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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
X QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES
- -- EXCHANGE ACT OF 1934
For the quarterly period ended July 30, 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. 000-50278
KMART HOLDING CORPORATION
-------------------------
(Exact name of registrant as specified in its charter)
Delaware 32-0073116
- -------------------------------- -----------------------------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
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
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed, by Section 13 or 15(d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No
--- ---
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes X No
--- ---
Indicate by check mark whether the registrant has filed all documents and
reports required to be filed by Sections 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court.
Yes X No
--- ---
As of July 30, 2003, 89,677,509 shares of Common Stock of Kmart Holding
Corporation were outstanding.
INDEX
PART I FINANCIAL INFORMATION PAGE
- ------ --------------------- ----
Item 1. Financial Statements
Condensed Consolidated Statements of Operations (Unaudited)-- 3
Successor Company - for the 13-weeks ended July 30, 2003
Predecessor Company - for the 13-weeks ended July 31, 2002
Condensed Consolidated Statements of Operations (Unaudited)-- 4
Successor Company - for the 13-weeks ended July 30, 2003
Predecessor Company - for the 13-weeks ended April 30, 2003 and the
26-weeks ended July 31, 2002
Condensed Consolidated Balance Sheets (Unaudited)-- 5
Successor Company - as of July 30, 2003
Predecessor Company - as of January 29, 2003 and July 31, 2002
Condensed Consolidated Statements of Cash Flows (Unaudited)-- 6
Successor Company - for the 13-weeks ended July 30, 2003
Predecessor Company - for the 13-weeks ended April 30, 2003 and the
26-weeks ended July 31, 2002
Notes to Unaudited Condensed Consolidated Financial Statements 7-23
Item 2. Management's Discussion and Analysis of Results of Operations and 24-33
Financial Condition
Item 3. Quantitative and Qualitative Disclosures about Market Risk 34
Item 4. Controls and Procedures 34
PART II OTHER INFORMATION
Item 1. Legal Proceedings 35
Item 5. Other Information 35
Item 6. Exhibits and Reports on Form 8-K and Form 8-K/A 35
Signatures 36
2
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
(UNAUDITED)
13-WEEKS ENDED
--------------------------------
SUCCESSOR PREDECESSOR
COMPANY COMPANY
JULY 30, 2003 JULY 31, 2002
-------------- -------------
Sales $ 5,652 $ 7,183
Cost of sales, buying and occupancy 4,418 5,912
------- -------
Gross margin 1,234 1,271
Selling, general and administrative expenses 1,228 1,535
Restructuring, impairment and other charges - 14
Equity income in unconsolidated subsidiaries (2) (14)
------- -------
Income (loss) before interest, reorganization items, income
taxes and discontinued operations 8 (264)
Interest expense, net (contractual interest for the 13-weeks
ended July 31, 2002 was $100) 21 32
Reorganization items, net - 4
Benefit from income taxes (5) -
------- -------
Loss before discontinued operations (8) (300)
Discontinued operations (net of income tax expense
of $2 and $0, respectively) 3 7
------- -------
Net loss $ (5) $ (293)
======= =======
Basic/diluted loss before discontinued operations $ (0.09) $ (0.60)
Discontinued operations 0.03 0.02
------- -------
Basic/diluted net loss per common share $ (0.06) $ (0.58)
======= =======
Basic/diluted weighted average shares (millions) 89.7 502.7
See accompanying Notes to unaudited Condensed Consolidated Financial Statements.
3
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
(UNAUDITED)
SUCCESSOR COMPANY PREDECESSOR COMPANY
----------------- ---------------------------------
13-WEEKS ENDED 13-WEEKS ENDED 26-WEEKS ENDED
JULY 30, 2003 APRIL 30, 2003 JULY 31, 2002
----------------- -------------- --------------
Sales $ 5,652 $ 6,181 $ 14,364
Cost of sales, buying and occupancy 4,418 4,762 12,431
-------- -------- --------
Gross margin 1,234 1,419 1,933
Selling, general and administrative expenses 1,228 1,421 3,205
Restructuring, impairment and other charges - 37 14
Equity income in unconsolidated subsidiaries (2) (7) (19)
-------- -------- --------
Income (loss) before interest, reorganization items, income
taxes and discontinued operations 8 (32) (1,267)
Interest expense, net (contractual interest for the 13-weeks ended
April 30, 2003 and the 26-weeks ended July 31, 2002 was $124
and $202, respectively) 21 57 65
Reorganization items, net - 769 255
Benefit from income taxes (5) (6) (12)
-------- -------- --------
Loss before discontinued operations (8) (852) (1,575)
Discontinued operations (net of income tax expense of $2, $0,
and $0, respectively) 3 (10) (160)
-------- -------- --------
Net loss $ (5) $ (862) $ (1,735)
======== ======== ========
Basic/diluted loss before discontinued operations $ (0.09) $ (1.63) $ (3.13)
Discontinued operations 0.03 (0.02) (0.32)
======== ======== ========
Basic/diluted net loss per common share $ (0.06) $ (1.65) $ (3.45)
======== ======== ========
Basic/diluted weighted average shares (millions) 89.7 522.7 502.8
See accompanying Notes to unaudited Condensed Consolidated Financial Statements.
4
CONDENSED CONSOLIDATED BALANCE SHEETS
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
(UNAUDITED)
SUCCESSOR
COMPANY PREDECESSOR COMPANY
--------- ---------------------------
JULY 30, JANUARY 29, JULY 31,
2003 2003 2002
-------- ----------- --------
ASSETS
CURRENT ASSETS
Cash and cash equivalents $ 1,200 $ 613 $ 1,003
Merchandise inventories 4,063 4,825 5,284
Other current assets 559 664 618
-------- -------- --------
TOTAL CURRENT ASSETS 5,822 6,102 6,905
Property and equipment, net 43 4,892 5,866
Other assets and deferred charges 90 244 247
-------- -------- --------
TOTAL ASSETS $ 5,955 $ 11,238 $ 13,018
======== ======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT)
CURRENT LIABILITIES
Long-term debt due within one year $ 66 $ - $ -
Accounts payable 1,083 1,248 1,438
Accrued payroll and other liabilities 636 710 653
Taxes other than income taxes 333 162 244
-------- -------- --------
TOTAL CURRENT LIABILITIES 2,118 2,120 2,335
-------- -------- --------
LONG-TERM LIABILITIES
Mortgages payable 51 - -
Capital lease obligations 401 623 682
Pension obligation 861 - -
Unfavorable operating leases 334 - -
Other long-term liabilities 482 181 175
-------- -------- --------
TOTAL LONG-TERM LIABILITIES 2,129 804 857
TOTAL LIABILITIES NOT SUBJECT TO COMPROMISE 4,247 2,924 3,192
LIABILITIES SUBJECT TO COMPROMISE - 7,969 7,445
Predecessor Company obligated mandatorily redeemable convertible
preferred securities of a subsidiary trust holding solely 7 3/4% convertible
junior subordinated debentures (redemption value $648 and $898, respectively) - 646 889
SHAREHOLDERS' EQUITY (DEFICIT)
Successor Company preferred stock 20,000,000 shares authorized;
no shares outstanding - - -
Predecessor Company common stock $1 par value, 1,500,000,000 shares
authorized; 519,123,988 and 503,294,515 shares outstanding, respectively - 519 503
Successor Company common stock $0.01 par value, 500,000,000 shares
authorized; 89,677,509 shares outstanding 1 - -
Capital in excess of par value 1,712 1,922 1,694
Accumulated deficit (5) (2,742) (705)
-------- -------- --------
TOTAL SHAREHOLDERS' EQUITY (DEFICIT) 1,708 (301) 1,492
-------- -------- --------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT) $ 5,955 $ 11,238 $ 13,018
======== ======== ========
See accompanying Notes to unaudited Condensed Consolidated Financial Statements.
5
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN MILLIONS)
(UNAUDITED)
SUCCESSOR COMPANY PREDECESSOR COMPANY
------------------- -------------------------------------
13-WEEKS 13-WEEKS 26-WEEKS
ENDED ENDED ENDED
JULY 30, 2003 APRIL 30, 2003 JULY 31, 2002
------------------- ------------------ -----------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net Loss $ (5) $ (862) $(1,735)
Adjustments to reconcile net loss to net cash
provided by operating activities:
Restructuring, impairments and other charges - 44 791
Reorganization items, net - 769 278
Depreciation and amortization 5 177 375
Equity income in unconsolidated subsidiaries (2) (7) (19)
Dividends received from Meldisco - 36 45
Cash used for store closings and other charges (5) (64) (131)
Cash used for payments of exit costs and other
reorganization items (451) (19) (50)
Change in:
Inventories 368 480 (156)
Accounts payable (77) (117) 703
Deferred income taxes and taxes payable (11) (16) (10)
Other assets 99 123 74
Other liabilities (93) 32 123
------- ------- -------
NET CASH (USED FOR) PROVIDED BY OPERATING ACTIVITIES (172) 576 288
------- ------- -------
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from sale of property and equipment 44 64 10
Capital expenditures (27) (4) (126)
------- ------- -------
NET CASH PROVIDED BY (USED FOR) INVESTING ACTIVITIES 17 60 (116)
------- ------- -------
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from issuance of debt 60 - -
Payments on DIP Credit Facility - - (300)
Payments on debt (4) (1) (49)
Debt issuance costs (46) - (30)
Payments on capital lease obligations (14) (16) (35)
Fees paid to Plan Investors (13) - -
Issuance of common shares 140 - -
------- ------- -------
NET CASH PROVIDED BY (USED FOR) FINANCING ACTIVITIES 123 (17) (414)
------- ------- -------
NET CHANGE IN CASH AND CASH EQUIVALENTS (32) 619 (242)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 1,232 613 1,245
------- ------- -------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 1,200 $ 1,232 $ 1,003
======= ======= =======
See accompanying Notes to unaudited Condensed Consolidated Financial Statements.
6
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
1. EMERGENCE FROM CHAPTER 11 BANKRUPTCY PROTECTION
Confirmation of Plan of Reorganization
On May 6, 2003 ("Effective Date") Kmart Corporation (the "Predecessor
Company") emerged from reorganization proceedings under Chapter 11 of the
federal bankruptcy laws ("Bankruptcy Code" or "Chapter 11") pursuant to the
terms of the "Plan of Reorganization" (as hereinafter defined). The Predecessor
Company became a wholly-owned subsidiary of Kmart Management Corporation, which
is a newly-formed, wholly-owned subsidiary of a newly-created holding company,
Kmart Holding Corporation ("Kmart," "we," "us," "our," the "Company" or
"Successor Company"). Kmart is the nation's third largest discount retailer and
the sixth largest general merchandise retailer.
On January 22, 2002 ("Petition Date"), the Predecessor Company and 37
of its U.S. subsidiaries (collectively, the "Debtors") filed voluntary petitions
for reorganization under Chapter 11 in the United States Bankruptcy Court for
the Northern District of Illinois ("Court"). During the reorganization
proceedings, the Debtors continued to operate their business as
debtors-in-possession under the jurisdiction of the Court and in accordance with
the applicable provisions of the Bankruptcy Code and orders of the Court. On
January 24, 2003, the Debtors filed a Plan of Reorganization and related
Disclosure Statement and on February 25, 2003, filed an Amended Joint Plan of
Reorganization (the "Plan of Reorganization") and related amended Disclosure
Statement with the Court. The Plan of Reorganization received the formal
endorsement of the statutory creditors' committees and, as modified, was
confirmed by the Court by order docketed on April 23, 2003 ("Confirmation
Date").
In connection with our emergence from bankruptcy, we reflected the
terms of the Plan of Reorganization in our consolidated financial statements
applying the terms of the American Institute of Certified Public Accountants
Statement of Position 90-7, "Financial Reporting by Entities in Reorganization
Under the Bankruptcy Code" ("SOP 90-7") with respect to financial reporting upon
emergence from Chapter 11 ("Fresh-Start accounting"). Upon applying Fresh-Start
accounting, a new reporting entity (the Successor Company) is deemed to be
created and the recorded amounts of assets and liabilities are adjusted to
reflect their estimated fair values (see Note 3 - Fresh-Start Accounting). The
reported historical financial statements of the Predecessor Company for periods
ended prior to May 1, 2003 generally are not comparable to those of the
Successor Company. In this Quarterly Report on Form 10-Q, references to our
13-weeks ended April 30, 2003 and periods ended in fiscal 2002 refer to the
Predecessor Company.
Plan Investors
At the time of emergence, ESL Investments, Inc. ("ESL") and Third
Avenue Trust, on behalf of certain of its investment series ("Third Avenue," and
together with ESL, the "Plan Investors"), made a substantial investment in the
Successor Company in furtherance of our financial and operational restructuring
plan. The Plan Investors and their affiliates received approximately 32 million
shares of Kmart Holding Corporation's new common stock in satisfaction of
pre-petition claims they held, and we issued 14 million shares of new common
stock to affiliates of ESL and to Third Avenue, in exchange for $127, net of $13
of commitment fees and Plan Investor expenses. In addition, we issued a 9%, $60
principal amount convertible note to affiliates of ESL. The principal and
accrued interest in respect to the 9% convertible note is convertible at any
time, at the option of the holder, into new common shares at a conversion price
equal to $10 per share. ESL was also granted the option, exercisable at its own
discretion prior to May 6, 2005, to purchase from the Successor Company
approximately 6.6 million new common shares at a price of $13 per share. A
portion of the option was assigned to Third Avenue. The investment was made
pursuant to the Investment Agreement dated January 24, 2003 (as amended, the
"Investment Agreement").
ESL and its affiliates beneficially own over 50% of the common stock
of the Successor Company, including shares received in exchange for pre-petition
obligations, as well as shares obtainable upon exercise of options and
conversion of the $60 convertible note issued to affiliates of ESL. Each of the
Plan Investors is represented on our Board of Directors.
7
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
Discharge of Liabilities
(all amounts in actual dollars unless otherwise noted)
On the Effective Date, all then-outstanding equity securities of the
Predecessor Company, as well as substantially all of its pre-petition
liabilities, were cancelled. New common stock of the Successor Company was
issued in satisfaction of certain of those claims. The new securities of the
Successor Company issued on the Effective Date pursuant to the Plan of
Reorganization and related transactions, consisted of 89,677,509 shares of new
common stock and options to purchase 8,324,883 shares of new common stock. All
of the shares of common stock issued on May 6, 2003 were or will be distributed
pursuant to the Plan of Reorganization in satisfaction of pre-petition claims,
except for 14 million shares issued to affiliates of ESL and to Third Avenue in
exchange for $127 million, net of $13 million of commitment fees and Plan
Investor expenses. All such shares were issued without registration under the
Securities Act of 1933 in reliance on the provisions of Section 1145 of the
Bankruptcy Code and Section 4(2) of the Securities Act of 1933. In addition, as
part of the Plan of Reorganization, Kmart has established an independent
creditor litigation trust ("Creditor Trust") for the benefit of the Predecessor
Company's pre-petition creditors and equity holders, to pursue claims which
arose from the Predecessor Company's prior accounting and stewardship
investigations. The following table outlines the discharge of the Predecessor
Company's Liabilities subject to compromise pursuant to the Plan of
Reorganization:
TYPE OF CLAIM/SECURITY TREATMENT UNDER THE PLAN OF REORGANIZATION
---------------------- ------------------------------------------
Class 1 - Secured Claims 100% cash recovery.
Class 3 - Pre-petition Lender Claims Issued 18,723,775 shares of new common stock of the
Successor Company and cash recovery of $243 million.
Class 4 - Pre-petition Note Claims Issued 25,008,573 shares of new common stock of the
Successor Company. Holders may also receive, as described
below, recoveries under the Creditor Trust.
Class 5 - Trade Vendor and Lease Rejection Claims Issued 31,945,161 shares of new common stock of the
over $30,000 Successor Company. Holders may also receive, as described
below, recoveries under the Creditor Trust.
Class 6 - Other Unsecured Claims over $30,000 Claim holders will receive their pro-rata share of the
"Other Unsecured Claims Cash Payment" on the third
anniversary of the effective date of the Plan of
Reorganization. In addition, the holder of any Other
Unsecured claim may elect to be treated, in lieu of
payment, as a Trade Vendor/Lease Rejection claim holder.
Holders may also receive, as described below, recoveries
under the Creditor Trust.
Class 7 - General Unsecured Convenience Claims less Recovery to be paid in cash equal to 6.25% of allowed
than or equal to $30,000 claims or $1,875 if the amount of such allowed claims is
greater than $30,000 and the holder of such claim has
made the convenience claim election. In addition, the
holder of any General Unsecured Convenience Claim that
would otherwise constitute a Trade Vendor/Lease Rejection
claim may elect to be treated, in lieu of payment, as a
Trade Vendor/Lease Rejection claim holder.
Class 8 - Trust Preferred Obligations These obligations were cancelled upon emergence. Holders
may receive, as described below, recoveries under the
Creditor Trust.
Class 10 - Subordinated Security Claims Current holders, together with those who held common
stock of the Predecessor Company, may receive up to 2.5%
of the recoveries under the Creditor Trust.
8
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
Class 11 - Existing Common Stock The Predecessor Company's stock was cancelled upon
emergence. Holders, together with those who hold
Subordinated Security Claims, may receive up to 2.5% of
the recoveries under the Creditor Trust.
Class 12 - Other Interests Cancelled - no recovery.
Holders of Pre-petition Note Claims, Trade Vendor and Lease Rejection
Claims over $30,000, Other Unsecured Claims over $30,000 and Trust Preferred
Obligations will receive their pro-rata share of recoveries in the Creditor
Trust (excluding up to 2.5% of such recoveries, which may be payable to holders
of Subordinated Securities Claims and Predecessor Company's Common Stock).
In addition to the classes described above, the Plan of Reorganization
allows for two additional classes of claims, Class 2 - Other Priority Claims and
Class 9 - Intercompany Claims. The Class 2 claims are primarily claims held by
current and former employees for unpaid wages, salaries, bonuses, severance pay,
vacation pay and other unpaid employee benefits. We believe we have paid all
such valid and otherwise allowable amounts, and therefore, there should be no
significant amount of such claims, if any, that remain unpaid. The Class 9
claims are claims by one or more of Kmart and its affiliates against other Kmart
affiliates on account of various matters. Kmart, at its option, may either
reinstate or eliminate intercompany claims.
There are also other unclassified claims, including administrative
claims, priority tax claims, Pension Benefit Guarantee Corporation claims,
workers' compensation programs and consignment claims. Administrative claims
will receive a 100% cash recovery; priority tax claims will receive a 100% cash
recovery paid over a six-year period beginning on their assessment date; and the
Pension Benefit Guarantee Corporation claims, workers' compensation programs and
consignment claims were assumed by the Successor Company.
Claims Resolution
We continue to make progress in the reconciliation and settlement of
the various classes of claims. On May 30, 2003, the Bankruptcy Court confirmed
and established May 6, 2003 as the record date for purposes of establishing the
persons that are claimholders of record to receive distributions in accordance
with the terms of the Plan of Reorganization. Beginning June 30, 2003, the first
distribution date established in the Plan, we distributed approximately 4.2
million shares to holders of Class 5 claims from the shares previously issued to
us as disbursing agent with respect to such claims and approximately $1.7 in
cash to holders of Class 7 claims. Due to the significant volume of claims filed
to-date and the receipt of additional claims through August 22, 2003 (the
supplemental bar date set for certain claims), it is premature to estimate with
any degree of accuracy the ultimate allowed amount of such claims for each class
of claims under the Plan of Reorganization. Differences between amounts filed
and our estimate will be investigated and resolved in connection with our claims
resolution process. In this regard, it should be noted that the claims
reconciliation process may result in material adjustments to current estimates
of allowable claims.
The next scheduled distribution under the Plan of Reorganization is
expected to commence on or about October 1, 2003. The amount of each quarterly
distribution will depend on the amount of the claims allowed and the reserve
established for disputed claims, in either instance as of the respective
distribution date.
2. BASIS OF PRESENTATION
These interim unaudited Condensed Consolidated Financial Statements
have been prepared in accordance with the rules and regulations of the
Securities and Exchange Commission ("SEC"). Accordingly, they do not include all
of the information and footnotes required by accounting principles generally
accepted in the United States of America for complete financial statements. In
the opinion of management, all adjustments (which include normal recurring
adjustments) considered necessary for a fair presentation have been included.
All significant inter-company accounts and transactions have been eliminated.
Operating results for the interim period are not necessarily indicative of the
results that may be expected for the full year. Readers of these statements
should refer to the Predecessor Company's audited consolidated financial
statements and notes thereto which are included in our Current Report on Form
8-K, filed with the SEC on August 8, 2003, for the 13-weeks ended April 30, 2003
and the Predecessor Company's Annual Report on Form
9
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
10-K for the year ended January 29, 2003. Certain reclassifications of prior
period financial statements have been made to conform to the current interim
period presentation.
SOP 90-7 requires that the financial statements for the period
following the Chapter 11 filing through the Confirmation Date distinguish
transactions and events that are directly associated with the reorganization
from the ongoing operations of the business. Accordingly, revenues, expenses,
realized gains and losses and provisions for losses directly associated with the
reorganization and restructuring of the business are reported separately as
Reorganization items, net in the Predecessor Company's unaudited Condensed
Consolidated Statement of Operations. The unaudited Condensed Consolidated
Balance Sheet for periods prior to the emergence date distinguishes pre-petition
liabilities subject to compromise from both those pre-petition liabilities that
are not subject to compromise and from post-petition liabilities. Liabilities
subject to compromise are reported at the amounts expected to be allowed, even
if they may be settled for lesser or greater amounts. In addition, cash used for
reorganization items is disclosed separately in the unaudited Condensed
Consolidated Statements of Cash Flows.
In accordance with SOP 90-7, we adopted Fresh-Start accounting as of
the Confirmation Date. However, in light of the proximity of such date to our
April 30, 2003 quarter-end, for accounting purposes, the effects of Fresh-Start
accounting and the Plan of Reorganization, including the cancellation of the
existing common stock and the issuance of the new common stock, were reported
"as if" they occurred on April 30, 2003. References to the Successor Company in
the unaudited Condensed Consolidated Financial Statements and the Notes thereto
refer to the Company on and after April 30, 2003, after giving effect to the
provisions of the Plan of Reorganization and the application of Fresh-Start
accounting. On August 8, 2003, the Company filed, as an exhibit to Form 8-K,
audited financial statements for the 13-weeks ended April 30, 2003 reflecting
the impact of fresh-start accounting upon the emergence from bankruptcy.
3. FRESH-START ACCOUNTING
Fresh-Start Adjustments
In accordance with Fresh-Start accounting, all assets and liabilities
were recorded at their respective fair market values. Such fair values
represented our best estimates based on independent appraisals and valuations.
To facilitate the calculation of the enterprise value of the Successor
Company, we developed a set of financial projections. Based on these financial
projections, the enterprise value was determined by the Company, with the
assistance of a financial advisor, using various valuation methods, including
(i) a comparison of the Company and its projected performance to the market
values of comparable companies, (ii) a review and analysis of several recent
transactions of companies in similar industries to the Company, and (iii) a
calculation of the present value of the future cash flows under the projections.
The estimated enterprise value is highly dependent upon achieving the future
financial results set forth in the projections as well as the realization of
certain other assumptions which are not guaranteed. The estimated enterprise
value of Kmart was calculated to be approximately $2.3 billion to $3.0 billion.
We selected the midpoint of the range, $2.6 billion, as the estimated enterprise
value. In applying Fresh-Start accounting, adjustments to reflect the fair value
of assets and liabilities, on a net basis, and the write-off of the Predecessor
Company's equity accounts resulted in a charge of $5.6 billion. The
restructuring of Kmart's capital structure and resulting discharge of
pre-petition debt resulted in a gain of $5.6 billion. The charge for the
revaluation of the assets and liabilities and the gain on the discharge of
pre-petition debt are recorded in Reorganization items, net in the unaudited
Condensed Consolidated Statement of Operations. In addition, the excess of fair
value of net assets over reorganization value ("negative goodwill") was
allocated on a pro-rata basis and reduced our non-current assets, with the
exception of financial instruments, to $10 as of April 30, 2003 in accordance
with SFAS No. 141, "Business Combinations."
As part of the provisions of SOP 90-7, we were required to adopt on
April 30, 2003 all accounting guidance that was going to be effective within a
twelve-month period. See Note 20 - Recently Adopted Accounting Pronouncements
for a discussion of the impact on our financial statements of the accounting
guidance we were required to adopt.
Changes to Significant Accounting Policies
Fresh-Start accounting requires the selection of appropriate accounting
policies for the Successor Company. The significant accounting policies
disclosed in the Predecessor Company's Current Report on Form 8-K filed with
the SEC on August 8, 2003, for the 13-weeks ended April 30, 2003 will continue
to be used by the Successor Company except for the policy related to merchandise
inventories. We elected to change the method of accounting for our merchandise
inventories from the last-in, first-out ("LIFO") method to the first-in, first
out ("FIFO") method. We believe that this change is preferable to provide a
better
10
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
matching of expenses and revenues given falling product costs that have resulted
in the value of inventories under the LIFO method to be approximately equal to
their replacement cost on a FIFO basis.
The following table reflects the reorganization adjustments to Kmart's
Consolidated Balance Sheet as of April 30, 2003:
PREDECESSOR
COMPANY SUCCESSOR COMPANY
APRIL 30, 2003 ADJUSTMENTS RECAPITALIZATION APRIL 30, 2003
---------------- ----------- ---------------- -----------------
ASSETS
CURRENT ASSETS
Cash and cash equivalents $ 1,232 $ - $ - $ 1,232
Merchandise inventories 4,446 (15) (1) - 4,431
Other current assets 528 168 (1) 195 (2) 891
---------------- ------------ ------------- ----------------
TOTAL CURRENT ASSETS 6,206 153 195 6,554
Property and equipment, net 4,623 (4,613) (1) - 10
Other assets and deferred charges 212 (154) (1) 38 (2) 96
---------------- ------------ ------------- ----------------
TOTAL ASSETS $ 11,041 $ (4,614) $ 233 $ 6,660
================ ============ ============= ================
LIABILITIES AND
SHAREHOLDERS' EQUITY (DEFICIT)
CURRENT LIABILITIES
Long-term debt due within one year $ - $ - $ 8 (2) $ 8
Accounts payable 1,151 - 9 (2) 1,160
Other current liabilities 915 117 (1) 563 (2) 1,595
---------------- ------------ ------------- ---------------
TOTAL CURRENT LIABILITIES 2,066 117 580 2,763
LONG-TERM LIABILITIES
Long-term debt - - 108 (2) 108
Capital lease obligations 415 - - 415
Other long-term liabilities 174 279 (1) 1,208 (2) 1,661
---------------- ------------ ------------- ---------------
TOTAL LONG-TERM LIABILITIES 589 279 1,316 2,184
TOTAL LIABILITIES NOT
SUBJECT TO COMPROMISE 2,655 396 1,896 4,947
LIABILITIES SUBJECT TO COMPROMISE 8,896 114 (1) (9,010)(2) -
Trust convertible securities 387 (387) (1) - -
SHAREHOLDER'S EQUITY (DEFICIT)
Accumulated Other Comprehensive Income (907) 907 (1) - -
Common stock 537 (537) (1) 1 (3) 1
Other equity (527) (5,107) (1) 7,346 (4) 1,712
---------------- ------------ ------------- -----------------
TOTAL SHAREHOLDERS' EQUITY (DEFICIT) $ (897) $ (4,737) $ 7,347 $ 1,713
TOTAL LIABILITIES AND
SHAREHOLDERS' EQUITY (DEFICIT) $ 11,041 $ (4,614) $ 233 $ 6,660
================ ============ ============= =================
1. To adjust assets and liabilities to fair market value ("FMV"), and reflect
the write-off of the Predecessor Company's equity and the application of
negative goodwill to long-lived assets.
2. To record assumption or discharge of Liabilities subject to compromise and
cash received from the Plan Investors.
3. To record par value of new common stock of the Successor Company.
4. To record gain on discharge of liabilities subject to compromise and
additional paid-in-capital of new common stock of the Successor Company.
11
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
4. DISCONTINUED OPERATIONS
During the first quarter of fiscal 2003 and the second quarter of
fiscal 2002, we closed 316 and 283 stores, respectively. SFAS No. 144,
"Accounting for the Impairment or Disposal of Long-Lived Assets," ("SFAS No.
144") requires closed stores to be classified as discontinued operations when
the operations and cash flows of the stores have been (or will be) eliminated
from ongoing operations and the Company no longer has any significant continuing
involvement in the operations associated with the stores after closure. The
Company determined that it had met the second criteria, as upon closure of the
stores, operations ceased and the Company had no continuing involvement. To
determine if cash flows had been or would be eliminated from ongoing operations,
the Company evaluated a number of qualitative and quantitative factors,
including: proximity to a remaining open store, physical location within a
metropolitan or non-metropolitan statistical area and transferability of sales
between open and closed trade areas. Based on these criteria, we identified a
small number of stores closed in fiscal 2002 that met the criteria for
discontinued operations; however, in management's opinion they were not
considered material to our consolidated results of operations and were not
separately presented. Upon closure of the 316 stores in 2003, which included a
substantial exit of the state of Texas, we reevaluated the 283 stores that were
closed in 2002 and the 316 stores closed in 2003 to identify stores that should
be accounted for as discontinued operations. This analysis resulted in a total
of 121 stores identified as meeting the criteria for discontinued operations
treatment for all periods presented in our unaudited Condensed Consolidated
Statements of Operations. The table below sets forth the components of the net
loss associated with the discontinued operations for the 13-weeks ended April
30, 2003 and July 31, 2002 and the 26-weeks ended July 31, 2002.
Predecessor Company
---------------------------------------------------
13-Weeks 13-Weeks 26-Weeks
Ended Ended Ended
April 30, 2003 July 31, 2002 July 31, 2002
-------------- ------------- -------------
Sales $ 232 $ 336 $ 794
Cost of sales, buying and occupancy 150 292 794
-------------- ------------- -------------
Gross margin 82 44 -
Selling, general and administrative expenses 43 72 172
Restructuring, impairments and other charges 5 1 1
Reorganization items, net 44 - 23
-------------- ------------- -------------
Discontinued operations from 2002 and 2003 store closings (10) (29) (196)
Previous discontinued operations - 36 36
-------------- ------------- -------------
Discontinued operations $ (10) $ 7 $ (160)
============== ============= =============
For the 13-weeks ended July 30, 2003, we recorded income of $5 ($3, net
of taxes) primarily related to the recovery of claims through the bankruptcy of
Hechinger Company, successor to our former Builder's Square subsidiary, a
previous discontinued operation. In connection with our bankruptcy filing, we
recorded primarily non-cash credits in the second quarter of fiscal 2002 of $36.
The credits related to the reduction of existing lease obligations of
previously-reported discontinued operations. The fiscal 2002 amounts also
include income related to the recovery of claims through the bankruptcy of
Hechinger Company.
5. STOCK BASED COMPENSATION
In December 2002, the FASB issued SFAS No. 148, "Accounting for
Stock-Based Compensation - Transition and Disclosure, an Amendment of FASB
Statement No. 123" ("SFAS No. 148"), which provides three alternative methods of
transition to the fair value method of accounting for stock options. SFAS No.
148 also amends the disclosure requirements of SFAS No. 123, "Accounting for
Stock-Based Compensation."
In the second quarter of fiscal 2003, the Company voluntarily elected
to account for stock based compensation using the fair value method on a
prospective basis as permitted by SFAS 148. During the 13-week period,
approximately 1.7 million employee stock options of the Successor Company were
granted. The impact of this election was not material to the results of
operations for the 13-weeks ended July 30, 2003.
The Predecessor Company accounted for stock options using the intrinsic
value method in accordance with Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees (APB No. 25)" and related
12
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
interpretations, which did not require the recognition of expense for the fair
value of stock-based compensation. All outstanding stock options of the
Predecessor Company were cancelled in accordance with the Plan of
Reorganization.
In accordance with the disclosure requirements of SFAS No. 148, the pro
forma effects of recognizing compensation income (expense) on net loss and loss
per share, had we applied the fair value method to stock options issued by the
Predecessor Company, is as follows:
Predecessor Company
--------------------------------------------------
13-Weeks 13-Weeks 26-Weeks
Ended Ended Ended
April 30, 2003 July 31, 2002 July 31, 2002
-------------- ------------- -------------
Net loss, as reported $ (862) $ (293) $(1,735)
Deduct: Total stock-based employee compensation income (expense)
determined under the fair value-based method for all awards, net
of related tax effects 38 - (11)
------- ------- -------
Pro forma net loss $ (824) $ (293) $(1,746)
======= ======= =======
Basic/diluted loss per share:
As reported $ (1.65) $ (0.58) $ (3.45)
======= ======= =======
Pro forma $ (1.58) $ (0.58) $ (3.47)
======= ======= =======
Pro forma stock-based employee compensation income of $38 for the
13-weeks ended April 30, 2003 is due to the reversal of expense for options that
were not vested upon cancellation of the outstanding stock awards of the
Predecessor Company.
6. DEBT RESTRUCTURING
Exit Financing Facility
On May 6, 2003, our $2 billion exit credit agreement (the "Exit
Financing Facility"), which was an integral part of the Plan of Reorganization,
syndicated by General Electric Capital Corporation, Fleet Retail Finance Inc.
and Bank of America, N.A became effective. Debt issuance costs associated with
the Exit Financing Facility totaled $58 of which $46 was paid during the
26-weeks ended July 30, 2003 and all of which will be amortized through May
2006. The Exit Financing Facility is a revolving credit facility under which
Kmart Corporation is the borrower and contains an $800 letter of credit sub
facility. Availability under the Exit Financing Facility is also subject to an
inventory borrowing base formula. The Exit Financing Facility is guaranteed by
the Successor Company, Kmart Management Corporation, Kmart Services Corporation
(a subsidiary of Kmart Management Corporation) and Kmart's direct and indirect
domestic subsidiaries. The Exit Financing Facility is secured by first liens on
inventory, the proceeds thereof and certain related assets of Kmart and the
guarantors. Borrowings under the Exit Financing Facility currently bear interest
at either the Prime rate plus 2.5% per annum or the LIBOR rate plus 3.5% per
annum, at our discretion, which interest rate margin may be reduced after the
first anniversary of the effective date of the Exit Financing Facility if Kmart
meets certain earnings before interest, taxes, depreciation, amortization and
other charges ("EBITDA") targets. In addition, we are required to pay a fee
based on the unutilized commitment under the Exit Financing Facility equal to
0.75% per annum.
The Exit Financing Facility financial covenants include a requirement
that Kmart maintain certain specified excess availability minimums, and failure
to do so triggers additional required minimum levels of EBITDA. The Exit
Financing 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 investments, pay dividends or
make other equity distributions, sell or dispose of stock or 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 receipt of notice and/or the expiration of a grace period) result in an
event of default that could result in our inability to access the funds
necessary to maintain our operations.
13
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
Predecessor Company Debt
Borrowings of the Predecessor Company were available through the
Court-approved $2 billion 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. Debt issuance
costs of $71 were amortized through April 30, 2003. The DIP Credit Facility was
a revolving credit facility under which the Predecessor Company was the borrower
and the rest of the Debtors were guarantors, and was collateralized by first
liens on substantially all of the Debtors assets (subject to valid and
unavoidable pre-petition liens and certain other permitted liens). Borrowings
under the DIP Credit Facility were denominated in U.S. dollars bearing interest
at the Prime Rate plus 2.5% per annum, or at the Predecessor Company's option,
in Eurodollars bearing interest at the LIBOR rate plus 3.5% per annum. On May 6,
2003, in connection with the Debtors' emergence from Chapter 11, the DIP Credit
Facility was terminated.
Due to its filing for Chapter 11, the Predecessor Company was in
default on all of its debt agreements entered into prior to January 22, 2002.
While operating under Chapter 11, the Predecessor Company was prohibited under
the Bankruptcy Code from paying interest on unsecured pre-petition debts.
Included in Interest expense, net in the unaudited Condensed
Consolidated Statements of Operations is interest income of $2, $1 and $1, for
the 13-weeks ended July 30, 2003, April 30, 2003 and July 31, 2002,
respectively. Included in Interest expense, net in the unaudited Condensed
Consolidated Statements of Operations is interest income of $2, for the 26-weeks
ended July 31, 2002. On the Petition Date, we stopped accruing interest on all
unsecured pre-petition debt until the Company emerged from bankruptcy in
accordance with SOP 90-7. Contractual interest expense not accrued or recorded
by the Predecessor Company on certain pre-petition debt totaled $67 and $68 for
the 13-weeks ended April 30, 2003 and July 31, 2002, respectively. Contractual
interest expense not accrued or recorded on certain pre-petition debt totaled
$137 for the 26-weeks ended July 31, 2002.
7. 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. During fiscal
2002, 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. Their effect on the 13-weeks ended April
30, 2003 and July 31, 2002 and the 26-weeks ended July 31, 2002 are summarized
below.
Accelerated Depreciation
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 to be closed, recorded charges of $52 during the 13-weeks ended
April 30, 2003 for accelerated depreciation on unimpaired assets to be disposed
of following the store closings. Of the charge, $47 is included in
Restructurings, impairments and other charges and $5 is included in Discontinued
operations in the unaudited Condensed Consolidated Statements of Operations.
On September 6, 2001, we announced that we would restructure certain
aspects of our supply chain operations. Depreciation was accelerated on the
existing supply chain to reflect the revised remaining useful life. We recorded
a charge of $5 and $9 for the 13-weeks and 26-weeks ended July 31, 2002,
respectively, related to the accelerated depreciation of these assets. For the
13-weeks and 26-weeks ended July 31, 2002, $2 of the charge is included in SG&A
and $3 and $7 of the charge is included in Cost of sales, buying and occupancy,
respectively, in the unaudited Condensed Consolidated Statements of Operations.
In the fourth quarter of fiscal 2001 we recorded a non-cash charge for
the impairment of long-lived assets in accordance with SFAS No. 144. Included in
the charge was the write-down to fair value of long-lived assets at our 283
stores for which we received Court approval to close. Depreciation on the
remaining asset values was accelerated to reflect the revised useful lives and
the assets were fully-depreciated by the end of the second quarter of fiscal
2002. We recorded charges of $4 and $18 for the 13-weeks and 26-weeks ended July
31, 2002, respectively, related to the accelerated depreciation of these assets.
The charges are included in Cost of sales, buying and occupancy in the unaudited
Condensed Consolidated Statements of Operations.
14
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
Corporate Cost Reduction Initiatives
During the fourth quarter of fiscal 2002, we announced our intention to
eliminate in the first quarter of fiscal 2003 approximately 500 corporate
support positions. As a result of the expected job eliminations, we recorded a
charge of $36 during the fourth quarter of fiscal 2002. For the 13-weeks ended
April 30, 2003 we recorded a credit of $10 as a result of a change in our
estimated expense. This credit is included in Restructurings, impairments and
other charges in the accompanying unaudited Condensed Consolidated Statements of
Operations.
As a result of the closing of 283 stores during the second quarter of
fiscal 2002, we eliminated approximately 400 positions at our corporate
headquarters and approximately 50 national positions that provided corporate
support. As a result of the job eliminations we recorded a charge of $15 during
the second quarter of fiscal 2002. This charge is included in Restructuring,
impairment and other charges in the accompanying unaudited Condensed
Consolidated Statements of Operations.
Markdowns for Inventory Liquidation
For the 13-weeks and 26-weeks ended July 31, 2002, we recorded charges
of $27 and $785, respectively, to write-down inventory liquidated at our 283
closing stores to net realizable value. Of the charges, $27 and $652 is included
in Cost of sales, buying and occupancy for the 13-weeks and 26-weeks ended July
31, 2002, respectively. The remainder for the 26-weeks ended July 31, 2002 is
included in Discontinued operations in the accompanying unaudited Condensed
Consolidated Statements of Operations.
Of the $785 charge, $348 relates to the write-down of inventory to
estimated selling value in connection with liquidation sales in the 283 stores
for which we received Court approval to close on March 20, 2002. The liquidation
sales and store closings were completed on June 2, 2002. During the liquidation
sales, the actual markdowns required to liquidate the inventory were lower than
expected. As a result, in the second quarter, we recorded a credit of $36 to
adjust our estimate. In addition, a charge of $320 was recorded related to the
acceleration of markdowns on approximately 107,000 stock keeping units (SKUs) of
inventory items that were transferred from our remaining open stores to the 283
closing stores and included in the liquidation sales. The SKUs were no longer
carried as part of our product assortment in our remaining open stores and were
reduced to estimated selling value. The liquidation of these SKUs required
higher markdowns than anticipated; accordingly, an adjustment of $54 was
recorded in the second quarter of 2002. The remaining $117 of the charge related
to liquidation fees and expenses associated with the disposition of inventory
through the liquidation sales at the 283 closing stores, of which $9 was
recorded in the second quarter.
The following table summarizes the components of the charge for
markdowns for inventory liquidation during the 26-weeks ended July 31, 2002:
Predecessor Company
26-weeks ended July 31, 2002
------------------------------------------------------------------
Accelerated
Markdown of
Write-down Liquidator Fees Discontinued
of Inventory and Expenses SKUs Total
------------ ------------ ---- -----
First Quarter $ 384 $ 108 $ 266 $ 758
Second Quarter:
Adjustments for actual selling values (36) - 54 18
Additional fees and expenses - 9 - 9
----- ----- ----- -----
Total $ 348 $ 117 $ 320 $ 785
===== ===== ===== =====
As part of Fresh-Start accounting, reserves established in connection
with certain restructurings were discharged as of April 30, 2003 in accordance
with the Plan of Reorganization. See Note 1 - Emergence from Chapter 11
Bankruptcy Protection for a detailed discussion of the discharge of Liabilities
subject to compromise under the Plan of Reorganization. Restructuring reserves
related to the 2002 employee severance program of $36 were assumed by the
Successor Company. Payments made against this reserve were $19 in the second
quarter of fiscal 2003.
15
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
8. REORGANIZATION ITEMS, NET
Reorganization items represent amounts the Predecessor Company incurred
as a result of its Chapter 11 reorganization, and are presented separately in
the unaudited Condensed Consolidated Statements of Operations.
The following paragraphs provide additional information relating to
costs that were recorded in the line Reorganization items, net in our unaudited
Condensed Consolidated Statement of Operations for the 13-weeks ended April 30,
2003 and July 31, 2002, and the 26-weeks ended July 31, 2002:
Predecessor Company
--------------------------------------------------------
13-Weeks 13-Weeks 26-Weeks
Ended Ended Ended
April 30, 2003 July 31, 2002 July 31, 2002
-------------- ------------- -------------
Gain on extinguishment of debt $(5,642) $ - $ -
Revaluation of assets and liabilities 5,642 - -
Fleming settlement 385 - -
Estimated claims for rejected executory contracts 200 - -
2003 store closings 158 - -
2002 store closings - (10) 193
Other 26 14 62
------- ------- -------
Reorganization items, net $ 769 $ 4 $ 255
======= ======= =======
Gain on extinguishment of debt/Revaluation of assets and liabilities
See Note 3 - Fresh-Start Accounting for a discussion on the
extinguishment of debt and the revaluation of assets and liabilities.
Fleming settlement
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
the Debtor's Chapter 11 reorganization. As part of the bankruptcy proceedings,
Fleming filed a claim of $1.5 billion on March 11, 2003. Kmart and Fleming came
to an agreement on a settlement of Fleming's claims, and on March 27, 2003, the
Court approved our settlement of all claims asserted by Fleming. Under the
settlement, Kmart paid Fleming $15 of Fleming's net post-petition administrative
claim, which exceeded $30. Additionally, Fleming's general unsecured claim was
reduced from approximately $1.5 billion to $385, which was recorded in the first
quarter of 2003.
2003 store closings
On January 28, 2003, the Court approved the closure of 326 stores
located in 40 states, which number was later reduced to 316. 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 which were completed by April 13, 2003. In accordance with SFAS
No. 144, 66 of the 316 closed stores were considered discontinued operations
(see Note 4 - Discontinued Operations). As a result of our decision to close the
316 stores, we determined that $395 was the estimated allowed claim amount for
lease terminations and other costs. During the first quarter of fiscal 2003 we
reclassified $181 of capital lease obligations to the closed store reserve and
we recorded a charge of $214 for lease terminations and other costs, of which
$56 is included in discontinued operations and the remaining $158 is included in
Reorganization items, net in the unaudited Condensed Consolidated Statements of
Operations. The liability for estimated allowed claims was recorded in
accordance with SFAS No. 146, "Accounting for Costs Associated with Exit or
Disposal Activities." On April 30, 2003, upon adoption of Fresh-Start
accounting, this liability was discharged in accordance with the Plan of
Reorganization; see Note 1 - Emergence from Chapter 11 Bankruptcy Protection.
16
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
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. In accordance with SFAS
No. 144, 55 of the 283 closed stores were considered discontinued operations
(see Note 4 - Discontinued Operations). As a result of our decision to close the
283 stores, we determined that $372 was the estimated allowed claim amount for
lease terminations and other costs. During the first quarter of fiscal 2002 we
reclassified $144 of capital lease obligations to the closed store reserve and
recorded a charge of $228 for lease terminations and other costs, of which $25
is included in Discontinued operations and the remaining $203 is included in
Reorganization items, net in the unaudited Condensed Consolidated Statements of
Operations. During the second quarter of fiscal 2002, we recorded a credit of
$10 to revise our reserve for estimated allowable claims. The closed store
reserve is included in the line Liabilities subject to compromise in our
unaudited Condensed Consolidated Balance Sheet as of January 29, 2003. The
liability for estimated allowed claims was recorded in accordance with EITF
94-3, "Liability Recognition for Certain Employee Termination Benefits and Other
Costs to Exit an Activity (including Certain Costs Incurred in a
Restructuring)." On April 30, 2003, upon adoption of Fresh-Start accounting,
this liability was discharged in accordance with the Plan of Reorganization; see
Note 1 - Emergence from Chapter 11 Bankruptcy Protection.
As a result of both store closing actions, Kmart's existing store base
was reduced from 2,114 stores prior to the announcement of the 2002 store
closings to 1,513 upon completion of the 2003 store closings. As of July 30,
2003, Kmart's existing store base was 1,512 stores.
Estimated claims for rejected executory contracts
For the 13-weeks ended April 30, 2003, we recorded expense of $200 for
estimated allowable claims for rejected executory contracts, primarily equipment
leases and service contracts. The estimate was based on a review of each class
of contracts. Our estimate of claims may be different from actual amounts
alleged to be owing and filed by our creditors. Differences between amounts
filed and our estimate will be investigated and resolved in connection with our
claims resolution process. In this regard, it should be noted that the claims
reconciliation process may result in material adjustments to current estimates
of allowable claims. On April 30, 2003, upon adoption of Fresh-Start accounting,
these liabilities were discharged in accordance with the Plan of Reorganization;
see Note 1 - Emergence from Chapter 11 Bankruptcy Protection.
Other reorganization items
For the 13-weeks ended April 30, 2003, we recorded professional fees of
$43, employee costs of $66 relating to the Key Executive Retention Plan
("KERP"), a gain of $17 for the sale of pharmacy lists, income of $65 for lease
auction proceeds related to the 2003 and 2002 closed stores, a gain of $15 for
the settlement of pre-petition liabilities and net expenses of $14 for other
miscellaneous reorganization items. For the 13-weeks ended July 31, 2002, we
recorded professional fees of $29, employee costs of $37, a gain of $1 for the
sale of pharmacy lists, a gain of $29 for the settlement of pre-petition
liabilities and net income of $22 for other miscellaneous reorganization items.
For the 26-weeks ended July 31, 2002, we recorded professional fees of $67,
employee costs of $63, a gain of $15 for the sale of pharmacy lists, a gain of
$34 for the settlement of pre-petition liabilities and net income of $19 for
other miscellaneous reorganization items.
9. TRADE VENDORS' LIEN PROGRAM
On May 6, 2003, the post-emergence Trade Vendors' Lien Program became
effective. Under this program, certain vendors who provide retail merchandise to
us on credit after May 6, 2003, or who had provided merchandise to us on credit
after the Petition Date and before May 6, 2003 which was not paid for as of May
6, 2003, were granted mortgages on certain unencumbered owned and operated real
properties (the "Trade Vendor Lien"). The Trade Vendor Lien expires by its terms
on May 6, 2005, and may be terminated at the sole discretion of Kmart on or
after May 6, 2004.
In addition, under the Plan of Reorganization, any person or entity
acquiring property under the Plan of Reorganization, and any creditor and/or
equity security holder of the Debtors or the reorganized Kmart entities is
deemed to have contractually subordinated any existing or future claim, right or
interest they may have in and to any proceeds received from the disposition,
release or liquidation of any of Kmart's and Kmart's subsidiaries' leasehold
interests in any
17
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
open and operating stores as of May 6, 2003 to the claims of the trade vendors
participating in the Trade Vendors' Lien Program. The lenders under the Exit
Financing Facility and certain other parties are not subordinated in this
regard. So long as the Trade Vendors' Lien is still effective (i) we may not
encumber, sell, lease, transfer or otherwise dispose of or take other action to
impair the subordination granted under the program with respect to more than 20%
of the fair market value of the leases subject to the program, and (ii) any loan
or investment under a certain amount by ESL or Third Avenue is subject to the
subordination set forth in the provision. This claims subordination terminates
upon termination or expiration of the Trade Vendors' Lien.
10. PROPERTY HELD FOR SALE
Included in Other current assets in our unaudited Condensed
Consolidated Balance Sheet for the period ended July 30, 2003, is $117 of
property held for sale. During the first quarter of fiscal 2003, we classified
$160 of property held for sale in accordance with SFAS No. 144, "Accounting for
the Impairment or Disposal of Long-Lived Assets." For the 13-weeks ended April
30, 2003, we recorded a $7 loss on the impairment of certain of the property
held for sale. The loss is recorded in Selling, general and administrative
expenses in our unaudited Condensed Consolidated Statements of Operations.
During the second quarter of fiscal 2003, we sold $43 of assets classified as
property held for sale for $44, resulting in a gain of $1. Property held for
sale consists primarily of closed store locations and undeveloped property that
we are actively marketing and expect to sell within one year.
11. WORKERS' COMPENSATION
In March 2002, the Court issued an order providing for the continuation
of our existing surety bond coverage, which permits us to self-insure our
workers' compensation programs in various states. Discussions are continuing
with certain of the issuers of the surety bonds regarding the further
continuation of the bonds. If our discussions prove unsuccessful and the
existing surety bonds were to be cancelled, we could lose our self-insured
status in the states covered by the surety bonds and be required to pursue
alternative workers' compensation insurance programs. These alternative programs
include (i) retaining self-insurance privileges in certain states using
alternative forms of security, (ii) purchasing insurance policies to cover our
workers' compensation liabilities in certain states, and (iii) as a last resort,
participating in state-assigned risk and/or state fund insurance programs. We do
not expect that any such alternative programs would result in additional costs
having a material adverse effect on our financial position or results of
operations.
12. INCOME TAXES
We recorded a full valuation allowance against our net deferred tax
assets in accordance with SFAS No. 109, "Accounting for Income Taxes," for the
Predecessor Company, as realization of such assets in future years is uncertain.
Accordingly, we have not recognized any tax benefit from our losses in the first
quarters of 2003 and 2002 and the second quarter of 2002. The $6 tax benefit
recorded in the first quarter of fiscal 2003 related primarily to a special
provision of the Internal Revenue Code that allows a 10-year carry-back of
certain losses. For the Successor Company, we recorded a $5 tax benefit from our
losses during the 13-weeks ended July 30, 2003 based upon the estimated
effective tax rate for the nine month period ending January 28, 2004 (successor
period). We recorded a $12 tax benefit during the 26-weeks ended July 31, 2002
for the Predecessor Company related primarily to amounts refunded to Kmart as a
result of the Job Creation and Worker Assistance Act of 2002, which was enacted
in the first quarter of fiscal 2002.
13. LOSS PER SHARE
The Successor Company calculates loss per share in accordance with SFAS
No. 128, "Earnings Per Share." Basic and diluted earnings per share information
are presented in the unaudited Condensed Consolidated Statements of Operations.
In all periods presented, net losses were incurred; therefore dilutive common
stock equivalents were not used in the calculation of earnings per share as they
would have an anti-dilutive effect. For the 13-weeks ended July 30, 2003,
dilutive common stock equivalents include options to purchase approximately 8.3
million shares of the Successor Company's common stock at a price ranging from
$10 to $20 and the potential conversion of the $60 principal amount convertible
note to the Plan Investors.
Periods prior to April 30, 2003 include dilutive common stock
equivalents of the Predecessor Company. All outstanding stock options and trust
convertible securities of the Predecessor Company were cancelled in accordance
with the Plan of Reorganization. For the 13-weeks ended April 30, 2003, dilutive
common stock equivalents include options to purchase 43.3 million shares of
common stock at prices ranging from $4.86 to $24.03 and potential conversion of
18
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
certain trust preferred securities of 25.5 million common shares. For the
13-weeks and 26-weeks ended July 31, 2002, dilutive common stock equivalents
include options to purchase 51.4 million shares of common stock at prices
ranging from $4.86 to $26.03 and potential conversion of certain trust
convertible preferred securities of 59.9 million common shares.
14. COMPREHENSIVE LOSS
Comprehensive loss represents net loss, adjusted for the effect of other
items that are recorded directly to shareholders' equity. For the 13-weeks ended
April 30, 2003, comprehensive loss included a minimum pension liability
adjustment of $94 which was subsequently eliminated through the application of
Fresh-Start accounting. For the 13-weeks ended July 31, 2002, we recorded an
adjustment to shareholders' equity in accordance with SFAS No. 115, "Accounting
for Certain Investments in Debt and Equity Securities," of $2 to reduce the
value of our investment in certain equity securities to current market value.
Comprehensive loss and net loss are equivalent for all other periods presented.
15. RELATED PARTY TRANSACTIONS
Commencing March 2002, Kmart engaged various services of AP Services
(formerly known as JA&A Services), a consulting firm, whose Chairman and another
Principal held executive officer positions within Kmart. Specifically, their
Chairman, Albert A. Koch, previously served as our Chief Financial Officer, and
another Principal, Edward J. Stenger, previously served as our Treasurer. We
recorded expenses of $1 and paid fees of $3 for the 13-weeks ended July 30,
2003, and recorded expenses of $7 and paid fees of $1 for the 13-weeks ended
July 31, 2002, respectively, to the firm for services rendered under the
consulting agreement, including the services of Messrs. Koch and Stenger. We
recorded expenses of $8 and paid fees of $8 for the 26-weeks ended July 30,
2003, and recorded expenses of $9 and paid fees of $2 for the 26-weeks ended
July 31, 2002.
During the second quarter of fiscal 2003, the Company hired an employee of
ESL. This employee will continue to serve ESL as the Vice President - Research,
and will also assume the position of Vice President - Real Estate for the
Company. The Company also hired a former independent contractor of ESL to
assist with our operational strategy and business development. In addition,
William C. Crowley is expected to assume a Senior Vice President position at
the Company to assist primarily with financial matters while continuing in his
current role as President and Chief Operating Officer of ESL and as a Director
of Kmart Holding Corporation.
16. INVENTORIES AND COST OF MERCHANDISE SOLD
For the periods ended January 29, 2003 and July 31, 2002, our inventory is
accounted for using the LIFO method. Inventories valued on LIFO at January 29,
2003 and July 31, 2002 were $190 and $269 lower, respectively than the amounts
that would have been reported under the FIFO method. As previously discussed, we
elected to change our method of accounting for merchandise inventories from LIFO
to FIFO; see Note 3 - Fresh Start Accounting.
17. INVESTMENTS IN AFFILIATED RETAIL COMPANIES
Meldisco
Kmart footwear departments are operated under a license agreement with the
Meldisco subsidiaries of Footstar, Inc. ("FTS"), substantially all of which are
49% owned by Kmart and 51% owned by FTS. We are aware that FTS will be restating
its financial statements for prior periods. As a result, we have not received
final financial statements for fiscal 2002 or the first two quarters of fiscal
2003 for Meldisco at the time of our filing of this Quarterly Report on Form
10-Q. For the 13-weeks ended July 30, 2003 and April 30, 2003, we have received
preliminary financial statements and believe they provide a reliable basis for
making a reasonable estimate of $2 and $7, respectively, of equity income. For
the 13-weeks ended July 30, 2003 and April 30, 2003, Meldisco reported to us
that it had net sales of $222 and $246, respectively. For the 13-weeks ended
July 31, 2002, Meldisco reported to us that it had net sales of $290, gross
profit of $142 and net income of $23. For the 26-weeks ended July 31, 2002,
Meldisco reported to us that it had net sales of $596, gross profit of $280 and
net income of $39. We do not expect the restatement to have a material effect on
our equity income from Meldisco.
18. LIABILITIES SUBJECT TO COMPROMISE
Under bankruptcy law and in general, actions by creditors to collect
indebtedness we owed prior to the Petition Date were stayed and certain other
pre-petition contractual obligations were not enforced against the Debtors. We
19
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
received approval from the Court to pay certain pre-petition liabilities
including employee salaries and wages, benefits and other employee obligations.
Except for secured debt and capital lease obligations, all pre-petition
liabilities have been classified as Liabilities subject to compromise in the
unaudited Condensed Consolidated Balance Sheets as of January 29, 2003 and July
31, 2002. On the Effective Date, substantially all of the pre-petition
liabilities were cancelled. See Note 1 - Emergence from Chapter 11 Bankruptcy
Protection for a discussion of the discharge of pre-petition liabilities.
The following table summarizes the components of Liabilities subject to
compromise in our unaudited Condensed Consolidated Balance Sheets as of January
29, 2003 and July 31, 2002:
Predecessor Company
-----------------------------------
January 29, July 31,
2003 2002
---------------- ----------------
Debt and notes payable $ 3,348 $ 3,327
Accounts payable 2,343 2,493
Pension Obligation 741 185
Closed store reserves 722 731
General liability and workers compensation 320 288
Taxes payable 285 160
Other liabilities 210 261
---------------- ----------------
Total liabilities subject to compromise $ 7,969 $ 7,445
================ ================
19. OTHER COMMITMENTS AND CONTINGENCIES
Contingent Liabilities
The Predecessor Company had (i) guaranteed obligations for real
property leases of certain Debtors and former subsidiaries of Kmart including,
but not limited to, The Sports Authority, Inc., OfficeMax, Inc. and Borders
Group, Inc., some of which leases were assigned pre-petition; (ii) contingent
liabilities under real property leases assigned by Kmart pre-petition; and (iii)
guaranteed indebtedness of other parties related to certain of our leased
properties financed by industrial revenue bonds. To the extent not expressly
assumed or reinstated under the Plan of Reorganization these guarantees were
discharged subject to pre-petition claims administration, and to the extent
expressly assumed or reinstated, such guarantees are not considered to have a
material adverse effect on the Company's financial position or results of
operations.
Legal Proceedings
Fair Labor Standards Litigation
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 and enjoined as a result of Kmart Corporation's Chapter 11
proceedings and confirmation of the Plan and, based on our initial
investigations, we believe that we have meritorious defenses to each of these
claims. We presently do not expect to have any material 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
20
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
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 FLSA
class actions against Kmart have yet been certified. The actions described above
are the only FLSA related matters that are currently pending against Kmart.
To the extent that any awards are granted to the respective plaintiffs,
the Successor Company will be responsible only for any portion of any such award
relating to a post-petition period. Any portion of any such award that is a
monetary claim relating to a pre-petition period will be addressed in accordance
with the Plan of Reorganization.
Securities Action Litigation
Since February 21, 2002, five separate purported class actions have
been filed on behalf of purchasers of the Predecessor Company's 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 the Predecessor Company 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 the Predecessor Company's common stock and seek,
among other things, damages under Section 10(b) of the Securities Exchange Act
of 1934 and Rule 10b-5 promulgated thereunder. 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 the Predecessor Company's
securities between March 13, 2001 and May 15, 2002, and added former officers
and PricewaterhouseCoopers LLP as defendants. Kmart is not a defendant in this
litigation.
On July 31, 2002, attorneys for plaintiffs in the then 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 the Predecessor
Company's 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 the Predecessor Company's 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 Corporation
alleging breach of fiduciary duty under the Employee Retirement Income Security
Act for excessive investment in the Predecessor Company's stock; failure to
provide complete and accurate information about the Predecessor Company's common
stock; and failure to provide accurate information regarding the Predecessor
Company's financial condition. Subsequently, amended complaints were filed that
added additional current and former employees and directors of Kmart Corporation
as defendants. Kmart is not a defendant in this litigation. On July 29, 2002,
the plaintiffs filed proofs of claim with the Court in an aggregate amount equal
to $180.
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 (the "Softbank Funds") that purchased stock of Bluelight.com, a
subsidiary of Kmart Corporation, naming Charles C. Conaway, as former CEO and
Chairman of the Board of the Predecessor Company, 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 the Predecessor Company's stock and prevented
plaintiffs from realizing the market value of their stock. The complaint also
alleges violations of Section 10(b) of the Securities Exchange Act of 1934, Rule
10b-5 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 the Predecessor Company to cause the registration of the
plaintiffs' shares of the Predecessor Company's common stock to become
effective. This claim is essentially the same as count I of the lawsuit that was
dismissed on January 16, 2003. On May 2, 2002, the
21
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
plaintiffs filed proofs of claim with the Court in an aggregate amount equal to
$56. On June 26, 2003, the Circuit Court dismissed the complaint without
prejudice. The Softbank Funds filed a First Amended Complaint seeking $33 from
Mr. Conaway and a motion for Voluntary Dismissal of the Complaint on July 25,
2003. On August 4, 2003, the Circuit Court dismissed the First Amended Complaint
without prejudice.
The foregoing actions, which were brought by or on behalf of holders of
common stock of the Predecessor Company and are referred to as "Securities
Actions" under the Plan of Reorganization, were brought against persons other
than the Company and, therefore, were not extinguished when we emerged from
Chapter 11. Accordingly, to the extent that any awards are granted to the
respective plaintiffs under these actions and a claim is allowed against the
Predecessor Company under the proofs of claim previously filed with the Court,
the allowed claim, to the extent not covered by insurance, will be addressed and
treated solely in accordance with the Plan of Reorganization. Except as noted
above, the foregoing actions relate to periods occurring prior to the Petition
Date. Any obligations which we may have with respect to a claim for
indemnification by any of the defendants will be governed by the terms of the
Plan of Reorganization.
Other and Routine Actions
Kmart is a defendant in a putative class action pending in Colorado
relating to proper access to facilities for the disabled under the Americans
with Disabilities Act ("ADA"). The plaintiff claims he represents a class of
disabled customers who have been improperly denied access to facilities required
under the ADA. This case was filed on October 1, 1999 and is currently pending
in the United States District Court in Denver, Colorado. This action was stayed
pursuant to the automatic bankruptcy stay, however, on May 13, 2003, the
District Court granted plaintiff's motion to reopen the proceedings. No class
has been certified. At this time, the likelihood of a material unfavorable
outcome is not considered probable.
We are a party to a substantial number of other claims, lawsuits and
pending actions which are routine and incidental to our business. To the extent
that any claim relates to a contract which was assumed by us when we emerged or
relates to a time period occurring after the Petition Date, the Successor
Company shall be responsible for any damages which may result. In addition,
certain contracts allow for damage provisions or other repayments 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, 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. Our balance sheet as of July 30,
2003 only reflects potential losses for which the Successor Company may have
ultimate responsibility.
Investigative Matters
Prior to emergence, Kmart Corporation had been provided with copies of
anonymous letters that were sent to the SEC, our auditors, directors, legal
counsel and others, expressing concern with respect to various matters. The
letters purported to be sent by certain of our employees. The letters were
referred to the Predecessor Company's Audit Committee of the Board of Directors,
which 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 the investigations of these
matters. The staff of the SEC has expressed concerns about and is investigating
the manner in which we recorded vendor allowances before the change in
accounting principles at the end of fiscal 2001 and issues about the disclosure
of certain events bearing on the Predecessor Company's liquidity in the fall of
2001. The United States Attorney for the Eastern District of Michigan also is
undertaking an inquiry into these matters. 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 in our Chapter 11
proceedings, we had determined that the Creditor Trust was the preferred
available mechanism for resolving any legal claims that the Company might have
based on information from these investigations. As part of the Plan of
Reorganization, the trustee of the trust is charged with responsibility for
determining which claims to pursue and, thereafter, litigating such claims.
22
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
20. RECENTLY ADOPTED ACCOUNTING PRONOUNCEMENTS
In November 2002, the EITF reached a final consensus on EITF Issue No.
02-16, "Accounting by a Customer (Including a Reseller) for Certain
Consideration Received from a Vendor" ("EITF Issue No. 02-16"). This issue
addressed the income statement classification of cash consideration received
from a vendor and the recognition criteria for performance-driven vendor rebates
or refunds. This consensus, which was effective for all arrangements entered
into after December 31, 2002, resulted in certain co-op advertising recoveries,
which would previously have been recorded as a reduction of SG&A, being recorded
as a reduction of Cost of sales, buying and occupancy. We adopted EITF Issue No.
02-16 at the beginning of fourth quarter 2002.
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement
133 on Derivative Instruments and Hedging Activities" ("SFAS No. 149"). This
statement amends and clarifies the accounting for derivative instruments and
hedging activities under SFAS No. 133, "Accounting for Derivative Instruments
and Hedging Activities." As required by SOP 90-7, the Company must adopt, as of
the current reporting period, all accounting guidance that would otherwise
become effective within the next twelve months. We adopted SFAS No. 149
effective April 30, 2003. There was no impact to the Company upon the adoption
of SFAS No. 149.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity"
("SFAS No. 150"). SFAS No. 150 requires certain financial instruments with
characteristics of both liabilities and equity to be classified as liabilities.
As required by SOP 90-7, we are required to adopt, as of the current reporting
period, all accounting guidance that is effective within the next twelve month
period. We adopted SFAS No. 150 effective April 30, 2003. We did not have any
financial instruments that were classified prior to the adoption of SFAS No. 150
that were required to be reclassified to liabilities.
21. SUBSEQUENT EVENT
On August 28, 2003, the Company's Board of Directors approved the
repurchase of up to $10 of the Company's outstanding stock for the purpose of
providing restricted stock grants to certain employees. The repurchase was
subject to an amendment to the Credit Agreement of our Exit Financing Facility,
the approval of which was obtained. Certain of such grants may be subject to
shareholder approval.
23
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS
AND FINANCIAL CONDITION
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
Cautionary Statement Regarding Forward-Looking Information
This Form 10-Q, as well as other statements or reports made by or on
behalf of Kmart, may contain or may incorporate by reference material which
includes forward-looking statements within the meaning of the Private Securities
Litigation Reform Act of 1995 that reflect, when made, Kmart's current views
with respect to current events and financial performance. Statements, other than
those based on historical facts, which address activities, events or
developments that we expect or anticipate may occur in the future, are
forward-looking statements, which are based upon a number of assumptions
concerning future conditions that may ultimately prove to be inaccurate. Such
forward-looking statements are and will be, as the case may be, subject to many
risks, uncertainties and factors relating to Kmart's operations and business
environment, which may cause the actual results of Kmart to be materially
different from any future results, express or implied, by such forward-looking
statements. Factors that could cause actual results to differ materially from
these forward-looking statements include, but are not limited to, the following:
o general economic conditions,
o weather conditions, including those which affect buying patterns of our
customers,
o marketplace demand for the products of our key brand partners, as well
as the engagement of appropriate new brand partners,
o changes in consumer spending and our ability to anticipate buying
patterns and implement appropriate inventory strategies,
o competitive pressures and other third party actions, including
pressures from pricing and other promotional activities of competitors,
as well as new competitive store openings,
o the resolution of allowed claims for which we are obligated to pay cash
under the Plan of Reorganization,
o our ability to timely acquire desired goods in appropriate quantities
and/or fulfill labor needs at planned costs,
o our ability to properly monitor our inventory needs and remain
in-stock,
o our ability to successfully implement business strategies and otherwise
execute planned changes in various aspects of the business,
o our ability to operate pursuant to our Exit Financing Facility,
o outcome of negotiations on collective bargaining agreements and other
labor issues with unions representing employees in our distribution
centers,
o regulatory and legal developments,
o our ability to attract, motivate and/or retain key executives and
associates,
o our ability to attract and retain customers,
o our ability to offset the negative effects that filing for
reorganization under Chapter 11 had on our business, including the loss
in customer traffic and the impairment of vendor relations,
o our ability to obtain and maintain normal terms with vendors and
service providers,
o our ability to maintain contracts, including leases, that are critical
to our operations,
o our ability to implement our long-term strategy and/or develop a market
niche,
o our ability to fund and execute our business plan, and
o other factors affecting business beyond our control.
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.
24
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS
AND FINANCIAL CONDITION - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
Overview
On the Effective Date, Kmart Corporation (the "Predecessor Company")
emerged from reorganization proceedings under Chapter 11 of the federal
bankruptcy laws ("Bankruptcy Code" or "Chapter 11") pursuant to the terms of the
Debtors' Plan of Reorganization. The Predecessor Company became a wholly-owned
subsidiary of Kmart Management Corporation, which is a newly-formed,
wholly-owned subsidiary of a newly-created holding company, Kmart Holding
Corporation (the "Successor Company"). Kmart is the nation's third largest
discount retailer and the sixth largest general merchandise retailer.
On the Petition Date, the Predecessor Company and 37 of its U.S.
subsidiaries filed voluntary petitions for reorganization under Chapter 11. On
January 24, 2003, the Debtors filed a Plan of Reorganization and related
Disclosure Statement and on February 25, 2003, filed the Plan of Reorganization
and a related amended Disclosure Statement with the Court. The Plan of
Reorganization received the formal endorsement of the statutory creditors
committees and, as modified, was confirmed by the Court by order docketed on
April 23, 2003 ("Confirmation Date").
In accordance with SOP 90-7, we adopted Fresh-Start accounting as of
the Confirmation Date. However, in light of the proximity of such date to our
fiscal quarter end, we applied, for accounting purposes, the effects of
Fresh-Start accounting and the Plan of Reorganization, including the
cancellation of the existing common stock and the issuance of the new common
stock, "as if" they occurred on April 30, 2003. Upon applying Fresh-Start
accounting, a new reporting entity, the Successor Company, is deemed to be
created and the recorded amounts of assets and liabilities are adjusted to
reflect their estimated fair values (see Note 3 - Fresh-Start Accounting). The
reported historical financial statements of the Predecessor Company for periods
ended prior to May 1, 2003 generally are not comparable to those of the
Successor Company. In this Quarterly Report on Form 10-Q, references to our
results of operations for the 13-weeks ended April 30, 2003 and periods ended in
fiscal 2002 refer to the Predecessor Company.
At the time of emergence, the Plan Investors made a substantial
investment in the Successor Company in furtherance of our financial and
operational restructuring plan. The Plan Investors and their affiliates received
approximately 32 million shares of Kmart Holding Corporation's new common stock
in satisfaction of pre-petition claims they held, and we issued 14 million
shares of new common stock to affiliates of ESL and to Third Avenue, in exchange
for $127, net of $13 of commitment fees and Plan Investor expenses. In addition,
we issued a 9%, $60 principal amount convertible note to the affiliates of ESL.
The principal and unpaid interest in respect to the 9% convertible note is
convertible at any time, at the option of the holder, into new common shares at
a conversion price equal to $10 per share. ESL also was granted the option,
exercisable in its own discretion prior to May 6, 2005, to purchase from the
Successor Company approximately 6.6 million new Common Shares at a price of $13
per share. A portion of the option was assigned to Third Avenue. The investment
was made pursuant to the Investment Agreement.
ESL and its affiliates beneficially own over 50% of the common stock of
the Successor Company, including shares received in exchange for pre-petition
obligations, as well as shares obtainable upon exercise of options and
conversion of the $60 convertible note issued to affiliates of ESL. Each of the
Plan Investors is represented on our Board of Directors.
The Plan of Reorganization became effective on May 6, 2003, at which
time all then-outstanding equity securities of the Predecessor Company, as well
as substantially all of its pre-petition liabilities, were cancelled. Holders of
the Predecessor Company's stock may receive up to 2.5% of the recoveries under
the Creditor Trust; see Note 1 - Emergence from Chapter 11 Bankruptcy
Protection. New common stock of the Successor Company was issued in satisfaction
of certain of those pre-petition liability claims; see Note 1 - Emergence from
Chapter 11 Bankruptcy Protection. The new securities of the Successor Company
issued on the Effective Date pursuant to the Plan of Reorganization and related
transactions, consisted of 89,677,509 shares of new common stock and options to
purchase 8,324,883 shares of new common stock. All of the shares of common stock
issued on May 6, 2003 were or will be distributed pursuant to the Plan of
Reorganization in satisfaction of pre-petition claims, except for 14 million
shares of common stock of the Successor Company issued to affiliates of ESL and
Third Avenue for $127, net of $13 of commitment fees and Plan Investor expenses.
All such shares were issued without registration under the Securities Act of
1933 in reliance on the provisions of Section 1145 of the Bankruptcy Code and
Section 4(2) of the Securities Act of 1933. In addition, as part of the Plan of
Reorganization, Kmart has established a Creditor Trust for the benefit of the
Predecessor Company's pre-petition creditors and equity holders, to pursue
claims which arose from the Predecessor Company's prior accounting and
stewardship investigations.
25
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS
AND FINANCIAL CONDITION - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
The ability of Kmart to continue as a going concern is predicated upon
numerous issues, including our ability to achieve the following:
o implementing our business plan and returning Kmart to profitability;
o taking appropriate action to offset the negative effects that the
Chapter 11 filing had on our business, including the loss in customer
traffic and the impairment of vendor relations;
o operating within the framework of our $2 billion 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 terms; and
o 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. Refer to the "Cautionary Statement Regarding Forward-Looking
Information" above.
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. We have disclosed our critical accounting policies
and estimates in our Current Report on Form 8-K, filed with the Securities and
Exchange Commission on August 8, 2003. See Note 3 - Fresh Start Accounting for a
discussion of our change from the Last-in First-Out method of inventory
valuation to the First-in First-Out method for our accounting for merchandise
inventories.
RECENTLY ADOPTED ACCOUNTING PRONOUNCEMENTS
For a comprehensive discussion see Note 20 - Recently Adopted
Accounting Pronouncements.
26
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS
AND FINANCIAL CONDITION - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
As previously discussed, due to the application of Fresh-Start
accounting, the reported historical financial statements of the Predecessor
Company for periods prior to May 1, 2003 generally are not comparable to those
of the Successor Company. Therefore, the Results of Operations and the Liquidity
and Financial Condition of the Successor Company have not been combined with
those of the Predecessor Company in this Management's Discussion and Analysis.
RESULTS OF OPERATIONS
The following table is presented solely to complement management's
discussion and analysis.
Successor Company Predecessor Company
----------------- --------------------------------------------------
13-Weeks Ended 13-Weeks Ended 13-Weeks Ended 13-Weeks Ended
July 30, 2003 July 31, 2002 April 30, 2003 May 1, 2002
--------------- --------------- -------------- --------------
Sales $ 5,652 $ 7,183 $ 6,181 $ 7,181
Cost of sales, buying and occupancy 4,418 5,912 4,762 6,519
------- ------- ------- -------
Gross margin 1,234 1,271 1,419 662
Selling, general and administrative expenses 1,228 1,535 1,421 1,670
Restructuring, impairment and other charges - 14 37 -
Equity income in unconsolidated subsidiaries (2) (14) (7) (5)
------- ------- ------- -------
Income (loss) before interest, reorganization items, income
taxes and discontinued operations 8 (264) (32) (1,003)
Interest expense, net 21 32 57 33
Reorganization items, net - 4 769 251
Benefit from income taxes (5) - (6) (12)
------- ------- ------- -------
Loss before discontinued operations (8) (300) (852) (1,275)
Discontinued operations (net of income taxes of $2, $0, $0
and $0, respectively) 3 7 (10) (167)
------- ------- ------- -------
Net loss $ (5) $ (293) $ (862) $(1,442)
------- ------- ------- -------
13-WEEKS ENDED JULY 30, 2003 COMPARED TO 13-WEEKS ENDED JULY 31, 2002
Same-store sales and total sales decreased 5.4% and 21.3%,
respectively, for the 13-weeks ended July 30, 2003, as compared to the 13-weeks
ended July 31, 2002. Same-store sales include sales of all open stores that have
been open for greater than 13 full months. The decrease in same-store sales is
due primarily to decreased promotional activity, resulting in lower sales
volumes at improved rates of margin realization. The decrease in total sales is
attributable to the decrease in same-store sales, the closure of 283 stores
during the second quarter of fiscal 2002 and the closure of 316 stores during
the first quarter of fiscal 2003.
Gross margin decreased $37 to $1,234, for the 13-weeks ended July 30,
2003, from $1,271 for the 13-weeks ended July 31, 2002. Gross margin, as a
percentage of sales, increased to 21.8% for the 13-weeks ended July 30, 2003,
from 17.7% for the comparable period in the prior year. The improvement in the
gross margin rate is attributable to a decrease in shrinkage and an overall
improvement in our sales mix. In addition, the gross margin rate was positively
affected by the termination of our supply arrangement with Fleming, lower buying
and occupancy expenses as a result of the write-off of long-lived assets in
conjunction with the application of Fresh-Start accounting and the effect of
co-op recoveries recorded in Cost of sales, buying and occupancy in 2003.
Previously, co-op recoveries were recorded in Selling, general and
administrative expenses ("SG&A") prior to the adoption in the fourth quarter of
2002 of EITF 02-16, "Accounting by a Customer (Including a Reseller) for Certain
Consideration Received from a Vendor" ("EITF 02-16"). These improvements in the
gross margin rate were partially offset by the impact of clearance markdowns.
Selling, general and administrative expenses (SG&A), which includes
advertising costs (net of co-op recoveries of $91 in 2002), decreased $307 to
$1,228 for the 13-weeks ended July 30, 2003 from $1,535 for the 13-weeks ended
July 31, 2002. The decrease in SG&A is primarily due to the reduction of our
store base after closing 599 stores during fiscal 2002 and the first quarter of
2003, as well as a decrease in payroll and other related expenses from
27
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS
AND FINANCIAL CONDITION - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
corporate headquarters' cost reduction initiatives, and lower depreciation
expense due to adjustments to the book value of the Company's property and
equipment, resulting from impairment charges taken while operating in bankruptcy
and the write-off of long-lived assets in conjunction with Fresh-Start
accounting. Collectively, these reductions were partially offset by an increase
in workers' compensation expense and the impact of the reclassification of co-op
recoveries, as discussed above. SG&A, as a percentage of sales, increased to
21.7% for the 13-weeks ended July 30, 2003, from 21.4% for the comparable period
in the prior year.
Income before interest, reorganization items, income taxes and
discontinued operations for the 13-weeks ended July 30, 2003 was $8, or 0.1% of
sales, as compared to a loss of ($264), or (3.7%) of sales, for the 13-weeks
ended July 31, 2002. The increase in operating income from the comparable period
in the prior year was primarily due to the decrease in SG&A, partially offset by
the decrease in gross margin, as discussed above.
Interest expense, net for the 13-weeks ended July 30, 2003 and July 31,
2002 was $21 and $32, respectively. Included in net interest expense is interest
income of $2 and $1 for the 13-weeks ended July 30, 2003 and July 31, 2002,
respectively. The decrease in net interest expense is primarily attributable to
the decrease in our capital lease interest expense as a result of the store
closings. While operating under Chapter 11, we were prohibited from paying
interest on unsecured pre-petition debt. Interest at the stated contractual
amount on unsecured debt that was not charged to earnings for the 13-weeks ended
July 31, 2002 was $100.
Effective income tax rate was (38.5)% and 0.0% for the 13-weeks ended
July 30, 2003 and July 31, 2002, respectively. See Note 12 - Income Taxes.
13-WEEKS ENDED APRIL 30, 2003 COMPARED TO 13-WEEKS ENDED MAY 1, 2002
Same-store sales and total sales decreased 3.2% and 13.9%,
respectively, for the 13-weeks ended April 30, 2003 as compared to the 13-weeks
ended May 1, 2002. The decrease in same-store sales was primarily due to
sluggish retail sales as a result of consumer concerns over the war with Iraq,
general economic factors and unseasonable weather conditions. Same-store sales
include sales of all open stores that have been open for greater than 13 full
months. The decrease in total sales was attributable to the decrease in
same-store sales and the closure of 283 stores during the second quarter of
fiscal 2002.
Gross margin increased $757 to $1,419, for the 13-weeks ended April 30,
2003, from $662 for the 13-weeks ended May 1, 2002. Gross margin, as a
percentage of sales, increased to 23.0% for the 13-weeks ended April 30, 2003,
from 9.2% for the 13-weeks ended May 1, 2002. The increase in gross margin was
primarily related to the charge of $625 recorded in the first quarter of 2002 in
conjunction with the store closing liquidation sales. In addition, our gross
margin rate was positively affected by a favorable gross margin rate realized
from closing store liquidation sales, a decrease in sales of food and
consumables, which carry lower margins, and a decrease in promotional markdowns,
partially offset by the impact of clearance markdowns.
Selling, general and administrative expenses (SG&A), which includes
advertising costs (net of co-op recoveries of $69 in fiscal 2002) decreased $249
for the 13-weeks ended April 30, 2003 to $1,421, or 23.0% of sales, from $1,670,
or 23.3% of sales, for the 13-weeks ended May 1, 2002. The decrease in SG&A was
primarily the result of the closure of 283 stores in the second quarter of 2002
and lower payroll and other related expenses in the first quarter of 2003
stemming from corporate headquarters cost reduction initiatives. In addition,
SG&A was favorably impacted by a decrease in utility expenses and electronic
media advertising, and lower depreciation expense as a result of the impairment
charge recorded in the fourth quarter of fiscal 2002. Offsetting the positive
impact of these items was an increase in pension and workers' compensation
expense and the impact of the previously discussed reclassification of co-op
recoveries in accordance with EITF 02-16.
Loss before interest, reorganization items, income taxes and
discontinued operations for the 13-weeks ended April 30, 2003 was $32, or (0.5%)
of sales, as compared to a loss of $1,003, or (14.0%) of sales, for the same
period of the prior year. The decrease in operating loss was primarily due to
the 2002 charge for accelerated inventory markdowns of $625 and the decrease in
SG&A as previously discussed.
Interest expense, net for the 13-weeks ended April 30, 2003 and May 1,
2002 was $57 and $33, respectively. The increase in interest expense was due to
accelerated amortization on debt issuance costs related to our DIP Credit
Facility in conjunction with our emergence from Chapter 11. Included in net
interest expense was interest income of $1
28
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS
AND FINANCIAL CONDITION - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
for the 13-weeks ended April 30, 2003 and May 1, 2002. Interest at the stated
contractual amount on unsecured debt that was not charged to earnings for the
13-weeks ended April 30, 2003 and May 1, 2002 was $67 and $69, respectively.
Effective income tax rate was (0.7%) and (0.9%) for the 13-weeks ended
April 30, 2003 and May 1, 2002, respectively, see Note 12 - Income Taxes.
Significant changes were made to our April 30, 2003 unaudited Condensed
Consolidated Balance Sheet to reflect the application of Fresh-Start accounting.
See Note 3 - Fresh Start Accounting for further details of the adjustments.
26-WEEKS ENDED JULY 31, 2002 (PREDECESSOR COMPANY)
Total sales were $14,364 for the 26-weeks ended July 31, 2002.
Same-store sales decreased (11.4%). Same-store sales include sales of all open
stores that have been open for greater than 13 full months. Promotional activity
during the period benefited total and same-store sales.
Gross margin for the 26-weeks ended was $1,933, or 13.5% of sales.
Gross margin was negatively impacted by the inventory charge of $652 recorded in
fiscal 2002 in conjunction with the store closing liquidation sales.
SG&A, which includes advertising costs, was $3,205, or 22.3% of sales
for the period. The Company recorded $158 of co-op recoveries in SG&A prior to
the adoption of EITF 02-16 as discussed above.
Operating loss before interest, reorganization items, income taxes and
discontinued operations for the 26-weeks ended July 31, 2002 was ($1,267), or
(8.8%) of sales.
Interest expense, net was $65 for the 26-weeks ended July 31, 2002.
Included in net interest expense is interest income of $2.
Effective income tax rate was (0.8%) for the 26-weeks ended July 31,
2002. See Note 12 - Income Taxes.
LIQUIDITY AND FINANCIAL CONDITION
13-WEEKS ENDED JULY 30, 2003 (SUCCESSOR COMPANY)
Our cash needs are satisfied through working capital generated by our
business and funds available under our Exit Financing Facility. The level of
cash generated by our business is dependent, in significant part, on our level
of sales and the credit extended by our vendors. Since the Predecessor Company's
filing for reorganization under Chapter 11, most of our vendors continue to
support us and have resumed normal trade terms. We continue to focus on our
vendor relationships and do not expect to experience any significant disruption
of terms with our vendors. Should, however, we experience a significant
disruption of terms with our vendors, sales fail to improve, the Exit Financing
Facility for any reason becomes unavailable and/or actual results differ
materially from those projected, our compliance with financial covenants and our
cash resources could be adversely affected.
On May 6, 2003, our $2 billion Exit Financing Facility financed by
General Electric Capital Corporation, Fleet Retail Finance, Inc. and Bank of
America, N.A. became effective. Debt issuance costs associated with the Exit
Financing Facility totaled $58 and will be amortized through May 2006. The Exit
Financing Facility is a revolving credit facility under which Kmart Corporation
is the debtor and its parent entities and most direct and indirect subsidiaries
are guarantors. The Exit Financing Facility is collateralized by first liens on
inventory, the proceeds thereof, and certain intellectual property necessary to
realize the value of the inventory. Borrowings under the Exit Financing Facility
currently bear interest at either the Prime rate plus 2.5% per annum or the
LIBOR rate plus 3.5% per annum, at our discretion, which interest rate margin
may be reduced after the first anniversary of the effective date of the Exit
Financing Facility if Kmart meets certain EBITDA targets. In addition, we are
required to pay a fee based on the unutilized commitment under the Exit
Financing Facility equal to 0.75% per annum. The Exit Financing Facility
financial covenants include a requirement that Kmart maintain certain specified
excess availability minimums, and failure to do so triggers additional required
minimum levels of EBITDA. The Exit Financing 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
investments, pay dividends or make other equity distributions, sell or dispose
of stock or assets, change the nature of our business and enter into affiliate
transactions, mergers and consolidations. Failure to satisfy these
29
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS
AND FINANCIAL CONDITION - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
covenants would (in some cases, after the receipt of notice and/or the
expiration of a grace period) result in an event of default that could result in
our inability to access the funds necessary to maintain our operations. As of
July 30, 2003 we had utilized $480 of the Exit Financing Facility for letters of
credit issued for ongoing import purchasing operations, contractual and
regulatory purposes. Total availability under the Exit Financing Facility at
July 30, 2003 is $1.5 billion. We do not currently expect to borrow from the
Exit Financing Facility except in the normal course of business to possibly fund
the seasonal inventory build-up for the fourth quarter, as discussed below. The
Company is also exploring various alternatives to reduce the cost of our Exit
Financing Facility.
Net cash used for operating activities was $172 for the 13-weeks ended
July 30, 2003. Net cash used for operating activities was primarily driven by
payments of $451 during the second quarter of fiscal 2003 for exit costs and
reorganization items. The payments for exit costs and reorganization items
include $69 under the Key Employee Retention Program ("KERP"), $45 to retain
bankruptcy advisors and $243 to pre-petition lenders. The negative impact of
these items was partially offset by a reduction in inventory, net of accounts
payable.
Net cash provided by investing activities was $17 for the 13-weeks
ended July 30, 2003 and was the result of proceeds of $44 from the sale of
property classified as property held for sale (see Note 10 - Property Held for
Sale) offset by $27 for capital expenditures.
Net cash provided by financing activities was $123 for the 13-weeks
ended July 30, 2003. Upon emergence from bankruptcy, the Company received
proceeds of $140 from the issuance of common stock to the Plan Investors and
proceeds of $60 from the issuance of the convertible note to affiliates of ESL.
The positive impact of these items was offset by payments made for other
financing arrangements.
13-WEEKS ENDED APRIL 30, 2003 (PREDECESSOR COMPANY)
Net cash provided by operating activities was $576 for the 13-weeks
ended April 30, 2003. Net cash provided by operating activities was primarily
driven by a decrease in inventory of $480 due to store liquidation sales and
improved inventory management partially offset by a decrease in accounts
payable.
Net cash provided by investing activities was $60 for the 13-weeks
ended April 30, 2003. Net cash provided by investing activities was the result
of first quarter fiscal 2003 proceeds of $64 from the sale of four owned Kmart
store locations and the sale of furniture and fixtures from our closed store
locations offset by $4 for capital expenditures.
Net cash used for financing activities was $17 for the 13-weeks ended
April 30, 2003 primarily due to payments on debt and capital lease obligations.
26-WEEKS ENDED JULY 31, 2002 (PREDECESSOR COMPANY)
Net cash provided by operating activities for the 26-weeks ended July
31, 2002 was $288 and was primarily due to an increase in accounts payable,
partially offset by the net loss excluding non-cash items. The increase in
accounts payable was attributable to the bankruptcy filing as pre-petition
indebtedness was stayed.
Net cash used for investing activities was $116 for the 26-weeks ended
July 31, 2002. The Company had capital expenditures of $126 during the period.
Net cash used for financing activities was $414 for the 26-weeks ended
July 31, 2002. As of the Petition Date, pre-petition indebtedness was stayed.
During the first two quarters of fiscal 2002, we paid off $349 of borrowings
outstanding at fiscal year end 2001 relating to our Debtor-in-Possession Credit
Facility ("DIP Credit Facility") and certain other pre-petition liabilities.
Following the Petition Date and prior to emergence, the Predecessor
Company utilized cash flows from operations and the DIP Credit Facility as its
primary sources of working capital. The DIP Credit Facility was a revolving
credit facility under which the Predecessor Company was the borrower and the
rest of the Debtors were guarantors.
30
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS
AND FINANCIAL CONDITION - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
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 income and
cash flows from operations are 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 fiscal
2002 sales represented over 29% of total net sales in fiscal 2002. 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 has historically been higher for this period
of the year.
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 factors
substantially affect the world economy.
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 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 nine years, the Predecessor Company has not been required to make
contributions to the plans.
In light of losses 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 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 $700 and $1 billion in the aggregate. The actual level of
contributions will depend upon a number of factors, including actual demographic
experience, pension fund returns and other changes affecting valuations.
In addition to the funding described above, as a result of the returns
over the most recent years, decreases in our annual discount rate and expected
rate of return on assets, we recorded pension expense of $6 and $20 in the
13-weeks ended July 30, 2003 and the 13-weeks ended April 30, 2003,
respectively, as opposed to income as has been recorded in the most recent
years.
FRESH-START ADJUSTMENTS
In accordance with Fresh-Start accounting, all assets and liabilities
are recorded at their respective fair market values. Fair values used represent
our best estimates based on independent appraisals and valuations.
To facilitate the calculation of the enterprise value of the Successor
Company, we developed a set of financial projections. Based on these financial
projections, the enterprise value was determined by the Company, with the
assistance of a financial advisor, using various valuation methods, including
(i) a comparison of the Company and its projected performance to the market
values of comparable companies, (ii) a review and analysis of several recent
transactions of companies in similar industries to the Company, and (iii) a
calculation of the present value of the future cash flows under the projections.
The estimated enterprise value is highly dependent upon achieving the future
financial results set forth in the projections as well as the realization of
certain other assumptions which are not guaranteed. The estimated enterprise
value of Kmart was calculated to be approximately $2.3 billion to $3.0 billion.
We selected the midpoint of the range, $2.6 billion, as the estimated enterprise
value. In applying Fresh-Start accounting, adjustments to reflect the fair value
of assets and liabilities, on a net basis, and the write-off of the Predecessor
Company's equity
31
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS
AND FINANCIAL CONDITION - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
accounts resulted in a charge of $5.6 billion. The restructuring of Kmart's
capital structure and resulting discharge of pre-petition debt resulted in gain
of $5.6 billion. The charge for the revaluation of the assets and liabilities
and the gain on the discharge of pre-petition debt are recorded in
Reorganization items, net in the unaudited Condensed Consolidated Statement of
Operations. For a comprehensive discussion see Note 3 - Fresh-Start Accounting.
DISCONTINUED OPERATIONS
During the first quarter of fiscal 2003 and the second quarter of
fiscal 2002, we closed 316 and 283 stores, respectively. Of the total store
closings, we identified 121 stores that met the criteria for discontinued
operations. For a comprehensive discussion see Note 4 - Discontinued Operations.
Of the 599 stores that were closed in 2003 and 2002, 478 are included
in continuing operations, as they did not meet the criteria for discontinued
operations. For the 13-weeks ended April 30, 2003, 250 of the 316 stores closed
were accounted for in continuing operations. Total sales, gross margin and SG&A
for these 250 stores were $854, $301 and $146, respectively. For the 13-weeks
ended July 31, 2002, total sales, gross margin and SG&A for the 478 stores that
were reported in continuing operations were $1,210, $202 and $249, respectively.
For the 26-weeks ended July 31, 2002, total sales, gross margin and SG&A for the
478 stores that were reported in continuing operations were $2,884, $(35) and
$618, respectively.
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. During fiscal
2002, 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. For the 13-weeks ended April 30, 2003, and
the 13-weeks and 26-weeks ended July 31, 2002, we recorded special charges of
$42, $51 and $827, respectively. For a comprehensive discussion see Note 7 -
Special Charges.
REORGANIZATION ITEMS, NET
Reorganization items represent amounts the Predecessor Company incurred
as a result of Chapter 11, and are presented separately in the unaudited
Condensed Consolidated Statements of Operations. We recorded $4, $769 and $255
for the 13-weeks ended July 31, 2002, the 13-weeks ended April 30, 2003 and the
26-weeks ended July 31, 2002, respectively, for reorganization items. The net
increase in Reorganization items for the 13-weeks ended April 30, 2003 as
compared to the 26-weeks ended July 31, 2002, is primarily due to the Fleming
settlement of $385 and expense of $200 for estimated claims for rejected
executory contracts, partially offset by the 2002 store closings charge of $203.
For a comprehensive discussion see Note 8 - Reorganization Items, net.
OTHER MATTERS
Lawsuits, Investigations and Other Contingent Liabilities
The Company's stores are supplied by 17 distribution centers located
throughout the United States. Employees at 9 of these distribution centers are
parties to various collective bargaining agreements. The Company is in
negotiations with the UAW to renew collective bargaining agreements scheduled
to expire on September 1, 2003 that cover two of the distribution centers
supplying approximately 15% of the Company's stores. The Company cannot predict
the outcome of these negotiations. The Company has a contingency plan in place
to supply its stores from its other distribution centers with minimum
disruption in the short term in the event the employees take action that
impacts distribution center operations. If the disruption to the distribution
center operations is prolonged into the Company's peak sales season, the
Company may experience more significant difficulties supplying its stores.
We are a party to a substantial number of other claims, lawsuits and
pending actions which are routine and incidental to our business. To the extent
that any claim relates to a contract which was assumed by us when we emerged or
relates to a time period occurring after the Petition Date, the Successor
Company shall be responsible for any damages which may result. In addition,
certain contracts allow for damage provisions or other repayments as a result of
our termination of the contracts. For a comprehensive discussion see Note 19 -
Other Commitments and Contingencies.
Other
On August 6, 2003, Kmart announced the launch of the Thalia Sodi
Collection. The Collection captures the personal style and attitude of the
Hispanic actress and singer, Thalia Sodi, and her culture. It includes branded
apparel for women and girls, as well as footwear, accessories, jewelry,
intimates, hosiery and bed and bath products. The Thalia Sodi Collection is
available in 335 Kmart stores including those in the New York City, Los Angeles,
San Francisco, Miami, Denver, Las Vegas, Phoenix, San Diego, Chicago and Puerto
Rico areas.
32
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS
AND FINANCIAL CONDITION - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
On June 4, 2003, Martha Stewart was indicted in the United States
District Court of the Southern District of New York. The Martha Stewart brand is
considered a distinctive brand for Kmart and we currently sell Martha Stewart
home, garden, colors, baby, kitchen, keeping and decorating product lines, along
with candles and accessories. Martha Stewart has resigned her position as
Chairman and Chief Executive Officer of Martha Stewart Omnimedia, Inc; however,
she will serve as the Chief Creative Officer and remain on the Board of
Directors. To-date, we have not experienced any significant adverse impact from
this matter on the sales of Martha Stewart brand products. Although product
sales have not been significantly affected by past events, the Company is not
able to determine the potential effects that these events may have on the future
sales of its Martha Stewart brand products.
On August 28, 2003, the Company's Board of Directors approved the
repurchase of up to $10 of the Company's outstanding stock for the purpose of
providing restricted stock grants to certain employees. The repurchase was
subject to an amendment to the Credit Agreement of our Exit Financing Facility,
the approval of which was obtained. Certain of such grants may be subject to
shareholder approval.
33
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
At July 30, 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 Exit
Financing Facility, which is a variable rate financing agreement. We do not use
swaps or other interest rate protection agreements to hedge this risk.
ITEM 4. CONTROLS AND PROCEDURES
We carried out an evaluation, under the supervision of our management
Disclosure Committee (which includes the Chief Executive Officer and
Co-Principal Financial Officers), of the effectiveness of our disclosure
controls and procedures pursuant to Exchange Act Rules 13a-15(e) and 15d-15(e).
Based upon this evaluation, the Chief Executive Officer and Co-Principal
Financial Officers concluded that as of the end of the period covered by this
quarterly report, 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. No change in
our internal control over financial reporting occurred during our most recent
fiscal quarter that has materially affected, or is reasonably likely to
materially affect, our internal control over financial reporting.
34
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
See Note 19 of the Notes to unaudited Condensed Consolidated Financial
Statements for information concerning legal proceedings.
ITEM 5. OTHER INFORMATION
The employment of Mr. William D. Underwood as Executive Vice-President,
Sourcing and Global Operations with Kmart terminated June 24, 2003.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K AND FORM 8-K/A
(a) The following exhibits are filed as a part of this report:
Exhibit 10.1 - Letter Agreement to Credit Agreement
Exhibit 10.2 - Kmart Holding Corporation Annual Incentive Bonus Plan
Exhibit 10.3 - First Amendment to Credit Agreement
Exhibit 31.1 - Chief Executive Officer Certification pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002
Exhibit 31.2 - Co-Principal Financial Officer Certification pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002
Exhibit 31.3 - Co-Principal Financial Officer Certification pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002
(b) The following exhibit is furnished as a part of this report:
Exhibit 32 - Certifications pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
(c) Reports on Form 8-K and Form 8-K/A: We filed and furnished the
following Current Reports on Form 8-K and Form 8-K/A with the SEC:
1. On June 16, 2003, Kmart Holding Corporation furnished a Current
Report on Form 8-K to report the first quarter 2003 operating
results.
2. On June 17, 2003, Kmart Holding Corporation filed a Current Report
on Form 8-K/A to report that on May 30, 2003, the Bankruptcy Court
confirmed and established May 6, 2003 as the record date for
purposes of establishing the persons that are claimholders of
record to receive distributions in accordance with the terms of
the Plan of Reorganization; and to furnish revised certifications
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
3. On August 8, 2003, Kmart Holding Corporation filed a Current
Report on Form 8-K to report the audited financial statements for
the 13-weeks ended April 30, 2003 and Fiscal Years ended January
29, 2003, January 30, 2002 and January 31, 2001.
35
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this Report to be signed on its behalf by the
undersigned, thereunto duly authorized.
The signatory hereby acknowledges and adopts the typed form of his/her name in
the electronic filing of this document with the Securities and Exchange
Commission.
Date: AUGUST 29, 2003
Kmart Holding Corporation
----------------------------------
(Registrant)
By: /s/ Julian C. Day
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Julian C. Day
PRESIDENT AND CHIEF
EXECUTIVE OFFICER
(Principal Executive Officer)
/s/ Richard J. Noechel
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Richard J. Noechel
VICE PRESIDENT AND
CONTROLLER
(Principal Accounting Officer and Co-Principal
Financial Officer)
36
EXHIBIT INDEX
Exhibit No. Description
----------- -----------
Exhibit 10.1 - Letter Agreement to Credit Agreement
Exhibit 10.2 - Kmart Holding Corporation Annual Incentive Bonus Plan
Exhibit 10.3 - First Amendment to Credit Agreement
Exhibit 31.1 - Chief Executive Officer Certification pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002
Exhibit 31.2 - Co-Principal Financial Officer Certification
pursuant to Section 302 of the Sarbanes-Oxley Act of
2002
Exhibit 31.3 - Co-Principal Financial Officer Certification
pursuant to Section 302 of the Sarbanes-Oxley Act of
2002
(b) The following exhibit is furnished as a part of this report:
Exhibit 32 - Certifications pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002