable claims. The closed store reserve is included in the line
Liabilities subject to compromise in our unaudited Condensed Consolidated
Balance Sheet as of July 31, 2002. The reserve for estimated costs was recorded
in accordance with EITF 94-3. See Note 15 for a summary of reserve activity.
Professional fees
For the 13 and 26 week periods ended July 31 2002, we recorded
$29 and $67, respectively, for professional fees. Professional fees include
financial, legal, real estate and valuation services directly associated with
our reorganization process.
Employee costs
In March 2002, we received Court approval to implement our KERP
which provides cash incentives and certain benefits to key members of our
salaried management team. The retention program provisions of KERP are expected
to encourage employees to continue their employment with Kmart through the
reorganization process. For the 13 and 26 week periods ended July 31, 2002, we
recorded charges of $37 and $63, respectively, for the KERP bonuses and
retention bonuses for associates in our 283 stores that were closed.
Settlement of pre-petition liabilities
For the 13 and 26 week periods ended July 31, 2002, we recorded
gains of $20 and $34, respectively, representing the difference between the
settlement value of certain pre-petition obligations and the amounts recorded
for allowable claims, primarily related to lease termination agreements between
Kmart and its landlords.
Lease auction
Kmart and certain subsidiaries entered into several Asset
Purchase and Designation Rights Agreements ("Agreements") with Kimco Realty
Corporation, Schottenstein Stores Corporation and Klaff Realty, LP and other
purchasers ("Purchasers"), in accordance with the bidding procedures order
entered on May 10, 2002. Under the terms
29
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND
FINANCIAL CONDITION - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
of the Agreements we have agreed to sell to the Purchasers either the
designation rights with respect to, or our interest in, 57 leaseholds for closed
stores. During the designation period, as defined under the Agreements, the
Purchasers of designation rights shall have the sole, exclusive and continuing
right to select, identify and designate (i) which leases shall be assumed and
assigned or subleased, and to whom and (ii) which properties shall be excluded
from the transaction.
In consideration for the leasehold and designation rights
acquisitions, the Purchasers are obligated to pay $46, of which $12 was paid in
cash during the second quarter of fiscal 2002. The remaining $34 is to be paid
as the Purchaser receives net proceeds from the sale or assignment of the
properties, but not later than December 31, 2002. The Purchasers, are
responsible for paying all carrying costs related to such properties during the
designation period in accordance with the Agreements. In addition, we may be
entitled to additional proceeds in the event that designation rights
transactions exceed a specified level of proceeds.
A pro-rata portion of the guaranteed proceeds of $46 will be
recognized into income at either the effective date of the property assignment,
when we are informed by the Purchasers of their intention to exclude certain
leaseholds from future assignments, or upon termination or upon expiration of
the designation rights period. At the time we are legally released as the
primary obligor under the lease agreement, the allowed claim amount established
in connection with the Court's approval of our plan to close and reject the
lease shall be reversed. Both the income from the sale of the designation rights
and the reversal of the allowed claim amount are reported in the unaudited
Condensed Consolidated Statement of Operations as reorganization items.
During the second quarter of fiscal 2002, two leases have been
terminated and one has been excluded, resulting in the recognition of $2 of
proceeds from the sale of designation rights. The remaining funds received have
been deferred and will be recognized in our unaudited Condensed Consolidated
Statement of Operations as the performance criteria associated with these funds
are completed.
Other reorganization items
For the 13 and 26 week periods ended July 31, 2002, we recorded
gains of $1 and $18 for the sale of pharmacy lists and $5 and $9 for interest
income earned on excess cash balances, respectively. We also recorded credits of
$15 and $7 for the 13 and 26 week periods ended July 31, 2002, respectively,
primarily to adjust our estimated allowable lease obligation claims.
DISCONTINUED OPERATIONS
During the second quarter of fiscal year 2002 we recorded a
non-cash credit of $20 to reduce reserves for our remaining lease obligations
for the Builder's Square, Inc., Hechinger Company, Pace Membership Warehouse,
Inc. and Furr's Restaurants locations. The $20 credit primarily relates to
adjustments to our estimated allowable claims for the lease obligations.
ADJUSTMENTS RELATED TO PRIOR PERIODS
Included in the current period operating results are charges
totaling $90, primarily relating to prior fiscal years. Such adjustments include
the write-off of $57 of costs formerly capitalized into inventory. Inventory
included amounts added for internal purposes to comparably analyze gross margin
across all business units and to optimize purchasing decisions. These amounts
are commonly referred to in the retail industry as "inventory loads." Largely,
they represent costs of sales accrued at the time of purchase (e.g. royalties
and internal buying commissions) or amounts loaded to add consistency to
business practices (e.g. import defective merchandise which cannot be returned
and advertising costs not supported by vendors). These inventory loads should
have been eliminated for external reporting purposes. The current period
adjustment establishes a reserve to fully offset the current level of inventory
loads remaining in our inventory balance at July 31, 2002. The remaining $33
relates to other miscellaneous adjustments.
Due to their classification as SG&A, advertising cost loads not
directly related to third party contracts have had the impact of increasing cost
of sales, buying and occupancy expenses and reducing SG&A expenses by $16 and
$33 for the 13 and 26 weeks ended July 31, 2002, respectively. Similarly, such
amounts in prior years totaled $14 and $27 for the 13 and 26 weeks ended August
1, 2001, respectively.
30
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL
CONDITION- (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
INTERNAL INVESTIGATION - RECENT DEVELOPMENTS
The following sets forth recent developments that have occurred since
the filing of Kmart's Annual Report on Form 10-K for fiscal year 2001 (the "2001
10-K") in connection with the internal investigation and related stewardship
review being conducted under the supervision of the Audit Committee of the Board
of Directors. As previously disclosed, following the receipt of anonymous
letters, the Board of Directors had instructed that an internal investigation be
undertaken under the supervision of the Audit Committee by outside legal
counsel, with the assistance of independent accounting advisors. The 2001 10-K
had reflected, as of the date of filing, the results of the investigation with
respect to various accounting matters. As of the date of the filing, we believed
that the investigation was complete with respect to accounting matters affecting
the financial statements in the 2001 10-K. Set forth below is a discussion of
certain matters relating to vendor allowances and inventories that have been
investigated since the filing of the 2001 10-K.
Vendor Allowance Matters
Since the filing of our 2002 10-K we became aware of documents that
indicated that there were certain vendor allowance transactions prematurely
recorded in our fiscal year 2000 fourth quarter financial statements which
required investigation. In that regard, the terms of the transactions as
reflected in supporting agreements with vendors, indicating that the related
funds were earned by Kmart in fiscal year 2000, did not consistently reflect
certain existing oral arrangements or separate written agreements with such
vendors. Based on our review of underlying agreements and discussions with
company personnel and vendors, we have determined that, as a result of the
premature recording of vendor allowances, the fiscal year 2000 net loss was
understated by approximately $38 ($26, net of tax), the fiscal year 2001 net
loss was overstated by approximately $78 (both before and after taxes) including
$18 ($12, net of tax) and $57 ($38, net of tax) with respect to the 13 and 26
week periods ended August 1, 2001, respectively, and results for future fiscal
years would have been understated by approximately $20. We also determined that
such early recognition of vendor allowances occurred in other prior fiscal
periods, although the impact of such transactions on our financial statements
was less significant. We have not restated our prior period financial statements
due to the immaterial effect of such adjustments, particularly in the light of
our filing of a voluntary petition for reorganization under Chapter 11 on
January 22, 2002.
Since the filing of our 2001 10-K, we have reviewed documents and
conducted interviews relating to vendor allowance transactions that were
prematurely recorded. It is important to note that although we have conducted
all procedures we deemed reasonable under the circumstances to identify and
quantify vendor allowances that were prematurely recorded, there can be no
assurance that we have captured all of such allowance transactions. Furthermore,
we believe that our ability to accurately identify prematurely recorded
allowance transactions diminishes with the passage of time. We have taken
actions to strengthen our internal controls concerning vendor allowance
transactions.
Inventory Matters
Following the filing of the 2001 10-K and in response to inquiries from
the staff of the SEC, we have conducted an internal inventory quality review
with respect to our 1999, 2000 and 2001 fiscal years. We continue to believe,
following the conclusion of this review, that our inventory balances during
these periods were, in all material respects, appropriately valued at the lower
of cost or market and that, therefore, our financial statements require no
adjustment for inventory quality matters. However, we have provided the
following additional information with respect to our historical inventory
markdown and reserve practices so as to enhance a reader's understanding of our
financial statements as presented in Management's Discussion and Analysis in the
2001 10-K.
2000 Strategic Actions Charge and Related Matters
During the second quarter of fiscal year 2000, we reported a $740
charge for strategic actions including the closure of certain stores,
acceleration of certain inventory reductions and redefining our information
technology strategy. The $740 charge included $290 for the estimated loss on
disposal for the accelerated liquidation of certain discontinued product, which
was characterized in Management's Discussion and Analysis of our 2001 10-K as a
"non-comparable" item. During the course of the recent internal inventory
review, we analyzed the assumptions of the charge related to the accelerated
liquidation of the discontinued merchandise, including historical markdown
cadences, or the timing for recognizing markdowns in our financial statements,
for discontinued product. In carrying out such review, current management
observed that the effect of an accelerated markdown cadence, combined with
certain transfer costs, approximated $156. In light of these observations
31
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL
CONDITION- (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
with respect to accelerated markdown cadences, current management noted that
approximately $134, the remaining portion of the charge, could have been viewed
as an operating item and, as such, not reported as a "non-comparable" item.
Similarly, current management observes that if the $134 portion of the charge
had been reflected as an operating item, it could have been recorded against an
existing inventory reserve.
Inventory Valuation Reserves
At the end of fiscal year 1999, Kmart had designated valuation reserves
related to its discontinued and aged seasonal merchandise inventories of $63, as
well as general reserves existing in its LIFO provision of $158. In light of
these reserves, the inventory at the end of fiscal 1999 was, in the judgement of
current management, properly stated at the lower of cost or market in accordance
with generally accepted accounting principles. During the fourth quarter of
fiscal year 2000, the $158 general reserve that existed in our LIFO valuation
was recharacterized within inventory reserves as a reserve for markdowns on
discontinued and aged seasonal merchandise.
During the first quarter of 2001, we changed our method of recording
the effect of permanent markdowns and began to record them as a direct reduction
in the carrying value of the related inventory instead of being estimated and
recorded as a valuation reserve. At that time, the then existing reserves of
$172 for permanent markdowns on discontinued and aged seasonal merchandise were
applied directly to the marked-down merchandise. Accordingly, a permanent
markdown accrual was no longer necessary.
2001 Clearance Markdowns
As indicated in our 2001 10-K, inventory valuation is considered to be
one of our critical accounting policies as significant judgments and estimates
are required in determining merchandise markdowns, among other reasons. A number
of factors are considered in determining the timing and amount of merchandise
markdowns including rate of product sell-through, projected future demand, and
market conditions and weather conditions. The timing of such decisions may have
a significant effect on quarterly financial results.
During our recent internal inventory review, we noted that levels of
clearance markdowns in the second and third quarter of 2001 appeared low in
relation to historical markdown experience apparently as a result, among other
things, of decisions to minimize markdown activity and related charges in light
of Kmart's then operating performance. Although current management found that
inventory balances had been properly stated, in all material respects, under our
policy of valuing inventory at the lower of cost or market value during each of
the quarterly periods of 2001, current management noted that the lower markdowns
in the second and third quarters of 2001 served to increase reported earnings in
those quarters and increase markdowns and decrease reported earnings in the
first and fourth quarters. For example, we observed that had markdowns been
taken in each quarter of 2001 in a manner which, on a percentage of sales basis,
corresponded to the average of the markdowns taken, on a quarterly basis, during
fiscal years 1998, 1999 and 2000, excluding the effect of special events such as
store closings, the level of clearance markdowns in 2001 could have been
increased by $55 and $105 in the second and third quarters, respectively, and
reduced by $40 and $120 in the first and fourth quarters, respectively. The
actual effect, however, that a different markdown practice could have had on our
quarterly net income for the full fiscal year is difficult to predict, given the
numerous other factors, estimates and assumptions that would affect our results.
OTHER MATTERS
Guarantees
32
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL
CONDITION- (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
As of July 31, 2002, we had outstanding guarantees for real property
leases of certain former subsidiaries as follows:
Present Value of
Future Lease Gross Future
Obligations @ 7% Lease Obligations
--------------------- ---------------------
The Sports Authority, Inc. $ 176 $ 298
Borders Group, Inc. 85 144
OfficeMax, Inc. 62 90
---------- ----------
Total $ 323 $ 532
========== ==========
Our rights and obligations with respect to our guarantee of The Sports
Authority, Inc., OfficeMax, Inc. and Borders Group, Inc. leases are governed by
Lease Guaranty, Indemnification and Reimbursement Agreements dated as of
November 23, 1994, November 9, 1994 and May 24, 1995, respectively, as amended
from time to time. Should a reserve be required, it would be recorded at the
time the obligation was determined to be both probable and estimable. Kmart's
contingent obligation is dependent on the future operating results of these
former subsidiaries and is subject to settlement under a plan of reorganization
to be voted upon creditors and equity holders and approved by the Court.
In addition, as of July 31, 2002, we had guaranteed $72 of indebtedness
of other parties related to certain of our leased properties financed by
industrial revenue bonds. These agreements expire from 2004 through 2009. Our
contingent obligation is dependent on the future operating results of the
parties whose debt we guarantee and is subject to settlement under a plan of
reorganization to be voted upon by creditors and equity holders and approved by
the Court.
Key Brand Partners
On March 20, 2002, the Court authorized our business relationships with
several key brand partners. Motions were approved allowing Kmart to assume our
license agreements with Martha Stewart Living Omnimedia, Inc. for Martha Stewart
Everyday home, garden, colors, baby, kitchen, keeping and decorating products,
along with candles and accessories; Jaclyn Smith G.H. Production, Inc. for
Jaclyn Smith women's apparel, jewelry and accessories; Kathy Ireland World Wide,
Inc. for Kathy Ireland women's apparel, accessories and exercise equipment;
Disney Enterprises, Inc. for Disney apparel for infants and children; and Joe
Boxer Licensing, LLC. for JOE BOXER apparel, accessories and home furnishings.
On May 29, 2002, the Court authorized our business relationship with
Sesame Workshop. Motions were approved allowing Kmart to assume our license
agreement with Sesame Workshop for Sesame Street infants and children's apparel.
On July 24, 2002 the Court approved our motion allowing Kmart to assume
our license agreement for our proprietary Route 66 apparel line.
Our key brand partners will continue to be a key element in our
merchandising and marketing initiatives. As a result, a decline in the demand
for our key brands or their failure to achieve or maintain broad market
acceptance, could have a material effect on our results of operations.
Penske
On April 9, 2002, we reached an agreement with Penske Corporation,
Penske Auto Centers, Inc., and Penske Auto Centers, LLC (collectively "Penske")
whereby all parties would work together to achieve an orderly wind-down of
operations at auto service centers at more than 563 Kmart stores in 44 states
following Penske's unilateral decision to
33
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL
CONDITION- (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
close the business as of April 6, 2002. This matter has not had a material
adverse affect on our liquidity, financial position or results of operations.
34
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
At July 31, 2002, we did not have any derivative instruments that
increased our exposure to market risks for interest rates, foreign currency
rates, commodity prices or other market price risks. We do not use derivatives
for speculative purposes. Currently, our exposure to market risks results
primarily from changes in interest rates, principally with respect to the DIP
Credit Facility, which is a variable rate financing agreement. We do not use
swaps or other interest rate protection agreements to hedge this risk.
35
4. CONTROLS AND PROCEDURES
We have implemented certain enhancements, or are in the process of
enhancing internal controls relating to vendor allowance transactions and
inventory control. Our actions related to vendor allowances include, among
others, revising the vendor allowance transaction reporting form, providing
additional training to employees concerning financial reporting obligations with
an emphasis on vendor allowance transactions, establishing additional internal
committees to review, on a regular basis, our efforts in this area and providing
additional management oversight of vendor allowances.
With respect to inventory control, we have consolidated the
responsibility for merchandise planning and replenishment functions under one
executive, implemented a policy requiring that disposition strategies be
prepared for all items not designated for future replenishment,
developed/improved a number of exception reports to enhance our ability to
prevent and/or identify potential inventory valuation issues, and have
established a cross-functional senior management team to regularly review
inventory control issues.
Additionally, we recently conducted mandatory training on our Code of
Conduct and have appointed new management over our internal audit department.
We also intend to conduct a review of our internal control procedures
with a view towards making improvements as deemed appropriate.
36
PART II. OTHER INFORMATION
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
As a result of its Chapter 11 filing, Kmart has not made principal or
interest payments on unsecured indebtedness incurred prior to January 22, 2002.
In addition, Kmart is not permitted to pay dividends on its trust convertible
preferred securities. The dividend arrearage on the trust convertible securities
from December 18, 2001 through July 31, 2002 is approximately $36 million.
ITEM 5. OTHER INFORMATION
Kmart has made the following executive officer changes since the filing
of its Annual Report on Form 10-K for the 2001 fiscal year, filed on May 15,
2002:
William D. Underwood was appointed Executive Vice President, Kmart
Sourcing and Global Operations, effective as of June 3, 2002. Kmart has entered
into an employment agreement with Mr. Underwood. Previously, he was Senior Vice
President, Global Operations, Corporate Brands and Quality Assurance before
retiring from Kmart in May of 1999.
Randy L. Allen has assumed a new position with Kmart. Effective as of
July 15, 2002, Ms. Allen assumed the role of Senior Vice President, Strategic
Planning and Business Initiatives. The terms of her employment have been amended
to reflect her new non-executive officer position. Previously, she was Executive
Vice President, Strategic Initiatives and Chief Diversity Officer.
In addition to the executive officers set forth in the Annual Report on
Form 10-K for the 2001 fiscal year, James E. Defebaugh, IV, serves as Senior
Vice President, Chief Compliance Officer and Secretary. Mr. Defebaugh was
appointed to his current position as of March 11, 2002. Previously, he was Vice
President, Associate General Counsel and Secretary.
The employment of Cecil B. Kearse, Executive Vice-President,
Merchandising, was terminated effective May 31, 2002. Kmart notified Mr. Kearse
that it was reserving the right to determine its rights and obligations under
Mr. Kearse's employment agreement.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) The following exhibits are filed as a part of this report:
Exhibit 4.1 - Amendment to $2 Billion Senior Secured
Debtor-in-Possession Financing Facility, effective
August 23, 2002.
Exhibit 10.1 - Janet G. Kelley Form of 2001 Special Retention
Agreement.
Exhibit 10.2 - William D. Underwood 2002 Employment Agreement.
Exhibit 10.3 - Janet G. Kelley Promissory Note
Exhibit 99.1 - CEO Certification pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
Exhibit 99.2 - CFO Certification pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
(b) Reports on Form 8-K: We filed the following Current Reports on Form 8-K
with the SEC during the 13 weeks ended July 31, 2002:
1. May 9, 2002 - Notice of Filing, dated May 6, 2002, of slides
presented at the Section 341 Meeting of Creditors on May 2,
2002, and the slides presented at the Section 341 Meeting of
Creditors on May 2, 2002.
2. May 23, 2002 - Monthly Operating Report for the period from
March 28, 2002 to May 1, 2002, as filed with the Bankruptcy
Court.
3. June 21, 2002 - Monthly Operating Report for the period from
May 2, 2002 to May 29, 2002, as filed with the Bankruptcy
Court.
4. July 22, 2002 - Monthly Operating Report for the period from
May 30, 2002 to June 26, 2002, as filed with the Bankruptcy
Court.
37
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this Report to be signed on its behalf by the
undersigned, thereunto duly authorized.
The signatory hereby acknowledges and adopts the typed form of his/her name in
the electronic filing of this document with the Securities and Exchange
Commission.
Date: September 16, 2002
Kmart Corporation
----------------------------------------
(Registrant)
By: /s/ James B. Adamson
----------------------------------------
James B. Adamson
CHAIRMAN OF THE BOARD AND CHIEF
EXECUTIVE OFFICER
(Principal Executive Officer)
/s/ A. A. Koch
----------------------------------------
A. A. Koch
CHIEF FINANCIAL OFFICER
(Principal Financial Officer)
/s/ Richard J. Noechel
----------------------------------------
Richard J. Noechel
VICE PRESIDENT AND
CONTROLLER
(Principal Accounting Officer)
38
CERTIFICATIONS
CEO Certification
I, James B. Adamson, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Kmart
Corporation;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report; and
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this quarterly report.
Date: September 16, 2002
/s/ James B. Adamson
- ---------------------
James B. Adamson
Chairman of the Board and
Chief Executive Officer
39
CFO Certification
I, Albert A. Koch, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Kmart
Corporation;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report; and
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this quarterly report.
Date: September 16, 2002
/s/ Albert A. Koch
- ------------------
Albert A. Koch
Chief Financial Officer
40
EXHIBIT INDEX
EXHIBIT NO. EXHIBIT DESCRIPTION
----------- -------------------
4.1 - Amendment to $2 Billion Senior Secured Debtor-in
Possession Financing Facility, effective August 23, 2002.
10.1 - Janet G. Kelley Form of 2001 Special Retention Agreement.
10.2 - William D. Underwood 2002 Employment Agreement.
10.3 - Janet G. Kelley Promissory Note
99.1 - CEO Certification pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
99.2 - CFO Certification pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.