KMART CORP - 10-K Annual Report

Back to GetFilings.com

- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------

SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-K

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED JANUARY 29, 2003

OR

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO .

COMMISSION FILE NO. 1-327

KMART CORPORATION
(Exact name of registrant as specified in its charter)

MICHIGAN 38-0729500
(State or other jurisdiction of incorporation (I.R.S. Employer Identification No.)
or organization)

3100 WEST BIG BEAVER ROAD -- TROY, MICHIGAN 48084
(Address of principal executive offices) (zip code)

REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE
(248) 463-1000

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE SECURITIES EXCHANGE ACT
OF 1934:

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE SECURITIES EXCHANGE ACT
OF 1934:
COMMON STOCK, $1.00 PAR VALUE
(Title of Class)

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of the Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]

Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2) Yes [X] No [ ]

The aggregate market value of voting stock including Common Stock held by
non-affiliates of the Registrant July 31, 2002 was $361,914,618.

As of March 14, 2003, 519,211,986 shares of Common Stock of the Registrant
were outstanding.
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------

PART I

ITEM 1. BUSINESS

HISTORY

Kmart Corporation is the nation's third largest discount retailer and the
sixth largest general merchandise retailer. Kmart Corporation ("Kmart," "we,"
"us" or "our") was incorporated under the laws of the State of Michigan on March
9, 1916, as the successor to the business developed by its founder, S.S. Kresge,
who opened his first store in 1899. Kresge was the first retailer to launch a
newspaper advertising program to entice shoppers to its stores. After operating
Kresge department stores for over 45 years, our store program commenced with the
opening of the first Kmart store in March 1962. In 1977, Kresge Corporation
officially changed its name to Kmart. In 1991, Kmart opened the first Kmart
Supercenter in Medina, Ohio, offering a full-service grocery along with general
merchandise twenty-four hours a day, seven days a week. To further expand the
reach of the company, in December 1999, Kmart, with its investment partners
launched a new internet presence, BlueLight.com which operates an e-commerce
site. Shoppers now know the site as www.kmart.com. Kmart continues to be the
leading print promotional retailer, with weekly circulars reaching more than 70
million households. Our principal executive offices are located at 3100 West Big
Beaver Road, Troy, Michigan 48084.

Our website address is www.kmart.com. We make available free of charge
through our website our annual report on Form 10-K, quarterly reports on Form
10-Q, current reports on Form 8-K and all amendments to those reports as soon as
reasonably practicable after such material is electronically filed with or
furnished to the Securities Exchange Commission.

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." Included in the 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 of such non-filing subsidiaries are not
considered material to the Consolidated Financial Statements. We are currently
operating our 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 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,
to pay selected vendors and other providers for pre-petition amounts owed, and
to honor customer service programs, including warranty returns, layaways and
gift certificates. Following the filing, we obtained, and received Court
approval for 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.
The DIP Credit Facility requires that we maintain certain other financial
covenants and restricts liens, indebtedness, capital expenditures, dividend
payments and sales of assets. Certain of these covenants were successfully
amended and approved by the Court during the year.

1

In connection with Kmart's Chapter 11 cases, the United States Trustee
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 entities, together with the Plan Investors (as defined below), with
which Kmart has negotiated the terms of our Plan of Reorganization.

On September 11, 2002, the United States Trustee filed an amended notice of
appointment for the financial institutions committee pursuant to which two
holders of Kmart's bond debt were added to the financial institutions committee.
These holders, ESL Investments ("ESL") and Third Avenue Value Fund (together,
the "Plan Investors"), have acquired a significant amount of our pre-petition
balance sheet debt and are actively participating in the statutory committee
process and the Chapter 11 cases, including with respect to supporting our
emergence from Chapter 11 on the expedited timeframe we previously reported. The
Plan Investors have entered into an Investment Agreement with Kmart which is
described below.

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 approved by the
Court.

In addition, 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, some of which may be significant.
In addition, 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 some liabilities shown on our financial statements as
subject to compromise to post-petition liabilities. Kmart has incurred, and will
continue to incur pending emergence, significant costs associated with the
reorganization.

We filed with the Court, on April 15, 2002, 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 are subject to further amendment or
modification. We mailed notices to all known creditors that the deadline for
filing proofs of claim with the Court was July 31, 2002, with certain limited
exceptions for extensions granted by the Court. Kmart has amended the schedules
and statements of financial affairs previously filed with the Court to include
the names and addresses of certain personal injury and related creditors who
were inadvertently omitted from such filings and has filed a motion for an order
establishing a supplemental bar date for the filing of proofs of claim by such
creditors. Differences between amounts scheduled by Kmart and claims by
creditors are being 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 and claims filed, will take time to complete.
Accordingly, the ultimate number and amount of allowed claims is not presently
known.

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 real estate disposition matters, we have obtained orders
providing for, among other things, (i) implementation of a key employee
retention and incentive program ("KERP"), (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 numerous mechanics and materialmen's liens,

2

(vii) approval of standing bidding procedures to be utilized in connection with
asset sales, (viii) authority to compromise or settle certain classes of de
minimis controversy and allowed claims with encumbrances and to pay market rate
broker commissions in connection with such sales without further court approval,
(x) assumption of agreements with our key brand partners and other key vendor
partners and (xi) approval of an exit financing facility.

As provided by the Bankruptcy Code, the Debtors initially had the exclusive
right to solicit a plan of reorganization for 120 days. After several Court
approved extensions, on February 25, 2003, the Court extended to June 20, 2003
the period in which Kmart had the exclusive right to file a plan of
reorganization and extended to August 29, 2003 the period in which Kmart has the
exclusive right to submit acceptances to the plan.

On January 24, 2003, we filed a Plan of Reorganization and related
disclosure statement with the Court. On February 25, 2003, we filed our First
Amended Joint Plan of Reorganization (the "Plan of Reorganization" or the
"Plan") and a related amended disclosure statement (the "Disclosure Statement")
with the Court. The Plan of Reorganization received the formal endorsement of
our statutory creditors committees and, on February 25, 2003, the Court approved
our amended Disclosure Statement. All holders of claims as of February 18, 2003
received the Disclosure Statement, which was mailed to creditors and
shareholders on or about March 7, 2003. We are presently scheduled to seek
confirmation of the Plan of Reorganization by the Court at a hearing scheduled
for April 14 and 15, 2003 and to emerge from Chapter 11 by April 30, 2003.

Pursuant to the Plan of Reorganization, holders of our pre-petition bank
debt (other than the Plan Investors) will receive 40 cents for each dollar of
debt, holders of pre-petition notes and debentures, trade creditors, service
providers and landlords with lease rejection claims will share in the stock of
the reorganized company (other than shares held by the Plan Investors). The Plan
Investors, in accordance with the terms of the Investment Agreement with Kmart,
will invest: (i) at least $140 million in exchange for stock in the reorganized
company and (ii) up to $60 million for a convertible note of the reorganized
company. In addition, ESL has agreed that the cash that it would receive under
the Plan of Reorganization as a pre-petition lender, approximately $152 million,
will be used to purchase additional shares of common stock in the reorganized
company.

In light of the terms of the Investment Agreement and the Plan Investors'
holdings of pre-petition claims, upon consummation of the Plan, it is expected
that the Plan Investors will own slightly more than 50% of the Kmart common
stock that will be then outstanding.

The Plan of Reorganization also contemplates the establishment of a
creditor litigation trust (the "Creditor Trust") for the benefit of Kmart's
creditors and, subject to the receipt of requisite votes from classes under the
Plan of Reorganization, holders of trust preferred securities and/or common
stock, to pursue all causes of action arising out of our stewardship
investigation. Except for a minor interest of up to 2.5% of the proceeds, if
any, of the Creditor Trust, current holders of Kmart's common stock would not
receive any distributions following emergence and their equity interests would
be cancelled. As provided in the Plan of Reorganization, upon consummation of
the Plan of Reorganization the interests represented by the trust preferred
securities will be cancelled. Distributions to holders of trust preferred
securities will also be limited to recoveries from the Creditor Trust, as
provided for in the Plan of Reorganization. The interests represented by the
trust preferred securities will also be cancelled.

Until Kmart's Plan of Reorganization is confirmed by the Court the
recoveries of holders of pre-petition claims are subject to change. However, if
the final plan of reorganization confirmed by the Court is consistent with the
Plan of Reorganization recently filed, it would result in the cancellation of
the existing Kmart common stock with holders thereof receiving no distributions
under the Plan other than, possibly, for a minor interest in the Creditor Trust.
In addition, under certain conditions specified in the Bankruptcy Code, a plan
of reorganization may be confirmed notwithstanding its rejection by an impaired
class of creditors or equity holders and notwithstanding the fact that equity
holders do not receive or retain property on account of their equity interests
under the plan. In light of the foregoing, Kmart considers, the value of the
common stock to be highly speculative and cautions equity holders that the stock
may ultimately be determined to have no value. Accordingly, Kmart urges that
appropriate caution be exercised with respect to existing and future
3

investments in the Kmart common stock or in any claims related to pre-petition
liabilities and/or other Kmart securities.

The Plan of Reorganization and the transactions contemplated thereunder are
more fully described in the Disclosure Statement, which we filed as Exhibit 2.2
to our Current Report on Form 8-K dated March 7, 2003. The Disclosure Statement
includes detailed information about the Plan of Reorganization, Kmart's
five-year business plan, financial estimates regarding Kmart's reorganized
business enterprise value including support for the "best interest" requirements
for the Plan of Reorganization under the Bankruptcy Code; and events leading up
to Kmart's Chapter 11 case. Nothing contained in this Form 10-K is intended to
be, nor should it be construed as, a solicitation for a vote on the Plan of
Reorganization, which can only occur based on the official disclosure statement
package that, as described above, was being mailed on or about March 7, 2003.

The ability of Kmart to continue as a going concern is predicated upon
numerous issues, including our ability to achieve the following:

- having the Plan of Reorganization confirmed by the Court in a timely
manner;

- being able to successfully implement our business plans and otherwise
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 and/or the Exit
Financing Facility, including limitations on capital expenditures and its
financial covenants, our ability to generate cash flows from operations
or seek other sources of financing and the availability of projected
vendor credit terms; and

- attracting, motivating and/or retaining key executives and associates.

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" in
Item 7. Management's Discussion and Analysis of Results of Operations and
Financial Condition.

Upon emergence from bankruptcy, the amounts reported in subsequent
financial statements may materially change due to the restructuring of Kmart's
assets and liabilities as a result of the Plan of Reorganization and the
application of the provisions of Statement of Position ("SOP") 90-7, "Financial
Reporting by Entities in Reorganization under the Bankruptcy Code," ("SOP 90-7")
with respect to reporting upon emergence from Chapter 11 ("Fresh-Start"
accounting). Changes in accounting principles required under generally accepted
accounting principles ("GAAP") within twelve months of emerging from bankruptcy
are required to be adopted at the date of emergence. Additionally, we may choose
to make changes in accounting practices and policies at this time. For all these
reasons, our financial statements for periods subsequent to emergence from
Chapter 11 will not be comparable with those of prior periods. For details on
our currents expectations of those changes see the Disclosure Statement, which
we filed as Exhibit 2.2 to our Current Report on Form 8-K dated March 7, 2003.

The Consolidated Financial Statements contained herein 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 SOP 90-7. Please refer to Item 7. Management's Discussion
and Analysis of Results of Operations and Financial Condition, and Note 1 of the
Notes to Consolidated Financial Statements in Item 8. Financial Statements and
Supplementary Data, for additional information.

OPERATIONS

We operate in the general merchandise retailing industry through 1,829
Kmart discount stores with locations in 50 of the United States, Puerto Rico,
the U.S. Virgin Islands and Guam as of January 29, 2003, and through our
e-commerce shopping site, www.kmart.com. Our general merchandise retail
operations are located in 314 of the 331 Metropolitan Statistical Areas in the
United States. Kmart stores are generally one-floor,

4

free-standing units ranging in size from 40,000 to 194,000 square feet with an
average size of 98,000 square feet.

We currently operate 114 Kmart Supercenters that combine a full grocery,
deli, bakery, video rental and 24 hour/seven-days-a-week availability along with
the general merchandise selection of a Kmart discount store. Kmart Supercenters
currently represent the fourth largest super center operation in the United
States.

On January 28, 2003, the Court approved the closure of 326 stores located
in 40 states, which number was later reduced to 316 stores, or approximately 17%
of our 1,829 stores. Stores were selected by evaluating the market and financial
performance of every store and the terms of every lease. Several factors were
considered in the store closing analysis, including historical and projected
operating results; the anticipated impact of current and future competition;
future lease liability and real estate value; store age, size, and capital
spending requirements; the expected impact of store closings on Kmart's
competitive position; the estimated potential savings from exiting markets and
regions; the potential impact of store closings on purchasing power and
allowances; and the potential impact of store closings on market coverage.
Shortly after receiving Court approval, we commenced store closing sales. We
anticipate closing these locations in the first quarter of fiscal 2003, after
liquidation sales have been completed. We anticipate that approximately 34,000
employees will be impacted by these closures. These store closings include 54
Kmart Supercenters.

Kmart has relationships with more than 4,000 merchandise vendors worldwide
and is one of the countries largest purchasers of products in the United States.

Our fiscal year ends on the last Wednesday in January. Fiscal year 2002
consisted of 52 weeks and ended on January 29, 2003. Fiscal year 2001 consisted
of 52 weeks and ended on January 30, 2002. Fiscal year 2000 consisted of 53
weeks and ended on January 31, 2001. Unless otherwise stated, 2003, 2002, 2001
and 2000 refer to fiscal year 2003, fiscal year 2002, fiscal year 2001 and
fiscal year 2000, respectively.

COMPETITION

We have several major competitors on a national level, including Wal-Mart,
Target, Sears, Kohl's, and J.C. Penney, and many competitors on a local and
regional level which compete with our individual stores. In 2002, we experienced
a decrease in market share due to our store closings and the aggressive growth
of our major competitors. We expect that this trend will continue due to our
planned store closures in 2003, limited growth plans post-emergence and to the
projected store openings of our major competitors. Success in this competitive
market is based on factors such as price, quality, service, product assortment
and convenience.

STRATEGY

Our business plan, a summary of which is included in the Disclosure
Statement, contemplates that we will continue to implement several key
operational initiatives, including our focus on being "the store of the
neighborhood," an approach to servicing our customers which allows individual
store managers to customize their merchandise assortments to suit local
community needs and allows greater focus on high-volume and advertised items.
The "top sellers" program also focuses on improving sales and in-stock positions
for each of the store's top 300 selling items. Additionally, with further
testing of the "store of the future" prototype, we expect to achieve significant
improvements in the customer shopping experience. We intend to continue to
eliminate underperforming stock-keeping units (SKU's) and reallocate shelf space
to more profitable items.

We believe that with the continued support of our vendor partners through,
among other things, the vendor lien proposed in our Plan of Reorganization and
the $2 billion Exit Financing Facility we have arranged, we will be able to
continue to improve the shopping experience, win back customers we have
disappointed in the past and return to profitability.

Based upon the underperformance of sales and margin experienced under the
BlueLight Always pricing program, we eliminated the strategy in 2002 and our
marketing efforts were turned back to our roots as a high/low retailer. We have
successfully expanded and redesigned our weekly advertising circulars and have
implemented a strategic marketing plan aimed at Hispanics, Asians and African
Americans, who collectively comprise one of the fastest growing customer
segments. A key component of our merchandising and
5

marketing approach is brand positioning. Kmart believes that focusing our
merchandising and marketing approach on quality name brands builds customer
loyalty and increases customer frequency. We have successfully completed
initiatives to enhance our strategic positioning by offering exclusive brands
that will differentiate us from our competitors, including Martha Stewart
Everyday home, garden, colors, baby, kitchen, keeping and decorating products,
along with candles and accessories; Jaclyn Smith women's apparel, jewelry and
accessories; Kathy Ireland women's apparel, accessories and exercise equipment;
Sesame Street apparel for infants and children; Route 66 men's and women's
apparel and accessories; Curtis Mathis consumer video, audio and
telecommunications products; in the current year we have added Disney apparel
for infants and children and JOE BOXER apparel, accessories and home furnishings
and have signed an agreement with Thalia for junior's and women's apparel,
jewelry and accessories.

Kmart remains focused on being a leading discount retailer with promotional
pricing and exclusive national brands. We believe we can best maximize our
performance and improve our market position by continuing to focus on the
following key initiatives: driving profitable sales growth, controlling costs
and streamlining overhead, increasing asset productivity and improving customer
service.

Based upon the store closures in 2002 and the anticipated store closures in
2003, Kmart anticipates we will have eliminated approximately 57,000 positions
during the Chapter 11 reorganization. In part as a result of these store
closings and Kmart's overall cost-rationalization strategy, we have
significantly reduced our overhead costs.

We have also significantly improved our inventory management practices,
resulting in noticeable progress in keeping store shelves stocked with popular
items. These improvements stem from the implementation of new processes,
procedures and controls surrounding the inventory forecasting and replenishment
functions.

Information regarding our discontinued operations and dispositions appears
in Note 5 of the Notes to Consolidated Financial Statements in Item 8. Financial
Statements and Supplementary Data, of this Form 10-K.

Information regarding our analysis of operations and financial condition
appears in Item 7. Management's Discussion and Analysis of Results of Operations
and Financial Condition, of this Form 10-K.

SEASONALITY

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 cash flows are
generated in the fourth quarter. In preparation for the fourth quarter holiday
season, we significantly increase our merchandise inventories, which
traditionally have been financed by cash flows from operations, bank lines of
credit, trade credit and terms from vendors. Our profitability and cash flows
are primarily dependent upon the large sales volume generated during the fourth
quarter of our fiscal year. Fourth quarter sales represented 29% of total net
sales in fiscal 2002.

CREDIT SALES

Kmart and Capital One Financial Corporation ("Capital One") launched a
Kmart MasterCard on September 25, 2000. The Kmart MasterCard combines the
exclusivity of private label card benefits along with MasterCard's global
acceptance at more than 18 million locations. Capital One is the exclusive
issuer and creditor of the Kmart MasterCard and is responsible for the
evaluation and approval of credit applications for the Kmart MasterCard. As of
January 29, 2003, there were approximately 3,039,000 cardholders. Kmart bears no
credit risk or risk of loss with respect to any Kmart MasterCard account. The
former private label Kmart Credit Card through Household Bank (SB), N.A., a unit
of Household International, Inc. was discontinued in October 2000. In addition
to the Kmart MasterCard program, which is owned and operated by Capital One, all
of our stores accept major bank credit cards as payment for merchandise.

6

EMPLOYEES

We employed approximately 212,000 persons as of January 29, 2003, making us
one of the largest employers in the United States. We anticipate that our
employee base will decrease by over 34,000 as a result of the store closures and
headquarter reductions expected to be completed in the first quarter of fiscal
2003.

FOOD AND CONSUMABLES DISTRIBUTION AGREEMENT

In February 2001, we entered into an alliance with Fleming Companies, Inc.
("Fleming"). During the ten-year term of the agreement, Fleming was to supply
substantially all food, consumables and core pantry products in all current and
future Kmart stores and Kmart Supercenters. Under terms of the agreement,
Fleming provided procurement, storage, and logistics functions. Fees paid to
Fleming under the agreement for such services varied based on volume and other
factors. Due to increased capacity in our distribution centers after completing
our store closings in both 2002 and 2003, we have the ability to supply the food
and consumables products ourselves and manage the supply of food and consumables
by regional wholesalers at a significantly lower cost. Self-distribution should
additionally increase in-stock levels, particularly for advertised goods, and
should allow Kmart to cement relationships with individual food and consumable
vendors. As a result, on February 3, 2003 we announced that we had terminated
our supply relationship with Fleming by means of a rejection of the 2001
contract through Kmart's Chapter 11 reorganization. Fleming continued to supply
food and consumable products to us until March 8, 2003. We now facilitate the
supply of these products ourselves. Kmart has experienced minimal business
interruption in the transition. As part of the bankruptcy proceedings, Fleming
has filed a claim of $1.5 billion as of March 11, 2003. On March 18, 2003, we
came to an agreement with Fleming in regards to their claim, settling on a $15
million administrative claim and a $385 million pre-petition claim. This
agreement is subject to Court approval. Our estimate of our liability related to
this claim will be represented in our results of operations in the first quarter
of 2003.

EFFECT OF COMPLIANCE WITH ENVIRONMENTAL PROTECTION PROVISIONS

Compliance with federal, state and local provisions which have been enacted
or adopted regulating the discharge of materials into the environment, or
otherwise relating to the protection of the environment, has not had, and is not
expected to have, a material adverse effect on capital expenditures, earnings or
the competitive position of Kmart and its subsidiaries.

ITEM 2. PROPERTIES

At January 29, 2003, we operated a total of 1,829 general merchandise
stores which are located in the United States, Puerto Rico, the U.S. Virgin
Islands and Guam. We lease our store facilities, with the exception of 133
stores that we own. Our store leases are generally for terms of 25 years with
multiple five-year renewal options that allow us the option to extend the life
of the lease up to 50 years beyond the initial non-cancelable term. On January
29, 2003, the Court approved the closure of 326 stores in 40 states, and,
subsequently that number was reduced to 316 stores due to rent concessions
received from landlords at 10 stores.

We own our headquarters building in Troy, Michigan and lease an
administrative building in Royal Oak, Michigan. We own one distribution center
and lease 17 other distribution centers in the United States for initial terms
of 10 to 30 years with options to renew for additional terms. We intend to close
one distribution center that is a leased location.

A description of our leasing arrangements appears in Note 13 of the Notes
to Consolidated Financial Statements in Item 8. Financial Statements and
Supplementary Data, of this Form 10-K.

ITEM 3. LEGAL 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 Consolidated
Financial

7

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 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. We
presently expect, as determined in the Plan of Reorganization, 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 Item
1. Business Proceedings Under Chapter 11 of the Bankruptcy Code, of this Form
10-K.

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. A detailed
discussion of the investigation and stewardship review undertaken by counsel
under the supervision of the Audit Committee, as well as the results of such
investigation and review, is contained in the Disclosure Statement, which we
filed as Exhibit 2.2 to our Current Report on Form 8-K dated March 7, 2003.

Since February 21, 2002, five separate purported class actions have been
filed on behalf of purchasers of Kmart common stock. The initial complaints were
filed on behalf of purchasers of common stock between May 17, 2001 and January
22, 2002, inclusive, and named Charles C. Conaway, former 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, among other
things, 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. On October 15, 2002, an amended consolidated 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 former officers Jeffrey N. Boyer, Mark S. Schwartz, Matthew F.
Hilzinger, Martin E. Welch III, and PricewaterhouseCoopers LLP as defendants.
Kmart is not a defendant in this litigation by virtue of the automatic stay. On
July 31, 2002, attorneys for plaintiffs in the pending class action lawsuits
filed a class proof of claim in the Court (the "Class Proof of Claim") on behalf
of the plaintiffs and all purchasers of Kmart common stock between May 17, 2001
and January 22, 2002, inclusive. The Class Proof of Claim, which is asserted
against the Debtors, reserved the right to identify additional claimants or
members of the class group in the future. In support of the Class Proof of
Claim, the claimants rely on the above-referenced class actions filed against
the parties identified above. The claimants state that the grounds for liability
are alleged damages for violations of federal securities laws, including the
Securities Exchange Act of 1934, in connection with the purchase or acquisition
of Kmart common stock by the claimants during the class period. The Class Proof
of Claim alleges that the Debtors are liable to the claimants for damages in a
sum not presently determinable but believed to be not less than $700 million in
the aggregate, plus interest, costs and allowed attorneys' fees.

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
current and former employees and directors of Kmart alleging breach of fiduciary
duty under the Employee Retirement Income Security Act for excessive investment
in Kmart stock; failure to provide complete and accurate information about Kmart
common stock; and failure to provide accurate information regarding our
financial condition. Subsequently, amended complaints were filed that added
additional current and former employees and directors of Kmart as defendants.
Kmart is not a defendant in this litigation.

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 former CEO and Chairman of the Board of Kmart, as the sole
8

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 was not a defendant in
this litigation. On January 16, 2003, the District Court dismissed the
complaint. On February 14, 2003, a lawsuit was filed by the Softbank Funds
against Mr. Conaway in the Circuit Court of Cook County, Illinois. This lawsuit
seeks $33 million from the defendant for alleged breach of fiduciary duty in
connection with the failure of Kmart to cause the registration of the
plaintiffs' shares of Kmart common stock to become effective. This claim is
essentially the same as count I of the lawsuit that was dismissed on January 16,
2003.

In connection with the investigation by the United States Attorney in
Puerto Rico of alleged actions by Kmart's employees following the 1998 Hurricane
Georges, on October 28, 2002, Kmart's wholly owned subsidiary, S.F.P.R., Inc. a
Puerto Rico corporation, pled guilty to one count of mail fraud in violation of
18 U.S.C. Sections 1341 and 1342 pursuant to a plea agreement providing for a
three year probation period, a fine in the amount of $2 million and other
agreements. Kmart has paid the fine and taken certain other actions, none of
which have had a material adverse effect on Kmart's liquidity, financial
position or results of operations.

Kmart is a defendant in six putative class actions and one multi-plaintiff
case pending in California, all relating to Kmart's classification of assistant
managers and various other employees as "exempt" employees under the federal
Fair Labor Standards Act ("FLSA") and the California Labor Code and Kmart's
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
United States District Court for the Eastern District of California (Henderson
v. Kmart), the United States 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 could 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. We presently do not expect to have any
significant financial exposure as a result of these cases.

Kmart is a defendant in a putative class action pending in Oklahoma
relating to the proper payment of overtime to hourly associates under the FLSA.
The plaintiff claims he represents a class of all current and former Kmart
employees who have been improperly denied overtime pay. This case was filed on
March 4, 2003 and is currently pending in the U.S. District Court for the
Northern District of Oklahoma. At this time, the likelihood of a material
unfavorable outcome is not considered probable.

There is an increasing trend of high profile class action litigation,
particularly in the retail industry, against employers of large numbers of
people which allege violations of the FLSA. Other companies against which these
cases have been filed have paid significant settlements and/or had significant
judgments entered against them. Kmart has a large employee base; however, no
class actions against Kmart have yet been certified. The actions described above
are the only FLSA related matters that are currently pending against Kmart.

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. We assess the likelihood of potential losses on an ongoing
basis and when they are considered probable and reasonably estimable, we record
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.

9

In addition to the foregoing, there are numerous other matters filed with
the Bankruptcy 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 could be
negatively impacted by adverse determinations by the Court on certain of these
matters.

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

None.

PART II

ITEM 5. MARKET FOR KMART'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Our common stock and the trust preferred securities are presently being
quoted on the Pink Sheets Electronic Quotation Service maintained by the
National Quotation Bureau, Inc. The new ticker symbols KMRTQ and KMTPQ have been
assigned to our common stock and trust preferred securities, respectively, by
the over-the-counter bulletin board. There were approximately 76,658
shareholders of record of Kmart common stock as of March 1, 2003. As of December
19, 2002, our common stock and trust preferred securities were suspended from
trading by the NYSE and the Pacific and Chicago Exchanges and, thereafter,
delisted from such exchanges.

The quarterly high and low sales prices for our common stock for the two
most recent fiscal years are set forth below:

10

ITEM 6. SELECTED FINANCIAL DATA

The table below summarizes our recent financial information. For further
information, refer to our Consolidated Financial Statements and Notes to
Consolidated Financial Statements in Item 8. Financial Statements and
Supplemental Data, of this Form 10-K.

- ---------------

(1) Our fiscal year ends on the last Wednesday in January. Fiscal 2000 consisted
of 53 weeks.

(2) Comparable store sales for 2000 are based on the 52 week period ended
January 24, 2001.

(3) Net (loss) income from continuing operations includes the following
non-comparable items: in 2002, $1,256 for inventory write-downs, $695 for
asset impairments, $50 for cost reduction initiatives, and $26 for other
items; in 2001, $971 for asset impairments, $163 for supply chain
restructuring, $97 for BlueLight.com, and $23 for Voluntary Early Retirement
Program/Severance; in 2000, $728 ($463 net of tax) for strategic
initiatives; in 1999, $11 ($7 net of tax) to reflect the cumulative effect
of a change in accounting method for layaway sales; and in 1998, $19 ($13
net of tax) related to VERP.

(4) Consistent with the requirements of Statement of Financial Accounting
Standards No. 128, "Earnings per Share," preferred securities were not
included in the calculation of diluted earnings per share for 2002, 2001,
and 2000 due to their anti-dilutive effect.

(5) For fiscal years 2002 and 2001, working capital, long-term debt and current
ratio do not include liabilities classified as subject to compromise.

11

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS (DOLLARS IN MILLIONS, EXCEPT PER
SHARE DATA)

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION

This Form 10-K, 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 properly monitor 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 confirm and consummate the Plan of Reorganization in a
timely manner,

- 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,

12

- 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, the impairment of vendor relations and the
constraints placed on available capital,

- our ability to obtain and maintain normal terms with vendors and service
providers,

- the ability of our vendors to obtain satisfactory credit terms from
factors and other financing sources,

- 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 implement our long-term strategy and/or develop a 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.

Similarly, these and other factors, including the terms of the final
reorganization plan, if any, ultimately confirmed, can affect the value of our
various pre-petition liabilities, common stock and/or other equity securities.
Until Kmart's Plan of Reorganization is confirmed by the Court, the recoveries
of pre-petition claims holders are subject to change. Accordingly, no assurance
can be given as to what values, if any, will be ascribed in the bankruptcy
proceedings to each of these constituencies.

If the final plan of reorganization confirmed by the Court is consistent
with the Plan of Reorganization recently filed with the Court, it would result
in the cancellation of the existing Kmart common stock with holders thereof
receiving no distributions under the Plan of Reorganization other than,
possibly, for a minor interest in a creditor litigation trust to be established
pursuant to the Plan of Reorganization. In light of the foregoing, Kmart
considers the value of the common stock to be highly speculative and cautions
equity holders that the stock may ultimately be determined to have no value.
Accordingly, Kmart urges that appropriate caution be exercised with respect to
existing and future investments in Kmart common stock or any claims relating to
pre-petition liabilities and/or other Kmart securities.

OVERVIEW

As a result of a rapid decline in our liquidity resulting from our
below-plan sales and earnings performance in the fourth quarter of fiscal year
2001, the evaporation of the surety bond market, an erosion of supplier
confidence, intense competition, unsuccessful sales and marketing initiatives,
the continuing recession, and recent capital market volatility, Kmart and 37 of
its U.S. subsidiaries filed voluntary petitions for reorganization under Chapter
11 of the Bankruptcy Code in the Court, on January 22, 2002.

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 pre-petition contractual
obligations generally may not be enforced against Kmart. 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 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.

Following the filing for protection under Chapter 11, we obtained, and
received Court approval for, a $2 billion senior secured DIP Credit Facility for
payment of permitted pre-petition claims, working capital needs, letters of
credit and other general corporate purposes. The DIP Credit Facility requires
that we maintain certain financial covenants and restricts future liens,
indebtedness, capital expenditures, dividend
13

payments and sale of assets. A description of the DIP Credit Facility appears
under "Analysis of Financial Condition."

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 June 18, 2002, we completed an auction, in which 57 of the 283 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 Purchaser of 54 leases achieves a
certain level of proceeds on its sale of these leases. Designation rights allow
the purchasers to put the leases back to Kmart prior to any assignment or
termination of such leases. 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 for which we were authorized to sell designation
rights, 23 have been assigned, four have been terminated or rejected under
landlord agreements and nine have been excluded and rejected as of the end of
fiscal 2002. Two additional leases were excluded and rejected during the first
quarter of fiscal 2003. Six additional leases were approved for assignment
during the fourth quarter of fiscal 2002. These six leases were assigned during
the first quarter of fiscal 2003. The Purchaser of our interest in the remaining
closed store leasehold defaulted under its Agreement and the lease was rejected.
In addition, pursuant to the auction and bidding procedures, we entered into
lease termination agreements for 11 of the 283 leases for the aggregate amount
of $20 and the waiver of certain leasehold and rejection damages claims. There
was no successful bidder on the remaining leases which were rejected.

On September 24, 2002, the Court approved our request to pay eligible
reclamation claimants 75% of allowed reclamation claims in full satisfaction of
these claims. Payments were required by November 20, 2002 or 30 days after a
claimant elects to receive such payment. Vendors who elect to receive 75% of
their reclamation claims are required to comply with certain terms. We have paid
reclamation claims of approximately $18. Alternatively, holders of allowed
reclamation claims may elect to receive 100% of such claims when we emerge from
Chapter 11. As of March 20, 2003, out of a total of 693 reclamation claims, we
have settled 680 claims for a total of approximately $122.

On January 28, 2003, the Court approved the closure of 326 stores located
in 40 states, which number was later reduced to 316, or approximately 17% of our
1,829 stores. Stores were selected by evaluating the market and financial
performance of every store and the terms of every lease. Several factors were
considered in the store closing analysis, including historical and projected
operating results; the anticipated impact of current and future competition;
future lease liability and real estate value; store age, size, and capital
spending requirements; the expected impact of store closings on Kmart's
competitive position; the estimated potential savings from exiting markets and
regions; the potential impact of store closings on purchasing power and
allowances; and the potential impact of store closings on market coverage.
Shortly after receiving Court approval we commenced store closing sales. We
anticipate closing these locations in the first quarter of fiscal 2003, after
liquidation sales have been completed. We anticipate that approximately 34,000
employees will be impacted by these closures.

On February 3, 2003, we announced that we had terminated our supply
relationship with Fleming by means of a rejection of the parties' 2001 contract
through Kmart's Chapter 11 reorganization. Fleming continued to supply food and
consumable products to us until March 8, 2003. We now facilitate the supply of
these products ourselves. The transition to self-sourcing has not had a material
adverse effect on our results of operations. As part of the bankruptcy
proceedings, Fleming has filed a claim of $1.5 billion as of March 11, 2003. On
March 18, 2003, we came to an agreement with Fleming in regards to their claim,
settling on a $15 administrative claim and a $385 pre-petition claim. This
agreement is subject to Court approval. Our estimate of our liability related to
this claim will be represented in our results of operations in the first quarter
of 2003.

14

On February 25, 2003, the Court approved Kmart's Disclosure Statement with
respect to the Plan of Reorganization and authorized a balloting and
solicitation process that commenced on or about March 7, 2003 and is expected to
conclude on April 4, 2003. A hearing on confirmation of the Plan of
Reorganization is scheduled to commence in the Court on April 14, 2003. Assuming
confirmation of the Plan of Reorganization, we would plan to emerge by April 30,
2003. There can be no assurance, however, that the Plan of Reorganization will
be confirmed by the Court, or that such Plan of Reorganization will be
consummated; in addition, the timing of such actions may be other than currently
planned by Kmart. A Plan of Reorganization cannot become effective until
confirmed by the Court, upon certain findings being made by the Court which are
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. If it
is determined, as is expected, that liabilities subject to compromise in the
Chapter 11 cases exceed the fair value of the assets available to satisfy them,
unsecured claims may be satisfied at less than 100% of their face value and the
equity interests of Kmart's shareholders may have no value.

Additional information regarding the Chapter 11 case appears in Item 1.
Business -- Proceedings Under Chapter 11 of the Bankruptcy Code, of this Form
10-K.

The ability of Kmart to continue as a going concern is predicated upon
numerous issues, including our ability to achieve the following:

- having the Plan of Reorganization confirmed by the Court in a timely
manner;

- being able to successfully implement our business plans and otherwise
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 and/or the Exit
Financing Facility, including limitations on capital expenditures and its
financial covenants, our ability to generate cash flows from operations
or seek other sources of financing and the availability of projected
vendor credit terms; and

- attracting, motivating and/or retaining key executives and associates.

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" in
Item 7. Management's Discussion and Analysis of Results of Operations and
Financial Condition.

The Consolidated Financial Statements contained herein 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 SOP 90-7. Upon emergence from bankruptcy, the amounts
reported in subsequent financial statements may materially change, due to the
restructuring of Kmart's assets and liabilities as a result of the Plan of
Reorganization and the application of "Fresh Start" accounting.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The preparation of financial statements requires that we make estimates and
assumptions that affect the reported amounts of assets and liabilities at the
date of the financial statements and revenues and expenses during the period. We
base our estimates on historical experience and other assumptions that we
believe to be reasonable under the circumstances, the results of which form the
basis for making judgments about carrying values of assets and liabilities that
are not readily apparent from other sources. We continually evaluate the
information used to make these estimates as our business and the economic
environment change. The use of estimates is pervasive throughout our financial
statements, but the accounting policies and estimates we consider most critical
are as follows:

15

INVENTORY VALUATION

Our inventories are valued primarily using the retail inventory method.
Inventories are valued at the lower of cost, determined primarily by the
last-in, first-out method, utilizing internal inflation indices, or market
value, using the retail inventory method. Under the retail inventory method, the
valuation of inventories at cost and resulting gross margins are determined by
applying a calculated cost-to-retail ratio, for various groupings of similar
items, to the retail value of inventories. The cost of inventory is decreased by
charges to Cost of sales, buying and occupancy at the time the retail value of
inventory is lowered through the use of permanent markdowns. Therefore, earnings
are negatively impacted as the merchandise is marked-down, prior to sale. The
areas requiring significant management judgment include: (1) setting the
original retail value for merchandise, (2) evaluating merchandise for which the
customer's perception of value has declined and appropriately marking the retail
value of the merchandise down to the perceived value, and (3) provisions for
shrinkage. If actual market or weather conditions are more or less favorable
than those projected by management, adjustments may result.

VENDOR ALLOWANCES

Periodic payments from vendors in the form of buydowns, volume or other
purchase discounts that are evidenced by signed agreements are reflected in the
carrying value of the inventory when earned and as a component of Cost of sales,
buying and occupancy as the merchandise is sold. Up-front consideration received
from vendors linked to purchases or other commitments is initially deferred and
amortized ratably to cost of goods sold over the life of the contract or as
performance of the activities specified by the vendor to earn the fee is
completed. To the extent our agreements with vendors specify co-op advertising,
prior to the fourth quarter of 2002, we have classified such credits as a
reduction to advertising expense in Selling, general and administrative
expenses. Emerging Issues Task Force ("EITF") 02-16, Accounting by a Customer
(Including a Reseller) for Certain Consideration Received from a Vendor ("EITF
02-16"), which is effective for all arrangements entered into after December 31,
2002, requires, vendor allowances to be classified as a reduction to cost of
sales unless evidence exists supporting an alternative classification. We early
adopted the provisions of EITF 02-16, on a prospective basis, in the fourth
quarter of 2002 and, as a result, we classified $209 of co-op recoveries as a
reduction of Cost of sales, buying and occupancy, which would otherwise have
been recorded as a reduction of selling, general and administrative expenses
("SG&A").

RESTRUCTURING CHARGES

We have provided restructuring charges in fiscal 2002, 2001 and 2000 to
close stores, liquidate inventory, and optimize our information systems, supply
chain and e-commerce business. These charges required judgments about exit costs
to be incurred for employee severance, contract and lease terminations, the
future net realizable value of long-lived assets and inventory to be disposed
of, and other liabilities. As a result of the bankruptcy proceedings, certain
estimates for store closings are now calculated based on statutory formulas;
however, significant judgment is involved in estimating the claims of lessors
for items other than rent, including cure costs, taxes, utilities, etc. The
ability to obtain agreements with lessors to terminate leases or with other
parties to assign leases can also affect the accuracy of current estimates.

LONG-LIVED ASSET IMPAIRMENTS

It is our policy to review our long-lived assets for possible impairment
whenever events or circumstances indicate that the carrying amount of an asset
may not be recoverable and annually when no such event has occurred. We review
assets held and used on a store-level basis, which is the lowest level of assets
for which there are identifiable cash flows. An impairment of long-lived assets
exists when future undiscounted cash flows are less than an asset groups'
carrying value over the estimated remaining useful life of the store. Impairment
is measured as the difference between carrying value and fair market value. Fair
value was based on appraised value or estimated sales values of similar assets
in recent transactions. Assumptions and estimates used in the evaluation of
impairment, including current and future economic trends for stores in

16

many geographic regions, are subject to a high degree of judgment and complexity
and changes in the assumptions and estimates may affect the carrying value of
long-lived assets, and could result in additional impairment charges in future
periods.

SELF-INSURANCE RESERVES

We self-insure or retain a portion of the exposure for losses related to
workers compensation and general liability costs. General liability costs relate
primarily to litigation that arises from store operations. It is our policy to
record our self-insurance reserves, as determined actuarially, based upon claims
filed and an estimate of claims incurred but not yet reported. Any actuarial
projection of losses concerning workers compensation and general liability is
subject to a high degree of variability. Among the causes of this variability
are unpredictable external factors affecting future inflation rates, litigation
trends, legal interpretations, benefit level changes and claims settlement
patterns, including the effect of the bankruptcy proceedings.

PENSION BENEFITS

Prior to 1996, Kmart maintained defined benefit pension plans covering
eligible associates. Effective January 31, 1996, the pension plans were frozen,
and associates no longer earn additional benefits under the plans (except for
the purpose of the subsidized early retirement program provided by the plan).
For the past eight years, Kmart has not been required to make contributions to
the plans. These plans have net pension income/expense determined by actuarial
valuations. Inherent in these valuations are key assumptions including discount
rates, expected returns on plan assets and the rate of future compensation
increases. We are required to consider current market conditions, including
changes in interest rates and plan asset investment returns, in determining
these assumptions. Actuarial assumptions may differ materially from actual
results due to changing market and economic conditions, changes in investment
strategies and higher or lower withdrawal rates or longer or shorter life spans
of participants. These differences may result in a significant impact to the
amount of net pension income/expense recorded in future periods.

LEGAL RESERVES

Kmart is periodically involved in various legal actions arising in the
normal course of business. Management is required to assess the probability of
any adverse judgments as well as the potential range of any losses. Management
determines the required accruals after a careful review of the facts of each
legal action. Kmart's accruals may change in the future due to new developments
in these matters.

VALUATION ALLOWANCES ON DEFERRED INCOME TAXES

Kmart accounts for income taxes in accordance with Statement of Financial
Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes" ("SFAS No.
109") which requires that deferred tax assets and liabilities be recognized
using enacted tax rates for the effect of temporary differences between the
financial reporting and tax bases of recorded assets and liabilities. SFAS No.
109 also requires that deferred tax assets be reduced by a valuation allowance
if it is more likely than not that some portion or all of the deferred tax asset
will not be realized. We have evaluated the realizability of the deferred tax
assets and have recorded a full valuation allowance against such assets as
ultimate realization is uncertain. Our assumptions regarding future realization
may change due to future operating performance and other factors.

For a detailed discussion of our accounting policies and related estimates
and judgments, see Note 2 of the Notes to Consolidated Financial Statements, in
Item 8. Financial Statements and Supplementary Data, of this Form 10-K. While we
believe that the historical experience and other factors considered provide a
meaningful basis for the accounting policies applied in the preparation of the
Consolidated Financial Statements, we cannot guarantee that our estimates and
assumptions will be accurate, which could require us to make adjustments to
these estimates in future periods.

17

RESULTS OF OPERATIONS

The following MD&A discussion provides a comparative analysis of operating
results as reported for fiscal 2002, 2001 and 2000.

FISCAL 2002 COMPARED TO FISCAL 2001

In the 2002 and 2001 fiscal years there were certain significant
restructuring efforts that drove the major changes in our operating results
including, in the current year, two store closing programs that drove
significant inventory markdowns, impairments of long-lived assets and reductions
in workforce. In 2001, significant actions included restructuring of our
e-commerce business and supply chain. See discussion below on Special charges
for more details.

Same-store sales and total sales for 2002 decreased (10.1%) and (14.9%),
respectively. In addition to negative customer perception stemming from our
Chapter 11 filing, the decrease in same-store sales is primarily due to lower
sales transactions associated with the loss of customers and continued
competitive pressures. Same-store sales include sales of all open stores, 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 was $4,504 and decreased ($1,794) from $6,298 in fiscal 2001.
Gross margin, as a percentage of sales, was 14.6% in 2002 and 17.4% in 2001. The
decrease in gross margin as a percentage of sales is primarily related to
accelerated inventory markdowns of $1,256 in conjunction with store closing
liquidations, an increase in promotional markdowns designed to drive customer
traffic, an increase in clearance markdowns to improve sell-through on seasonal
apparel, and increased shrinkage; partially offset by a higher regular gross
margin rate due to the elimination of our BlueLight Always initiative which
began in fiscal year 2001, a decrease in sales of food and consumables, which
carry lower margins, approximately $200 of vendor credits which would otherwise
have been recorded as co-op advertising recoveries in SG&A as a result of our
adoption of EITF 02-16, a difference in our LIFO inventory valuation adjustment
of $154 and the prior year supply chain restructuring charge of $75. See further
discussion on 2001 clearance markdowns under "Internal Investigation -- Vendor
Allowance and Inventory Matters."

Gross margin also decreased as a result of a decrease in total sales due to
the closure of 283 stores in the second quarter of 2002 and a decrease in
same-store sales.

SG&A, which includes advertising costs (net of co-op recoveries of $276 in
2002 and $427 in 2001), was 21.3% of sales in 2002 versus 21.0% in 2001. The
decrease of ($1,044) from the prior year is due primarily to decreased payroll
and benefits due to the closure of 283 stores in the second quarter of fiscal
2002, decreases in expenses for general liability claims due to a second quarter
2001 adjustment of $167 to align general liability reserves with actuarial
findings, lower depreciation expense due to an impairment charge recorded in the
fourth quarter of fiscal 2001, a 2001 supply chain restructuring charge of $88
and a reduction in electronic media and direct mail advertising, partially
offset approximately $200 of co-op recoveries which were recorded in gross
margin in accordance EITF 02-16 and an increase in weekly circular advertising.

Operating loss was ($2,745), or (8.9%) of sales, for 2002 compared to a
loss of ($2,381), or (6.6%) of sales, for 2001. The increase in operating loss
is attributable to lower gross margin partially offset by a reduction in SG&A,
lower impairment charges in the current year and the prior year restructuring
charge for our e-commerce business.

Interest expense, net was $155 and $344 in 2002 and 2001, respectively.
Included in interest expense, net is interest income of $4 for 2002 and 2001.
Interest expense, net decreased by $189 as a result of the Chapter 11 filing. As
of the Petition Date, we stopped accruing interest on unsecured debt classified
as Liabilities subject to compromise in our Consolidated Balance Sheet in
accordance with SOP 90-7.

Effective income tax rate was (0.7%) and 0.0% in 2002 and 2001,
respectively. In the fourth quarter of fiscal year 2001, we recorded a valuation
allowance against our net deferred tax assets, in accordance with SFAS No. 109
as realization of such assets in future years is uncertain. We have continued to
maintain a

18

valuation allowance against our net deferred tax assets, and accordingly, we did
not recognize any tax benefit from our losses in fiscal year 2002. See Note 17
of the Notes to Consolidated Financial Statements, in Item 8. Financial
Statements and Supplementary Data, of this Form 10-K.

FISCAL 2001 COMPARED TO FISCAL 2000

In the 2001 and 2000 fiscal years there were certain significant
restructuring efforts that resulted in major changes in our operating results
including, in 2001, impairments of long-lived assets, restructuring of our
e-commerce business and supply chain, and reductions in workforce. In 2000,
significant actions included a store closing program that resulted in
significant inventory markdowns. See discussion below on Restructuring,
impairments and other charges for more details.

Fiscal 2001, which ended on January 30, 2002, included 52 weeks. Fiscal
2000, which ended on January 31, 2001, included 53 weeks. Same-store sales for
fiscal 2001 compare the 52 week period ended January 30, 2002, to the 52 week
period ended January 31, 2001, and therefore exclude the first week of fiscal
year 2000. Same-store sales include sales of all stores that have been open for
greater than 13 full months.

Same-store sales and total sales for 2001 decreased (0.1%) and (2.4%),
respectively. The decrease in same-store sales is due primarily to fewer sales
transactions due to reduced promotional activity and increased competition in
the discount retail industry, the deflationary effect of our BlueLight Always
program under which we lowered prices on a significant number of high-frequency
items and the effect of prior year clearance sales of discontinued merchandise.
In addition, total sales decreased due to an additional week of sales in 2000
due to the 53 week fiscal year and the net effect of store openings and
closings.

Gross Margin decreased by ($998) from fiscal 2000 and was, as a percentage
of sales, 17.4% in 2001 and 19.7% in 2000. The decline in gross margin rate is
driven by a 13.6% rate in the fourth quarter, attributable to the pricing
effects of our BlueLight Always program; higher markdowns of seasonal apparel
due to unseasonably warm weather; an increase in sales of food and consumables,
which on a percent of sales basis, carry lower margins; an adjustment to
inventory for LIFO, and restructuring of our supply chain of $75; partially
offset by accelerated markdowns on the 2000 inventory liquidation sales of $365,
a decrease in clearance sales in 2001 as compared to 2000 and lower distribution
costs under our arrangement with Fleming.

SG&A, which includes advertising costs (net of co-op recoveries of $427 in
2001 and $633 in 2000), was 21.0% of sales in 2001 versus 19.9% in 2000. The
increase of $222 over the prior year is due primarily to increased expenses for
general liability and workers compensation claims as reserves were increased by
approximately $210 in 2001 following significant analysis and actuarial studies,
a decrease in co-op recoveries caused by erosion in supplier confidence as a
result of the events leading up to our bankruptcy filing under Chapter 11,
employee compensation, utility rate increases and restructuring of our supply
chain, partially offset by fiscal 2000 store closing expenses and a reduction in
advertising expense.

Operating loss was ($2,381), or (6.6)% of sales, for 2001 compared to
operating loss of ($83), or (0.2%) of sales, for 2000. The higher operating loss
is attributable to impairment charges of $971 in 2001, the restructuring charge
for our e-commerce business of $97 in 2001, lower sales, a lower gross margin
rate and an increase in SG&A expenses as discussed above, partially offset by
store closing charges and accelerated inventory markdowns in 2000.

Net interest expense was $344 and $287 in 2001 and 2000, respectively.
Included in net interest expense is interest income of $4 and $17 for 2001 and
2000, respectively. Net interest expense increased by $57 as a result of the
issuance in January 2001 of $400 million of 9.375% Notes due January 2006, the
issuance in June 2001 of $430 million of 9 7/8% Notes due June 2008, increased
borrowings under our Revolving Credit Agreement and lower investment income. As
of the Petition Date, we stopped accruing interest on debt classified as
Liabilities subject to compromise in our Consolidated Balance Sheets in
accordance with SOP 90-7.

Effective income tax rate was (0.0%) and (40.0%) in 2001 and 2000,
respectively. In the fourth quarter of fiscal year 2001, we recorded a valuation
allowance against our net deferred tax assets, in accordance with SFAS No. 109
as realization of such assets in future years is uncertain. The decrease in
effective income tax
19

rate is due to this valuation allowance. See Note 17 of the Notes to
Consolidated Financial Statements, in Item 8. Financial Statements and
Supplementary Data, of this Form 10-K.

ANALYSIS OF FINANCIAL CONDITION

Following the Petition Date, we have utilized cash flows from operations
and the DIP Credit Facility as our primary sources of working capital. Shortly
after the Petition Date, in conjunction with our filing under Chapter 11, we
entered into a $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
pre-petition liens and certain other permitted liens) and provides that proceeds
be used for working capital needs and other general corporate purposes. This
superpriority claim and lien position is shared on an equal and ratable basis
with up to $200 of claims of our principal cash management banks relating to
overdrafts, fees and certain other liabilities arising from the provision of
treasury, depository and cash management services to the Debtors.

Borrowings under the DIP Credit Facility bear interest at the Prime Rate
plus 2.5% per annum or, at Kmart's option, at the LIBOR rate plus 3.5% per
annum. The DIP Credit Facility stipulates that borrowings thereunder may not
exceed the lesser of 95% of our borrowing base (which is tied to our eligible
inventory levels) or 95% of the commitment (currently $2 billion). Kmart is
obligated to pay an unused commitment fee to the DIP Credit Facility lenders
equal to (i) 1% per annum on the total unused commitment to the extent that the
average total commitment usage is less than or equal to 33 1/3% of the total
commitment, (ii) 3/4% per annum on the total unused commitment to the extent
that the average total commitment usage is greater than 33 1/3% but less than or
equal to 66 2/3% of the total commitment and (iii) 1/2% per annum on the total
unused commitment to the extent that the average total commitment usage is
greater than 66 2/3% of the total commitment.

To the extent that the cumulative net cash proceeds from the sale of
certain leasehold interests and fixed assets exceeds $150 from and after the
Petition Date, the DIP Credit Facility requires us to prepay loans and reduce
commitments thereunder in an amount equal to 50% of such excess.

Under the DIP Credit Facility, capital expenditures are restricted to $650
during fiscal 2002, $800 during fiscal 2003 and $212 during fiscal 2004 up to
April 22, 2004, the maturity date, providing that no more than 55% of the
capital expenditures permitted in any fiscal year may be made in the first two
fiscal quarters and 20% of the unused portion of permitted capital expenditures
in any fiscal year may be carried forward to and used in the following year. We
are also required to maintain specified levels of cumulative earnings before
interest, taxes, depreciation, amortization and special charges as defined by
the DIP Credit Facility ("EBITDA") for periods ending as early as June 2002 and
thereafter. The DIP Credit Facility also contains other customary covenants,
including certain reporting requirements and covenants that restrict our ability
to incur or create liens, indebtedness and guarantees, make dividend payments,
sell or dispose of assets, change the nature of our business and enter into
affiliate transactions, mergers and consolidations. Failure to satisfy these
covenants would (in some cases, after the expiration of a grace period) result
in an event of default that could cause, absent the receipt of appropriate
waivers, the funds necessary to maintain our operations to become unavailable.
The DIP Credit Facility contains other customary events of default, including
(i) certain ERISA events, (ii) a change of control and (iii) the occurrence of
certain specified events in the Chapter 11 cases.

We had no borrowings outstanding under the DIP Credit Facility and $393 and
$676 of borrowings outstanding under our $400 credit facility and $1.1 billion
credit facility, respectively, at the end of fiscal year 2002. There were $330,
$400 and $684 of borrowings outstanding under our DIP Credit Facility, $400
credit facility and $1.1 billion credit facility, respectively, at the end of
fiscal year 2001.

Net cash provided by operating activities was $252 in 2002 as compared to
$927 in 2001. The decrease in cash provided by operations is due to increased
payments on accounts payable in the current year due to the stay of pre-petition
liabilities following our filing for protection under Chapter 11.

20

Net cash used for reorganization items was $135. This spending relates
primarily to payments under the Key Employee Retention Program ("KERP") and
payments to retain bankruptcy advisors.

Net cash used for investing activities was $252 in 2002 compared to $1,430
in 2001. The decrease in cash used for investing activities is due to the
decrease in capital expenditures as a result of restrictions related to our DIP
Credit Facility. The majority of capital expenditures in the current year were
for store improvements.

Net cash used for financing activities was ($497) in 2002 compared to cash
provided of $1,353 in 2001. The decrease was primarily the result of increased
borrowing activity in 2001, including the issuance of $430 of 9 7/8% Notes due
June 2008, increased borrowings under the Credit Facility and the 364-day
Facility (as defined below) in 2001 as well as the repayment of $330 on our DIP
Credit Facility in 2002.

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 29% 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 and/or our Exit Financing 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. Should, however, we experience a
significant disruption of terms with our vendors, the DIP Credit Facility and/or
the Exit Financing Facility for any reason become unavailable, or actual results
differ materially from those projected, our compliance with financial covenants
and our cash resources could be adversely affected.

INFLATION

Inflation has not had a significant impact on our business over the past
three years and we do not expect it to have a significant impact on operations
in the foreseeable future, unless global or geo-political situations
substantially affect the world economy.

FUTURE LIQUIDITY ITEMS

On January 13, 2003, Kmart received an Exit Financing Facility commitment
for $2 billion from GE Commercial Finance, Fleet Retail Finance Inc. and Bank of
America, N.A. (the "Exit Financing Facility"). This credit facility, which will
be collateralized primarily by inventory, would replace our current $2 billion
DIP Credit Facility on the effective date of our Plan of Reorganization. On
January 29, 2003, the Court approved this financing which is subject to the
satisfaction of customary conditions to closing and would be available to Kmart
to help meet help fund exit costs upon emergence from bankruptcy, its ongoing
working capital needs, including borrowings for seasonal increases in inventory
and other general corporate purposes.

We expect to make payments of approximately $800 to $850 in conjunction
with our planned emergence from Chapter 11. We expect to fund these cash
payments through cash flows from our going-out-of-business sales and/or the Exit
Financing Facility as well as cash contributions received from Plan Investors
upon emergence from Chapter 11.

Kmart also expects cash flows from operations and/or the Exit Financing
Facility to be sufficient to satisfy its capital needs following emergence.

PENSION PLAN

Prior to 1996, Kmart maintained defined benefit pension plans covering
eligible associates. Effective January 31, 1996, the pension plans were frozen,
and associates no longer earn additional benefits under the

21

plans (except for purposes of the subsidized early retirement program provided
by the plan). The plans' assets consist primarily of equity and fixed income
securities. For the past 8 years, Kmart has not been required to make a
contribution to the plans.

In light of returns in the equity markets in 2002 and prior years and the
effect of such returns on the value of the plans' assets, we presently expect
that we likely will be required to commence making significant contributions to
the plans in 2005 or 2006, although it is possible that contributions could be
required earlier. Given that the plans are frozen, the timing for the
commencement of our future funding requirements will depend, in large part, on
the future investment performance of the plans' assets. Once funding obligations
commence, we presently anticipate that such obligations could continue for a
period of five or six years at an average rate of between $100 and $200 a year,
or between $800 and $900 in the aggregate. The actual level of contributions
will depend upon a number of factors, including the actual demographic and other
changes affecting valuations.

In addition to the funding described above, as a result of the returns over
the most recent years, expected decreases in our annual discount rate and
expected rate of return on assets, we will record pension expense in 2003 as
opposed to income as has been recorded in the most recent years.

SPECIAL CHARGES

Special charges are transactions which, in management's judgment, may make
meaningful comparisons of operating results between reporting periods difficult.
In determining what amounts constitute a special charge, management considers
the nature, magnitude and frequency of their occurrence. Summarized below is the
impact of implementing key corporate initiatives, asset impairments, and
significant inventory liquidations as a result of the stores closed under
Kmart's Chapter 11 proceedings.

During fiscal years 2002 and 2001, we instituted certain restructuring
actions to improve our operations. Also, in accordance with SFAS No. 144,
Accounting for the Impairment or Disposal of Long-Lived Assets,

22

("SFAS No. 144") we recorded impairment charges in fiscal 2002 and 2001. These
actions are summarized below.

2002 MARKDOWNS FOR INVENTORY LIQUIDATION

During fiscal 2002, we recorded charges aggregating $1,256 to write-down
inventory to be liquidated at the 316 stores to be closed during the first
quarter of fiscal 2003 and the 283 stores that were closed in the second quarter
of fiscal 2002 to net realizable value, given the accelerated liquidation
strategy. These charges are included in Cost of sales, buying and occupancy in
the Consolidated Statements of Operations.

During the fourth quarter of 2002, we recorded $395 relating to the
write-down of inventory to its estimated selling value in connection with the
liquidation sales in the 316 closing stores. $76 of this charge relates to
liquidator fees and expenses associated with the disposition of inventory.

During the first quarter of 2002, $384 was recorded relating to the
write-down of inventory initially existing at the closed 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 original estimate. $117 of the charge relates to liquidator
fees and expenses associated with the disposition of inventory.

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 closed 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 to adjust our original estimate of $266.

The following table summarizes the components of the charges for markdowns
for inventory liquidation during fiscal year 2002:

LONG-LIVED ASSET IMPAIRMENTS

During the fourth quarter of fiscal 2002 we recorded a non-cash charge of
$695 in accordance with SFAS No. 144 as a result of our strategic decision to
close 316 stores in the first quarter of 2003.

During the fourth quarter of fiscal 2001, due to below-plan sales and
earnings performance in the fourth quarter, our filing under Chapter 11 and
planned actions under such filings, we performed a recoverability test on our
long-lived assets. In accordance with SFAS No. 144, we recorded a non-cash
charge of $971. Of the charge, $921 relates to long-lived assets in the 283
stores we closed in the second quarter of 2002. We performed an additional
assessment of assets that were not included in the above store analysis and
recorded charges totaling $50 for capital projects that were cancelled due to
capital expenditure restrictions in our DIP Credit Facility.

23

CORPORATE COST REDUCTION INITIATIVES

During fiscal 2002 we recorded charges totaling $50 to realign our
organization to reflect our current business needs as a result of store closings
and other cost reduction initiatives we recorded the charges in accordance with
SFAS No. 112, "Employers' Accounting for Postemployment Benefits" ("SFAS No.
112"). These charges include severance, outplacement services and continuation
of healthcare benefits in accordance with the severance plan provisions of our
KERP, which was approved by the Court in March 2002. These charges relate to
actions we will carry out in the first quarter of 2003 with expected annualized
expense savings of approximately $100 and to the second quarter 2002 action
whereby we eliminated approximately 400 positions at our corporate headquarters
and approximately 50 positions nationally that provided corporate support, as a
result of the closing of the 283 stores. We expect to realize annualized expense
savings of $110 associated with this action.

SUPPLY CHAIN OPERATIONS

On September 6, 2001 we restructured certain aspects of our supply chain
infrastructure, including the reconfiguration of our distribution center network
and implementation of new operating software across our supply chain. In
conjunction with these actions, we recorded a charge of $163 in fiscal 2001. The
charge was comprised of $93 related to the disposal of supply chain software and
hardware and other assets that are no longer utilized and $23 of accelerated
depreciation related to these assets. In addition, $47 was recorded for lease
terminations and contractual employment obligations for staff reductions of 956
employees at our distribution centers.

We recorded $9 for accelerated depreciation in fiscal 2002.

BLUELIGHT.COM

In the second quarter of fiscal 2001, we recorded charges totaling $97
($76, net of tax) related to our e-commerce site, BlueLight.com, comprised of
$41 for the impairment of our investment in BlueLight.com, $29 for asset
impairments as a result of the restructured business and $27 for lease and
contract terminations, severance and other charges for the restructuring of our
e-commerce business.

Based upon the changing environment for the 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 which included acquiring the
remaining 40% interest in the company, restructuring the business, outsourcing
certain aspects of our overall e-commerce business and severing employees at the
BlueLight.com headquarters.

In the third quarter of fiscal 2002 we reduced the reserves established for
BlueLight.com contract terminations by $6 based on our revised estimates for the
remaining obligations.

The results of BlueLight.com's operations are fully consolidated in our
financial statements commencing July 31, 2001.

2000 STRATEGIC ACTIONS

In the second quarter of fiscal year 2000, we announced a series of
strategic actions aimed at strengthening financial performance by achieving
improvements in return on invested capital. These actions included deciding to
close certain Kmart and Kmart Supercenters, accelerating certain inventory
reductions and redefining our information technology strategy. As a result of
these initiatives, we recorded a pre-tax charge of $740 ($471 net of tax) during
the second quarter of 2000. During the third quarter of fiscal year 2000, we
reduced this charge by $12 ($8 net of tax) due to changing the number of
scheduled store closings from 72 to 69, thus reducing the reserve for closed
stores from $300 to $288. In connection with the bankruptcy filing, we recorded
to the reserve a non-cash adjustment of $37 for the rejection of certain leases
associated with the 2000 strategic actions charge to reduce the reserve to the
allowed estimated claim amount under the Bankruptcy Code.
24

The following table summarizes the significant components of the charge for
strategic actions taken during fiscal year 2000 and the presentation in our
Consolidated Statements of Operations:

OTHER

Kmart incurred charges of $26, $23 and $0 for 2002, 2001 and 2000,
respectively, for other special charges. In 2002, these special charges included
the sale of our Internet Service Provider ("ISP") and e-mail business to
Netbrands, a unit of United Online, Inc., which closed on November 4, 2002 and
resulted in a gain of $4. The sale of the ISP assets does not affect the
www.kmart.com online shopping site. Additionally, in 2002 we recorded $30 of
accelerated depreciation on assets to be disposed of following store closings.
During 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).

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 Consolidated
Statements of Operations. For fiscal 2002 and 2001 the following have been
recorded:

The following paragraphs provide additional information relating to costs
that were reported in the line Reorganization items, net in our Consolidated
Statement of Operations for the 2002 fiscal year:

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.

25

'SFAS No. 144 requires closed stores to be classified as discontinued operations
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. Based
on these criteria, we evaluated the 283 stores closed during the second quarter
and determined that in substantially all the cases, the operations and cash
flows of the stores would not be eliminated from our ongoing operations. The
results of operations for 28 stores were considered to be discontinued
operations under the criteria set forth in SFAS No. 144; however, total Sales,
Gross margin, and SG&A for these stores represented less than 1% of Kmart's
total Sales, Gross margin and SG&A, and were not considered material for
separate presentation in the Consolidated Statement of Operations.

We recorded charges of $207 for expenses related to store closings during
fiscal 2002. We charged $228 to our closed store reserve for estimated allowable
claims related to lease terminations and other costs and reclassified $140 of
capital lease obligations to the closed store reserve during the first quarter
of fiscal 2002. During the second, third and fourth quarters of fiscal 2002, we
recorded a net credit of $(21) to adjust our estimated allowable claims. The
reserve for estimated costs was recorded in accordance with EITF 94-3.

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 their employment with Kmart through the
reorganization process. For fiscal year 2002, we recorded charges of $106 for
the KERP retention benefits and $50 for other enhanced employee severance
benefits for associates in our 283 and 316 stores that were closed and are not
covered under the KERP.

PROFESSIONAL FEES

We recorded $112 and $8 for professional fees during 2002 and 2001,
respectively. Professional fees include financial, legal, real estate and
valuation services directly associated with our reorganization process.

GENERAL LIABILITY RESERVES

During the fourth quarter of 2001, we recorded a credit of $174 for the
reduction of our estimated obligation for general liability claims based upon
the actuarial determination of the effect of the bankruptcy process on the
ultimate development of case reserves and claims incurred but not reported. In
the fourth quarter of 2002, we recorded $51 of expense to revise our estimate of
our pre-petition obligation for general liability claims.

SETTLEMENT OF PRE-PETITION LIABILITIES

We recorded gains of $107 in 2002 representing the difference between the
settlement value of certain pre-petition obligations and the estimated 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 by the
Court on May 10, 2002. Under the terms of the Agreements we agreed to sell to
the Purchasers the designation rights with respect to 56 leaseholds for closed
stores and our interest in the leasehold for one closed store, (the Purchaser of
which defaulted under its Agreement and the lease was rejected). During the
designation period, as defined under the Agreements, the Purchaser of
designation rights has the sole, exclusive and continuing right to select,
identify and designate (i) which leases shall be assumed and assigned (and if
assigned to whom), or terminated, and (ii) which properties shall be excluded
from the transaction. During fiscal 2002, the leaseholds on the 283 stores not
covered by the Agreements have been rejected or terminated.
26

In consideration for the designation rights acquisitions, the Purchasers
paid $46, all of which was paid in cash during the year. 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.

The guaranteed proceeds of $46 are being recognized as income on a pro-rata
basis at either the effective date of the property assignment or termination,
when we are informed by the Purchasers of their intention to exclude certain
leaseholds from future assignments or terminations, 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 the store and reject
the lease will be reversed. Both the income from the sale of the designation
rights and the reversal of allowed claim amounts are reported as Reorganization
items, net in the Consolidated Statement of Operations.

During fiscal 2002, 23 leases under the Agreements have been assigned, four
have been terminated or rejected under landlord agreements and nine have been
excluded and rejected as of the end of fiscal 2002. Two additional leases were
excluded and rejected during the first quarter of fiscal 2003. Six additional
leases were approved for assignment during the fourth quarter of fiscal 2002.
These six leases were assigned during the first quarter of fiscal 2003. During
the year we recognized $29 of proceeds from the sale of designation rights. The
remaining funds received have been deferred and will be recognized in our
Consolidated Statement of Operations as described above.

OTHER REORGANIZATION ITEMS

We recorded $18 of income for the sale of pharmacy lists and $10 for
interest income earned on excess cash balances. We also recorded expense of $24
and income of $17 in 2002 and 2001, respectively, for other reorganization
items.

DISCONTINUED OPERATIONS

In connection with Kmart's bankruptcy filing, we recorded primarily
non-cash credits in 2002 and 2001 of $43 and $166, respectively, for the
reduction of existing lease obligations for certain discontinued operations due
to the rejection of such leases, to the amount of the allowed claim under the
Bankruptcy Code. The 2002 amounts also include income related to the recovery of
claims through the bankruptcy of Hechinger Company.

CONTRACTUAL OBLIGATIONS AND OTHER COMMERCIAL COMMITMENTS

Information concerning our obligations and commitments to make future
payments under contracts, such as debt and lease agreements, and under
contingent commitments is aggregated in the following tables.

Included in the foregoing amounts are significant pre-petition obligations.
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 may not be enforced. In addition, we may assume or reject
executory contracts, including lease obligations, such as the 316 leases for
stores we were authorized to close on January 28, 2003. Therefore, the
commitments shown in the above table and discussed above may not reflect actual
cash outlays in the future periods.

GUARANTEES

As of January 29, 2003, we had (i) guaranteed obligations for real property
leases of certain current and former subsidiaries of Kmart including, but not
limited to, The Sports Authority, Inc., OfficeMax, Inc. and Borders Group, Inc.,
some of which leases have been assigned pre-petition (These amounts totaled
approximately $550 and $600 for 2002 and 2001, respectively. The present value
at 7% of the gross lease for 2002 was over $325); (ii) contingent liabilities
under real property leases assigned by Kmart pre-petition; and (iii) guaranteed
$64 of indebtedness of other parties related to certain of our leased properties
financed by industrial revenue bonds. Our rights and obligations with respect to
our guarantee of leases of the former subsidiaries The Sports Authority, Inc.,
Office Max, Inc., and Borders Group, Inc., which are detailed below, are
governed by Lease Guarantee, Indemnification and Reimbursement Agreements dated
as of November 23, 1994, November 9, 1994 and May 24, 1995, respectively, as
they may be amended from time to time. Kmart's contingent obligations, described
above, which are not reflected in our financial statements, are dependent on the
future performance by the parties whose obligations we guarantee and are
intended by Kmart, as set forth in the Plan of Reorganization, to be discharged
thereunder if such Plan is confirmed and consummated subject to prepetition
claims administration as appropriate.

We are a party to a substantial number of other contracts which are routine
and incidental to our business. Certain contracts allow for damage provisions or
other paybacks as a result of our termination of the contracts. We assess the
likelihood of potential losses on an ongoing basis and when they are considered
probable and reasonably estimable, record 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.

INTERNAL INVESTIGATION -- VENDOR ALLOWANCE AND INVENTORY MATTERS

VENDOR ALLOWANCE MATTERS

2001 Interim Recognition of Allowances

During the Fall of 2002 and in response to inquiries from the staff of the
SEC, Kmart reviewed its historical practices for the recording of allowances
prior to the adoption in the fourth quarter of fiscal year 2001 of a new
accounting policy, effective February 1, 2001, for the interim financial
reporting of vendor allowances. The effect of these practices relates only to
Kmart's interim financial statements.

For interim reporting periods in fiscal 2000 and prior, our policy was to
record allowances not yet subject to a written agreement during the first three
quarters of a fiscal year based upon our estimate of annual allowances ("our
plan") as determined by historical experience and current understandings with
our vendors. These amounts were supplemented by allowances obtained that were
not contemplated in our plan ("incrementals"). During the fourth quarter of
fiscal 2001, we adopted a new accounting policy, effective as of

28

February 1, 2001, for interim financial reporting only, requiring that cost
recoveries from vendors be recognized only when a formal agreement for such
amount has been obtained and the underlying activity for which the amount was
provided has been performed.

As part of its review of allowances, the current management of Kmart
observed that the total level of allowances originally recorded during the first
three quarters of fiscal year 2001 appeared high, given the challenges that
faced the business in fiscal year 2001 and the fact that sales failed to
increase as originally contemplated in Kmart's business plan. In that regard, it
was noted that had Kmart recorded allowances during the first three quarters of
fiscal year 2001 at rates which corresponded to more historical rates, Kmart
would have recorded fewer allowances.

During the first three quarters of fiscal year 2001, Kmart characterized
and recorded as incremental allowances $110, $163 and $50, respectively. Kmart
selectively identified for review certain of such allowances that had been
characterized and recorded as incrementals prior to the adoption of the new
accounting policy. Of those reviewed, the amount of allowances which appeared to
be questionable, other than those previously disclosed, were $27, $42 and $23,
respectively. The questions about these allowances relate to, among other
things, the failure to have appropriate signed documentation in place, the
failure to have adequate records demonstrating that the allowance was
collectible or the failure to otherwise comply with Kmart's historical policies.
Based on the investigation, it appears that some of these allowances may have
been reported in error in the quarterly financial statements. Given, however,
that Kmart's review of allowances was selective, as well as the difficulties of
confirming on a retroactive basis whether an incremental allowance is
supplemental to the plan, Kmart cannot exclude the possibility that there may be
additional incremental allowances in fiscal year 2001 which could be subject to
question. In fact, during the fourth quarter of fiscal year 2002, we identified
a $2 transaction that had been improperly recorded as an "incremental allowance"
during the third quarter of 2001 and have reversed this transaction in our 2002
statement of operations.

Any errors, as described in the preceding paragraphs, concerning the
recording of allowances that were reflected in our fiscal year 2001 interim
unaudited financial statements prior to the change in accounting policy were no
longer reflected in our restated financial statements as filed with the SEC on
May 15, 2002. This results from the change in accounting policy, given that
under the new accounting policy there is no longer a distinction between planned
and incremental allowances, no allowances are recognized absent a formal
agreement and the recording of allowances is no longer based on a plan.

Premature Recording of Vendor Allowances

In addition, in 2002 and after the filing of our original 2001 Annual
Report on Form 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 that required investigation. We also
determined that such early recognition of vendor allowances occurred in other
prior fiscal periods, although the impact of these transactions on our financial
statements was less significant. We described the effect of these items in our
Form 10-Q for the thirteen week period ended July 31, 2002 that we filed with
the SEC on September 16, 2002. In addition, we thereafter became aware of
allowances received from a vendor aggregating $14, which had previously been
recognized in our fiscal year 2000 financial statements and that we have
determined should more appropriately have been recognized over the five-year
life of the contract that we entered into with this vendor.

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, and which were restated to correct
and record such allowances in the appropriate period, 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 and
have restated our prior period financial statements for these adjustments.

29

INVENTORY MATTERS

Also, 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 herein.

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 is characterized
in Management's Discussion and Analysis of this 2001 Form 10-K as a special
charge. 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 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 valuation reserves existing in its LIFO provision of $158. In
light of these reserves, the inventory at the end of fiscal 1999 was, in the
judgment 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 this Form 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 this 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 of, among other things,
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
30

during each of the quarterly periods of 2001, current management noted that the
fewer 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.

RECORDING OF TAX VALUATION ALLOWANCE

In the fourth quarter of fiscal year 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 did not recognize any tax benefit from
our losses in fiscal year 2002. The $24 tax benefit recorded during fiscal year
2002 relates to: (i) a $12 tax benefit refunded to Kmart as a result of the
alternative minimum tax net operating loss provisions of the Job Creation and
Worker Assistance Act of 2002; (ii) a $14 tax benefit refunded to Kmart as a
result of the ten year carryback of certain deduction for net operating losses,
and (iii) a net $2 in federal, state and foreign income taxes.

STORE ACTIVITY

Due primarily to the closure of 283 stores in 2002, we ended the year with
a 13% decrease in our number of stores, from 2,114 in 2001 compared to 1,829 in
2002. The closures include 270 Kmart discount stores and 12 Kmart Supercenters
in 40 states, and one Kmart store in Puerto Rico.

On January 28, 2003 we received Court approval to close an additional 326
stores. This number was subsequently reduced to 316 stores in 44 states, which
include 54 Kmart Supercenters.

As a result of these store closings, we recorded a charge of $695 in the
fourth quarter of 2002, included in the long-lived asset impairment charge
described above. In the first quarter of fiscal 2003, we expect to record an
additional charge of approximately $300 primarily for exit costs to be incurred
for lease rejections and severance.

NEW ACCOUNTING PRONOUNCEMENTS

ADOPTED PRONOUNCEMENTS

In June 2002, the FASB issued SFAS No. 146, "Accounting for Exit or
Disposal Activities" ("SFAS No. 146"). SFAS No. 146 addresses significant issues
regarding the recognition, measurement, and reporting of costs associated with
exit and disposal activities. This statement is effective for activities that
are initiated after December 31, 2002. We have applied the provisions of this
statement to restructuring activities following the effective date.

In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation -- Transition and Disclosure," which provides transition guidance
for a voluntary change to the fair value method of accounting from stock option
awards. We have included appropriate disclosures required by this statement in
our Annual Report on Form 10-K for the year ending January 29, 2003.

In November 2002, the EITF reached a final consensus on Issue No. 02-16,
"Accounting by a Customer (including a Reseller) for Certain Consideration
Received from a Vendor," which addresses how a reseller of a vendor's product
should account for cash consideration received from a vendor. All cash
consideration received from a vendor should be recognized as a reduction of cost
of sales in the reseller's income statement, unless the consideration is
reimbursement for selling costs or payment for assets or services delivered to
the

31

vendor, and performance-driven vendor rebates or refunds should be recognized
only if the payment is considered probable, and the method of allocating such
payments in the financial statements should be systematic and rational based on
the reseller's progress in achieving the underlying performance targets. We have
applied the classification provisions on a prospective basis beginning with our
fourth quarter ended January 29, 2003. The impact of the application of the new
standard was to classify $209 of amounts, which would otherwise have been
recorded as co-op advertising recoveries in SG&A, as a reduction of Cost of
sales, buying and occupancy. We have applied the volume provisions, as required,
to all new contracts entered into subsequent to November 21, 2002.

PENDING PRONOUNCEMENTS

In June 2001, the Financial Accounting Standards Board issued SFAS No. 143,
"Accounting for Asset Retirement Obligations" ("SFAS No. 143"). SFAS No. 143
addresses the accounting and reporting for obligations associated with the
retirement of tangible long-lived assets and the associated asset retirement
costs. SFAS No. 143 will be effective for Kmart's 2003 fiscal year beginning on
January 30, 2003. We do not believe the provisions of SFAS No. 143 will have a
material impact on our financial statements.

In May of 2002, the FASB issued SFAS No. 145, "Rescission of FASB
Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical
Corrections" ("SFAS No. 145"). SFAS No. 145 addresses the treatment of gains and
losses from the extinguishment of debt. SFAS No. 145 is effective January 30,
2003. We will apply the provisions of this statement for all debt
extinguishments going forward.

In January 2003, the FASB issued FASB Interpretation ("FIN") No. 46,
"Consolidation of Variable Interest Entities" ("FIN No. 46"). FIN No. 46 is an
interpretation of Accounting Research Bulletin No. 51, "Consolidated Financial
Statements," and addresses consolidation by business enterprises of variable
interest entities -- a new term. Under current practice, two enterprises
generally have been included in consolidated financial statements because one
entity controls the other. FIN No. 46 defines "variable interests" and requires
existing unconsolidated variable interest entities to be consolidated by their
primary beneficiaries if the entities do not effectively disperse risks among
the parties involved. FIN No. 46 applies immediately to variable interest
entities created after January 31, 2003. It applies in the first fiscal year or
interim periods beginning after June 15, 2003, to variable interest entities in
which an enterprise holds a variable interest that it acquired before February
1, 2003. If it is reasonably possible that an enterprise will consolidate or
disclose information about a variable interest entity when FIN No. 46 becomes
effective, the entity must disclose information about those entities in all
financial statements issued after January 31, 2003. FIN No. 46 may be applied
prospectively with a cumulative-effect adjustment as of the date on which it is
first applied or by restating previously issued financial statements for one or
more years with a cumulative-effect adjustment as of the beginning of the first
year restated. We have performed an analysis to identify such entities and do
not believe that we have any entities that fall within the scope of this
standard.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

At January 29, 2003, 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.

32

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The following information is submitted pursuant to the requirements of Item
8:

33

CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED JANUARY 29, 2003, JANUARY 30, 2002 AND JANUARY 31, 2001

See accompanying Notes to Consolidated Financial Statements
34

CONSOLIDATED BALANCE SHEETS
AS OF JANUARY 29, 2003 AND JANUARY 30, 2002

See accompanying Notes to Consolidated Financial Statements.
35

CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED JANUARY 29, 2003, JANUARY 30, 2002 AND JANUARY 31, 2001

See accompanying Notes to Consolidated Financial Statements.
36

CONSOLIDATED STATEMENTS OF SHAREHOLDER'S (DEFICIT) EQUITY

See accompanying Notes to Consolidated Financial Statements.
37

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)

1) PROCEEDINGS UNDER CHAPTER 11 OF THE BANKRUPTCY CODE

On January 22, 2002 ("Petition Date"), Kmart Corporation 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"). The reorganization is being jointly administered
under the caption "In re Kmart Corporation, et al. case No. 02 B 02474."
Included in the 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
of such non-filing subsidiaries are not considered material to the Consolidated
Financial Statements. Kmart Corporation and all of its consolidated subsidiaries
are collectively referred to herein as "Kmart," "we," "us," or "our." We decided
to seek judicial reorganization based upon a rapid decline in liquidity
resulting from below-plan sales and earnings performance in the fourth quarter
of the 2001 fiscal year, the evaporation of the surety bond market, an erosion
in supplier confidence, intense competition in the discount retail industry,
unsuccessful sales and marketing initiatives, the continuing recession and
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. 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 may not be enforced. In addition, under
the Bankruptcy Code we may assume or reject executory contracts, including lease
obligations. Parties affected by these rejections may file claims with the Court
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.

Following the filing, we obtained, and received Court approval for a $2
billion senior secured debtor-in-possession financing facility ("DIP Credit
Facility") for payment of permitted pre-petition claims, working capital needs,
letters of credit and other general corporate purposes. The DIP Credit Facility
requires that we maintain certain financial covenants and restricts liens,
indebtedness, capital expenditures, dividend payments and sales of assets.

On or about March 7, 2003, Kmart commenced a balloting and solicitation
process with respect to the Plan of Reorganization, which is expected to
conclude on April 4, 2003. A hearing on confirmation of the Plan of
Reorganization is scheduled to commence in the Court on April 14, 2003. Assuming
confirmation of the Plan of Reorganization, we would plan to emerge from Chapter
11 by April 30, 2003. There can be no assurance, however, that the Plan of
Reorganization will be confirmed by the Court, or that such plan will be
consummated. In addition, the timing of such actions may be other than currently
planned by Kmart. A plan of reorganization cannot be effective until confirmed
by the Court, upon certain findings being made by the Court which are required
by the Bankruptcy Code.

Upon emergence from bankruptcy, the amounts reported in subsequent
financial statements may materially change due to the restructuring of Kmart's
assets and liabilities as a result of the Plan of Reorganization and the
application of the provisions of Statement of Position ("SOP") 90-7, "Financial
Reporting by Entities in Reorganization under the Bankruptcy Code," ("SOP 90-7")
with respect to reporting upon emergence from Chapter 11 ("Fresh-Start"
accounting). Changes in accounting principles required under generally accepted
accounting principles (or statutory regulations) within 12 months of emerging
from bankruptcy are required to be adopted at the date of emergence.
Additionally, we may choose to make changes in accounting practices and policies
at this time. For all these reasons, our financial statements for periods
subsequent to emergence from Chapter 11 will not be comparable with those of
prior periods. For details on our currents expectations of those changes see our
amended disclosure statements (the "Disclosure Statement"), which we filed as
Exhibit 2.2 to our Current Report on Form 8-K dated March 7, 2003.

38

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The accompanying 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 SOP 90-7. Accordingly, all pre-petition liabilities subject
to compromise have been segregated in the 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. Cash used for reorganization items is
disclosed separately in the Consolidated Statements of Cash Flows.

The ability of Kmart to continue as a going concern is predicated upon
numerous issues, including our ability to achieve the following:

- having the Plan of Reorganization confirmed by the Court in a timely
manner;

- being able to successfully implement our business plans and otherwise
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, pending emergence, within the framework of our DIP Credit
Facility and/or the Exit Financing Facility, including its limitations on
capital expenditures, its financial covenants, our ability to generate
cash flows from operations or seek other sources of financing and the
availability of projected vendor credit terms; and

- attracting, motivating and/or retaining key executives and associates.

These challenges are in addition to those operational and competitive
challenges faced by Kmart in connection with our business as a discount
retailer.

2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Nature of Operations: Kmart operates discount department stores located in
50 states, Puerto Rico, the U.S. Virgin Islands, and Guam. Kmart's equity
investments consist primarily of our 49% interest in substantially all of the
Meldisco subsidiaries of Footstar, Inc. ("FTS"), which operate the footwear
department in Kmart stores. We have one operating segment that comprises our
retail business.

Basis of Consolidation: The Consolidated Financial Statements include all
majority-owned subsidiaries in which we exercise control. Investments in which
we exercise significant influence, but which we do not control (generally 20% to
50% ownership interest), are accounted for under the equity method of
accounting. All material intercompany transactions and balances have been
eliminated.

Fiscal Year: Our fiscal year ends on the last Wednesday in January. Fiscal
year 2002 consisted of 52 weeks and ended on January 29, 2003. Fiscal year 2001
consisted of 52 weeks and ended on January 30, 2002. Fiscal year 2000 consisted
of 53 weeks and ended on January 31, 2001. Unless otherwise stated, 2003, 2002,
2001 and 2000 refer to fiscal year 2003, fiscal year 2002, fiscal year 2001 and
fiscal year 2000, respectively.

Bankruptcy Accounting: Since the Chapter 11 bankruptcy filing, we have
applied the provisions of SOP 90-7, which does not significantly change the
application of accounting principles generally accepted in the United States;
however, it does require that the financial statements for periods including and
subsequent to filing the Chapter 11 petition distinguish transactions and events
that are directly associated with the reorganization from the ongoing operations
of the business.

Cash: Cash and cash equivalents include all highly-liquid investments with
maturities of three months or less. Included are temporary investments of $323
and $0, at year end 2002 and 2001, respectively, and receivables for credit card
sales transactions of $41 and $79 at year end 2002 and 2001, respectively. Also

39

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

included in cash and cash equivalents is $5 and $29 of restricted cash at
January 29, 2003 and January 30, 2002, respectively.

Merchandise Inventories: Inventories are stated at the lower of cost or
market, primarily using the retail method. The last-in, first-out ("LIFO")
method, utilizing internal inflation indices, was used to determine the cost for
$4,730, $5,525 and $6,091 of inventory as of fiscal year end 2002, 2001 and
2000, respectively. Inventories valued on LIFO were $190, $269 and $194 lower
than amounts that would have been reported using the first in, first out
("FIFO") method at fiscal year end 2002, 2001 and 2000, respectively. In the
fourth quarter of fiscal year 2002, we recorded a LIFO credit of $79 and
decreased the LIFO reserve. We recorded a charge of $75 to increase the reserve
in 2001 and a credit of $8 to decrease the reserve in 2000.

Property and Equipment: Property and equipment are recorded at cost.
Additions and betterments are capitalized and include expenditures that
materially extend the useful lives of existing facilities and equipment.
Maintenance and repairs that do not materially improve or extend the lives of
the respective assets are expensed as incurred.

Long-lived Assets: Long-lived assets consist primarily of land, buildings,
furniture and equipment and leasehold improvements. It is our policy to review
our long-lived assets for possible impairment whenever events or circumstances
indicate that the carrying amount of an asset may not be recoverable and
annually when no such event has occurred. We review assets held and used on a
store-level basis, which is the lowest level of assets for which there are
identifiable cash flows. An impairment of long-lived assets exists when future
undiscounted cash flows are less than an asset groups' carrying value over the
estimated remaining useful life of the store. Impairment is measured as the
difference between carrying value and fair market value. Fair value is based on
appraised value or estimated sales values of similar assets in recent
transactions. Assets to be disposed of are reported at the lower of carrying
amount or fair value less the cost to sell.

Capitalized Software Costs: Costs associated with the acquisition or
development of software for internal use are capitalized and amortized using the
straight-line method over the expected useful life of the software, which ranges
from 3 to 7 years.

Depreciation and Amortization: Depreciation and amortization, including
depreciation of property held under capital leases, are computed based upon the
estimated useful lives of the respective assets using the straight-line method
for financial statement purposes and accelerated methods for tax purposes. The
general range of lives are 25 to 50 years for buildings, 5 to 25 years for
leasehold improvements, 3 to 17 years for furniture and fixtures and 3 to 5
years for computer systems and equipment.

Financial Instruments: Cash and cash equivalents, trade accounts payable
and accrued liabilities are reflected in our financial statements at cost, which
approximates fair value. The fair value of our debt and other financial
instruments is discussed in Note 12.

Derivative Instruments and Hedging Activities: We do not engage in hedging
transactions or invest in derivative instruments. Accordingly, the provisions of
Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for
Derivative Instruments and Hedging Activities," do not have a material impact on
our Consolidated Financial Statements.

Self-insurance: We self-insure or retain a portion of the exposure for
losses related to workers compensation and general liability costs. It is our
policy to record our self-insurance reserves, as determined actuarially, based
upon claims filed and an estimate of claims incurred but not yet reported.

Revenue Recognition: We recognize revenue from the sale of merchandise at
the time the merchandise is sold, net of anticipated returns. We defer the
recognition of layaway sales and profit until the period the merchandise is
delivered to the customer. Our deferred revenue is recorded in Accrued payroll
and other liabilities in the Consolidated Balance Sheets.

Vendor Rebates and Allowances: Periodic payments from vendors in the form
of buydowns, volume or other purchase discounts that are evidenced by signed
agreements are reflected in the carrying value of the
40

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

inventory when earned and as a component of Cost of sales, buying and occupancy
as the merchandise is sold. Up-front consideration received from vendors linked
to purchases or other commitments is initially deferred and amortized ratably to
cost of goods sold over the life of the contract or as performance of the
activities specified by the vendor to earn the fee is completed. To the extent
our agreements with vendors specify co-op advertising, we have historically
classified such credits as a reduction to advertising expense in Selling,
general and administrative expenses. Emerging Issues Task Force ("EITF") Issue
No. 02-16, "Accounting by a Customer (Including a Reseller) for Certain
Consideration Received from a Vendor" ("EITF 02-16"), which was effective for
all arrangements entered into after December 31, 2002, requires vendor
allowances to be classified as a reduction to cost of sales unless evidence
exists supporting an alternative classification. We early adopted the provisions
of EITF 02-16, on a prospective basis, in the fourth quarter of 2002 and we
classified $209 of co-op recoveries as a reduction of Cost of sales, buying and
occupancy, which would otherwise have been recorded as a reduction of selling,
general and administrative expenses ("SG&A").

Pre-Opening Costs: The costs of start-up activities are expensed in the
period in which they occur.

Advertising Costs: Advertising costs, net of co-op recoveries from vendors
of $276, $427 and $633 for fiscal years 2002, 2001 and 2000, respectively, are
expensed as incurred and amounted to $625, $623 and $508 in 2002, 2001 and 2000,
respectively. These costs are included in SG&A in the Consolidated Statements of
Operations.

Income Taxes: Deferred income taxes are provided for temporary differences
between financial statement and taxable income. We accrue U.S. and foreign taxes
payable on our pro rata share of the earnings of subsidiaries, except with
respect to earnings that are intended to be permanently reinvested, or expected
to be distributed free of additional tax by operation of relevant statutes
currently in effect, and by utilization of available tax credits and deductions.
In accordance with SFAS No. 109 "Accounting for Income Taxes," we have recorded
a full valuation allowance on net deferred tax assets as realization of such
assets in future years is uncertain. See Note 17.

Stock Option Plans: Kmart accounts for its stock option plans in
accordance with Accounting Principles Board ("APB") Opinion No. 25, "Accounting
for Stock Issued to Employees" ("APB No. 25") and related interpretations. APB
No. 25 provides for measuring stock option awards issued to employees using the
intrinsic value. When we award stock options, no compensation expense is
recorded because the exercise price is equal to the market value of the stock
award on the grant date. The pro forma effects of recognizing compensation
expense on net loss and loss per share had we applied fair value method is as
follows:

41

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

To determine these amounts, the fair value of each stock option has been
estimated on the date of the grant using a Black-Scholes option-pricing model
with a dividend yield of 0%. Options generally vest over 3 years on a
straight-line basis with a term of 10 years. No stock options were granted in
fiscal year 2002 following our Chapter 11 filing.

Use of Estimates: The preparation of the Consolidated Financial Statements
in conformity with accounting principles generally accepted in the United States
of America requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities and disclosure of contingent assets
and liabilities at the date of the financial statements and the reported amounts
of revenues and expenses during the reporting period. Significant estimates are
required as part of inventory valuation, restructuring charges, long-lived asset
impairments, self-insurance reserves, pension benefits, legal reserves, and
valuation allowances on deferred income taxes. Actual amounts, particularly with
respect to matters impacted by the proceedings under Chapter 11, could differ
from those estimates.

Reclassifications: Certain reclassifications of prior year amounts have
been made to conform to the current year presentation.

New Accounting Pronouncements: In June 2001, the Financial Accounting
Standards Board ("FASB") issued SFAS No. 143, "Accounting for Asset Retirement
Obligations" ("SFAS No. 143"), 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 interest expense. If
the obligation is settled for other than the carrying amount of the liability, a
gain or loss will be recognized on settlement. The provisions of SFAS No. 143
will be effective for our fiscal year beginning January 30, 2003. We do not
believe the provisions of SFAS No. 143 will have a material effect on our
financial statements.

In May of 2002, the FASB issued SFAS No. 145, "Rescission of FASB
Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical
Corrections" ("SFAS No. 145"). The statement rescinds SFAS No. 4, "Reporting
Gains and Losses from Extinguishment of Debt," and an amendment of that
statement, SFAS No. 64, "Extinguishments of Debt Made to Satisfy Sinking-Fund
Requirements." As a result, gains and losses from extinguishment of debt will be
classified as extraordinary items only if they are determined to be unusual and
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 of SFAS No. 145 will be
effective for our fiscal year beginning January 30, 2003. We will apply the
provisions of this statement for all debt extinguishments going forward.

In June 2002, the FASB issued SFAS No. 146, "Accounting for Exit or
Disposal Activities" ("SFAS No. 146"). 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 No. 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 was effective for exit or disposal activities that were initiated after
December 31, 2002. We have applied the provisions of this statement to
restructuring activities following

42

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

the effective date. As a result of adopting the provisions of this standard,
certain lease termination and other restructuring costs that otherwise would
have been accrued in the fourth quarter of 2002 will be recorded in the first
quarter of 2003 at the point that the liability is incurred under the new
guidance.

In December 2002, FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation -- Transition and Disclosure" ("SFAS No. 148") which provides
transition guidance for a voluntary change to the fair value method of
accounting (from the intrinsic value method) for stock option awards. The
Statement also amends the disclosure requirements of SFAS No. 123, "Accounting
for Stock-Based Compensation" ("SFAS No. 123"). The disclosure requirements
apply to annual as well as interim disclosures, and are applicable whether APB
No. 25 or SFAS No. 123 is used to account for stock-based awards. Kmart will
continue to apply the provisions of APB No. 25 (intrinsic value) in accounting
for stock-based awards, therefore the transition provisions will have no impact
to us. We have included the SFAS No. 148 disclosure requirements in this Annual
Report on Form 10-K for the year ended January 29, 2003 and will do so in all
subsequent interim reports.

In November 2002, the EITF reached a final consensus on EITF 02-16 which
addresses how a reseller of a vendor's product should account for cash
consideration received from a vendor. The EITF issued guidance on the following
two issues, as follows: (1) cash consideration received from a vendor should be
recognized as a reduction of cost of sales in the reseller's income statement,
unless the consideration is reimbursement for selling costs or payment for
assets or services delivered to the vendor, and (2) performance-driven vendor
rebates or refunds (e.g., minimum purchase or sales volumes) should be
recognized only if the payment is considered probable, and the method of
allocating such payments in the financial statements should be systematic and
rational based on the reseller's progress in achieving the underlying
performance targets. We have applied the provisions of item (1) above beginning
with our fourth quarter ended January 29, 2003. The impact of the application of
the new standard was to reclassify $209 of amounts previously classified as
co-op advertising recoveries from SG&A to Cost of sales, buying and occupancy.
We have applied the provisions of item (2) above, as required, to all new
contracts entered into subsequent to November 21, 2002. The impact of item (2)
is not expected to have a material effect on our results of operations or cash
flows.

In January 2003, the FASB issued FASB Interpretation ("FIN") No. 46,
"Consolidation of Variable Interest Entities" ("FIN No. 46"). FIN No. 46 is an
interpretation of Accounting Research Bulletin No. 51, "Consolidated Financial
Statements," and addresses consolidation by business enterprises of variable
interest entities -- a new term. Under current practice, two enterprises
generally have been included in consolidated financial statements because one
entity controls the other. FIN No. 46 defines "variable interests" and requires
existing unconsolidated variable interest entities to be consolidated by their
primary beneficiaries if the entities do not effectively disperse risks among
the parties involved. FIN No. 46 applies immediately to variable interest
entities created after January 31, 2003. It applies in the first fiscal year or
interim periods beginning after June 15, 2003, to variable interest entities in
which an enterprise holds a variable interest that it acquired before February
1, 2003. If it is reasonably possible that an enterprise will consolidate or
disclose information about a variable interest entity when FIN No. 46 becomes
effective, the entity must disclose information about those entities in all
financial statements issued after January 31, 2003. FIN No. 46 may be applied
prospectively with a cumulative-effect adjustment as of the date on which it is
first applied or by restating previously issued financial statements for one or
more years with a cumulative-effect adjustment as of the beginning of the first
year restated. We have performed an analysis to identify such entities and do
not believe that we have any entities that fall within the scope of this
standard.

3) SPECIAL CHARGES

During fiscal years 2002 and 2001, we instituted certain restructuring
actions to improve our operations and executed significant inventory
liquidations as a result of the stores closed under Kmart's Chapter 11
proceedings. Also, in accordance with SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets," we recorded impairment charges in
fiscal 2002 and 2001. These actions are summarized below.

43

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

2002 MARKDOWNS FOR INVENTORY LIQUIDATION

During fiscal 2002, we recorded charges aggregating $1,256 to write-down
inventory to be liquidated at the 316 stores to be closed during the first
quarter of fiscal 2003 and the 283 stores that were closed in the second quarter
of fiscal 2002 to net realizable value, given the accelerated liquidation
strategy. These charges are included in Cost of sales, buying and occupancy in
the Consolidated Statements of Operations.

During the fourth quarter of 2002, we recorded $395 relating to the
write-down of inventory to its estimated selling value in connection with the
liquidation sales in the 316 closing stores. In addition, $76 of this charge
relates to liquidator fees and expenses associated with the disposition of
inventory.

During the first quarter, a $384 charge was recorded relating to the
write-down of inventory existing at the closed 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 original estimate. $117 of the charge relates to liquidator
fees and expenses associated with the disposition of inventory.

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 closed 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 to adjust our original estimate of $266.

The following table summarizes the components of the charges for markdowns
for inventory liquidation during fiscal year 2002.

LONG-LIVED ASSET IMPAIRMENTS

During the fourth quarter of fiscal 2002 we analyzed our stores based on
profitability, lease terms and geographic areas. As a result of the analysis, we
decided to close 316 stores and in light of the shortened recoverability period
in the stores intended to be closed, performed a recoverability test on our
long-lived assets. As a result, we recorded a non-cash charge of $695 in
accordance with SFAS No. 144. The charge primarily relates to long-lived assets
in the closing store locations.

During the fourth quarter of fiscal 2001, due to below-plan sales and
earnings performance in the fourth quarter, our filing under Chapter 11 and
planned actions under such filings, we performed a recoverability test on our
long-lived assets. In accordance with SFAS No. 144, we recorded a non-cash
charge of $971. Of the charge, $921 relates to long-lived assets in our stores.
We performed an additional assessment of assets that were not included in the
above store analysis and recorded charges totaling $50 for capital projects that
were cancelled due to capital expenditure restrictions in our DIP Credit
Facility.

The above charges are included in the Restructuring, impairment and other
charges line in the Consolidated Statements of Operations.

44

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

CORPORATE COST REDUCTION INITIATIVES

During fiscal 2002 we recorded charges totaling $50 relating to the
realignment of our organization to reflect our current business needs as a
result of store closings and other cost reduction initiatives to improve
profitability, in accordance with SFAS No. 112, "Employers' Accounting for
Postemployment Benefits" ("SFAS No. 112"). These charges include severance,
outplacement services and continuation of healthcare benefits in accordance with
the severance plan provisions of our KERP, which was approved by the Court in
March 2002. These charges are included in the line Restructuring, impairment and
other charges in our Consolidated Statement of Operations.

During the fourth quarter of 2002, we announced our intention to eliminate
positions at our corporate headquarters and positions nationally that provide
corporate support in the first quarter of 2003. As a result of the expected job
eliminations, we recorded a charge of $36 during the fourth quarter of fiscal
2002.

During the second quarter of 2002, we eliminated approximately 400
positions at our corporate headquarters and approximately 50 positions
nationally that provided corporate support, as a result of the closing of the
283 stores. As a result of the job eliminations we recorded a charge of $15
during the second quarter of fiscal 2002. In the fourth quarter of 2002, we
recorded a credit of $1 as a result of a change in our estimated expenses.

SUPPLY CHAIN OPERATIONS

On September 6, 2001 we announced the restructuring of certain aspects of
our supply chain infrastructure, including the reconfiguration of our
distribution center network and implementation of new operating software across
our supply chain. In conjunction with these actions, we recorded a charge of
$163 in fiscal 2001.

We recorded a $93 charge related to the disposal of supply chain software
and hardware and other assets that are no longer utilized, in accordance with
SFAS No. 144.

Operating software was replaced at four of our distribution centers in
2002; however, we have suspended the replacement initiative at our other
fourteen distribution centers. Accordingly, we have discontinued the
acceleration of depreciation at these centers and any remaining net book value
of assets is being depreciated over the original useful lives. In fiscal 2001 we
recorded a charge of $23 related to the accelerated depreciation. This charge
was included in Cost of sales, buying and occupancy in the Consolidated
Statement of Operations. There was $9 related to accelerated depreciation in
fiscal 2002 of which $7 and $2 was included in Cost of sales, buying and
occupancy and SG&A, respectively.

A $47 charge was recorded for lease terminations and contractual employment
obligations for staff reductions of 956 employees at our distribution centers in
accordance with Emerging Issues Task Force Issue No. 94-3, "Liability
Recognition for Certain Employee Termination Benefits and Other Costs to Exit an
Activity" ("EITF 94-3").

The following table summarizes the significant components and presentation,
in the Consolidated Statements of Operations, of the charge for the
restructuring of our supply chain operations during the third quarter of fiscal
2001:

45

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

In the second quarter of fiscal 2002, we recorded a credit of $5 in
Reorganization items, net related to lease settlement agreements with our
landlords.

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.

Based upon the changing environment for the 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 in the second quarter of 2001, 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 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 with SFAS No. 144. Fair value was
determined using the present value of estimated future cash flows. In connection
with the transaction, the return of capital put rights for $63 and the 4.4
million warrants for Kmart stock originally granted to SOFTBANK Venture Capital
(currently Mobius Venture Capital) and other investors were terminated. The $63
liability for the return of capital puts, recorded due to uncertainties
surrounding a start-up operation in the highly competitive e-commerce industry,
was relieved.

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 in accordance with EITF 94-3 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.

During the third quarter of 2001, we continued executing our restructuring
plan, including formally communicating severance benefits to 114 employees at
the BlueLight.com headquarters. We recorded an additional $5 ($3, net of tax)
charge to provide for these costs.

In the third quarter of fiscal 2002 we reduced the reserves established for
BlueLight.com contract terminations by $6 based on our revised estimates for the
remaining obligations. All charges related to the impairment of our investment
and restructuring of BlueLight.com are included in the line Restructuring,
impairment and other charges in the Consolidated Statements of Operations.

The results of BlueLight.com's operations are fully consolidated in our
financial statements commencing July 31, 2001.

2000 STRATEGIC ACTIONS

In the second quarter of fiscal year 2000, we announced a series of
strategic actions aimed at strengthening financial performance by achieving
improvements in return on invested capital. These actions included deciding to
close certain Kmart and Kmart Supercenters, accelerating certain inventory
reductions

46

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

and redefining our information technology strategy. As a result of these
initiatives, we recorded a pre-tax charge of $740 ($471 net of tax) during the
second quarter of 2000. During the third quarter of fiscal year 2000, we reduced
this charge by $12 ($8 net of tax) due to changing the number of scheduled store
closings from 72 to 69, thus reducing the reserve for closed stores from $300 to
$288. In connection with the bankruptcy filing, we recorded to the reserve a
non-cash adjustment of $37 for the rejection of certain leases associated with
the 2000 strategic actions charge to reduce the reserve to the allowed claim
amount under the Bankruptcy Code.

The following table summarizes the significant components of the charge for
strategic actions taken during fiscal year 2000 and the presentation in our
Consolidated Statements of Operations:

OTHER

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 Consolidated Statement of Operations in the
line item Restructuring, impairments and other charges. 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.

Accelerated Depreciation

We recorded charges totaling $30 related to the accelerated depreciation of
the remaining assets in these stores. This charge is recorded in cost of sales,
buying and occupancy in our Consolidated Statements of Operations.

Reserve Activity

The following table provides information regarding reserve activity during
fiscal year 2002 and 2001 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 include charges of
$228 relating to estimated allowable claims associated with lease rejections.
Reserves established for 2002 employee severance include $51 for corporate cost
reductions, $22 for

47

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

employees in the 283 stores closed in 2002 and $28 for employees in stores to be
closed in 2003. The liabilities aggregated $466 and $127 for 2002 and 2001,
respectively.

4) 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 Consolidated
Statements of Operations. For fiscal 2002 and 2001 the following have been
recorded:

The following paragraphs provide additional information relating to costs
that were reported in the line Reorganization items, net in our Consolidated
Statement of Operations for the 2002 fiscal year:

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
48

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

stores that did not meet our financial requirements for ongoing operations. All
of the stores were closed as of June 2, 2002.

SFAS No. 144 requires closed stores to be classified as discontinued
operations 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. Based on these criteria, we evaluated the 283 stores closed during the
second quarter and determined that in substantially all the cases, the
operations and cash flows of the stores would not be eliminated from our ongoing
operations. The results of operations for 28 stores were considered to be
discontinued operations under the criteria set forth in SFAS No. 144; however,
total Sales, Gross margin, and SG&A for these stores represented less than 1% of
Kmart's total Sales, Gross margin and SG&A, and were not considered material for
separate presentation in the Consolidated Statement of Operations.

We recorded charges of $207 for expenses related to store closings during
fiscal 2002. We charged $228 to our closed store reserve for allowable claims
related to lease terminations and other costs and reclassified $140 of capital
lease obligations to the closed store reserve during the first quarter of fiscal
2002. During the second, third and fourth quarters of fiscal 2002, we recorded a
net credit of ($21) to adjust our estimated allowable claims. The reserve for
estimated costs was recorded in accordance with EITF 94-3.

EMPLOYEE COSTS

In March 2002, we received Court approval to implement the Key Employee
Retention Program ("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 their employment
with Kmart through the reorganization process. For fiscal year 2002, we recorded
charges of $106 for the KERP retention benefits and $50 for other enhanced
employee severance benefits for associates in our closing stores and are not
covered under the KERP.

PROFESSIONAL FEES

We recorded $112 and $8 for professional fees during 2002 and 2001,
respectively. Professional fees include financial, legal, real estate and
valuation services directly associated with our reorganization process.

GENERAL LIABILITY RESERVES

During the fourth quarter of 2001 we recorded a credit of $174 for the
reduction of our estimated obligation for general liability claims based upon
the actuarial determination of the effect of the bankruptcy process on the
ultimate development of case reserves and claims incurred but not reported. In
the fourth quarter of 2002 we recorded $51 of expense to revise our estimate of
our pre-petition obligation for general liability claims.

SETTLEMENT OF PRE-PETITION LIABILITIES

We recorded gains of $107 in 2002 representing the difference between the
settlement value of certain pre-petition obligations and the estimated 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 by the
Court on May 10, 2002. Under the terms of the Agreements we agreed to sell to
the Purchasers the designation rights with respect to 56 leaseholds for closed
stores and our interest in the leasehold for one closed store, (the

49

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Purchaser of which defaulted under its Agreement and the lease was rejected).
During the designation period, as defined under the Agreements, the Purchaser of
designation rights has the sole, exclusive and continuing right to select,
identify and designate (i) which leases shall be assumed and assigned (and if
assigned to whom), or terminated, and (ii) which properties shall be excluded
from the transaction. During fiscal 2002, the leaseholds on the 283 stores not
covered by the Agreements have been rejected or terminated.

In consideration for the designation rights acquisitions, the Purchasers
paid $46, all of which was paid in cash during the year. 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.

The guaranteed proceeds of $46 are being recognized as income on a pro-rata
basis at either the effective date of the property assignment or termination,
when we are informed by the Purchasers of their intention to exclude certain
leaseholds from future assignments or terminations, 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 the store and reject
the lease will be reversed. Both the income from the sale of the designation
rights and the reversal of allowed claim amounts are reported as Reorganization
items, net in the Consolidated Statement of Operations.

During fiscal 2002, 23 leases under the Agreements have been assigned, nine
have been terminated or rejected under landlord agreements and nine have been
excluded and rejected. Two additional leases were excluded and rejected during
the first quarter of fiscal 2003. Six additional leases were approved for
assignment during the fourth quarter of fiscal 2002. These six leases were
assigned during the first quarter of fiscal 2003. Five of the excluded leases
were rejected before the end of the fiscal 2002. The two remaining excluded
leases have been or will be assigned, terminated or rejected in the fourth
quarter. During the year we recognized $29 of proceeds from the sale of
designation rights. The remaining funds received have been deferred and will be
recognized in our Consolidated Statement of Operations as described above.

OTHER REORGANIZATION ITEMS

We recorded $18 of income for the sale of pharmacy lists and $10 for
interest income earned on excess cash balances. We also recorded expense of $24
and income of $17 in 2002 and 2001, respectively, for other reorganization
items.

5) DISCONTINUED OPERATIONS

In connection with Kmart's bankruptcy filing, we recorded primarily
non-cash credits in 2002 and 2001 of $43 and $166, respectively, for the
reduction of existing lease obligations for prior discontinued operations for
owned subsidiaries due to the rejection of such leases, to the amount of the
allowed claim under the Bankruptcy Code. The 2002 amounts also include income
related to the recovery of claims through the bankruptcy of Hechinger Company.

50

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

6) EARNINGS PER SHARE

In fiscal years 2002, 2001 and 2000, all outstanding stock options were
excluded from the computation of diluted earnings per share because they would
have been anti-dilutive. For fiscal year 2002, options to purchase 44.9 million
shares of common stock at prices ranging from $4.86 to $24.06 were excluded from
the calculations. For fiscal year 2001, options to purchase 60.0 million shares
of common stock at prices ranging from $4.86 to $26.03 were excluded from the
calculations. For fiscal year 2000, options to purchase 46.3 million shares of
common stock at prices ranging from $5.34 to $26.03 were excluded from
calculations. The calculations also exclude the effect of Preferred Securities
(as defined below). For fiscal year 2002, diluted shares outstanding exclude
approximately 43.2 million common shares from potential conversion of certain
Preferred Securities due to their anti-dilutive effect. For fiscal years 2001
and 2000, diluted shares outstanding exclude approximately 59.9 million common
shares from potential conversion of certain Preferred Securities due to their
anti-dilutive effect. For fiscal year 2000 diluted shares outstanding exclude
approximately 0.2 million shares from the potential conversion of written put
options due to their anti-dilutive effect.

During fiscal year 2002, we received conversion notices from holders of
4,998,439 Preferred Securities. Such securities were convertible into 16,661,297
shares of Kmart common stock.

7) RELATED PARTY DISCLOSURE

Commencing March 2002, Kmart engaged various services of AP Services
(formerly known as JA&A Services), a consulting firm, whose Chairman and another
Principal hold executive officer positions within Kmart. Specifically, their
Chairman, Albert A. Koch, currently serves as our Chief Financial Officer, and
another Principal, Edward J. Stenger, currently serves as our Treasurer. During
fiscal 2002, we recorded expenses of $13 and paid fees of $11 to the firm for
services rendered under the consulting agreement, including the services of
Messrs. Koch and Stenger. In addition to hourly fees and expenses, AP Services
could also receive an annual performance fee of 0.75% of earnings before
interest, taxes, depreciation, amortization and other charges as defined by the
DIP Credit Facility ("EBITDA") exceeding a certain minimum threshold for each
year services are rendered under terms of the agreement.

8) INVESTMENTS IN AFFILIATED COMPANIES

MELDISCO

All Kmart footwear departments are operated under a license agreement with
the Meldisco subsidiaries of FTS, substantially all of which are 49% owned by
Kmart and 51% owned by FTS. Income earned under

51

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

various agreements was $222, $255 and $270 in 2002, 2001 and 2000, respectively.
In each of 2002, 2001 and 2000 we received dividends from Meldisco of $45, $51
and $44, respectively representing distributions of prior years earnings.
Unremitted earnings included in consolidated retained earnings were estimated at
$34 at January 29, 2003 and were $46 and $51 at January 30, 2002 and January 31,
2001, respectively.

The amounts stated above are current estimates based upon all information
that was available to Kmart as of the date of our filing. We are aware that FTS
will be restating its financial statements for prior periods and has not yet
issued its third quarter report on Form 10-Q. As a result, we have not received
financial statements for fiscal 2002 for Meldisco at the time of our filing of
our Annual Report on Form 10-K. We do not expect their restatement to have a
material effect on our equity income from Meldisco.

BLUELIGHT.COM

On July 31, 2001, we acquired the remaining 40% interest in BlueLight.com
through the purchase of all outstanding common and preferred stock of
BlueLight.com, Inc., a holding company, and certain limited liability company
interests not owned by Kmart, at which time BlueLight.com became a wholly-owned
subsidiary of Kmart. The results of BlueLight.com's operations are fully
consolidated in our financial statements commencing July 31, 2001. For the
period from February 1, 2001 to July 31, 2001, BlueLight.com had net sales of $8
million, gross profit of $1 million and a net loss of $55 million.

52

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

PENSKE

In November 1995, we sold our auto service center business to Penske Auto
Centers, Inc., a corporation controlled by Penske Corporation ("Penske"). In
connection with the sale, Kmart and Penske entered into a multi-year master
sublease agreement for the auto service center locations that are operated by
Penske and Penske Auto Centers. We entered an agreement effective January 1,
2000 with Penske under which we acquired a 22 percent interest in Penske LLC, an
entity formed to own and operate the Penske Auto Centers. In January 2001, Kmart
and Penske entered into an agreement to increase our interest in Penske LLC from
22 percent to 36 percent. 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. Our investment in Penske LLC is accounted for under the equity method and
had no carrying value at January 29, 2003 or January 30, 2002.

9) CURRENT ASSETS

Other current assets included in the Consolidated Balance Sheets consist of
the following:

10) PROPERTY AND EQUIPMENT

53

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The following table provides a breakdown of the number of stores leased
compared to owned:

Of the 316 stores we anticipate closing during the first quarter of 2003,
13 stores are owned locations and 303 are leased locations.

11) CURRENT LIABILITIES

Accrued payroll and other liabilities included in the Consolidated Balance
Sheets consist of the following:

As discussed in Note 14, all pre-petition liabilities except for secured
debt, employee payroll and benefits, sales and use taxes and capital lease
obligations, have been classified as Liabilities subject to compromise.

12) LONG-TERM DEBT AND NOTES PAYABLE

On January 25, 2002, the Court authorized borrowings up to $1.15 billion of
the 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.
Debt issuance costs associated with the DIP Credit Facility totaled $71 and are
being amortized through our expected emergence date of April 30, 2003. The DIP
Credit Facility is a revolving credit facility in which Kmart is the borrower
and the rest of the debtors are guarantors. The DIP Credit Facility is
collateralized by

54

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

first liens on substantially all of our assets (subject to valid and unavoidable
pre-petition liens and certain other permitted liens). Borrowings under the DIP
Credit Facility can be denominated in U.S. dollars bearing interest at the Prime
Rate plus 2.5% per annum, or at Kmart's option, in Eurodollars bearing interest
at the LIBOR rate plus 3.5% per annum.

Under the DIP Credit Facility, capital expenditures are restricted to $650
during fiscal 2002, $800 during fiscal 2003 and $212 during fiscal 2004 up to
April 22, 2004, the maturity date, providing that no more than 55% of the
capital expenditures permitted in any fiscal year may be made in the first two
fiscal quarters and 20% of the unused portion of permitted capital expenditures
in any fiscal year may be carried forward to and used in the following year. We
are also required to maintain specified levels of EBITDA for periods ending as
early as June 2002 and thereafter. The DIP Credit Facility also contains other
customary covenants, including certain reporting requirements and covenants that
restrict our ability to incur or create liens, indebtedness and guarantees, make
dividend payments, sell or dispose of assets, change the nature of our business
and enter into affiliate transactions, mergers and consolidations. Failure to
satisfy these covenants would (in some cases, after the expiration of a grace
period) result in an event of default that could cause, absent the receipt of
appropriate waivers, the funds necessary to maintain our operations to become
unavailable. The DIP Credit Facility contains other customary events of default,
including (i) certain ERISA events, (ii) a change of control and (iii) the
occurrence of certain specified events in the Chapter 11 cases.

Prior to the Petition Date, our primary sources of working capital had been
cash flows from operations and borrowings under our $1.1 billion credit facility
("Credit Facility") and $400 credit facility ("364-day Facility"). On June 15,
2001, we sold in an underwritten offering $430 of 9 7/8% Notes due June 2008.
Interest was payable semiannually on June 15 and December 15. On January 30,
2001, we sold in an underwritten offering $400 of 9.375% Notes due February 1,
2006 ("Notes"). Interest was payable semi-annually on February 1 and August 1.
We used the proceeds from the notes for the paydown of certain collateralized
mortgage backed securities and other general corporate purposes. The various
facilities contain certain affirmative and negative covenants customary to these
types of agreements. Due to the proceedings under Chapter 11, we are in default
on our debt agreements, with the exception of the DIP Credit Facility. While
operating under Chapter 11, we are prohibited from paying interest on unsecured
pre-petition debts. We ceased accruing interest on all unsecured long-term debt
subject to compromise in accordance with SOP 90-7. The estimated fair market
value of debentures included in long-term debt classified in Liabilities subject
to compromise, was approximately $332 at the end of fiscal year 2002. Fair
market value for medium term notes classified in Liabilities subject to
compromise cannot be reasonably estimated at year end 2002. The estimated fair
market value of long-term debt was $2,016 at fiscal year end 2001. The estimated
fair market value was based on the quoted market prices for the same or similar
issues or on the current rates offered to Kmart for debt of the same remaining
maturities. There were $0, $393 and $676 of borrowings outstanding under our DIP
Credit Facility, 364-day Credit Facility and Credit Facility, respectively, at
the end of fiscal year 2002.

The contractual principal maturities of long-term debt for the five years
subsequent to 2002 are: 2003 -- $1,204; 2004 -- $330; 2005 -- $113;
2006 -- $615; 2007 -- $7 and 2008 and later -- $1,079. Cash paid for interest
was $7, $205 and $285 in 2002, 2001 and 2000, respectively.

Included in the foregoing amounts are significant pre-petition obligations.
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 may not be enforced. Therefore, the commitments shown above may
not reflect actual cash outlays in the future period.

Included in the line Interest expense, net in the Consolidated Statements
of Operations is interest income of $4, $4 and $17 for fiscal years 2002, 2001
and 2000, respectively. On the Petition Date we stopped accruing interest on all
unsecured pre-petition debt in accordance with SOP 90-7. Contractual interest
expense not accrued or recorded on certain pre-petition debt totaled $271 and $8
in fiscal 2002 and 2001, respectively.

55

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

13) LEASES

We conduct our operations primarily in leased facilities. Kmart store
leases are generally for terms of 25 years with multiple five-year renewal
options that allow us the option to extend the life of the lease up to 50 years
beyond the initial noncancelable term. In certain Kmart leased facilities,
selling space has been sublet to other retailers, including Olan Mills, Inc. and
the Meldisco subsidiaries of FTS.

Under the Bankruptcy Code we may assume or reject executory contracts,
including lease obligations. Therefore, the commitments shown above may not
reflect actual cash outlays in the future periods. See Note 22, Subsequent
Events.

14) 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 the Debtors. 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 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.

56

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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. A
limited number of personal injury claimants omitted from such notice process
will be given additional time to file their claims. An estimated 45,000 claims
were filed as of July 31, 2002 out of an estimated 1.1 million notices sent to
constituents. Amounts that we have recorded are in many instances different from
amounts filed by our creditors. Differences between amounts scheduled by Kmart
and claims by creditors are being investigated and resolved in connection with
our claims resolution process. Until the process is complete, the ultimate
number and amount of allowable claims cannot be ascertained. In this regard, it
should be noted that the claims reconciliation process may result in material
adjustments to current estimates of allowable claims. The ultimate resolution of
these claims will be based upon the final plan of reorganization.

The following table summarizes the components of Liabilities subject to
compromise in our Consolidated Balance Sheets as of January 29, 2003 and as of
January 30, 2002:

Following is a reconciliation of the changes in Liabilities subject to
compromise for the period from the Petition Date through January 29, 2003:

15) CONVERTIBLE PREFERRED SECURITIES

In June 1996, a trust sponsored and wholly-owned by Kmart issued to the
public 20,000,000 trust convertible preferred securities ("Preferred
Securities"). The proceeds from the sale of the Preferred Securities, together
with the proceeds of a sale of common trust securities to Kmart, were used to
purchase from Kmart 7 3/4% subordinated convertible debentures due June 15,
2016. The debentures are the sole asset of the trust.

57

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The Preferred Securities accrue and pay cash distributions quarterly at a
rate of 7 3/4% per annum. We have stopped accruing distributions on the
Preferred Securities in accordance with SOP 90-7. Contractual distributions for
fiscal year 2002 and 2001 on the Preferred Securities were $65 and $72,
respectively.

The Preferred Securities are convertible at the option of the holder at any
time at the rate of 3.3333 shares of Kmart common stock for each Preferred
Security, and are mandatorily redeemable upon repayment of the debentures,
either at maturity on June 15, 2016, or upon their earlier redemption. The
debentures became callable at our option beginning June 15, 1999.

During fiscal year 2000 we repurchased approximately 2 million shares of
Preferred Securities at a cost of approximately $84. For purposes of computing
earnings per share, the discount on the repurchase, net of tax, was added to net
income to arrive at income available to common shareholders.

Based on the quoted market prices, fair value of the Preferred Securities
was approximately $130 as of fiscal year end 2001. There was no active market
for the Preferred Securities at fiscal year end 2002, therefore, fair value
could not be reasonably estimated.

16) STOCK OPTION PLANS

Stock options granted under various plans have an exercise price equal to
the average of the highest and lowest prices at which Kmart common stock was
traded on the New York Stock Exchange on the date of grant. Stock options that
have been granted generally become exercisable one-third after one year from the
date of grant, an additional one-third after two years, in full after three
years and expire ten years from the date of grant.

The following table summarizes information about stock options outstanding
as of January 29, 2003:

58

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

17) INCOME TAXES

59

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

In the fourth quarter of fiscal year 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 did not recognize any tax benefit from
our losses in fiscal year 2002. The $24 tax benefit recorded during fiscal year
2002 relates to: (i) a $12 tax benefit refunded to Kmart as a result of the
alternative minimum tax net operating loss provisions of the Job Creation and
Worker Assistance Act of 2002; (ii) a $14 tax benefit refunded to Kmart as a
result of the ten-year carryback of certain deductions for net operating losses,
and (iii) a net $2 in federal, state and foreign income taxes.

At January 29, 2003, we have unused NOL carryforwards of approximately
$3,102. The federal tax benefits of these NOL carryforwards will expire in 2021
and 2022 and the state tax benefits will predominantly expire between 2016 and
2022. Additionally, we have (i) available foreign tax credit carryforwards of
approximately $73 which would expire as follows: 2003 -- $19, 2004 -- $17,
2005 -- $20, 2006 -- $10 and 2007 -- $7; (ii) general business tax credit
carryforwards of approximately $70 which would expire as follows: 2011 -- $6,
2017 -- $7, 2018 -- $10, 2019 -- $12, 2020 -- $14, 2021 -- $13 and 2022 -- $8 ,
and (iii) AMT credit carryforwards of approximately $96 which may be carried
forward indefinitely.

Cash (received) paid for income taxes was ($31), ($69) and $50 in 2002,
2001 and 2000, respectively.

18) PENSION PLANS AND OTHER POST-RETIREMENT BENEFITS

Prior to 1996, Kmart had defined benefit pension plans covering eligible
associates who met certain requirements of age, length of service, and hours
worked per year. Effective January 31, 1996, the pension plans were frozen, and
associates no longer earn additional benefits under the plans.

60

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The plan's assets consist primarily of equity and fixed income securities.
Contributions to the plans were not required for fiscal years 2002, 2001 and
2000. Total consolidated pension income was $20, $72 and $71 in 2002, 2001 and
2000, respectively.

The $741 liability reported in the fiscal year 2002 Consolidated Balance
Sheet has been included as a component of Liabilities subject to compromise
pending final resolution of the bankruptcy claim filed by the Pension Benefit
Guaranty Corporation.

The following tables summarize the change in benefit obligation, change in
plan assets, funded status, amounts recognized and actuarial assumptions for our
employee pension plans.

61

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

We have non-qualified plans for directors and officers which were partially
funded as of years ended 2002 and 2001. Benefits under the plans totaled $22 and
$36 at the end of 2002 and 2001, respectively, which have been accrued in the
Consolidated Balance Sheets. Plan assets totaled $12 and $16 as of year end 2002
and 2001, respectively.

Full-time associates who have worked 10 years and who have retired after
age 55 have the option of participation in Kmart's medical plan until age 65.
The plan is contributory, with retiree contributions adjusted annually. The
accounting for the plan anticipates future cost-sharing changes that are
consistent with our expressed intent to increase the retiree contribution rate
annually. The accrued post-retirement benefit costs were $32 and $40 as of year
end 2002 and 2001, respectively.

19) RETIREMENT SAVINGS PLAN

The Retirement Savings Plan provides that associates of Kmart who have
completed 1,000 hours of service within a twelve month period can invest from 1%
to 16% of their earnings in their choice of various investments. For each dollar
the participant contributed up to 6% of earnings, we contributed an additional
50 cents which was invested in the Employee Stock Ownership Plan. In February
2002, the Employee Stock Ownership Plan provision was removed and the Employer
Match Contribution was invested at the discretion of the participant.

The Retirement Savings Plan also had a profit sharing feature whereby we
would make contributions based on profits, with minimum yearly contributions
required of $30. The profit sharing feature was discontinued in 2001. Our total
expense related to the Retirement Savings Plan was $31, $39 and $73 in 2002,
2001 and 2000, respectively.

20) COMMITMENTS AND CONTINGENCIES

CONTINGENT LIABILITIES:

As of January 29, 2003, we had (i) guaranteed obligations for real property
leases of certain current and former subsidiaries of Kmart including, but not
limited to, The Sports Authority, Inc., OfficeMax, Inc. and Borders Group, Inc.,
some of which leases have been assigned pre-petition (These amounts totaled
approximately $550 and $600 for 2002 and 2001, respectively. The present value
at 7% of the gross lease for 2002 was over $325.); (ii) contingent liability
under real property leases assigned by Kmart pre-petition; and (iii) guaranteed
$64 of indebtedness of other parties related to certain of our leased properties
financed by industrial revenue bonds. Our rights and obligations with respect to
our guarantee of leases of the former subsidiaries The Sports Authority, Inc.,
Office Max, Inc., and Borders Group, Inc., which are detailed below, are
governed by Lease Guarantee, Indemnification and Reimbursement Agreements dated
as of November 23, 1994, November 9, 1994 and May 24, 1995, respectively, as
they may be amended from time to time. Kmart's contingent obligations, described
above, which are not reflected in our financial statements, are dependent on the
future performance by the parties whose obligations we guarantee and are
intended by Kmart, as set forth in the Plan of Reorganization, to be discharged
thereunder if such Plan is confirmed and consummated subject to pre-petition
claims administration as appropriate.

We are a party to a substantial number of other contracts which are routine
and incidental to our business. Certain contracts allow for damage provisions or
other paybacks as a result of our termination of the contracts. We assess the
likelihood of potential losses on an ongoing basis and when they are considered
probable and reasonably estimable, record 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.

62

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

LEGAL 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 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
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. We presently expect, as determined in the Plan of
Reorganization, 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 Item 1. Business Proceedings Under Chapter 11 of the
Bankruptcy Code, of this Form 10-K.

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. A detailed
discussion of the investigation and stewardship review undertaken by counsel
under the supervision of the Audit Committee, as well as the results of such
investigation and review, is contained in the Disclosure Statement, which we
filed as Exhibit 2.2 to our Current Report on Form 8-K dated March 7, 2003.

Since February 21, 2002, five separate purported class actions have been
filed on behalf of purchasers of Kmart common stock. The initial complaints were
filed on behalf of purchasers of common stock between May 17, 2001 and January
22, 2002, inclusive, and named Charles C. Conaway, former 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, among other
things, 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. On October 15, 2002, an amended consolidated 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 former officers Jeffrey N. Boyer, Mark S. Schwartz, Matthew F.
Hilzinger, Martin E. Welch III, and PricewaterhouseCoopers LLP as defendants.
Kmart is not a defendant in this litigation by virtue of the automatic stay. On
July 31, 2002, attorneys for plaintiffs in the pending class action lawsuits
filed a class proof of claim in the Court (the "Class Proof of Claim") on behalf
of the plaintiffs and all purchasers of Kmart common stock between May 17, 2001
and January 22, 2002, inclusive. The Class Proof of Claim, which is asserted
against the Debtors reserved the right to identify additional claimants or
members of the class group in the future. In support of the Class Proof of
Claim, the claimants rely on the above-referenced class actions filed against
the parties identified above. The claimants state that the grounds for liability
are alleged damages for violations of federal securities laws, including the
Securities Exchange Act of 1934, in connection with the purchase or acquisition
of Kmart common stock by the claimants during the class period. The Class Proof
of Claim alleges that the Debtors are liable to the claimants for damages in a
sum not presently determinable but believed to be not less than $700 in the
aggregate, plus interest, costs and allowed attorneys' fees.

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
current and former employees and directors of Kmart alleging breach of fiduciary
duty under the Employee Retirement Income Security Act for excessive investment
in Kmart stock; failure to provide complete and accurate information about Kmart
common stock; and failure to provide accurate information regarding our
financial condition. Subsequently, amended complaints were filed that added
63

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

additional current and former employees and directors of Kmart as defendants.
Kmart is not a defendant in this litigation.

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 former 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 was not a defendant in
this litigation. On January 16, 2003, the District Court dismissed the
complaint. On February 14, 2003, a lawsuit was filed by the Softbank Funds
against Mr. Conaway in the Circuit Court of Cook County, Illinois. This lawsuit
seeks $33 from the defendant for alleged breach of fiduciary duty in connection
with the failure of Kmart to cause the registration of the plaintiffs' shares of
Kmart common stock to become effective. This claim is essentially the same as
count I of the lawsuit that was dismissed on January 16, 2003.

In connection with the investigation by the United States Attorney in
Puerto Rico of alleged actions by Kmart's employees following the 1998 Hurricane
Georges, on October 28, 2002, Kmart's wholly owned subsidiary, S.F.P.R., Inc. a
Puerto Rico corporation, pled guilty to one count of mail fraud in violation of
18 U.S.C. Sections 1341 and 1342 pursuant to a plea agreement providing for a
three year probation period, a fine in the amount of $2 and other agreements.
Kmart has paid the fine and taken certain other actions, none of which have had
a material adverse effect on Kmart's liquidity, financial position or results of
operations.

Kmart is a defendant in six putative class actions and one multi-plaintiff
case pending in California, all relating to Kmart's classification of assistant
managers and various other employees as "exempt" employees under the federal
Fair Labor Standards Act ("FLSA") and the California Labor Code and Kmart's
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
United States District Court for the Eastern District of California (Henderson
v. Kmart), the United States 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 could 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. We presently do not expect to have any
significant financial exposure as a result of these cases.

Kmart is a defendant in a putative class action pending in Oklahoma
relating to the proper payment of overtime to hourly associates under the FLSA.
The plaintiff claims he represents a class of all current and former Kmart
employees who have been improperly denied overtime pay. This case was filed on
March 4, 2003 and is currently pending in the U.S. District Court for the
Northern District of Oklahoma. At this time, the likelihood of a material
unfavorable outcome is not considered probable.

There is an increasing trend of high profile class action litigation,
particularly in the retail industry, against employers of large numbers of
people which allege violations of the FLSA. Other companies against which these
cases have been filed have paid significant settlements and/or had significant
judgments entered against them. Kmart has a large employee base; however no
class actions against Kmart have yet been certified. The actions described above
are the only FLSA related matters that are currently pending against Kmart.

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. We assess the likelihood of potential losses on an ongoing
basis and when they are considered probable and reasonably estimable, we record
an estimate of the ultimate outcome. If there is

64

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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 other matters filed with
the Bankruptcy 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 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, legal counsel and others, 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, and with our three statutory committees, with
respect to the investigations of these matters. 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
was extended to January 9, 2003, with our consent, and may be further extended
to April 29, 2003 by stipulation to be filed with the Court. In addition, in
July 2002 The United States House 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. A detailed discussion of the
investigation and stewardship review, as well as the results of such
investigation and review, is contained in the Disclosure Statement, which we
filed as Exhibit 2.2 to our Current Report on Form 8-K dated March 7, 2003.

After consultation with the statutory committees, we have determined that a
creditor litigation trust is the preferred available mechanism for resolving any
legal claims that may arise out of these investigations. As part of the Plan of
Reorganization, the trustee of the trust would be charged with responsibility
for determining which claims to pursue and litigating such claims. Pursuant to
the Plan of Reorganization, we will share with the trustee evidence gathered and
certain work product developed during the investigations.

OTHER:

Minimum royalty payments in certain vendor contracts for the five years
subsequent to 2002 are: 2003 -- $87; 2004 -- $86; 2005 -- $87; 2006 -- $84;
2007 -- $90 and 2008 and later -- $441.

21) QUARTERLY FINANCIAL INFORMATION (UNAUDITED)

- ---------------

* As previously reported in quarterly reports on Form 10-Q/A filed on January
14, 2003.

65

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Earnings per share amounts for each quarter are required to be computed
independently and may not equal the amount computed for the total year. In the
fourth quarter of fiscal year 2002, we recorded charges for impairments of $695,
in accordance with SFAS No. 144, a charge for inventory write-downs of $471, a
charge of $93 for a change in workers' compensation and general liability
reserves ($51 related to reorganization), a decrease in the LIFO reserve of $79
and $64 relating to the realignment of our organization to reflect our current
business needs as a result of store closings and other cost reduction
initiatives to improve profitability.

22) SUBSEQUENT EVENTS

FLEMING

On February 3, 2003 we announced that we had terminated our supply
relationship with Fleming by means of a rejection of the 2001 contract through
Kmart's Chapter 11 reorganization. Fleming continued to supply food and
consumable products to us until March 8, 2003. We now facilitate the supply of
food and consumables ourselves. Kmart has experienced minimal business
interruption in the transition. As part of the bankruptcy proceedings, Fleming
has filed a claim of $1.5 billion as of March 11, 2003. On March 18, 2003, we
came to an agreement with Fleming in regards to their claim, settling on a $15
administrative claim, and a $385 pre-petition claim. This agreement is subject
to Court approval. Our estimate of our liability related to this claim will be
represented in our results of operations in the first quarter of 2003.

KIMCO

On February 14, 2003 Kmart announced that it has reached an agreement with
Kimco Realty Corporation for the joint marketing of approximately 316 Kmart
locations and related properties in the United States and Puerto Rico that we
are in the process of closing. Kmart received Court approval on January 28, 2003
to close these stores. Under the agreement, Kimco or its affiliate will work
with Kmart in identifying retailers, investors, landlords and other parties
interested in obtaining these properties. Kimco may invest in, redevelop and/or
improve the properties in order to maximize their value. The locations to be
marketed range in size from approximately 50,000 square feet to more than
190,000 square feet and are located in freestanding, strip and mall locations in
44 states and Puerto Rico. This group of stores includes 57 Kmart SuperCenter
locations.

EXPIRATION OF SURETY BONDS SUPPORTING CERTAIN WORKERS' COMPENSATION
SELF-INSURANCE PROGRAMS

On March 21, 2003 a surety bond order supporting certain of our
self-insured workers' compensation programs expired. We expect these surety
bonds to be cancelled 30 to 90 days following the expiration date. In certain
states, we have initiated discussions to explore retention of self-insurance
privileges using alternative forms of security. Concurrently, we are in
negotiations with insurance brokers, who are in contact with multiple insurance
carriers, regarding issuance of insurance policies to cover these liabilities
under alternative programs. To the extent that such discussions and negotiations
are unsuccessful, we expect that we will be able to participate in
state-assigned risk and/or state funded insurance programs. Although it is too
soon to adequately estimate the cost of the resulting program, we expect the
costs to exceed levels incurred historically. However, we do not expect this
additional cost to have a material effect on our financial position or results
of operations.

66

KMART CORPORATION

SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
FISCAL YEARS 2002, 2001 AND 2000

67

MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL STATEMENTS

Management is responsible for the preparation of our Consolidated Financial
Statements and related information appearing in this report. These financial
statements have been prepared in conformity with accounting principles generally
accepted in the United States of America on a consistent basis applying certain
estimates and judgments based upon currently available information and
management's view of current conditions and circumstances. On this basis, we
believe that these financial statements reasonably present our financial
position and results of operations.

To fulfill our responsibility, we maintain comprehensive systems of
internal controls designed to provide reasonable assurance that assets are
safeguarded and transactions are executed in accordance with established
procedures. The concept of reasonable assurance is based upon recognition that
the cost of the controls should not exceed the benefit derived. We believe our
system of internal controls provide this reasonable assurance.

We have adopted a code of conduct to guide our management in the continued
observance of high ethical standards of honesty, integrity, and fairness in the
conduct of business and in accordance with the law. Compliance with the
guidelines and standards is periodically reviewed and is acknowledged by all
management associates.

Our Board of Directors has an Audit Committee consisting solely of outside
directors. The duties of the Audit Committee include keeping informed of the
financial condition of Kmart and reviewing our financial policies and
procedures, our internal accounting controls, and the objectivity of our
financial reporting. Both our independent accountants and the internal auditors
have free access to the Audit Committee and meet with the Audit Committee
periodically, with and without management present.

Julian C. Day
Chief Executive Officer

A.A. Koch
Chief Financial Officer

68

REPORT OF INDEPENDENT ACCOUNTANTS

To the Shareholders and
Board of Directors of
Kmart Corporation

In our opinion, the consolidated financial statements listed in the
accompanying index present fairly, in all material respects, the financial
position of Kmart Corporation and its subsidiaries at January 29, 2003 and
January 30, 2002, and the results of their operations and their cash flows for
each of the three years in the period ended January 29, 2003, in conformity with
accounting principles generally accepted in the United States of America. In
addition, in our opinion, the financial statement schedule listed in the
accompanying index presents fairly, in all material respects, the information
set forth therein when read in conjunction with the related consolidated
financial statements. These financial statements and financial statement
schedule are the responsibility of Kmart's management; our responsibility is to
express an opinion on these financial statements and financial statement
schedule based on our audits. We conducted our audits of these statements in
accordance with auditing standards generally accepted in the United States of
America, which require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.

The accompanying consolidated financial statements have been prepared
assuming that Kmart Corporation will continue as a going concern, which
contemplates continuity of Kmart's operations and realization of its assets and
payment of its liabilities in the ordinary course of business. As more fully
described in the notes to the consolidated financial statements, on January 22,
2002, Kmart Corporation filed a voluntary petition for reorganization under
Chapter 11 of the United States Bankruptcy Code. The uncertainties inherent in
the bankruptcy process and Kmart's recurring losses from operations raise
substantial doubt about Kmart Corporation's ability to continue as a going
concern. Kmart Corporation is currently operating its business as a
Debtor-in-Possession under the jurisdiction of the Bankruptcy Court, and
continuation of Kmart as a going concern is contingent upon, among other things,
the confirmation of a Plan of Reorganization, Kmart's ability to comply with all
debt covenants under the existing debtor-in-possession financing agreement and
the post-emergence financing facility, and Kmart Corporation's ability to
generate sufficient cash from operations and obtain financing sources to meet
its future obligations. If no reorganization plan is approved, it is possible
that Kmart's assets may be liquidated. The consolidated financial statements do
not include any adjustments to reflect the possible future effects on the
recoverability and classification of assets or the amount and classification of
liabilities that may result from the outcome of these uncertainties.

As discussed in Note 2 to the consolidated financial statements, effective
October 31, 2002, the Company changed its method of accounting for cash
consideration received from vendors to comply with Emerging Issues Task Force
Issue No. 02-16, "Accounting by a Customer (Including a Reseller) for Certain
Consideration Received from a Vendor," and effective January 1, 2003, changed
its method of accounting for exit or disposal activities as required by
Statement of Financial Accounting Standards No. 146, "Accounting for Exit or
Disposal Activities."

/s/ PRICEWATERHOUSECOOPERS LLP
--------------------------------------
PricewaterhouseCoopers LLP

Detroit, Michigan
March 24, 2003

69

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURES

None.

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

DIRECTORS OF THE REGISTRANT

James B. Adamson, 55, Chairman of the Board of Kmart from February 2002 to
January 2003. Previously served as Chief Executive Officer and Chairman of the
Board of Kmart. Former Chairman, Advantica Restaurant Group (formerly Flagstar
Corporation) (food services and restaurant franchises). Previously served as
Chief Executive Officer and President, Denny's Inc. and as Chief Executive
Officer, Chief Operating Officer and Retail President of Burger King
Corporation. Has served as a director of Kmart Corporation since 1996.

Lilyan H. Affinito, 71, Former Vice Chairman of the Board of Maxxam Group
Inc. (forest products operations, real estate management and development and
aluminum production). Director of Caterpillar, Inc. Has served as a director of
Kmart since 1990.

Richard G. Cline, 68, Chairman, Hawthorne Investors, Inc. (management
advisory services and private investments). Previously served as Chairman and
Chief Executive Officer and as Chairman, President and Chief Executive Officer
of Nicor, Inc. (natural gas distribution and containerized shipping) and as
Chairman, Hussmann International, Inc. (refrigerated merchandising equipment).
Director of Ryerson Tull, Inc. and PepsiAmericas, Inc. Chairman and Trustee of
Northern Funds and Northern Institutional Funds. Has served as a director of
Kmart since 1995.

Willie D. Davis, 68, President of All Pro Broadcasting, Inc. (radio
stations). Director of Alliance Bank, Bassett Furniture Industries,
Incorporated, Checkers, Inc., The Dow Chemical Company, Johnson Controls, Inc.,
MGM Mirage, Inc., MGM, Inc., Sara Lee Corporation, Strong Funds and Wisconsin
Energy Corporation. Has served as a director of Kmart since 1986.

Joseph P. Flannery, 71, Chairman of the Board, President and Chief
Executive Officer of Uniroyal Holding, Inc. (investment management company).
Director of ArvinMeritor, Inc., Ingersoll Rand Company, Newmont Mining
Corporation and The Scotts Company. Has served as a director of Kmart since
1985.

Robert D. Kennedy, 70, Former Chairman and Chief Executive Officer of Union
Carbide Corporation (chemicals and plastics manufacturer). Director of Hercules,
Inc., International Paper, Inc. and Sunoco, Inc. Has served as a director of
Kmart since 1996.

Robin B. Smith, 63, Chairman of Publishers ClearingHouse (distribution of
publications). Previously served as President and Chief Executive Officer of
Publishers ClearingHouse. Director of BellSouth Corp. and of Prudential
Investments mutual funds. Has served as a director of Kmart since 1996.

Thomas T. Stallkamp, 56, Vice Chairman and Chief Executive Officer, MSX
International (provider of technology based business systems and services).
Previously served as Vice Chairman and as President of DaimlerChrysler
Corporation and as President of Chrysler Corporation. Director of Baxter
International, Inc. and Visteon Corporation. Has served as a director of Kmart
since 1999.

Richard J. Statuto, 45, President and Chief Executive Officer of St. Joseph
Health Systems (provider of hospital, physician, homecare, wellness and
insurance services). Previously served as Chief Operating Officer and Vice
President of Marketing and Planning of St. Joseph Health System. Also
Vice-Chairman of Christus Health. Has served as a director of Kmart since 2001.

The following were the Executive Officers of the Registrant as of March 24,
2003.

Julian C. Day, 50, Chief Executive Officer. Mr. Day was appointed to his
current position on January 14, 2003. Prior thereto he held the position of
President and Chief Operating Officer in 2002. Prior thereto he was
70

the Executive Vice President and Chief Operating Officer at Sears Roebuck, Inc.
from 1999 to 2002; Executive Vice President and Chief Financial Officer at
Safeway, Inc. from 1993 to 1998; and President and Chief Executive Officer of
Bradley Printing Company from 1991 to 1992.

Ronald B. Hutchison, 53, Executive Vice President, Chief Restructuring
Officer. Mr. Hutchison joined Kmart under his current title on January 17, 2002.
Prior thereto he was the Executive Vice President, Chief Financial Officer at
Advantica Restaurant Group from 1995 to 2002; and Vice President,
Treasurer/Taxes at Leaseway Corporation from 1980 to 1995.

Albert A. Koch, 60, Chief Financial Officer. Mr. Koch joined Kmart under
his current title on March 11, 2002 pursuant to an agreement between Kmart and
Alix Partners, LLC. Prior thereto he held the following positions at Alix
Partners, LLC: Chairman from 2001 to the present and Managing Principal from
1995 to 2001.

Michael T. Macik, 56, Executive Vice President, Human Resources. Mr. Macik
joined Kmart under his current title on April 9, 2002. Prior thereto he was the
Executive Vice President, Chief Operating Officer at Right Management Associates
from 2001 to 2002 and the Vice President, Human Resources at Kmart from 1992 to
2001.

William D. Underwood, 62, Executive Vice President, Kmart Sourcing and
Global Operations. Mr. Underwood joined Kmart in 1962 when it was still U.S.
Kresge Company, as a Management Trainee, thereafter working his way through
Store Manager, District Manager and other positions until becoming Senior Vice
President, Global Sourcing in 1997 through 1998; and Senior Vice President,
Global Operations, Corporate Brands and Quality Assurance in 1998 through 1999,
after which Mr. Underwood retired. Mr. Underwood rejoined Kmart in June 2002.

James E. Defebaugh, IV, 48, Senior Vice President, Chief Compliance Officer
and Secretary. Mr. Defebaugh assumed his current position in 2002. Prior thereto
he held the following positions at Kmart: Vice President, Associate General
Counsel and Secretary from 2001 to 2002; Vice President and Secretary during
2001; and Vice President, Legal from 2000 to 2001.

Richard J. Noechel, 34, Vice President, Controller. Mr. Noechel assumed his
current position in 2001. Prior thereto he was the Divisional Vice President,
Financial Reporting at Kmart in 2001; Senior Manager International Accounting at
DaimlerChrysler Corporation from 2000 to 2001; Forecast Team Leader at
DaimlerChrysler Corporation from 1998 to 2000; Accounting Research Specialist at
Chrysler Corporation from 1997 to 1998; and a manager at Price Waterhouse LLP
from 1996 to 1997.

Edward J. Stenger, 45, Treasurer. Mr. Stenger joined Kmart under his
current title on March 11, 2002 pursuant to an agreement between Kmart and Alix
Partners, LLC. Prior thereto he held the following positions at Alix Partners,
LLC: Co-Managing Director from 2000 to 2002 and a Principal from 1992 to 2000.

ITEM 11. EXECUTIVE COMPENSATION

The following table sets forth information concerning total compensation
paid to Kmart's current Chief Executive Officer during fiscal 2002 and the four
other most highly compensated executive officers of Kmart who served in such
capacities as of January 29, 2003 (the "named executive officers") for services
rendered to Kmart during each of the last three fiscal years, if applicable.
Pursuant to SEC rules, the table also sets forth

71

information concerning the compensation of former executive officers of Kmart
who are also deemed by SEC rules to be named executive officers for fiscal 2002.

- ---------------

(1) Mr. Conaway's employment was terminated effective March 11, 2002; Mr.
Adamson returned to his position as non-executive Chairman effective
January 17, 2003.

(2) Mr. Day's employment commenced effective April 9, 2002; Mr. Macik had
retired from Kmart in 2000 and returned to employment effective April 8,
2002; Mr. Hutchison's employment commenced effective January 21, 2002; Mr.
Koch and Mr. Stenger began providing services to Kmart during March 2002;
Mr. Conaway's employment commenced effective May 30, 2000; Mr. Adamson's
service as CEO commenced effective March 11, 2002. During Mr. Macik's prior
employment with Kmart, he was not an executive officer.

(3) Includes amounts deferred during fiscal years 2000 and 2001 under Kmart's
Management Deferred Compensation and Restoration Plan, which was closed to
new deferrals effective January 22, 2002.

(4) Mr. Day's bonus consists of a signing bonus of $775,000 and a payment of
$1,500,000 in respect of payments and benefits foregone from Mr. Day's
previous employer; Mr. Macik's 2002 bonus consists of a $425,000 signing
bonus; Mr. Hutchison's bonus consists of a $250,000 signing bonus.

(5) The dollar amounts under "Other Annual Compensation" include: Reimbursement
of Housing and Temporary Living Costs plus associated tax gross-up -- Mr.
Day -- $154,438 (2002); Mr. Hutchison -- $143,009 (2002); Mr.
Conaway -- $109,197 (2001), $414,076 (2000); Mr. Adamson -- $248,904
(2002); Non-Business Use of Company Plane plus associated tax
gross-up -- Mr. Conaway -- $23,409 (2002), $97,838 (2001); Car Allowance
plus associated tax gross-up -- Mr. Conaway -- $15,178 (2002); Tax gross-up
associated with bonus -- Mr. Day -- $616,900 (2002); Mr.
Hutchison -- $232,100 (2002). The value of perquisites and other personal
benefits not specified in this footnote did not exceed 25% of the value of
the total perquisites and other personal benefits reported.

(6) No stock options were granted in fiscal year 2002.

(7) As of January 29, 2003, none of the named executive officers held any
restricted stock. All shares of restricted stock held by Mr. Conaway were
cancelled in connection with the termination of his employment.

72

(8) The dollar amounts for fiscal year 2002 set forth under "All Other
Compensation" include: Value of Life Insurance Premiums -- Mr. Day -- $917;
Mr. Macik -- $1,115; Mr. Hutchison -- $972; Mr. Conaway -- $307; Mr.
Adamson -- $2,645; Reimbursement of Legal Fees -- Mr. Day -- $75,000; Mr.
Macik -- $4889; Mr. Adamson -- $352,024; Other Compensation -- Mr. Macik
received $70,159 in fiscal year 2002 under a prior severance agreement and
$9,855 under the Supplemental Pension Plan; in connection with his
termination of employment, Mr. Conaway received a $4,039,709 severance
payment and his $5 million retention loan was to be forgiven (See, however,
the discussion of Mr. Conaway's separation agreement at "Former Executive
Officer Services, Employment and Separation Arrangements -- Charles
Conaway -- Separation Agreement").

(9) Amounts represent fees paid or payable by Kmart to Alix Partners LLC
(formerly JA&A Services, LLC), Mr. Koch's and Mr. Stenger's employer,
attributable to their services rendered to Kmart (see "Executive Officer
Employment Arrangements -- Albert Koch and Edward Stenger"). Such amounts
do not include reimbursement of business expenses incurred by Messrs. Koch
and Stenger in connection with the performance of their services to Kmart.

(10) Includes fees paid to Mr. Adamson for the period February 1, 2002 through
March 11, 2002 pursuant to the terms of his services agreement. See "Former
Executive Officer Services, Employment and Separation Arrangements -- James
Adamson -- Services Agreement."

OPTION GRANTS IN FISCAL YEAR 2002

No stock options were granted to the named executive officers during fiscal
year 2002.

OPTION EXERCISES AND VALUES FOR FISCAL YEAR 2002

The table below shows the number of exercisable options held by each of the
named executive officers at January 29, 2003. None of the options held by the
named executive officers are "in-the-money". None of the named executive
officers exercised stock options during fiscal year 2002.

PENSION PLANS

The accrual of benefits under Kmart's tax-qualified Employee Pension Plan
and Supplemental Pension Benefit Plan was frozen as of January 31, 1996.
Therefore, service after January 31, 1996 is not recognized for benefit
accumulation purposes, but is recognized for vesting purposes. Kmart's
Supplemental Pension Benefit Plan provides benefits to the extent that ERISA
limits the pension to which an employee would otherwise be entitled under the
Employee Pension Plan absent such limitation. Of the named executive officers,
only Mr. Macik is eligible to receive benefits under Kmart's frozen Employee
Pension and Supplemental Pension Benefit Plans. Mr. Macik has 26 years of
service under the Plans after age 21. His estimated accrued benefit under the
combined Plans and under the "final average compensation formula" is $5,584.79
per month at age 65. This amount is based on the pension being paid during his
lifetime and would be reduced on an actuarial equivalent basis in the event of a
survivor benefit or optional form of payment. The "final average compensation
formula" is 1.50% of the average of the officer's best five compensation years
prior to January 31, 1996 multiplied by years of service after age 21 and prior
to January 31, 1996 up to 35 years minus 2% of the applicable Social Security
benefit for each year of services up to 30 years at age 65.

73

Kmart has also adopted a Supplemental Executive Retirement Plan for the
purpose of providing income to executive officers of Kmart who retire prior to
age 65 or who are hired by Kmart later in their careers, whom the Board of
Directors approves as eligible to receive benefits under the plan. Benefits are
determined by the Board based on the position, responsibilities and rate of
compensation of the employee, benefits payable or which would have been payable
under other plans and such other factors as the Board may deem relevant. Mr.
Macik is a participant in this plan.

Kmart has also adopted a Special Supplemental Executive Retirement Plan to
provide supplemental retirement income to certain senior officers and other key
executives designated by the Compensation and Incentives Committee of the Board.
Participants who retire at or after age 60 are entitled to receive an annual
benefit equal to 5% of "Final Average Compensation" multiplied by the number of
years of participation in the plan (up to a maximum of 10). Benefits become
vested at the rate of 50% (after 3 years of participation), 75% (after 4 years
of participation) and 100% (after 5 or more years of participation).
Participants who retire between ages 55 and 60 can begin receiving their vested
benefits, but the benefits will be reduced at the rate of 6 percent per year to
reflect commencement prior to age 60. Final Average Compensation means the
average of the participant's highest base pay plus bonus for any three years (or
lesser period of employment). Mr. Conaway is the only named executive officer to
have been designated as a participant in this plan. Since he had not accrued any
vested benefits under this plan at the time of his termination of employment,
his accrued benefits have been forfeited.

DIRECTOR COMPENSATION

During fiscal year 2002, each director of Kmart who was not employed by
Kmart was entitled to an annual retainer of $25,000, and each committee chairman
was entitled to an additional annual fee of $10,000. Each non-employee director
was also entitled to a $2,000 fee for attendance at a board meeting, and $2,000
for attendance at committee meetings.

Under Kmart's Deferred Compensation Plan for Non-Employee Directors and the
Directors Stock Plan, a director could elect to defer all or any portion of his
or her compensation for services as a director which was payable in cash or
Common Stock. Under these Plans, deferred cash amounts earn interest at a rate
equivalent to the ten-year U.S. Treasury Note plus 5%, and deferred shares of
Common Stock are credited with an amount equal to any dividends payable on such
shares, which are converted on a quarterly basis to additional shares. Effective
January 22, 2002, no further deferrals were permitted under these plans.

During fiscal year 2002, Mr. Adamson served as non-executive Chairman of
the Board of Directors until March 11, 2002, when he was appointed to the
additional office of Chief Executive Officer. Mr. Adamson's service as Chief
Executive Officer terminated effective January 17, 2003, at which time he
resumed his role as non-executive Chairman pursuant to the terms of his
separation agreement, described at "Former Executive Officer Services,
Employment and Separation Agreements -- James Adamson -- Separation Agreement."
From and after resuming the position of non-executive Chairman, Mr. Adamson is
entitled to the fees described above.

Effective January 1, 1996, benefits under Kmart's Directors Retirement Plan
were terminated with respect to new directors and the accrual of future benefits
for existing directors was terminated. Non-employee directors who served on the
Board prior to December 31, 1995 and who served at least five years are entitled
to benefits under the Plan. Upon retirement from the Board, such directors will
receive an annual benefit equal to the annual retainer at the time of retirement
for a period equal to the director's accrual years under the frozen Plan, not to
exceed ten years. Ms. Affinito and Messrs. Davis and Flannery have vested
benefits under the frozen Directors Retirement Plan.

Directors who are employees of Kmart or its subsidiaries do not receive the
above compensation or benefits.

74

EXECUTIVE OFFICER EMPLOYMENT AGREEMENTS

Julian Day. Kmart appointed Julian Day to the office of President and
Chief Operating Officer effective April 9, 2002 and, in connection with his
appointment, entered into an employment agreement with Mr. Day as of such date
(the "prior employment agreement"). The prior employment agreement had an
initial term running until April 30, 2004, with one-year extensions on each
anniversary of the effective date. In addition to salary and bonus
opportunities, the prior employment agreement provided for an inducement payment
of $775,000; reimbursement of up to $1.5 million in respect of compensation and
benefits from a previous employer forfeited by Mr. Day as a result of his being
employed by Kmart; an emergence bonus to be determined in connection with the
process during which Kmart's plan of reorganization is developed; reimbursement
of relocation expenses; and cash severance in the event his employment was
terminated either by Kmart without cause (other than because of disability or
death), by Mr. Day under a constructive termination, or because of the
expiration of the prior employment agreement. The prior employment agreement
provided for 24-month post-termination non-competition and non-solicitation
covenants.

Kmart appointed Mr. Day to the offices of Chief Executive Officer and
President effective January 17, 2003. In connection with his appointment, it is
expected that Kmart and Mr. Day will enter into an amended and restated
employment agreement (referred to as the "amended agreement") effective as of
such date. The amended agreement has a term ending on January 31, 2006, and
provides for an increase of Mr. Day's base salary from $775,000 to $1 million.
The amended agreement provides for an annual incentive award to be determined
based on the Company's actual performance compared to targeted performance
included in Kmart's business plan as approved as part of the Plan of
Reorganization, provided that for fiscal year 2003, Mr. Day's annual cash bonus
(if any) will be determined by the Compensation and Incentives Committee of the
Board of Directors in its discretion. In addition, the amended agreement
provides for an emergence payment equal to $1 million, to be paid promptly
following the date (referred to as the "restructuring date") on which the Plan
of Reorganization is confirmed by the Court, unless Mr. Day's employment has
been terminated earlier either by Kmart for cause or by Mr. Day other than under
a constructive termination (each term as defined in the amended agreement). The
amended agreement also provides for the grant, effective on the restructuring
date, of a 10-year option to purchase a number of shares of Kmart's common stock
representing 1.5% of the fully diluted equity of Kmart as of the restructuring
date. The option is to be granted under the equity plan that Kmart intends to
adopt for its senior executives and other key employees in connection with the
Plan of Reorganization. Among other terms and conditions, the exercise price
with respect to 2/3 of the shares subject to the option will be determined based
upon a $2 billion valuation of Kmart's equity as of the restructuring date, and
the exercise price with respect to the remaining 1/3 of the shares subject to
the option will be determined based upon a $1 billion valuation of Kmart's
equity as of the restructuring date.

If Mr. Day's employment is terminated because of his death or the
expiration of the term of the amended agreement, or by Kmart without cause, or
by Mr. Day under a constructive termination, Mr. Day would be entitled to
receive, in addition to accrued but unpaid salary and benefits under Kmart
benefit plans, cash severance equal to two times (three times, if such
termination occurs prior to February 1, 2004) his then-current base salary, plus
a prorated amount of his annual bonus, based on Kmart's performance to the date
of such termination of employment. Mr. Day would also be entitled to continued
health and life insurance benefits for two years (three years, if such
termination occurs prior to February 1, 2004). The amended agreement provides
that if Kmart does not emerge from bankruptcy as a going concern, the aggregate
amount of Mr. Day's claims under the amended agreement may not exceed the
amounts to which he would have been entitled under his prior employment
agreement. The amended agreement further provides for 24-month post-termination
non-competition and non-solicitation covenants.

Albert Koch and Edward Stenger. Mr. Koch was appointed to the position of
Chief Financial Officer, and Mr. Stenger was appointed to the position of
Treasurer, reporting to Mr. Koch, pursuant to the terms of a letter agreement,
effective March 10, 2002 (the "Alix Agreement"), entered into between Kmart and
Alix Partners LLC (formerly JA&A Services, LLC) ("Alix"), which is the employer
of Messrs. Koch and Stenger. Under this arrangement, Kmart compensates Alix for
Mr. Koch and Stenger's services at an hourly rate of $640 and $620,
respectively. Alix is entitled to review its billing rates effective January 1
of each year.
75

The Alix Agreement provides that Mr. Koch and Mr. Stenger will be entitled to
the benefit of indemnities provided by Kmart to its officers and directors.
During the term of the Alix Agreement, in addition to hourly fees and expenses,
Kmart is obligated to pay Alix an annual performance fee based on Kmart's EBITDA
for each year. If at any time prior to the earlier of (i) the second anniversary
of the effective date of the Alix Agreement or (ii) confirmation of a plan of
reorganization, a new chief executive officer is employed and there is a
material change in the responsibilities or duties of Mr. Koch or Mr. Stenger
without Alix's consent, the Alix Agreement will terminate and Alix will be
entitled to a $2,000,000 fee.

Ronald Hutchison. Kmart appointed Ronald Hutchison to the office of Chief
Restructuring Officer on January 21, 2002 and, in connection with his
appointment, entered into an employment agreement with Mr. Hutchison as of such
date. Mr. Hutchison's agreement provides for a term ending on the earlier of
January 31, 2003, or the date on which Kmart emerges from Chapter 11 as an
ongoing business (referred to as the "emergence date"), provided that the term
has been automatically extended for an additional year (but not beyond the
emergence date) since Kmart did not deliver a written notice of non-extension to
Mr. Hutchison prior to December 31, 2002. The agreement provides for a lump sum
inducement payment of $250,000 and, in addition to base salary and other
benefits, provides for a lump sum emergence bonus of $1 million. In the event
that Mr. Hutchison's employment is terminated by Kmart other than for disability
or cause or by Mr. Hutchison following a constructive termination (each term as
defined in the agreement), he is entitled to receive, in addition to accrued but
unpaid salary and benefits under Kmart benefit plans, (i) a lump sum cash
payment equal to his base salary as in effect on the date of termination, (ii)
if the emergence date occurs within 12 months following such termination, a lump
sum cash payment of $525,000 and (iii) continued participation in welfare
benefit plans for 12 months following such termination. Payments to Mr.
Hutchison will be "grossed-up" to compensate for the imposition of any golden
parachute excise taxes thereon. Mr. Hutchison's agreement provides for customary
confidentiality, non-disparagement and cooperation covenants.

Michael Macik. Kmart appointed Michael Macik to the office of Executive
Vice President, Human Resources effective April 8, 2002 and in connection with
his appointment, entered into an employment agreement with Mr. Macik as of such
date. Mr. Macik's agreement has an initial term ending April 30, 2004, provided
that the term will be automatically extended for an additional year on each
anniversary of the effective date of the agreement, unless earlier terminated as
provided in the agreement. Mr. Macik received a lump sum inducement payment of
$425,000. In addition to base salary and other benefits, the agreement provides
for an annual target cash bonus equal to 60% of base salary. Pursuant to the
agreement, Mr. Macik is entitled to receive a bonus in connection with Kmart's
emergence from bankruptcy, the amount and form of which bonus are to be
determined in the process of developing Kmart's plan of reorganization. Mr.
Macik will be entitled to participate in the long-term cash and equity-based
compensation programs that Kmart may provide following its emergence from
bankruptcy. In the event that Mr. Macik's employment is terminated by Kmart
other than for disability or cause or by Mr. Macik following a constructive
termination (each term as defined in the agreement) or because the term of the
agreement is not renewed, he will be entitled to cash severance as follows:

- if such termination (other than a termination because of the expiration
of the agreement) occurs on or prior to April 30, 2003 and prior to the
date on which a confirmed plan of reorganization (other than a plan of
liquidation) is approved by the Court (referred to as the "plan
confirmation date"), a cash lump sum equal to the sum of 300% of his
then-current base salary and 100% of his target bonus in effect for the
year of termination; provided that this severance amount will be offset
by an amount equal to $250,000;

- if such termination (other than a termination because of the expiration
of the agreement) occurs following April 30, 2003 but prior to the plan
confirmation date, then an initial payment equal to his base salary and
target bonus as in effect immediately prior to the time of termination
would be made at the time of termination, and an additional payment equal
to 200% of the executive's base salary as in effect immediately prior to
the time of termination would be made if and when the plan confirmation
date occurred;

76

- if such termination (other than a termination because of the expiration
of the agreement) occurs following the plan confirmation date (or in
contemplation of the plan confirmation date in order to reduce the
amounts payable under the agreement), a cash lump sum equal to the sum of
300% of his base salary and 100% of his target bonus in effect for the
year of termination; or

- if such termination is because of the expiration of the term of his
agreement, a lump sum cash severance payment at the time of termination
equal to 200% of his base salary as in effect immediately prior to the
time of termination.

Following such a termination of employment, Mr. Macik would also be
entitled to continued health and life insurance benefits for two years. The
agreement provides for 24-month post-termination non-competition and
non-solicitation covenants.

FORMER EXECUTIVE OFFICER SERVICES, EMPLOYMENT AND SEPARATION ARRANGEMENTS

JAMES ADAMSON

Services Agreement. Mr. Adamson was appointed to the position of
non-executive Chairman of the Board of Kmart effective as of January 17, 2002.
In connection with his appointment, Kmart entered into a services agreement with
Mr. Adamson as of that date which provided for annual fees of $1 million and had
a term ending on the earlier of the date on which Kmart emerged from bankruptcy
as an ongoing business (referred to as the "emergence date") or April 30, 2004.
This agreement provided that Mr. Adamson would provide services to Kmart as its
Chairman of the Board, with overall responsibility for managing and implementing
Kmart's restructuring initiatives and assisting Mr. Conaway in connection with
Kmart's merchandising and marketing functions. Under this agreement, and with
Court approval, Mr. Adamson was paid an inducement payment equal to $2.5
million, "grossed-up" for income and other taxes, which amount was subject to
repayment on a pro-rata basis if his services were terminated prior to January
31, 2003 either by Kmart for cause or because of Mr. Adamson's voluntary
resignation (other than by reason of a breach by Kmart of a material provision
of the services agreement). Mr. Adamson's services agreement provided for a
"success payment" of a maximum of $4 million relating to Kmart's emergence from
bankruptcy as an on-going business; the maximum success payment would be made if
the emergence date occurred on or prior to July 31, 2003 and would be reduced on
a daily basis until no success payment would be made if the emergence date
occurred following April 30, 2004. The services agreement also provided for
certain benefits, such as reimbursement for travel expenses and the provision by
Kmart of suitable housing for Mr. Adamson and his spouse in the Detroit
metropolitan area. These benefits would be "grossed-up" by Kmart to compensate
for the imposition of any taxes on Mr. Adamson with respect to these benefits.
Under the services agreement, Kmart established a $10 million letter of credit
for the purpose of satisfying Kmart's obligations.

Employment Agreement. Effective March 11, 2002, Mr. Adamson was appointed
to the position of Chairman of the Board and Chief Executive Officer of Kmart.
In connection with his appointment, Kmart entered into an employment agreement
with Mr. Adamson, effective as of March 11, 2002, which superceded Mr. Adamson's
services agreement with Kmart. The employment agreement with Mr. Adamson
provided for a term of employment ending on April 30, 2004, provided that the
term would automatically extend for an additional year on each anniversary of
the effective date, unless earlier terminated as provided in the agreement. Mr.
Adamson's employment agreement provided for an annual base salary of $1.5
million and participation in the Company's annual bonus plan at a target bonus
level equal to 125% of his annual salary. Under the terms of the employment
agreement, Mr. Adamson would no longer be required to repay, following certain
terminations of employment, any portion of the inducement payment paid pursuant
to his services agreement. Mr. Adamson's employment agreement provided for the
payment of an emergence bonus, the amount and other terms and conditions of
which were to be determined during the process during which Kmart's plan of
reorganization was developed and finalized. Mr. Adamson's employment agreement
provided for the continuation of certain reasonable travel and housing benefits
as were originally provided under his services agreement, and for participation
in the Company's welfare and other benefit plans made available to Kmart's
senior executives in general. Following Court approval of the employment
agreement, the $10 million letter of credit that Kmart established for the
purpose of satisfying its obligations to Mr. Adamson was

77

terminated. Mr. Adamson's employment agreement provided for 12-month
post-termination non-competition and non-solicitation covenants.

Separation Agreement. Mr. Adamson's service as Chief Executive Officer of
Kmart terminated effective January 17, 2003 pursuant to the terms of a
separation agreement and general release as of such date. Pursuant to the
separation agreement, Mr. Adamson resigned his position as Chief Executive
Officer, but will continue to serve as Kmart's non-executive Chairman until the
emergence date, subject to his right to resign earlier than such date. While
serving as non-executive Chairman, Mr. Adamson is entitled to receive fees and
other compensation payable generally to Kmart's non-employee directors. Pursuant
to the separation agreement, and in full settlement of Mr. Adamson's rights to
severance and certain other benefits under his employment agreement, Kmart paid
$250,000 in respect of Mr. Adamson's legal fees incurred during fiscal year 2002
and Mr. Adamson will be entitled to receive, at the emergence date, a cash
payment equal to $3.6 million. The restrictive covenants under Mr. Adamson's
employment agreement (described above) will continue in effect.

CHARLES CONAWAY

Employment Agreement. Kmart entered into an employment agreement with Mr.
Conaway as of May 30, 2000, which was amended during May 2001 and during
November 2001. This agreement had a term ending on May 30, 2005, subject to
automatic annual one-year extensions, commencing on May 20, 2004, and provided
for an annual salary of at least $1.5 million and an annual target bonus
opportunity of at least 125% of his then-current annual salary based on the
attainment of performance goals. Mr. Conaway was also eligible for option grants
during the term of his employment with a target value equal to 400% of his base
salary, such grants to be made based upon the achievement of performance goals
established by the Compensation Committee. In connection with the May 2001
amendment to his employment agreement, Kmart made a retention loan to Mr.
Conaway in the principal amount of $5 million, the terms of which are set forth
at "Transactions with Executive Officers". Mr. Conaway's agreement also provided
for payment over time of approximately $5 million in cash and $10 million in
shares of restricted stock to compensate Mr. Conaway for amounts that he was
required to forego from his prior employer in order to accept employment with
Kmart in 2000. Mr. Conaway's employment agreement provided that if his
employment was terminated by Kmart during the term of the agreement other than
for cause of disability or if he terminated under a constructive termination, he
would be entitled to receive monthly severance payments equal to his monthly
base salary at the time of termination, plus 1/12th of the annual on-plan bonus
for the year in which termination occurred, which payments would be made during
a severance period of 36 months, but would be paid in a lump sum at Kmart's
discretion. Payments to Mr. Conaway would be "grossed-up" to compensate for the
imposition of any golden parachute excise taxes. Under this agreement, Mr.
Conaway was to be subject to 18-month post-termination non-competition and
non-solicitation covenants.

Separation Agreement. Mr. Conaway's employment and services as a director
with Kmart terminated effective March 11, 2002 pursuant to the terms of a
separation agreement dated as of such date. This agreement provided for, among
other things, receipt by Mr. Conaway of a cash severance payment equal to
approximately $4 million, in connection with which Mr. Conaway executed a
release in favor of Kmart. This agreement also acknowledged that the principal
amount of and accrued interest on the $5 million retention loan to Mr. Conaway
(evidenced by a May 2001 promissory note) were to be forgiven. In February,
2003, as more fully described in the Disclosure Statement relating to the Plan
of Reorganization, in connection with its examination of Mr. Conaway's
stewardship of Kmart, the Board reaffirmed its earlier direction to Kmart to,
among other things, demand the return of full retention loan amounts from all
employees who had received such loans, including Mr. Conaway. In addition, the
Board concluded that there is credible and persuasive evidence to support a
finding that Mr. Conaway engaged in conduct that should support the commencement
against Mr. Conaway of claims brought by the creditors' litigation trust
contemplated by the Plan of Reorganization, and which may also be subsumed
within the contractual definition of "cause," as that term is defined in his
employment agreement.

78

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS

The following table provides information as of January 29, 2003 with
respect to shares of Kmart common stock that may be issued under our existing
equity compensation plans, including the Kmart Corporation 1997 Long-Term Equity
Compensation Plan (the "1997 Plan") and the Kmart Corporation 2001 Broad-Based
Employee Long-Term Equity Compensation Plan (the "2001 Plan").

The table does not include information with respect to shares subject to
outstanding options granted under equity compensation plans that are no longer
in effect (the Kmart Corporation 1992 Stock Option Plan). Footnote (3) to the
table sets forth the total number of shares of Kmart common stock issuable upon
the exercise of options under the expired Kmart Corporation 1992 Stock Option
Plan as of January 29, 2003, and the weighted average exercise price of those
options.

- ---------------

(1) Consists of the 1997 Plan. Under this Plan, awards can be made in the form
of options and restricted stock.

(2) Consists of the 2001 Plan which is described below.

(3) The table does not include information for equity compensation plans that
have expired. The Kmart Corporation 1992 Stock Option Plan expired on
January 20, 2002. As of January 29, 2003, a total of 10,624,912 shares of
Kmart common stock were issuable upon the exercise of outstanding options
under the expired plan. The weighted average exercise price of those
outstanding options is $13.14 per share. No additional options may be
granted under this expired plan.

THE 2001 PLAN

The 2001 Plan was adopted by the Board of Directors on January 16, 2001.
The 2001 Plan has not been approved by our shareholders. The 2001 Plan provides
for the granting of options, stock appreciation rights, restricted stock,
unrestricted stock, performance shares and performance units.

The number of shares which may be issued to Participants under the Plan
shall be eighteen million (18,000,000), of which no more than three million
(3,000,000) may be granted in the form of Restricted Stock. Shares issued or
subject to an award under the Plan may be either authorized and unissued shares
or issued shares which have been reacquired by the Company. In the event that
any award or portion thereof expires or is canceled, surrendered, forfeited, or
terminated for any reason, such shares shall again become available for issue
under the Plan.

Awards may be granted under the 2001 Plan to any employee who is actively
employed by Kmart or its subsidiaries. However, no awards may be granted under
the Plan to officers or directors of the Company. All option grants have an
exercise price per share that is no less than the fair market value per share of
Kmart common stock on the grant date and may have a term of no longer than ten
years and two days from grant date. The options generally vest and become
exercisable in three equal annual installments, commencing one

79

year from the date of grant. The options vest on an accelerated basis in the
event of a change in control of the company.

The 2001 Plan is included as Exhibit 10.51 in our Annual Report on Form
10-K for the annual period ended January 29, 2003, filed with the Securities and
Exchange Commission.

OWNERSHIP OF KMART COMMON STOCK BY DIRECTORS AND EXECUTIVE OFFICERS

The following table shows the Kmart common stock ownership of Kmart's
directors, the named executive officers and all of the directors and current
executive officers of Kmart as a group, in each case as of January 29, 2003.

- ---------------

* Less than 1% of the outstanding shares of Kmart common stock.

(1) Includes restricted Kmart common stock units accrued under the Directors
Stock Plan as follows: Mr. Adamson -- 16,300 units; Ms. Affinito -- 15,194
units; Mr. Cline -- 16,566 units; Mr. Flannery -- 1,515 units; Mr.
Kennedy -- 16,300 units; Ms. Smith -- 14,686 units; Mr. Stallkamp -- 7,816
units; and Mr. Statuto -- 2,486 units.

(2) Includes shares of Kmart common stock that can be acquired by exercise of
stock options within 60 days of January 29, 2003, as follows: Mr.
Adamson -- 20,067 shares; Ms. Affinito -- 20,067 shares; Mr. Cline -- 25,067
shares; Mr. Davis -- 20,067 shares; Mr. Flannery -- 25,067 shares; Ms.
Kelley -- 26,667 (exercisable for 90 days from the date of Ms. Kelley's
termination of employment); Mr. Kennedy -- 20,067 shares; Ms.
Smith -- 20,067 shares; Mr. Stallkamp -- 15,067 shares; and all directors
and executive officers as a group -- 165,536 shares (the group total does
not include options exercisable by Ms. Kelley).

(3) Mr. Cline may be deemed to share voting and investment power as to 64,300
shares of Kmart common stock owned by Northern Funds of which he is Chairman
and a Trustee. If such additional shares were included, directors and
current executive officers as a group would be considered to beneficially
own 550,285 shares of Kmart common stock, which is less than 1% or the
outstanding shares of Kmart

80

common stock outstanding as of January 29, 2003. Mr. Cline disclaims
beneficial ownership of such shares.

(4) Mr. Conaway and Ms. Kelley were no longer employed by Kmart as of January
29, 2003. Information concerning their ownership of Kmart common stock is
based on the most recent SEC documents filed by Mr. Conaway and Ms. Kelley.

(5) Includes 3,333 shares of Kmart common stock that can be acquired by
conversion of 1,000 shares of Kmart Financing I Trust Convertible Preferred
Stock held by Mr. Kennedy.

(6) The group total does not include any Kmart common stock owned by Mr. Conaway
and Ms. Kelley.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

TRANSACTIONS WITH EXECUTIVE OFFICERS

Pursuant to an amendment to his original May 2000 employment agreement,
Kmart made a full recourse retention loan to Mr. Conaway in the principal amount
of $5 million in May 2001. Pursuant to employment agreements entered into in
December, 2001, the Company made full recourse retention loans to each of
Messrs. Anthony B. D'Onofrio (former EVP, Systems Capability and Chief Supply
Chain Officer), Cecil B. Kearse (former EVP, Merchandising), John T. McDonald,
Jr. (former EVP, Chief Financial Officer) and David P. Rots (former EVP, Chief
Administrative Officer) in December 2001 in the aggregate principal amount of
$2.5 million each. Mr. McDonald's aggregate $2.5 million loan was to be made in
two installments, one in December 2001 and one in December, 2002. The loan
originally to be made in December 2002 was made in January 2002. These loans are
hereinafter referred to as the "Executive Loans." Each of the Executive Loans
originally had a term of approximately five years, accruing interest at 3.97%
per year, payment of which was deferred until the due date. When the executives'
employment agreements were amended and restated in January 2002, the maturity
dates of each of the Executive Loans were amended to January 31, 2004. Each of
the Executive Loans was to be forgiven in full on the due date if the executive
was employed by the Company on that date, with earlier forgiveness in the event
that the executive was terminated (a) by the Company without cause, (b) because
of death or disability or (c) voluntarily by the executive under a constructive
termination (in connection with the revision of the maturity date, a
constructive termination was limited in this instance to a reduction in base
salary or due to a failure by the Company to pay the executive's base salary).
Each Executive Loan also provided that in the event the loan was forgiven, the
Company was obligated to "gross-up" the executive with respect to income and
other taxes incurred by the executive with respect to loan forgiveness.

In December 2001, Kmart also made full recourse retention loans to Messrs.
David Montoya (former SVP, Specialty Operations) and Gregg Treadway (former EVP,
Store Operations), each in the amount of $750,000, and to Ms. Janet Kelley
(Former EVP, General Counsel) in the amount of $500,000. The terms of these
loans are substantially similar to the Executive Loans described above, except
that the maturity date was January 31, 2005 and there was no tax "gross-up"
obligation on the part of Kmart in connection with any loan forgiveness. The
employment of Messrs. Montoya and Treadway and Ms. Kelley terminated, effective
March 22, 2002, May 6, 2002 and January 15, 2003, respectively.

In February, 2003, as more fully described in the Disclosure Statement, in
connection with its stewardship investigations, the Board reaffirmed its earlier
direction to Kmart to, among other things, demand the return of full retention
loan amounts from all employees who had received such loans, including the
executives named above. Ms. Kelley repaid her loan in February 2003. Pursuant to
the Plan of Reorganization, any recoveries of the loans would be paid by Kmart
to the creditors' litigation trust to be formed to pursue any claims arising
under the stewardship and accounting investigation.

Mr. Koch is chairman and managing principal, and Mr. Stenger is co-managing
director and principal, of Alix Partners LLC (formerly JA&A Services, LLC).
Kmart has retained Alix Partners LLC for the services of Messrs. Koch and
Stenger. See Item 11. Executive Officer Employment Arrangements -- Albert Koch
and Edward Stenger, of this Form 10-K for additional information.

81

ITEM 14. CONTROLS AND PROCEDURES

Within the 90-day period prior to the date of filing this report, we
carried out an evaluation, under the supervision of our recently formed
management Disclosure Committee (which includes the Chief Executive Officer and
the Chief Financial Officer), of the effectiveness of the design and operation
of our disclosure controls and procedures pursuant to Exchange Act Rules 13a-14
and 15d-14. Based upon this evaluation, the Chief Executive Officer and the
Chief Financial Officer concluded that our disclosure controls and procedures
are effective to ensure that information required to be disclosed in our
periodic SEC reports is recorded, processed, summarized, and reported as and
when required.

There have not been any significant changes to our internal controls or any
other factors that could significantly affect these controls subsequent to the
date of management's evaluation.

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

a) The following documents are filed as part of this report

1. Financial Statements

Financial statements filed as part of this Form 10-K are listed under
Part II, Item 8.

2. Financial Statement Schedules

Financial statement schedules filed as part of this Form 10-K are
listed under Part II, Item 8.

The separate financial statements and summarized financial information
of majority-owned subsidiaries not consolidated and of 50% or less owned
persons have been omitted because they are not required pursuant to
conditions set forth in Rules 3-09 and 1-02(w) of Regulation S-X.

All other schedules have been omitted because they are not required
under the instructions contained in Regulation S-X because the information
called for is contained in the financial statements and notes thereto.

3. Exhibits

See Exhibit Index included in this report.

b) Reports on Form 8-K:

We filed a Current Report on Form 8-K dated December 9, 2002 to report that
Kmart issued a press release, dated December 9, 2002, in which we announced our
intention to restate its financial statements for prior fiscal years, as well as
the first two quarters of 2002, to reflect certain adjustments identified as a
result of Kmart's ongoing review of its accounting practices and procedures.

We filed a Current Report on Form 8-K dated December 23, 2002 to report
that Kmart filed its monthly operating reports for the period commencing
September 26, 2002 and ended October 30, 2002 with the United States Bankruptcy
Court for the Northern District of Illinois in connection with its voluntary
petitions for reorganization under Chapter 11 of title 11 of the United States
Bankruptcy Code in Case No. 02 B02474.

We filed a Current Report on Form 8-K dated December 23, 2002 to report
that Kmart filed its monthly operating reports for the period commencing October
31, 2002 and ended November 27, 2002 with the United States Bankruptcy Court for
the Northern District of Illinois in connection with its voluntary petitions for
reorganization under Chapter 11 of title 11 of the United States Bankruptcy Code
in Case No. 02 B02474.

We filed a Current Report on Form 8-K dated January 14, 2003 to report that
Kmart filed its monthly operating report for the period commencing November 28,
2002 and ended January 1, 2003 with the United States Bankruptcy Court for the
Northern District of Illinois in connection with its voluntary petitions for
reorganization under Chapter 11 of title 11 of the United States Bankruptcy Code
in Case No. 02-B02474.

We filed a Current Report on Form 8-K dated January 14, 2003 to report that
Kmart issued a press release, dated January 24, 2003, in which it announced a
number of significant developments as it prepares to

82

complete its fast-track reorganization and emerge from Chapter 11 by April 30,
2003, including that: (i) it has received a commitment for up to $2 billion in
exit financing for use upon Kmart's emergence from Chapter 11; (ii) its Board of
Directors has approved in principle a five-year business plan and a framework
for an all-equity Plan of Reorganization and has directed Kmart's management and
advisors to complete negotiations with the statutory committees representing
Kmart's stakeholders as to the final terms of the plan; (iii) it has completed a
review of its store portfolio and distribution network and, subject to
bankruptcy court approval, will close 326 stores and one distribution center;
and (iv) it has entered into an amendment to its DIP Credit Facility to permit
the store closings and to adjust certain covenants to provide Kmart with
additional flexibility under the DIP Credit Facility.

We filed a Current Report on Form 8-K dated January 17, 2003 to report that
Kmart issued a press release announcing that it had promoted our President,
Julian C. Day, to the additional post of Chief Executive Officer, succeeding
James B. Adamson. In the press release, we indicated that Mr. Adamson will
continue to serve as a non-executive Chairman of Kmart's Board of Directors
through the final stages of Kmart's reorganization and projected emergence from
Chapter 11. In connection therewith, Kmart entered into a Term Sheet with Mr.
Day setting forth the amended and restated terms of his employment agreement,
and a Separation Agreement with Mr. Adamson. Copies of the press release, the
Term Sheet and the Separation Agreement were attached as exhibits to the
document.

We filed a Current Report on Form 8-K dated January 24, 2003 to report that
Kmart filed a Plan of Reorganization and related Disclosure Statement with the
United States Bankruptcy Court for the Northern District of Illinois and to file
a copy of the related press release.

83

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) 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 on March 24, 2003.

Each signatory hereby acknowledges and adopts the typed form of his or her
name in the electronic filing of this document with the Securities and Exchange
Commission.

KMART CORPORATION

By: /s/ JULIAN C. DAY
------------------------------------
Julian C. Day
Chief Executive Officer
(Principal Executive Officer)

By: /s/ A. A. KOCH
------------------------------------
A. A. Koch
Chief Financial Officer
(Principal Financial Officer)

By: /s/ RICHARD J. NOECHEL
------------------------------------
Richard J. Noechel
Vice President and Controller
(Principal Accounting Officer)

Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons, on behalf of the
Registrant and in the capacities indicated, on March 24, 2003.

Each signatory hereby acknowledges and adopts the typed form of his or her
name in the electronic filing of this document with the Securities and Exchange
Commission.

/s/ JAMES B. ADAMSON
-----------------------------------------
James B. Adamson, Chairman of the Board of Directors

/s/ LILYAN H. AFFINITO /s/ ROBERT D. KENNEDY
- -------------------------------------------- --------------------------------------------
Lilyan H. Affinito, Director Robert D. Kennedy, Director

/s/ RICHARD G. CLINE /s/ ROBIN B. SMITH
- -------------------------------------------- --------------------------------------------
Richard G. Cline, Director Robin B. Smith, Director

/s/ WILLIE D. DAVIS /s/ THOMAS T. STALLKAMP
- -------------------------------------------- --------------------------------------------
Willie D. Davis, Director Thomas T. Stallkamp, Director

/s/ JOSEPH P. FLANNERY /s/ RICHARD J. STATUTO
- -------------------------------------------- --------------------------------------------
Joseph P. Flannery, Director Richard J. Statuto, Director

84

CERTIFICATIONS

CEO CERTIFICATION

I, Julian C. Day, certify that:

1. I have reviewed this annual report on Form 10-K of Kmart Corporation;

2. Based on my knowledge, this annual 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 annual
report;

3. Based on my knowledge, the financial statements, and other financial
information included in this annual 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 annual report;

4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:

(a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this annual report is being
prepared;

(b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the filing
date of this annual report (the "Evaluation Date"); and

(c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;

5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):

(a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have identified
for the registrant's auditors any material weaknesses in internal controls;
and

(b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and

6. The registrant's other certifying officers and I have indicated in the
annual report whether there were significant changes in internal controls or in
other factors that could significantly affect internal controls subsequent to
the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.

/s/ JULIAN C. DAY
--------------------------------------
Julian C. Day
Chief Executive Officer

Date: March 24, 2003

85

CFO CERTIFICATION

I, Albert A. Koch, certify that:

1. I have reviewed this annual report on Form 10-K of Kmart Corporation;

2. Based on my knowledge, this annual 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 annual
report;

3. Based on my knowledge, the financial statements, and other financial
information included in this annual 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 annual report;

4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:

(a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this annual report is being
prepared;

(b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the filing
date of this annual report (the "Evaluation Date"); and

(c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;

5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):

(a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have identified
for the registrant's auditors any material weaknesses in internal controls;
and

(b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and

6. The registrant's other certifying officers and I have indicated in the
annual report whether there were significant changes in internal controls or in
other factors that could significantly affect internal controls subsequent to
the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.

/s/ ALBERT A. KOCH
--------------------------------------
Albert A. Koch
Chief Financial Officer

Date: March 24, 2003

86

EXHIBIT INDEX

[A] This document is a management contract or compensatory plan.

The Registrant agrees to furnish a copy to the Commission upon request
of the following instruments defining the rights of holders of long-term
debt:

Indenture dated as of February 1, 1985, between Kmart Corporation and
The Bank of New York, Trustee, as supplemented by the First Supplemental
Indenture dated as of March 1, 1991

12 1/2% Debentures Due 2005
8 3/8% Notes Due 2004
8 1/8% Notes Due 2006
7 3/4% Debentures Due 2012
8 1/4% Notes Due 2022
8 3/8% Debentures Due 2022
7.95% Debentures Due 2023
Fixed-Rate Medium-Term Notes (Series A, B, C, D)
7 3/4% Trust Convertible Preferred Securities