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UNITED STATES
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 28, 2004
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 August 6, 2004, 89,647,641 shares of Common Stock of the Registrant were
outstanding.
1
INDEX
PAGE
-----
PART I FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Statements of Operations (Unaudited) -- for the 13-
weeks ended July 28, 2004 and July 30, 2003 3
Condensed Consolidated Statements of Operations (Unaudited)--
Successor Company -- for the 26-weeks ended July 28, 2004 and
13-weeks ended July 30, 2003
Predecessor Company -- for the 13-weeks ended April 30, 2003 4
Condensed Consolidated Balance Sheets (Unaudited)-- as of July 28, 2004,
January 28, 2004 and July 30, 2003 5
Condensed Consolidated Statements of Cash Flows (Unaudited)--
Successor Company -- for the 26-weeks ended July 28, 2004 and the 13-weeks
ended July 30, 2003
Predecessor Company -- for the 13-weeks ended April 30, 2003 6
Notes to Unaudited Condensed Consolidated Financial Statements 7-19
Item 2. Management's Discussion and Analysis of Financial Condition and Results of
Operations 20-27
Item 3. Quantitative and Qualitative Disclosures about Market Risk 28
Item 4. Controls and Procedures 28
PART II OTHER INFORMATION
Item 1. Legal Proceedings 29
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity
Securities 29
Item 4. Submission of Matters to a Vote of Security Holders 29
Item 6. Exhibits and Reports on Form 8-K 29-30
Signatures 31
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 13-WEEKS ENDED
JULY 28, 2004 JULY 30, 2003
-------------- --------------
Sales $ 4,785 $ 5,652
Cost of sales, buying and occupancy 3,543 4,419
------------ ------------
Gross margin 1,242 1,233
Selling, general and administrative expenses 1,039 1,225
Net gains on sales of assets (72) (2)
------------ ------------
Operating income 275 10
Interest expense, net 31 21
Bankruptcy-related recoveries (5) -
Equity income in unconsolidated subsidiaries - (2)
------------ ------------
Income (loss) from operations before income taxes 249 (9)
Provision for (benefit from) income taxes 94 (4)
------------ ------------
Net income (loss) $ 155 $ (5)
============ ============
Basic net income (loss) per common share $ 1.73 $ (0.06)
============ ============
Diluted net income (loss) per common share $ 1.54 $ (0.06)
============ ============
Basic weighted average shares (millions) 89.5 89.7
Diluted weighted average shares (millions) 101.5 89.7
See accompanying Notes to Unaudited Condensed Consolidated Financial
Statements.
3
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
(UNAUDITED)
PREDECESSOR
SUCCESSOR COMPANY COMPANY
------------------------------ ---------------
26-WEEKS ENDED 13-WEEKS ENDED 13-WEEKS ENDED
JULY 28, 2004 JULY 30, 2003 APRIL 30, 2003
-------------- -------------- ---------------
Sales $ 9,400 $ 5,652 $ 6,181
Cost of sales, buying and occupancy 7,021 4,419 4,762
----------- ----------- -----------
Gross margin 2,379 1,233 1,419
Selling, general and administrative expenses 2,043 1,225 1,421
Net gains on sales of assets (104) (2) -
Restructuring, impairment and other charges - - 37
----------- ----------- -----------
Operating income (loss) 440 10 (39)
Interest expense, net 57 21 57
Bankruptcy-related recoveries (12) - -
Equity income in unconsolidated subsidiaries (3) (2) (7)
Reorganization items, net - - 769
----------- ----------- -----------
Income (loss) from continuing operations before income taxes 398 (9) (858)
Provision for (benefit from) income taxes 150 (4) (6)
----------- ----------- -----------
Income (loss) from continuing operations 248 (5) (852)
Discontinued operations (net of income taxes of $0) - - (10)
----------- ----------- -----------
Net income (loss) $ 248 $ (5) $ (862)
=========== =========== ===========
Basic income (loss) per common share from continuing operations $ 2.77 $ (0.06) $ (1.63)
Discontinued operations - - (0.02)
----------- ----------- -----------
Basic net income (loss) per common share $ 2.77 $ (0.06) $ (1.65)
=========== =========== ===========
Diluted income (loss) per common share from continuing operations $ 2.47 $ (0.06) $ (1.63)
Discontinued operations - - (0.02)
----------- ----------- -----------
Diluted net income (loss) per common share $ 2.47 $ (0.06) $ (1.65)
=========== =========== ===========
Basic weighted average shares (millions) 89.5 89.7 522.7
Diluted weighted average shares (millions) 101.1 89.7 522.7
See accompanying Notes to Unaudited Condensed Consolidated Financial
Statements.
4
CONDENSED CONSOLIDATED BALANCE SHEETS
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
(UNAUDITED)
JULY 28, JANUARY 28, JULY 30,
2004 2004 2003
---------- ---------- ----------
ASSETS
CURRENT ASSETS
Cash and cash equivalents $ 2,626 $ 2,088 $ 1,200
Merchandise inventories 3,212 3,238 4,063
Accounts receivable, net 225 301 305
Other current assets 130 184 254
---------- ---------- ----------
TOTAL CURRENT ASSETS 6,193 5,811 5,822
Property and equipment, net 240 153 43
Other assets and deferred charges 212 120 90
---------- ---------- ----------
TOTAL ASSETS $ 6,645 $ 6,084 $ 5,955
========== ========== ==========
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES
Long-term debt and mortgages payable due within one year $ 4 $ 4 $ 66
Accounts payable 977 820 1,083
Accrued payroll and other liabilities 772 671 636
Taxes other than income taxes 291 281 333
---------- ---------- ----------
TOTAL CURRENT LIABILITIES 2,044 1,776 2,118
LONG-TERM LIABILITIES
Long-term debt and mortgages payable 103 103 51
Capital lease obligations 335 374 401
Pension obligations 880 873 861
Unfavorable operating leases 316 342 334
Other long-term liabilities 430 424 482
---------- ---------- ----------
TOTAL LIABILITIES 4,108 3,892 4,247
SHAREHOLDERS' EQUITY
Preferred stock 20,000,000 shares authorized; no shares outstanding - - -
Common stock $0.01 par value, 500,000,000 shares authorized;
89,647,641, 89,633,760 and 89,677,509 shares issued, respectively 1 1 1
Treasury stock, at cost (1) (1) -
Capital in excess of par value 2,041 1,943 1,712
Retained earnings (Accumulated deficit) 496 248 (5)
Accumulated other comprehensive income - 1 -
---------- ---------- ----------
TOTAL SHAREHOLDERS' EQUITY 2,537 2,192 1,708
---------- ---------- ----------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 6,645 $ 6,084 $ 5,955
========== ========== ==========
See accompanying Notes to Unaudited Condensed Consolidated Financial
Statements.
5
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN MILLIONS)
(UNAUDITED)
PREDECESSOR
SUCCESSOR COMPANY COMPANY
---------------------------- --------------
26-WEEKS 13-WEEKS 13-WEEKS
ENDED ENDED ENDED
JULY 28, 2004 JULY 30, 2003 APRIL 30, 2003
------------- ------------- --------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss) $ 248 $ (5) $ (862)
Adjustments to reconcile net income (loss) to net cash
provided by (used for) operating activities:
Depreciation and amortization 24 5 177
Store closings inventory charges 17 - -
Net gains on sales of assets (104) (2) -
Deferred income taxes 22 - -
Equity income in unconsolidated subsidiaries (3) (2) (7)
Restructuring, impairments and other charges - - 44
Reorganization items, net - - 769
Dividends received from Meldisco 3 - 36
Cash used for store closings and other charges - (5) (64)
Cash used for payments of exit costs and other
reorganization items - (451) (19)
Change in:
Merchandise inventories 10 368 480
Accounts receivable 41 75 114
Accounts payable 156 (77) (117)
Taxes payable 133 (11) (16)
Other assets 13 26 9
Other liabilities (24) (93) 32
------------ ------------ ------------
NET CASH PROVIDED BY (USED FOR) OPERATING ACTIVITIES 536 (172) 576
------------ ------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from sales of assets 153 44 64
Capital expenditures (124) (27) (4)
------------ ------------ ------------
NET CASH PROVIDED BY INVESTING ACTIVITIES 29 17 60
------------ ------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES
Payments on capital lease obligations (25) (14) (16)
Payments on mortgages (2) (4) (1)
Proceeds from issuance of debt - 60 -
Debt issuance costs - (46) -
Fees paid to Plan Investors - (13) -
Issuance of common shares - 140 -
------------ ------------ ------------
NET CASH (USED FOR) PROVIDED BY FINANCING ACTIVITIES (27) 123 (17)
------------ ------------ ------------
NET CHANGE IN CASH AND CASH EQUIVALENTS 538 (32) 619
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 2,088 1,232 613
------------ ------------ ------------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 2,626 $ 1,200 $ 1,232
============ ============ ============
See accompanying Notes to Unaudited Condensed Consolidated Financial
Statements.
6
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION
Kmart Holding Corporation ("Kmart," "we," "us," "our," the "Company"
or the "Successor Company") is the nation's third largest discount
retailer. We operate in the general merchandise retailing industry through
1,503 Kmart discount stores and Supercenters with locations in 49 states,
Puerto Rico, the U.S. Virgin Islands, Guam and through our e-commerce
shopping site, www.kmart.com.
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 intercompany 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 interim period statements should refer
to the audited consolidated financial statements and notes thereto which
are included in our Annual Report on Form 10-K for the year ended January
28, 2004. Certain prior period amounts have been reclassified to conform
to the current interim period presentation.
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") requires that the financial statements
for the period following filing for Chapter 11 bankruptcy protection
through the date a plan of reorganization is confirmed 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 reorganization and restructuring of the business
during the Predecessor Company's (defined below) bankruptcy proceedings
have been reported separately as Reorganization items, net in the
Unaudited Condensed Consolidated Statements of Operations. See below for a
more detailed discussion of the Company's Chapter 11 proceedings.
2. EMERGENCE FROM CHAPTER 11 BANKRUPTCY PROTECTION AND FRESH-START ACCOUNTING
Confirmation of Plan of Reorganization
On May 6, 2003 (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 Plan of Reorganization (defined below).
The Predecessor Company became a wholly-owned subsidiary of Kmart
Management Corporation, which is a wholly-owned subsidiary of Kmart
Holding Corporation.
On January 22, 2002 (the "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 (the
"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.
7
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -
(CONTINUED)
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 our newly issued common stock
("Common Stock") in satisfaction of pre-petition claims they held, and we
issued 14 million shares of Common Stock to affiliates of ESL and to Third
Avenue, in exchange for $127 million, net of commitment fees and Plan
Investor expenses of $13 million. In addition, we issued a 9 percent, $60
million principal convertible note (the "Note") to affiliates of ESL. The
term of the Note was extended two years to May 2006 by notice given in
December 2003, consistent with the terms of the agreement. With respect to
the Note, the principal is convertible at any time, at the option of the
holder, into 6 million shares of Common Stock at a conversion price equal
to $10 per share. ESL was also granted the option to purchase, prior to
May 6, 2005, approximately 6.6 million shares of Common Stock at a price
of $13 per share. A portion of the option was assigned to Third Avenue.
The investment was made pursuant to an Investment Agreement dated January
24, 2003, as amended (the "Investment Agreement").
Each of the Plan Investors is represented on our Board of Directors.
Discharge of Liabilities
Under Chapter 11, actions by creditors to collect indebtedness owed
prior to the Petition Date were stayed and certain other pre-petition
contractual obligations were not enforced against the Debtors. The
Predecessor Company received approval from the Court to pay certain
pre-petition liabilities including employee salaries and wages, benefits
and other employee obligations.
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. Common Stock was issued in satisfaction of
certain of those claims. On the Effective Date, 89,677,509 shares of
Common Stock and 8,173,145 options to purchase shares of Common Stock were
issued pursuant to the Plan of Reorganization. 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 that
14 million shares were issued to affiliates of ESL and to Third Avenue
pursuant to the Investment Agreement described above. The options to
purchase shares of Common Stock were issued to the Plan Investors and the
Successor Company's Chief Executive Officer. All 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, an independent creditor litigation trust was established
for the benefit of the Predecessor Company's pre-petition creditors and
equity holders, and to pursue claims which arose from the Predecessor
Company's prior accounting and stewardship investigations.
Fresh-Start Adjustments
In connection with our emergence from Chapter 11, we reflected the
terms of the Plan of Reorganization in our consolidated financial
statements, applying the terms of SOP 90-7 with respect to financial
reporting. 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. 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 the 13-weeks ended April 30, 2003 and prior
periods refer to the Predecessor Company. References to the Successor
Company 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.
8
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -
(CONTINUED)
To facilitate the calculation of the enterprise value of the
Successor Company, we developed a set of financial projections. Based on
these financial projections and with the assistance of a financial
advisor, we determined the enterprise value 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
the Company 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 fair value adjustments included
the recognition of approximately $2.2 billion of intangible assets that
were previously not recorded in the Predecessor Company's financial
statements, such as favorable leasehold interests, Kmart brand rights,
pharmacy customer relationships and other lease and license agreements.
The restructuring of the Predecessor Company'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
Statements of Operations. In addition, the excess of fair value of net
assets over reorganization value (i.e., "negative goodwill") of
approximately $5.6 billion was allocated on a pro-rata basis reducing our
non-current, non-financial instrument assets, including the previously
unrecorded intangible assets, to $10 million as of April 30, 2003.
Refer to our Annual Report on Form 10-K for the year ended January
28, 2004 for a more detailed discussion.
Claims Resolution
We continue to make progress in the reconciliation and settlement of
the various classes of claims associated with the discharge of the
Predecessor Company's liabilities subject to compromise pursuant to the
Plan of Reorganization. Since June 30, 2003, the first distribution date
established in the Plan of Reorganization, approximately 19.7 million
shares of the 31.9 million shares previously issued to us as disbursing
agent with respect to such claims have been distributed to holders of
Class 5 claims and approximately $4.1 million in cash has been distributed
to holders of Class 7 claims. Due to the significant volume of claims
filed to-date, 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. Accordingly, our current distribution reserve for
claim settlements is approximately 20 percent of shares issued.
Differences between amounts filed and our estimates are being investigated
and will be 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.
During the second quarter of fiscal 2004, we reduced the
distribution reserve from 30 percent to 20 percent, resulting in the
distribution of approximately 2.2 million shares to claimants who had
previously received shares for allowed claims. The remaining shares in the
distribution reserve will be issued to claimants on a pro-rata basis if,
upon settlement of all claims, the ultimate amount allowed for Class 5
claims is consistent with the Plan of Reorganization.
The next scheduled distribution under the Plan of Reorganization is
expected to commence on or about October 1, 2004.
Bankruptcy-Related Recoveries
For the 13-weeks and 26-weeks ended July 28, 2004, we recognized
recoveries of $5 million and $12 million, respectively, from vendors who
had received cash payments for pre-petition obligations or preference
payments. See Note 18 - Commitments and Contingencies for a more
detailed discussion.
3. NEW ACCOUNTING PRONOUNCEMENTS
In December 2003, the SEC issued Staff Accounting Bulletin ("SAB")
No. 104, "Revenue Recognition" ("SAB 104"). SAB 104 supercedes SAB 101,
"Revenue Recognition in Financial Statements" ("SAB 101") to include the
guidance from Emerging Issues Task Force Issue No. 00-21, "Accounting for
Revenue Arrangements with Multiple Deliverables." The primary purpose of
SAB 104 is to rescind accounting guidance contained in SAB 101 related to
multiple element revenue arrangements. There was no impact to the Company
upon adoption of SAB 104.
9
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -
(CONTINUED)
4. REAL ESTATE AND PROPERTY TRANSACTIONS
Home Depot U.S.A., Inc.
On June 3, 2004, the Company entered into multiple definitive
agreements with Home Depot U.S.A., Inc. (a subsidiary of The Home Depot,
Inc.) ("Home Depot") to sell up to four owned properties and assign up to
20 leased properties for a maximum purchase price of $365 million in cash.
Pursuant to the first of these agreements, on June 15, 2004, the Company
completed the sale of four owned properties to Home Depot for $59 million
in cash, resulting in a net gain of $43 million. On August 10, 2004, the
second agreement was amended, which limited the number of leased
properties to be assigned to not more than 15 properties with a maximum
purchase price of $230 million in cash. We completed the assignment of
nine of these properties on August 13, 2004, resulting in proceeds to the
Company of $114 million in cash. We anticipate that Home Depot may close
on the remaining six leases by the end of August 2004, subject to closing
conditions being satisfied. In the event Home Depot does not close on
certain of these properties, we have the option to assign up to two of
these properties to Home Depot for a maximum of $42 million in cash.
Sears, Roebuck and Co.
On June 29, 2004, the Company entered into an agreement with Sears,
Roebuck and Co. ("Sears") to sell up to two owned properties and assign up
to 52 leased properties for a maximum purchase price of $621 million in
cash. Pursuant to this agreement, certain closing conditions for a minimum
of 43 of the properties must be satisfied by August 31, 2004. However, if
the closing conditions have not been satisfied by August 31, 2004, the
Company, at its option, may give written notice to Sears by September 9,
2004 to proceed with the closing with respect to those properties for
which closing conditions have been satisfied. In the event the closing
conditions for the 43 properties have not been satisfied by August 31,
2004 and written notice has not been given to Sears by the Company, either
party may terminate the purchase agreement subsequent to September 9,
2004, but prior to the date closing conditions are satisfied for at least
43 properties. Assuming such conditions are met, the Company will receive
30% of the purchase price in September 2004. The remaining 70% of the
purchase price will be received when Sears has been assigned the leases
and occupies the properties, which shall take place no later than April
15, 2005.
Other
The Company also sold certain other assets, resulting in net gains
of $29 million and $61 million for the 13-weeks and 26-weeks ended July
28, 2004, respectively. Included within this gain for the 26-week period
was $17 million related to the sale of the Company's Trinidad subsidiary
and its associated property, $12 million related to the sale of the
Company's corporate airplanes and $32 million from sales of other real and
personal property. During this same time period, the Company acquired 22
previously-leased properties for $84 million.
5. PENSION PLAN
The following table summarizes the net periodic benefit cost
recognized for our qualified employee pension plan.
Predecessor
Successor Company Company
---------------------------------------------------- ---------------
26-Weeks Ended 13-Weeks Ended 13-Weeks Ended 13-Weeks Ended
(dollars in millions) July 28, 2004 July 28, 2004 July 30, 2003 April 30, 2003
--------------------- ------------- ---------------- ------------- ---------------
Components of Net Periodic Expense
Interest costs $ 77 $ 39 $ 38 $ 38
Expected return on plan assets (69) (35) (29) (33)
Net loss recognition - - - 18
Amortization of unrecognized transition asset - - - (2)
------------ -------------- ------------ ---------------
Net periodic expense $ 8 $ 4 $ 9 $ 21
============ ============== ============ ===============
During the 13-weeks and 26-weeks ended July 28, 2004 contributions
to the plan were approximately $1 million. Contributions to the plan were
not required for the 13-weeks ended July 30, 2003 or April 30, 2003. The
estimated contribution for fiscal 2004 is $11 million.
10
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -
(CONTINUED)
6. EARNINGS PER SHARE
Basic earnings per share is calculated by dividing net income by the
weighted average number of common shares outstanding during each period.
Diluted earnings per share assumes the exercise of stock options, the
conversion of convertible debt and the impact of restricted stock when
dilutive.
A reconciliation of basic weighted average common shares outstanding
to diluted weighted average common shares outstanding is as follows:
13-Weeks Ended 26-Weeks Ended
(in millions) July 28, 2004 July 28, 2004
------------- -------------- --------------
Basic weighted average common shares 89.5 89.5
Dilutive effect of stock options 6.0 5.6
9% convertible note 6.0 6.0
----- -----
Diluted weighted average common shares 101.5 101.1
===== =====
A reconciliation of net income available to common shareholders to
net income available to common shareholders with assumed conversions is as
follows:
13-Weeks Ended 26-Weeks Ended
(dollars in millions) July 28, 2004 July 28, 2004
--------------------- ------------- -------------
Net income available to common shareholders $ 155 $ 248
Interest on 9% convertible note, net of tax 1 2
------------- -------------
Income available to common shareholders with assumed conversions $ 156 $ 250
============= =============
Common stock equivalents were excluded from the calculation of
diluted earnings per share for the 13-weeks ended July 30, 2003 and April
30, 2003 as they were anti-dilutive. Upon our emergence from bankruptcy,
all common stock equivalents of the Predecessor Company were cancelled.
7. DEBT
Credit Facility
Our credit agreement (the "Credit Facility") is a $1.0 billion
revolving credit facility with an $800 million letter of credit sub-limit
under which Kmart Corporation is the borrower. From its inception, we have
only used the Credit Facility to support issuances of letters of credit.
In July 2004, we voluntarily reduced the size of the Credit Facility from
$1.5 billion to $1.0 billion to reduce the overall cost of the facility.
In conjunction with the reduction of our Credit Facility, we accelerated
the amortization of $9 million of the associated debt issuance costs.
Availability under the Credit Facility is subject to an inventory
borrowing base formula. The Credit Facility is guaranteed by the Successor
Company, Kmart Management Corporation, Kmart Services Corporation (a
subsidiary of Kmart Management Corporation) and Kmart Corporation's direct
and indirect domestic subsidiaries. The Credit Facility is secured
primarily by first liens on inventory, the proceeds thereof and certain
related assets of Kmart Corporation and the guarantors.
Borrowings under the Credit Facility are subject to a sliding
pricing scale based on our earnings before interest, taxes, depreciation,
amortization and other charges ("EBITDA") levels and such adjustments are
implemented quarterly. Borrowings currently bear interest at either (i)
the Prime rate plus 1.5% per annum or (ii) the LIBOR rate plus 2.5% per
annum, at our discretion, and utilization of the letter of credit
sub-facility in support of trade and standby letters of credit currently
bears interest at 1.25% and 2.50% per annum, respectively. In addition, we
are currently required to pay a fee based on the unutilized commitment
under the Credit Facility equal to 0.50% per annum. The Credit Facility
gives the Company the ability to repurchase up to $500 million of the
Company's Common Stock, depending on our EBITDA levels and subject to the
approval of the Company's Board of Directors.
11
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -
(CONTINUED)
As of July 28, 2004, we had utilized $341 million of the Credit
Facility for letters of credit issued for ongoing import purchasing
operations, and contractual and regulatory purposes, including letters of
credit utilized as collateral to support our self-insurance programs.
During the first six months of fiscal 2004, we replaced letters of credit
used as collateral for certain programs with cash collateral to reduce
fees on our letters of credit. We continue to classify the cash collateral
in Cash and cash equivalents due to our ability to convert the cash to
letters of credit at any time at our discretion. As of July 28, 2004, $214
million of cash was posted as collateral.
Total availability under the Credit Facility as of July 28, 2004 was
approximately $630 million.
The Credit Facility financial covenants include a requirement that
we maintain certain availability minimums, and failure to do so triggers
additional required minimum levels of EBITDA. The Credit Facility also
contains other customary covenants, including certain reporting
requirements and covenants that restrict our ability to incur or create
liens, indebtedness and guarantees, make 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. As of July 28, 2004, and in all periods since our
emergence from Chapter 11, we have been in compliance with all Credit
Facility covenants.
Predecessor Company Debt
Borrowings of the Predecessor Company during Chapter 11 proceedings
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. 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. On the Petition Date, the Predecessor Company stopped
accruing interest on all unsecured pre-petition debt until it 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 million for the 13-weeks ended April 30, 2003.
Interest Expense, Net
Predecessor
Successor Company Company
----------------------------------------------------- --------------
26-Weeks Ended 13-Weeks Ended 13-Weeks Ended 13-Weeks Ended
(dollars in millions) July 28, 2004 July 28, 2004 July 30, 2003 April 30, 2003
--------------------- -------------- -------------- ------------- --------------
Components of Interest Expense, Net
Interest expense $ 28 $ 13 $ 18 $ 21
Accretion of obligations at net present
value 25 13 - -
Amortization of debt issuance costs 16 12 5 37
Interest income (12) (7) (2) (1)
------------- ------------- ----------- --------------
Interest expense, net $ 57 $ 31 $ 21 $ 57
============= ============= =========== ==============
Cash paid for interest was $28 million, $13 million, $17 million and
$19 million for the 26-weeks ended July 28, 2004 and the 13-weeks ended
July 28, 2004, July 30, 2003 and April 30, 2003, respectively.
8. INCOME TAXES
We recorded a tax provision of $94 million and $150 million during
the 13-weeks and 26-weeks ended July 28, 2004, respectively, based on the
estimated effective tax rate for fiscal 2004 of 37.6%. We recorded a $4
million tax benefit from our losses during the 13-weeks ended July 30,
2003 based upon the estimated effective tax rate for the 39-weeks ended
January 28, 2004 (successor period). The $6 million tax benefit recorded
during the first quarter of fiscal 2003 relates to an Internal Revenue
Code provision allowing for the 10-year carryback of certain losses.
12
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -
(CONTINUED)
The Predecessor Company recorded a full valuation allowance against
its net deferred tax assets in accordance with SFAS No. 109, "Accounting
for Income Taxes," as realization of such assets in future years was
uncertain. Accordingly, no tax benefit was realized from the Predecessor
Company's losses in the first quarter of fiscal 2003. Given the Company's
actual and forecasted levels of profitability in fiscal 2004, management
believes that a portion of the pre-emergence net deferred tax assets will
more likely than not be realized. As such, the Company reduced the
valuation allowance on its pre-emergence net deferred tax assets by $92
million in the second quarter of fiscal 2004 to reflect its estimated
utilization through the end of fiscal 2004. The Company will continue to
assess the likelihood of realization of its pre-emergence net deferred tax
assets and would reduce the valuation allowance on such assets in the
future if it becomes more likely than not that the net deferred tax assets
will be utilized. In accordance with SOP 90-7, subsequent to emergence
from Chapter 11, the benefit from the reduction of the valuation allowance
is recorded as a direct credit to Capital in excess of par value with no
impact on the Company's earnings or cash flows.
During the 26-weeks ended July 28, 2004, we reduced our reserves for
Predecessor Company income tax liabilities by $5 million, primarily due to
favorable claims settlements. We recorded this adjustment to Capital in
excess of par value in our Unaudited Condensed Consolidated Balance Sheet
as of July 28, 2004.
As of July 28, 2004, the Company has post-emergence net deferred tax
assets of $57 million. It is the Company's position that this net deferred
tax asset will be utilized in the near future and no valuation allowance
is required.
Cash paid for income taxes was $2 million, $1 million and $1 million
for the 26-weeks ended July 28, 2004, and the 13-weeks ended July 28, 2004
and July 30, 2003, respectively. Cash received for tax refunds and credits
was $2 million for the 13-weeks ended April 30, 2003.
9. TREASURY STOCK
On August 28, 2003, the Company's Board of Directors approved the
repurchase of up to $10 million of the Company's outstanding stock for the
primary purpose of providing restricted stock grants to certain employees.
On June 29, 2004, the Company's Board of Directors increased the existing
share repurchase authorization to $100 million and broadened the scope of
future repurchases to include the repurchase of shares in furtherance of
general corporate purposes. During fiscal 2003, we repurchased 128,400
shares of Common Stock (weighted-average price of $28.87 per share)
primarily for the purpose of providing restricted stock grants, at a cost
of approximately $4 million. We issued 17,109 and 32,061 shares of
restricted stock during the 13-weeks and 26-weeks ended July 28, 2004,
respectively; see Note 10 - Stock-Based Compensation. There were 29,868
and 43,749 shares in treasury as of July 28, 2004 and January 28, 2004,
respectively. There were no shares in treasury as of July 30, 2003.
10. STOCK-BASED COMPENSATION
The Company accounts for stock-based compensation using the fair
value method. Total stock-based compensation expense of approximately $1
million will be recognized in fiscal 2004 for outstanding stock options.
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" and related
interpretations, which did not require the recognition of expense for the
fair value of stock-based compensation.
In accordance with the disclosure requirements of SFAS No. 148,
"Accounting for Stock-Based Compensation - Transition and Disclosure, an
Amendment of FASB Statement No. 123" the pro forma effects of recognizing
the fair value of stock-based compensation on net loss and loss per share
had the Predecessor Company applied the fair value method to stock options
granted by the Predecessor Company would have resulted in a pro forma
adjustment of $38 million for stock-based employee compensation income, a
pro forma net loss of $824 million and a pro forma basic/diluted loss per
share of $1.58 for the 13-weeks ended April 30, 2003. Pro forma
stock-based employee compensation income of $38 million 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.
Upon our emergence from Chapter 11, all outstanding stock options of
the Predecessor Company were cancelled in accordance with the Plan of
Reorganization.
13
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -
(CONTINUED)
During the 26-weeks ended July 28, 2004, we issued 32,061 shares of
restricted stock at grant prices ranging from $29.23 to $33.44. We
accounted for these restricted stock grants as fixed awards, and recorded
deferred employee compensation to Capital in excess of par value. Deferred
employee compensation of $1 million is being amortized to compensation
expense on a straight-line basis over the vesting period of three years
for these grants.
11. PROPERTY HELD FOR SALE
Property held for sale was $35 million, $56 million and $117 million
as of July 28, 2004, January 28, 2004 and July 30, 2003, respectively, and
is included within Other current assets in our Unaudited Condensed
Consolidated Balance Sheets. During the 13-weeks and 26-weeks ended July
28, 2004, we sold $15 million and $17 million of these assets for their
book value, respectively. During the second quarter of fiscal 2003, we
sold $43 million of these assets for a net gain of $1 million.
12. COMPREHENSIVE INCOME (LOSS)
Comprehensive income (loss) represents net income or loss, adjusted
for the effect of other items that are recorded directly to shareholders'
equity. During the 26-weeks ended July 28, 2004, we sold
available-for-sale equity securities and in conjunction with these sales,
reduced accumulated other comprehensive income by $1 million.
Comprehensive income and net income are equivalent for the 13-weeks ended
July 28, 2004. For the 13-weeks ended April 30, 2003, comprehensive loss
included a minimum pension liability adjustment of $94 million. No
adjustments were made to comprehensive income (loss) for the 13-weeks
ended July 30, 2003.
13. INVESTMENTS IN AFFILIATED RETAIL COMPANIES
Kmart footwear departments are operated under a master agreement
and license agreement with certain Meldisco subsidiaries of Footstar, Inc.
("FTS"), substantially all of which are 49% owned by Kmart and 51% owned by
FTS. On March 2, 2004, FTS and its direct and indirect subsidiaries,
including all Meldisco subsidiaries, filed for Chapter 11 protection in the
United States Bankruptcy Court for the Southern District of New York. FTS
continues to operate its businesses and manage its properties as
debtors-in-possession. Given the profitability of the Meldisco subsidiaries
with which we do business, and the likelihood of future receipts of the
amounts due from those Meldisco subsidiaries, no valuation reserve has been
established for $24 million due to us from FTS as of July 28, 2004. On
August 12, 2004, FTS filed a motion with the Bankruptcy Court to assume the
master agreement and the license agreements. In order to effect such
assumption, FTS must cure all past defaults. FTS asserts that the amount
required to cure past defaults is $18 million, and that such amount should
be reduced by overpayments FTS alleges it made to the Company for certain
fees. We filed a proof of claim in the FTS bankruptcy case for an amount in
excess of our recorded receivable; however, at this time, we are not able
to accurately determine the ultimate amount to be realized as we have not
received all information from FTS necessary for us to complete our claim.
The Company believes the cure amount may be substantially in excess of $18
million. If no resolution is achieved consensually with FTS with respect to
the assumption of the master agreement and the license agreements and the
cure amount, the issue will be resolved by the Bankruptcy Court.
On May 7, 2004, FTS sold 353 of its Footaction stores to Foot
Locker, Inc. for $225 million. Following the sale of the Footaction
stores, FTS consists primarily of the Meldisco business.
We have been advised that FTS will be restating its financial
statements for certain prior periods. As a result, we have not received
final financial statements for fiscal 2002, 2003 or the first and second
quarters of fiscal 2004 for the Meldisco subsidiaries with which we do
business at the time of our filing of this Quarterly Report on Form 10-Q.
We have received preliminary financial results from FTS which we believe
provide a reliable basis to estimate equity income as recognized in all
periods presented in our Unaudited Condensed Consolidated Statements of
Operations. For the 26-weeks ended July 28, 2004 and the 13-weeks ended
July 28, 2004, July 30, 2003 and April 30, 2003, those Meldisco
subsidiaries had net sales at our footwear departments of $384 million,
$198 million, $222 million and $246 million, respectively. We had no
equity income from the Meldisco subsidiaries for the 13-weeks ended July
28, 2004. For the 26-weeks ended July 28, 2004 and the 13-weeks ended July
30, 2003 and April 30, 2003, our equity income in those Meldisco
subsidiaries was $3 million, $2 million and $7 million, respectively.
Although there can be no assurance until FTS restates its financial
statements, at this time, we do not expect the restatement to have a
material effect on our equity income or other fees earned from the
Meldisco subsidiaries.
The Company has reviewed FTS' monthly operating reports for periods
following their Chapter 11 filing, and noted that FTS has allocated
certain of their reorganization costs to the Meldisco business. These
charges have adversely impacted our estimated earnings recorded in fiscal
2004. We disagree with their approach and have notified FTS of our
position.
14
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -
(CONTINUED)
14. RELATED PARTY TRANSACTIONS
During the second quarter of fiscal 2004, ESL hired an employee of
the Company. This employee has assumed the role of Vice President of ESL,
and will continue to serve Kmart as Vice President - In-Store Business
Development.
As further discussed in the Company's MD&A, the Company is
considering various uses of its cash, including investments in various
forms of securities. The Board of Directors of the Company has delegated
authority to invest the Company's surplus cash to Edward Lampert, subject
to various limitations including those in the Company's existing Credit
Facility as well as additional limitations that have been or may be from
time to time adopted by the Board of Directors and/or the Finance
Committee of the Board of Directors. Mr. Lampert is Chairman of the
Company's Board of Directors and is the Chairman and Chief Executive
Officer of ESL. Neither Mr. Lampert nor ESL will receive compensation for
any such investment activities undertaken on behalf of the Company.
Further, to clarify the expectations that the Board of Directors has
with respect to the investment of our surplus cash, the Board has
renounced, in accordance with Delaware law, any interest or expectancy of
the Company associated with any investment opportunities in securities
that may come to the attention of Mr. Lampert or any employee, officer,
director or adviser to ESL and its affiliated investment entities who also
serves as an officer or director of the Company (each, a "Covered Party")
other than (a) investment opportunities that come to such Covered Party's
attention directly and exclusively in such Covered Party's capacity as a
director of, officer or employee of the Company, (b) control investments
in companies in the mass merchandise or discount retailing industry and
(c) investment opportunities in companies or assets with a significant
role in the Company's retailing business, including investment in real
estate currently leased by the Company or in suppliers for which the
Company is a substantial customer representing over 10% of such companies'
revenues, unless in any such instance ESL has a pre-existing investment.
15. DISCONTINUED OPERATIONS
During the first quarter of fiscal 2003, the Predecessor Company
closed 316 stores, of which 66 stores met the criteria to be accounted for
as discontinued operations. The Company applied the provisions of SFAS No.
144, "Accounting for the Impairment or Disposal of Long-Lived Assets,"
which 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 table below sets forth the components of the net
loss associated with the discontinued operations for the 13-weeks ended
April 30, 2003.
Predecessor Company
-------------------
13-Weeks Ended
(dollars in millions) April 30, 2003
-------------------- -------------------
Sales $ 232
Cost of sales, buying and occupancy 150
----------
Gross margin 82
Selling, general and administrative expenses 43
Restructurings, impairments and other charges 5
Reorganization items, net 44
----------
Discontinued operations, net of tax $ (10)
==========
16. 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, the Predecessor Company instituted certain
restructuring actions to improve operations and executed significant
inventory liquidations as a result of the stores closed under Chapter 11
proceedings. The effects of these actions on the 13-weeks ended April 30,
2003 are summarized below.
15
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -
(CONTINUED)
Corporate Cost Reduction Initiatives
During fiscal 2002 and the 13-weeks ended April 30, 2003, the
Predecessor Company eliminated approximately 950 positions with an initial
charge of $50 million recorded in fiscal 2002. The Predecessor Company
reduced its reserve for such corporate cost reductions by $10 million in
the 13-weeks ended April 30, 2003, as a result of a change in the
estimated expenses. This reduction is included in Restructuring,
impairment and other charges in the Unaudited Condensed Consolidated
Statements of Operations.
Accelerated Depreciation
The Predecessor Company recorded charges of $52 million during the
13-weeks ended April 30, 2003 for accelerated depreciation on unimpaired
assets to be disposed of following the 316 store closings. Of the $52
million recorded, $47 million is included in Restructurings, impairments
and other charges and $5 million is included in Discontinued operations in
the Unaudited Condensed Consolidated Statements of Operations.
Reserve Activity
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 2 - Emergence
from Chapter 11 Bankruptcy Protection and Fresh-Start Accounting for a
detailed discussion of the discharge of Liabilities subject to compromise
under the Plan of Reorganization.
Restructuring reserves related to the fiscal 2002 employee severance
program were assumed by the Successor Company. There was no activity to
the reserve for the 13-weeks ended July 28, 2004. Payments made against
the reserve were $1 million and $19 million for the 26-weeks ended July
28, 2004 and the 13-weeks ended July 30, 2003, respectively. During the
13-weeks ended April 30, 2003, the Predecessor Company recorded non-cash
reductions of $2 million and decreased the reserve by $10 million, as
noted above. As of July 28, 2004, January 28, 2004 and July 30, 2003, the
liability for the fiscal 2002 employee severance program was $1 million,
$4 million and $17 million, respectively.
17. 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. For the 13-weeks ended April 30, 2003, the following were
recorded:
Predecessor Company
-------------------
13-Weeks Ended
(dollars in millions) April 30, 2003
--------------------- -------------------
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
Other 26
----------
Reorganization items, net $ 769
==========
The following paragraphs provide additional information relating to
costs that were recorded in Reorganization items, net in the Unaudited
Condensed Consolidated Statement of Operations for the 13-weeks ended
April 30, 2003.
Gain on extinguishment of debt/Revaluation of assets and liabilities
See Note 2 - Emergence from Chapter 11 Bankruptcy Protection and
Fresh-Start Accounting for a discussion on the extinguishment of debt and
the revaluation of assets and liabilities.
16
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -
(CONTINUED)
Fleming settlement
On February 3, 2003, the Predecessor Company announced the
termination of the supply relationship with Fleming Companies, Inc.
("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. The Predecessor
Company and Fleming came to an agreement on a settlement of Fleming's
claims, and on March 27, 2003, the Court approved the settlement of all
claims asserted by Fleming. Under the settlement, the Predecessor Company
paid Fleming $15 million of Fleming's net post-petition administrative
claim, which exceeded $30 million. Additionally, Fleming's general
unsecured claim was reduced from approximately $1.5 billion to $385
million, which was recorded in the first quarter of fiscal 2003.
Estimated claims for rejected executory contracts
For the 13-weeks ended April 30, 2003, the Predecessor Company
recorded expense of $200 million 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 contract.
On April 30, 2003, upon adoption of Fresh-Start accounting, these
liabilities were discharged in accordance with the Plan of Reorganization;
see Note 2 - Emergence from Chapter 11 Bankruptcy Protection and
Fresh-Start Accounting.
2003 store closings
As a result of the decision to close the 316 stores, the Predecessor
Company recorded a charge of $214 million in the first quarter of fiscal
2003 for lease terminations and other costs, of which $56 million is
included in Discontinued operations and the remaining $158 million is
included in Reorganization items, net in the Unaudited Condensed
Consolidated Statements of Operations.
Other reorganization items
For the 13-weeks ended April 30, 2003, the Predecessor Company
recorded professional fees of $43 million, employee costs of $66 million
relating to the Key Executive Retention Program, a gain of $17 million for
the sale of pharmacy customer lists, income of $65 million for lease
auction proceeds related to the 2003 and 2002 closed stores, a gain of $15
million for the settlement of pre-petition liabilities and net expenses of
$14 million for other miscellaneous reorganization items.
18. COMMITMENTS AND CONTINGENCIES
Securities Action Litigation
On March 18, 2002, a 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 former 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 former directors of the
Predecessor Company 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 million. On August 20,
2003, the defendants' motion to dismiss the purported class action in the
United States District Court for the Eastern District of Michigan was
denied. That court certified the class on April 16, 2004, but the class
has yet to be defined.
17
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -
(CONTINUED)
Other and Routine Actions
Two of our past providers of surety bonds, Fireman's Fund Insurance
Company ("Fireman's Fund"), and the Hartford Insurance Company
("Hartford") elected not to participate in the continuation of our surety
program during the pendency of the Predecessor Company's bankruptcy case.
Fireman's Fund has now filed a motion with the Bankruptcy Court seeking
(i) recovery of $34 million that Fireman's Fund alleges it has paid
pursuant to pre-petition surety bonds it issued with regard to the
Predecessor Company's workers' compensation insurance programs, and (ii)
an order obligating us to make all payments of Fireman's Fund's future
obligations under the bonds, which Fireman's Fund contends could be in
excess of $35 million. We have filed an opposition to the motion
contending, among other things, that Fireman's Fund's claim is an
unsecured pre-petition claim that was resolved under the Plan of
Reorganization that was approved by the Bankruptcy Court, and therefore
Fireman's Fund has the same rights as any other general unsecured creditor
under that Plan. Kmart has been advised by Hartford that they may file a
similar motion.
On November 7, 2003, the Company filed suit in the United States
District Court for the Eastern District of Michigan against Capital One
Bank, Capital One, F.S.B., and Capital One Services, Inc. (collectively,
"Capital One"). The complaint alleges breach of contract, breach of the
covenant of good faith and fair dealing, unjust enrichment, promissory
estoppel and tortious interference with business relationships and
prospective economic advantage arising out of Capital One's alleged
failure to market and support a co-branded credit card under an agreement
the parties had with respect to a Kmart MasterCard. Kmart is seeking
monetary damages. On December 26, 2003 Kmart voluntarily dismissed the
federal court complaint and refiled the complaint in Oakland County
Circuit Court (State of Michigan) based on a lack of diversity of
citizenship amongst the parties. On January 29, 2004 Capital One filed a
petition for removal of the state court action back to the federal court
and, in response, Kmart filed a motion to remand on February 9, 2004. The
case was remanded to the Oakland County Circuit Court on June 10, 2004 and
is scheduled for trial on March 1, 2005.
In Capital Factors v. Kmart Corporation, the United States District
Court for the Northern District of Illinois ruled that the Court did not
have the authority to authorize the payment of pre-petition claims of
certain trade vendors by the Company. That ruling was appealed by the
Company to the Seventh Circuit Court of Appeals. Oral arguments were heard
by the Seventh Circuit on January 22, 2004 and an opinion was issued on
February 24, 2004. The Seventh Circuit upheld the decision of the District
Court. A critical vendor sought a rehearing by the Seventh Circuit, which
was denied, and a petition for Writ of Certiorari was filed in the Supreme
Court of the United States that is currently pending. Kmart is not
involved in the motion for a rehearing and will not further appeal the
Seventh Circuit's ruling. In order to satisfy our fiduciary responsibility
to pursue claims against the critical vendors during the pendency of the
appeal, on January 26, 2004 we filed 45 lawsuits against a total of 1,189
vendors that received these payments. Subsequently, many of the cases were
severed into lawsuits against individual defendants although all cases are
proceeding on a common pretrial procedural track. The lawsuits seek to
recover critical vendor payments in excess of $174 million. The Company
notified affected vendors that we are willing to settle these claims for a
percentage of the money they received, based on the amount of the claim.
The ultimate amount of recovery can not be determined at this time. As of
July 28, 2004, Kmart has settled 179 critical vendor claims.
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 Unaudited
Condensed Balance Sheet as of July 28, 2004 only reflects potential losses
for which the Successor Company may have ultimate responsibility.
18
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -
(CONTINUED)
19. SUBSEQUENT EVENTS
Corporate Cost Reductions
We initiated a corporate cost reduction program in August 2004, and
in connection with this program, eliminated approximately 250 positions at
our corporate headquarters in Troy, Michigan. Severance benefits,
outplacement services and continuing health insurance benefits, which
amounts are based on employees' years of service and job grade,
aggregating $6 million will be paid to affected employees primarily over
the next six months. The anticipated annual savings of this action is $18
million on a pre-tax basis. We are also continuing efforts to reduce other
corporate non-payroll expenses.
Letter of Credit Facility
On August 13, 2004, the Company entered into a letter of credit
agreement (the "LC Agreement") with a commitment amount of up to $200
million through January 7, 2005 and increasing to $600 million thereafter.
The standby letters of credit issued under the LC Agreement bear interest
at 0.20% per annum. The LC Agreement is subject to a pledge and security
agreement pursuant to which, after January 7, 2005, the Company must post
as collateral cash in an amount equal to 100.5% of the face value of the
letters of credit outstanding under the LC Agreement. Prior to January 7,
2005, the collateral posted by the Company is a leasehold mortgage on
certain properties leased by the Company.
19
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
Part I, Item 2 of this report should be read in conjunction with
Part II, Item 7 of our Annual Report on Form 10-K for the year ended
January 28, 2004. The information contained herein is not a comprehensive
discussion and analysis of the financial condition and results of
operations of the Company, but rather an update of the previous
disclosures.
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION
This Form 10-Q, as well as other statements or reports made by or on
behalf of Kmart, which address activities, events or developments that we
expect or anticipate may occur in the future are 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. Such forward-looking statements
are based upon assumptions concerning future conditions that may
ultimately prove to be inaccurate and involve risks, uncertainties and
factors that could cause actual results to differ materially from any
anticipated 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,
factors relating to Kmart's internal operations and the external
environment in which it operates; Kmart's ability to successfully
implement business strategies and otherwise fund and execute planned
changes in various aspects of the business; marketplace demand for the
products of Kmart's key brand partners, as well as the engagement of
appropriate new brand partners; changes in consumer spending and Kmart's
ability to anticipate buying patterns and implement appropriate inventory
strategies; Kmart's ability to reverse its negative same-store sales
trend; competitive pressures and other third party actions, including
pressures from pricing and other promotional activities of competitors, as
well as new competitive store openings; the resolution of allowed claims
for which we are obligated to pay cash under the Plan of Reorganization;
Kmart's ability to properly monitor its inventory needs in order to timely
acquire desired goods in appropriate quantities and/or fulfill labor needs
at planned costs; Kmart's ability to attract and retain customers; Kmart's
ability to maintain normal terms with vendors and service providers;
Kmart's ability to maintain contracts, including leases, that are critical
to its operations; Kmart's ability to develop a market niche; regulatory
and legal developments; general economic conditions; weather conditions,
including those which affect buying patterns of Kmart's customers; other
factors affecting business beyond Kmart's control; and Kmart's ability to
attract, motivate and/or retain key executives and associates. Kmart
undertakes no obligation to release publicly the results of any revisions
to these forward-looking statements to reflect events or circumstances
after the date such statements were made.
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.
20
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS - (CONTINUED)
RESULTS OF OPERATIONS
Due to the application of Fresh-Start accounting upon our emergence
from bankruptcy, 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.
The following table is presented solely to complement management's
discussion and analysis.
PREDECESSOR
SUCCESSOR COMPANY COMPANY
----------------------------------------------- --------------
13-WEEKS ENDED 13-WEEKS ENDED 13-WEEKS ENDED 13-WEEKS ENDED
(dollars in millions) JULY 28, 2004 JULY 30, 2003 APRIL 28, 2004 APRIL 30, 2003
--------------------- -------------- -------------- -------------- --------------
Sales $ 4,785 $ 5,652 $ 4,615 $ 6,181
Cost of sales, buying and occupancy 3,543 4,419 3,478 4,762
--------- --------- ---------- ---------
Gross margin 1,242 1,233 1,137 1,419
Selling, general and administrative expenses 1,039 1,225 1,004 1,421
Net gains on sales of assets (72) (2) (32) -
Restructuring, impairment and other charges - - - 37
--------- --------- ---------- ---------
Operating income (loss) 275 10 165 (39)
Interest expense, net 31 21 26 57
Bankruptcy related recoveries (5) - (7) -
Equity income in unconsolidated subsidiaries - (2) (3) (7)
Reorganization items, net - - - 769
--------- --------- ---------- ---------
Income (loss) from continuing operations
before income taxes 249 (9) 149 (858)
Provision for (benefit from) income taxes 94 (4) 56 (6)
--------- --------- ---------- ---------
Income (loss) from continuing operations 155 (5) 93 (852)
Discontinued operations - - - (10)
--------- --------- ---------- ---------
Net income (loss) $ 155 $ (5) $ 93 $ (862)
========= ========= ========== =========
13-WEEKS ENDED JULY 28, 2004 COMPARED TO 13-WEEKS ENDED JULY 30, 2003
Same-store sales and total sales decreased 14.9% and 15.3%,
respectively, for the 13-weeks ended July 28, 2004 as compared to the
13-weeks ended July 30, 2003. Same-store sales include sales of all open
stores that have been open for more than 13 full months. Factors affecting
same-store sales and total sales included reductions in promotional events
and newspaper advertising; the effect of unseasonably cool weather in the
current quarter on sales of summer seasonal products including lawn and
garden merchandise; and a transition in our apparel lines leading up to
back-to-school product launches.
Gross margin increased $9 million to $1.24 billion, for the 13-weeks
ended July 28, 2004, from $1.23 billion for the 13-weeks ended July 30,
2003. Gross margin, as a percentage of sales, increased to 26.0% for the
13-weeks ended July 28, 2004, from 21.8% in the prior year. The
improvement in our gross margin rate was primarily attributable to reduced
markdowns on promotions and clearance items and improvements in shrinkage
at our distribution centers and stores. Included in gross margin was a $16
million charge recorded in the second quarter of fiscal 2004 in
conjunction with the store closings inventory liquidations.
Selling, general and administrative expenses ("SG&A") decreased $186
million to $1.04 billion, or 21.7% of sales for the 13-weeks ended July
28, 2004, from $1.23 billion, also 21.7% of sales, for the 13-weeks ended
July 30, 2003. The decline resulted from a reduction in store payroll and
related expenditures due to increased operating efficiencies and reduced
sales volume at our stores, and to reductions in our weekly and mid-week
circular advertising, partially offset by an increase in electronic media
advertising. The remaining net reduction in SG&A is due to continued
efforts to reduce our operating expenses.
21
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS - (CONTINUED)
Operating income for the 13-weeks ended July 28, 2004 was $275 million, or
5.7% of sales, as compared to $10 million, or 0.2% of sales, for the same period
in the prior year. Operating income increased primarily due to the decrease in
SG&A and the increase in the gross margin rate, partially offset by reduced
gross margin dollars as a result of lower same-store sales, as discussed above.
Also increasing Operating income were net gains of $72 million from sales of
real and personal property, including $43 million of net gains from the sale of
four owned properties to Home Depot; see Note 4 - Real Estate and Property
Transactions for a more detailed discussion.
Interest expense, net for the 13-weeks ended July 28, 2004 and July 30,
2003 was $31 million and $21 million, respectively. In July 2004, we voluntarily
reduced the size of our credit agreement from $1.5 billion to $1.0 billion to
reduce the overall cost of the facility. In conjunction with this action, we
accelerated the amortization of $9 million of the associated debt issuance
costs, which is included in Interest expense, net for the 13-weeks ended July
28, 2004. During the 13-weeks ended July 28, 2004, $13 million of interest
expense was recorded for the accretion of obligations recorded at net present
value. Interest expense is net of interest income of $7 million and $2 million
for the 13-weeks ended July 28, 2004 and July 30, 2003, respectively.
The effective income tax rate was 37.6% and (44.4%) for the 13-weeks ended
July 28, 2004 and July 30, 2003, respectively; see Note 8 - Income Taxes for a
more detailed discussion.
13-WEEKS ENDED APRIL 28, 2004 COMPARED TO 13-WEEKS ENDED APRIL 30, 2003
Same-store sales and total sales decreased 12.9% and 25.3%, respectively,
for the 13-weeks ended April 28, 2004 as compared to the 13-weeks ended April
30, 2003. The decrease in same-store sales is due primarily to several
Company-wide promotional events occurring in the first quarter of fiscal 2003
along with a reduction in advertising, including the frequency of mid-week
circulars in the current year. The decrease in total sales is attributable to
the decrease in same-store sales and the closure of 316 stores in the first
quarter of fiscal 2003.
Gross margin decreased $282 million to $1.14 billion, for the 13-weeks
ended April 28, 2004, from $1.42 billion for the 13-weeks ended April 30, 2003.
Gross margin, as a percentage of sales, increased to 24.6% for the 13-weeks
ended April 28, 2004, from 23.0% for the 13-weeks ended April 30, 2003.
Favorably affecting the gross margin rate were fewer clearance markdowns and
reduced depreciation as a result of the write-off of long-lived assets in
conjunction with the application of Fresh-Start accounting.
SG&A decreased $417 million to $1.0 billion, or 21.8% of sales for the
13-weeks ended April 28, 2004, from $1.42 billion, or 23.0% of sales, for the
13-weeks ended April 30, 2003. The decrease in SG&A resulted from reduced
payroll and related expenses in our stores during the first quarter of the
current year, as well as the effect of store closings and corporate cost
reduction initiatives implemented in the first quarter of fiscal 2003. Also
affecting the decline was a reduction in advertising expenses and lower
depreciation as a result of the write-off of long-lived assets in conjunction
with the application of Fresh-Start accounting.
Operating income for the 13-weeks ended April 28, 2004 was $165 million,
or 3.6% of sales, as compared to a loss of $39 million, or (0.6%) of sales, for
the same period in the prior year. The improvement was primarily due to the
decrease in SG&A and the improvement in our gross margin rate, as discussed
above, partially offset by an overall decline in gross margin dollars due to our
reduced store base. Operating income was also affected by net gains on sales of
assets of $32 million in the first quarter of the current year and
Restructuring, impairment and other charges of $37 million in the first quarter
of fiscal 2003.
Interest expense, net for the 13-weeks ended April 28, 2004 and April 30,
2003 was $26 million and $57 million, respectively. During the 13-weeks ended
April 28, 2004, $12 million of interest expense was recorded for the accretion
of obligations recorded at net present value. Included in interest expense for
the 13-weeks ended April 30, 2003 was $37 million of amortization of debt
issuance costs associated with the Predecessor Company's Court-approved $2
billion debtor-in-possession financing facility. Interest at the stated
contractual amount on unsecured debt that was not charged to earnings for the
13-weeks ended April 30, 2003 was $67 million. Interest expense is net of
interest income of $5 million and $1 million for the 13-weeks ended April 28,
2004 and April 30, 2003, respectively.
The effective income tax rate was 37.6% and (0.7%) for the 13-weeks ended
April 28, 2004 and April 30, 2003, respectively; see Note 8 - Income Taxes for a
more detailed discussion.
22
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS - (CONTINUED)
26-WEEKS ENDED JULY 28, 2004 (SUCCESSOR COMPANY)
Total sales were $9.40 billion for the 26-weeks ended July 28, 2004.
Same-store sales decreased 13.9%. Reductions in promotions and advertising,
including the frequency of mid-week circulars in the current year, have affected
same-store sales and total sales.
Gross margin for the 26-weeks ended July 28, 2004 was $2.38 billion or
25.3% of sales. A reduction in clearance markdowns and improvements in shrinkage
at our distribution centers and stores favorably affected gross margin in the
current period. Included in gross margin was a $17 million charge in conjunction
with the store closings inventory liquidations.
SG&A was $2.04 billion, or 21.7% of sales for the period. Reduced payroll
and related expenses at our stores, as well as a reduction in advertising
expenses favorably affected SG&A for the period.
Operating income for the 26-weeks ended July 28, 2004 was $440 million, or
4.7% of sales. Operating income was favorably affected by the gross margin
improvements and reductions in SG&A, as discussed above. Also included in
operating income are net gains of $104 million from sales of real and personal
property, including $43 million of net gains from the sale of four owned
properties to Home Depot; see Note 4 - Real Estate and Property Transactions.
Interest expense, net for the 26-weeks ended July 28, 2004 was $57
million. In July 2004, we voluntarily reduced the size of our credit agreement
from $1.5 billion to $1.0 billion to reduce the overall cost of the facility. In
conjunction with this action, we accelerated the amortization of $9 million of
the associated debt issuance costs, which is included in Interest expense, net
for the 26-weeks ended July 28, 2004. During the 26-weeks ended July 28, 2004,
$25 million of interest expense was recorded for the accretion of obligations
recorded at net present value. Interest expense is net of interest income of $12
million.
The effective income tax rate was 37.6% for the 26-weeks ended July 28,
2004; see Note 8 - Income Taxes for a more detailed discussion.
LIQUIDITY AND FINANCIAL CONDITION
Kmart continued to maintain strong liquidity for the 26-weeks ended July
28, 2004 with cash flow from operations of $536 million and $153 million from
proceeds from asset sales. Our principal cash needs are for our operations and
capital expenditures, which are satisfied through working capital generated by
our business and our existing $2.6 billion balance in cash and cash equivalents
as of July 28, 2004. Working capital generated by our business, is significantly
affected by our level of sales and the credit extended by our vendors. In
addition, we have funds available under our $1.0 billion Credit Facility as of
July 28, 2004. From its inception, we have only used the Credit Facility to
support issuances of letters of credit. However, should we experience
significant negative sales trends, a significant disruption of terms with our
vendors, the Credit 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.
In the normal course of business, the Company considers opportunities to
purchase leased operating properties, as well as offers to sell owned or if
leased, assign operating and non-operating properties. These transactions may,
individually or in the aggregate, result in material proceeds or outlays of
cash. In addition, the Company reviews leases that will expire in the short-term
in order to determine the appropriate action to take with respect to the lease.
CREDIT FACILITY
Our Credit Facility is a $1.0 billion revolving credit facility with an
$800 million letter of credit sub-limit under which Kmart Corporation is the
borrower. From its inception, we have only used the Credit Facility to support
issuances of letters of credit. In July 2004, we voluntarily reduced the size of
the Credit Facility from $1.5 billion to $1.0 billion to reduce the overall cost
of the facility. Availability under the Credit Facility is subject to an
inventory borrowing base formula. The Credit Facility is guaranteed by the
Successor Company, Kmart Management Corporation, Kmart Services Corporation (a
subsidiary of Kmart Management Corporation) and Kmart Corporation's direct and
indirect domestic subsidiaries. The Credit Facility is secured primarily by
first liens on inventory, the proceeds thereof and certain related assets of
Kmart Corporation and the guarantors.
23
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS - (CONTINUED)
Borrowings under the Credit Facility are subject to a pricing grid based
on our earnings before interest, taxes, depreciation, amortization and other
charges ("EBITDA") levels and such adjustments are implemented quarterly.
Borrowings currently bear interest at either (i) the Prime rate plus 1.5% per
annum or (ii) the LIBOR rate plus 2.5% per annum, at our discretion, and
utilization of the letter of credit sub-facility in support of trade and standby
letters of credit currently bears interest at 1.25% and 2.50% per annum,
respectively. In addition, we are currently required to pay a fee based on the
unutilized commitment under the Credit Facility equal to 0.50% per annum. The
Credit Facility gives the Company the ability to repurchase up to $500 million
of the Company's Common Stock, depending on our EBITDA levels and subject to the
approval of the Company's Board of Directors.
In accordance with the terms and conditions of the Credit Facility, we are
submitting the required information to support a reduction in the current
interest rates. We anticipate borrowings, if any, under the Credit Facility will
bear interest at either (i) the Prime rate plus 1.0% per annum or (ii) the LIBOR
rate plus 2.0% per annum, at our discretion, and utilization of the letter of
credit sub-facility in support of trade and standby letters of credit will bear
interest at 1.25% and 2.00% per annum, respectively. The unutilized commitment
fee will equal 0.375% per annum.
As of July 28, 2004, we had utilized $341 million of the Credit Facility
for letters of credit issued for ongoing import purchasing operations, and
contractual and regulatory purposes, including letters of credit utilized as
collateral to support our self-insurance programs. During the first six months
of fiscal 2004, we replaced letters of credit used as collateral for certain
programs with cash collateral to reduce fees on our letters of credit. We
continue to classify the cash collateral in Cash and cash equivalents due to our
ability to convert the cash to letters of credit at any time at our discretion.
As of July 28, 2004, $214 million of cash was posted as collateral.
Total availability under the Credit Facility as of July 28, 2004 was
approximately $630 million.
The Credit Facility financial covenants include a requirement that we
maintain certain availability minimums, and failure to do so triggers additional
required minimum levels of EBITDA. The Credit Facility also contains other
customary covenants, including certain reporting requirements and covenants that
restrict our ability to incur or create liens, indebtedness and guarantees, make
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. As of July 28, 2004 and in all periods since our emergence
from Chapter 11, we have been in compliance with all Credit Facility covenants.
CASH FLOWS
Operating activities provided net cash of $536 million and $576 million
for the 26-weeks ended July 28, 2004 and the 13-weeks ended April 30, 2003,
respectively. During the 13-weeks ended July 30, 2003, operating activities used
$172 million of net cash. Improved net earnings and a reduction in working
capital primarily drove the cash flow increase for the 26-weeks ended July 28,
2004. For the 13-weeks ended July 30, 2003, the use of cash was primarily due to
payments of $451 million for exit costs and reorganization items, partially
offset by a reduction of inventory, net of accounts payable. For the 13-weeks
ended April 30, 2003, a decrease in inventory due to liquidation sales in
conjunction with store closings and improved inventory management, partially
offset by a decrease in accounts payable, had a favorable affect on operating
cash flow.
Investing activities generated $29 million, $17 million and $60 million
for the 26-weeks ended July 28, 2004 and the 13-weeks ended July 30, 2003 and
April 30, 2003, respectively. During the current period, we received proceeds of
$153 million from sales of real and personal property, including $59 million
from the sale of four owned properties to Home Depot. We have not received any
other proceeds as of July 28, 2004 for the sale and assignment of other
properties to Home Depot or Sears as remaining transactions had not yet been
consummated. See Note 4 - Real Estate and Property Transactions and Note 11 -
Property Held for Sale for a more detailed discussion of these transactions.
During the 26-weeks ended July 28, 2004, we purchased 22 previously-leased
operating properties for $84 million. Proceeds of $64 million were received
during the 13-weeks ended April 30, 2003, from the sale of four owned Kmart
store locations and the sale of furniture and fixtures from closed store
locations.
24
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS - (CONTINUED)
Payments on capital lease obligations and mortgages of $27 million and $17
million were the uses of cash for financing activities during the 26-weeks ended
July 28, 2004 and the 13-weeks ended April 30, 2003, respectively. Financing
activities provided $123 million in cash for the 13-weeks ended July 30, 2003.
Upon emergence from bankruptcy in May 2003, the Company received net proceeds of
$127 million from the issuance of Common Stock to the Plan Investors and
proceeds of $60 million from the issuance of the convertible note to affiliates
of ESL. The positive affect of these items was partially offset by payments made
for other financing arrangements. Refer to Note 2 - Emergence from Chapter 11
Bankruptcy Protection and Fresh-Start Accounting for a more detailed discussion.
On August 28, 2003, the Company's Board of Directors approved the
repurchase of up to $10 million of the Company's outstanding stock for the
primary purpose of providing restricted stock grants to certain employees. On
June 29, 2004, the Company's Board of Directors increased the existing share
repurchase authorization to $100 million and broadened the scope of future
repurchases to include the repurchase of shares in furtherance of general
corporate purposes. As of July 28, 2004, we had repurchased approximately $4
million of Common Stock.
FUTURE LIQUIDITY ITEMS
PENSION PLAN
Prior to 1996, the Predecessor Company 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. Prior to 2004, no contributions had been made to the plans for the
past eight years.
During the 13-weeks and 26-weeks ended July 28, 2004 contributions to the
plans were approximately $1 million. The estimated contribution for fiscal 2004
is $11 million. Contributions to the plans were not required for the 13-weeks
ended July 30, 2003 or April 30, 2003.
Pension expense was $8 million, $4 million, $9 million and $21 million for
the 26-weeks ended July 28, 2004 and the 13-weeks ended July 28, 2004, July 30,
2003 and April 30, 2003, respectively.
REAL ESTATE TRANSACTIONS
Home Depot U.S.A., Inc.
On June 3, 2004, the Company entered into multiple definitive agreements
with Home Depot U.S.A., Inc. (a subsidiary of The Home Depot, Inc.) ("Home
Depot") to sell up to four owned properties and assign up to 20 leased
properties for a maximum purchase price of $365 million in cash. Pursuant to the
first of these agreements, on June 15, 2004, the Company completed the sale of
four owned properties to Home Depot for $59 million in cash, resulting in a net
gain of $43 million. On August 10, 2004 the second agreement was amended, which
limited the number of leased properties to be assigned to not more than 15
properties with a maximum purchase price of $230 million in cash. We completed
the assignment of nine of these properties on August 13, 2004, resulting in
proceeds to the Company of $114 million in cash. We anticipate that Home Depot
may close on the remaining six leases by the end of August 2004, subject to
certain closing conditions being satisfied. In the event Home Depot does not
close on certain of these properties, we have the option to assign up to two of
these properties to Home Depot for a maximum of $42 million in cash.
25
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS - (CONTINUED)
Sears, Roebuck and Co.
On June 29, 2004, the Company entered into an agreement with Sears,
Roebuck and Co. ("Sears") to sell up to two owned properties and assign up to 52
leased properties for a maximum purchase price of $621 million in cash. Pursuant
to this agreement, certain closing conditions for a minimum of 43 of the
properties must be satisfied by August 31, 2004. However, if the closing
conditions have not been satisfied by August 31, 2004, the Company, at its
option, may give written notice to Sears by September 9, 2004 to proceed with
the closing with respect to those properties for which closing conditions have
been satisfied. In the event the closing conditions for the 43 properties have
not been satisfied by August 31, 2004 and written notice has not been given to
Sears by the Company, either party may terminate the purchase agreement
subsequent to September 9, 2004, but prior to the date closing conditions are
satisfied for at least 43 properties. Assuming such conditions are met, the
Company will receive 30% of the purchase price in September 2004. The remaining
70% of the purchase price will be received when Sears has been assigned the
leases and occupies the properties, which shall take place no later than April
15, 2005.
OTHER
In light of the Company's liquidity position and subject to compliance
with our Credit Facility, we may consider various uses of cash and other
resources in the future which could include investments in various forms of
securities, share repurchases, the acquisition of related or unrelated
businesses, and the payment of dividends.
STORE ACTIVITY
During the 26-weeks ended July 28, 2004 the Company purchased 22
previously leased store locations; closed four operating stores; and allowed
leases to expire on four stores. As of July 28, 2004, we operated 1,503 stores.
In the second quarter of fiscal 2003, we closed one store. In the first
quarter of fiscal 2003, the Predecessor Company closed 316 stores.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
In preparing our financial statements, certain of our accounting policies
require considerable judgment to select the appropriate assumptions to calculate
financial estimates. By their nature, these estimates are complex and subject to
an inherent degree of uncertainty. We base our estimates on historical
experience, terms of existing contracts, our evaluation of trends and other
assumptions that we believe to be reasonable under the circumstances. We
continually evaluate the information used to make these estimates as our
business and the economic environment change.
Management believes the current assumptions and other considerations used
to estimate amounts reflected in our financial statements are appropriate.
However, if actual experience differs from the assumptions and other
considerations used in estimating amounts, the resulting changes could have a
material adverse effect on our consolidated results of operations, and in
certain situations, could have a material adverse effect on our financial
condition. We have disclosed our critical accounting policies and estimates,
which include inventory valuation, self-insurance reserves, pension accounting
and deferred taxes, in our Annual Report on Form 10-K for the year ended January
28, 2004.
RECENTLY ADOPTED ACCOUNTING PRONOUNCEMENTS
For a comprehensive discussion see Note 3 - New Accounting Pronouncements.
DISCONTINUED OPERATIONS
During the first quarter of fiscal 2003, the Predecessor Company closed
316 stores. Of the total stores closed, 66 met the criteria for discontinued
operations. For a comprehensive discussion see Note 15 - Discontinued
Operations.
For the 13-weeks ended April 30, 2003, 250 of the 316 stores closed were
accounted for in continuing operations as they did not meet the criteria for
discontinued operations. Total sales, gross margin and SG&A for these 250 stores
were $854 million, $301 million and $146 million, respectively.
26
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS - (CONTINUED)
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. For the 13-weeks ended
April 30, 2003, the Predecessor Company recorded special charges of $42 million.
For a comprehensive discussion see Note 16 - 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 as required by SOP 90-7. The Predecessor
Company recorded $813 million for the 13-weeks ended April 30, 2003 for
reorganization items. For a comprehensive discussion see Note 17 -
Reorganization Items, net.
OTHER MATTERS
Martha Stewart was convicted on March 5, 2004 of conspiracy, obstruction
of justice and two counts of making false statements to federal investigators.
Ms. Stewart has been sentenced to five months in prison, five months of home
confinement and two years probation. Ms. Stewart is appealing the sentence. The
Martha Stewart Everyday brand is considered a distinctive brand for Kmart and we
currently sell Martha Stewart Everyday home, garden, colors, baby, kitchen,
keeping and decorating product lines, along with candles and accessories. To
date, we have not experienced any significant adverse impact from this matter on
the sales of Martha Stewart Everyday 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 Everyday brand products.
In March 2002, the Court issued an order providing for the continuation of
the Predecessor Company's existing surety bond coverage, which permitted the
Predecessor Company to self-insure its workers' compensation programs in various
states. We have reached agreements with four issuers of pre-petition surety
bonds on the terms and conditions of a continuation of their respective bonds.
27
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
At July 28, 2004, 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 Credit
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
Under the supervision of, and with the participation of our management,
including our Chief Executive Officer and Chief Financial Officer, we conducted
an evaluation of the effectiveness of the design and operation of our disclosure
controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the
Securities Exchange Act of 1934, as amended (the "Exchange Act"), as of the end
of the period covered by this report (the "Evaluation Date"). Based on this
evaluation, our Chief Executive Officer and Chief Financial Officer concluded
that, as of the Evaluation Date, our disclosure controls and procedures were
effective in alerting them on a timely basis to material information relating to
the Company (including its consolidated subsidiaries) required to be included in
the Company's periodic filings under the Exchange Act.
No changes in the Company's internal controls have come to management's
attention that occurred during the Company's last fiscal quarter that have
materially affected, or are reasonably likely to materially affect, the
Company's internal control over financial reporting.
28
PART II. OTHER INFORMATION
ITEM 1.LEGAL PROCEEDINGS
See Note 18 of the Notes to Unaudited Condensed Consolidated Financial
Statements for information concerning legal proceedings.
ITEM 2.CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY
SECURITIES
On August 28, 2003, the Company's Board of Directors approved the
repurchase of up to $10 million of the Company's outstanding stock for the
primary purpose of providing restricted stock grants to certain employees. On
June 29, 2004, the Company's Board of Directors increased the existing share
repurchase authorization to $100 million and broadened the scope of future
repurchases to include the repurchase of shares in furtherance of general
corporate purposes. We have the authorization to repurchase approximately $96
million of Common Stock under the program as of July 28, 2004.
Total Approximate
Number of Shares Dollar Value
Average Purchased as Part of Shares that
Total Price of Publicly May Yet Be
Number of Shares Paid per Announced Purchased Under
Period Purchased (1) Share Program the Program
- ------------------------------ ---------------- ----------- ----------------- ---------------
April 29, 2004 to May 26, 2004 - - - $ 6,000,000
May 27, 2004 to June 23, 2004 7,761 $ 65.00 - $ 6,000,000
June 24, 2004 to July 28, 2004 - - - $96,000,000
(1) During the second quarter of fiscal 2004, the Company repurchased 7,761
shares of Common Stock for purposes of paying withholding taxes for
certain former associates that were part of the Class 5 claimholders
incremental distribution.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The following information is furnished with respect to the 2004 Annual
Meeting of Shareholders of Kmart Holding Corporation held on May 25, 2004.
The shareholders voted to ratify the appointment of BDO Seidman, LLP as
independent auditors of the Corporation for fiscal year 2004. The vote was
65,656,595 for, 225,751 against and 51,686 abstentions. There were no broker
non-votes.
The shareholders also voted to approve the Company's incentive plans and
grant of shares. The vote was 57,932,608 for, 501,452 against and 72,004
abstentions. There were 7,427,968 broker non-votes.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits:
Exhibit 10.1 Employment Agreement dated as of June 1, 2004, between
Kmart Management Corporation and David Whipple
Exhibit 10.2 Asset Purchase Agreement dated as of June 29, 2004
between Kmart Corporation and Sears, Roebuck and Co.
Exhibit 10.3 Letter of Credit Agreement dated as of August 13, 2004
among Kmart Corporation, Bank of America, National
Association and Fleet National Bank as issuing banks
Exhibit 31.1 Chief Executive Officer Certification pursuant to Rule
13a-14(a)/15d-14(a) of the Securities Exchange Act of
1934, as Amended
29
Exhibit 31.2 Chief Financial Officer Certification pursuant to Rule
13a-14(a)/15d-14(a) of the Securities Exchange Act of
1934, as Amended
Exhibit 32.1 Certifications pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002
(b) Reports on Form 8-K:
We filed the following Current Reports on Form 8-K with the SEC:
1. On May 17, 2004, Kmart Holding Corporation furnished a Current
Report on Form 8-K to report the first quarter 2004 operating
results.
2. On June 4, 2004, Kmart Holding Corporation furnished a Current
Report on Form 8-K to announce it has signed definitive agreements
to sell up to 24 stores to The Home Depot, Inc.
3. On June 30, 2004, Kmart Holding Corporation furnished a Current
Report on Form 8-K to announce it has signed a definitive agreement
to sell up to 54 store to Sears, Roebuck and Co. and to announce
that the Company's Board of Directors has increased the Company's
existing share repurchase authorization to $100 million.
30
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended,
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 16, 2004
Kmart Holding Corporation
----------------------------------------------
(Registrant)
By: /s/ Julian C. Day
----------------------------------------------
Julian C. Day
President and Chief Executive Officer
(Principal Executive Officer)
/s/ James D. Donlon, III
----------------------------------------------
James D. Donlon, III
Senior Vice President, Chief Financial Officer
(Principal Financial Officer)
/s/ Richard J. Noechel
----------------------------------------------
Richard J. Noechel
Vice President, Controller
(Principal Accounting Officer)
31
EXHIBIT INDEX
Exhibit
Number Description
- ------- -----------------------------------------------------------------
10.1 Employment Agreement dated as of June 1, 2004, between Kmart
Management Corporation and David Whipple
10.2 Asset Purchase Agreement dated as of June 29, 2004 between Kmart
Corporation and Sears, Roebuck and Co.
10.3 Letter of Credit Agreement dated as of August 13, 2004 among Kmart
Corporation, Bank of America, National Association and Fleet
National Bank as issuing banks
31.1 Chief Executive Officer Certification pursuant to Rule
13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as
Amended
31.2 Chief Financial Officer Certification pursuant to Rule
13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as
Amended
32.1 Certifications pursuant to 18 U. S. C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002