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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the Fiscal Year ended January 26, 2005
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
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE SECURITIES EXCHANGE ACT
OF 1934:
None
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE SECURITIES EXCHANGE ACT
OF 1934:
Common Stock, $0.01 par value
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the Registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. YES X NO
----- -----
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of the Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2) YES X NO
----- -----
The aggregate market value of Common Stock held by non-affiliates of the
Registrant on July 28, 2004 was $3,445,656,322.
Indicate by check mark whether the Registrant has filed all documents and
reports to be filed by Section 12, 13 of 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 March 2, 2005, 94,946,985 shares of Common Stock of the Registrant were
outstanding.
PART I
Item 1. Business
HISTORY
Kmart Holding Corporation ("Kmart," "we," "us," "our," the "Company" or the
"Successor Company") is a mass merchandising company that serves America through
its 1,480 Kmart and Kmart Supercenter retail outlets in 49 states, Puerto Rico,
the U.S. Virgin Islands and Guam and through its e-commerce shopping site,
www.kmart.com. Kmart was incorporated in Delaware in April 2003, but the
businesses conducted by its predecessors began in 1899. Kmart Corporation (the
"Predecessor Company") was incorporated under the laws of the State of Michigan
on March 9, 1916, as the successor to the business developed by its founder,
S.S. Kresge, who opened his first store in 1899. Kresge was the first retailer
to launch a newspaper advertising program to entice shoppers to its stores.
After operating Kresge department stores for over 45 years, Kmart's store
program commenced with the opening of the first Kmart store in March 1962. In
1977, Kresge Corporation officially changed its name to Kmart Corporation. In
1991, Kmart opened the first Kmart Supercenter in Medina, Ohio, offering a
full-service grocery along with general merchandise twenty-four hours a day,
seven days a week.
We are the nation's third largest discount retailer. Our principal
executive offices are located at 3100 West Big Beaver Road, Troy, Michigan
48084.
BANKRUPTCY OF PREDECESSOR COMPANY
On January 22, 2002, Kmart Corporation and 37 of its U.S. subsidiaries
(collectively, the "Debtors") filed voluntary petitions for reorganization under
Chapter 11 of the federal bankruptcy laws ("Chapter 11"). The Debtors decided to
seek bankruptcy reorganization based upon a rapid decline in their liquidity
resulting from below-plan sales and earnings performance in the fourth quarter
of fiscal 2001, the evaporation of the surety bond market, an erosion of
supplier confidence, intense competition, unsuccessful sales and marketing
initiatives, the continuing recession and capital market volatility. The
Predecessor Company utilized Chapter 11 to strengthen its balance sheet and
reduce debt, focus its store portfolio on the most productive locations and
terminate leases for closed stores, develop a more efficient organization and
lower overall operating costs.
On May 6, 2003 (the "Effective Date"), Kmart Corporation emerged from
reorganization proceedings under Chapter 11 pursuant to the terms of an Amended
Joint Plan of Reorganization (the "Plan of Reorganization") and related amended
Disclosure Statement. This Plan received formal endorsement of the statutory
creditors' committee and, as modified, was confirmed by the U.S. Bankruptcy
Court on April 23, 2003. Kmart Corporation is presently a wholly-owned
subsidiary of Kmart Management Corporation, which is a wholly-owned subsidiary
of Kmart Holding Corporation.
MERGER WITH SEARS, ROEBUCK AND CO.
On November 17, 2004, Kmart and Sears, Roebuck and Co. ("Sears") announced
a business combination pursuant to an Agreement and Plan of Merger, dated as of
November 16, 2004 (the "Merger Agreement"). The combined company will be a new
retail company named Sears Holdings Corporation ("Holdings"). Upon the
consummation of the merger, which is subject to shareholder approval and other
conditions, Kmart and Sears will become wholly-owned subsidiaries of Holdings.
Holdings is expected to be the third largest retailer in the United States,
initially with approximately $55 billion in annual revenues and with
approximately 3,800 full-line and specialty stores in the United States and
Canada.
Under the terms of the Merger Agreement, Kmart shareholders will receive
one share of Holdings common stock for each Kmart share owned. Sears
shareholders have the right to elect $50 in cash or 0.5 of a share of Holdings
for each Sears share. Sears shareholder elections will be prorated to ensure
that in the aggregate 55 percent of Sears shares are converted into Holdings
shares and 45 percent of Sears shares are converted to cash. An aggregate of
approximately 61 million shares of Holdings common stock will be issued and
approximately $5 billion in cash will be paid in consideration for (i) all
outstanding common stock of Sears based upon the proration provisions set forth
above, and the exchange ratio of 0.5 of a share of Holdings common stock for one
share of Sears common stock and (ii) all outstanding stock options of Sears.
Approximately 95 million shares of Holdings common stock will be issued in
exchange for all outstanding common stock of Kmart based on the one-for-one
exchange ratio. As a result of the merger, the former shareholders of Kmart will
have an approximate 63% interest in Holdings (assuming the exercise of certain
options) and the former shareholders of Sears will have an approximate 37%
interest in Holdings.
2
The merger will be treated as a purchase business combination for
accounting purposes, and Sears' assets acquired and liabilities assumed will be
recorded at their fair values.
In several circumstances involving a change in a board's recommendation in
favor of the merger agreement or a third party acquisition proposal, Kmart may
become obligated to pay up to $380 million in termination fees, and Sears may be
obligated to pay up to $400 million in termination fees. In addition, if Sears
stockholders do not approve the merger agreement, Sears must reimburse Kmart for
all costs and expenses incurred by Kmart in connection with the merger agreement
up to $10 million.
ESL Investments, Inc. ("ESL") and its affiliates will beneficially own
between approximately 40% and 44% of Holdings common stock, including options to
purchase approximately 6.5 million shares of Holdings common stock, assuming
that approximately 156 million shares of Holdings common stock will be issued in
the merger. The actual ownership percentage will depend on the actual number of
shares of Holdings common stock that are issued in the merger and the elections
that Sears stockholders make. Prior to the merger, ESL and its affiliates
beneficially own approximately 14% of the outstanding shares of Sears common
stock.
Holdings common stock will be traded on the NASDAQ Stock Market under the
symbol "SHLD."
For additional information regarding the pending merger between Kmart and
Sears, refer to Sears Holdings Corporation's definitive joint proxy
statement-prospectus forming a part of its Registration Statement on Form S-4
(Registration No. 333-120954) filed with the SEC and available at the SEC's
Internet site www.sec.gov.
OPERATIONS
We operate in the general merchandise retailing industry through 1,480
Kmart discount stores and Supercenters as of January 26, 2005. Our general
merchandise retail operations are located in 284 of the 331 Metropolitan
Statistical Areas in the United States. Kmart stores are generally one-floor,
free-standing units ranging in size from 40,000 to 194,000 square feet with an
average size of 95,000 square feet.
Our 58 Kmart Supercenters combine a full grocery, deli, and bakery along
with the general merchandise selection of a Kmart discount store.
Our fiscal year ends on the last Wednesday in January.
STRATEGY OF SEARS HOLDINGS
Since emerging from Chapter 11, Kmart has focused on improving its
operating performance through (i) generating profitable sales; (ii) controlling
and reducing costs and (iii) improving asset productivity. Additionally,
management has implemented analytical rigor and financial discipline to
decision-making and capital allocation. Once Kmart established a profitable
business model and demonstrated superior and sustainable financial strength, the
Company sought to improve its operational performance by offering a
differentiated high-quality product selection, including its private label
apparel assortment. Kmart enhanced the quality and sourcing of its proprietary
apparel and home brands, improved in-stock levels, better tailored its store
assortments to specific trade areas, and redesigned its marketing program. Kmart
has also substantially upgraded its home electronics product offering to appeal
to all customers, including higher-end merchandise in the appropriate trade
areas and improved selection across the entire chain. Supporting both these
efforts, Kmart re-launched its website and introduced the Kmart Rewards Card, a
private-label credit card. At the same time, Kmart has also worked to improve
its supply chain and inventory management, thereby improving the quality of the
store experience.
The merger of Kmart and Sears will accelerate the execution of pre-existing
strategies of both retail organizations and build on the substantial cash
generation capabilities of both companies.
The merger will also enable Sears to accelerate its off-mall growth through
the conversion of approximately 400 Kmart stores to Sears' nameplates over the
next three years. The stores to be converted will most likely be locations that
feature customer demographics that are more similar to those of a typical Sears
shopper. Holdings also intends to evaluate opportunities to cross merchandise
its Kmart and Sears stores with a wealth of well-known proprietary and national
hardline, home and apparel brands. Holdings should be able to leverage over 75
million existing customer relationships in order to cross-sell ancillary
products and services. The opportunity to capture cost synergies, including
merchandise and non-merchandise purchasing, distribution and other selling,
general and administrative expenses is substantial. With a renewed focus on
capital allocation and a clear retail strategy, Holdings will be well positioned
to compete in the retail landscape. Holdings will also be in a position to
evaluate opportunities to monetize non-strategic, non-core assets.
3
COMPETITION
Our business is conducted under highly competitive conditions in the
discount store retail market. We have several major competitors on a national
level, including Wal-Mart, Target, Kohl's and J.C. Penney, and many competitors
on a local and regional level along with Internet and catalog businesses, which
handle similar lines of merchandise. Success in this competitive market is based
on factors such as price, quality, service, product assortment and convenience.
We have experienced a decrease in market share in part due to our store closings
and the aggressive growth of our major competitors. We expect that this trend
will continue in the near term.
DISTRIBUTION
We have 16 active distribution centers as of January 26, 2005.
Approximately 67% of our merchandise is received directly at these distribution
centers which then ship the product to individual stores up to five times a
week. The remaining merchandise is shipped by our vendors or their distributors
directly to our stores.
SEASONALITY
Due to the seasonal nature of the general merchandise retail industry,
where merchandise sales and cash flows from operations are historically higher
in the fourth calendar quarter than any other period, a disproportionate amount
of revenues and operating cash flows are generated in the fourth quarter. In
preparation for the fourth quarter holiday season, we significantly increase our
merchandise inventories, which traditionally have been financed by cash flows
from operations and credit terms from vendors. Our profitability and cash flows
are primarily dependent upon the large sales volume generated during the fourth
quarter of our fiscal year. Fourth quarter sales represented 30% of same-store
sales in fiscal 2004.
EMPLOYEES
As of January 26, 2005, we employed approximately 133,000 associates.
OUR WEBSITE AND AVAILABILITY OF SEC REPORTS
Our website address is www.kmart.com. None of the contents of our website
are intended to be incorporated herein. We make available free of charge through
our website our annual report on Form 10-K, quarterly reports on Form 10-Q,
current reports on Form 8-K and all amendments to those reports as soon as
reasonably practicable after such material is electronically filed with or
furnished to the Securities and Exchange Commission.
Item 2. Properties
At January 26, 2005, we operated a total of 1,480 general merchandise
stores located in the United States, Puerto Rico, the U.S. Virgin Islands and
Guam. We lease our store facilities, with the exception of 157 stores that we
own. Our store leases are generally for terms of 25 years with multiple
five-year renewal options that allow us the option to extend the life of the
lease up to 50 years beyond the initial non-cancelable term.
We own our headquarters building in Troy, Michigan and lease an
administrative building in Royal Oak, Michigan. We own 3 distribution centers
and lease 13 other distribution centers in the United States with initial terms
of 10 to 30 years and options to renew for additional terms.
A description of our leasing arrangements appears in Note 10 in Item 8 of
this Form 10-K.
Item 3. Legal Proceedings
We discuss certain legal proceedings pending against the Company in Part
II, and refer you to that discussion for important information concerning those
legal proceedings, including the basis for such action and relief sought. See
Note 24 in Item 8 of this Form 10-K for this discussion.
Item 4. Submission of Matters to a Vote of Security Holders
None.
4
PART II
Item 5. Market for Kmart's Common Equity, Related Stockholder Matters and Issuer
Purchases of Equity Securities
Our common stock is presently being quoted on the NASDAQ Stock Market under
the ticker symbol KMRT. There were approximately 2,300 shareholders of record of
Kmart Holding Corporation common stock ("Common Stock") as of March 1, 2005.
The quarterly high and low sales prices for the Predecessor Company's
common stock and the Successor Company's Common Stock for the two most recent
fiscal years are set forth below:
2004
-------------------------------------
Successor Company
-------------------------------------
First Second Third Fourth
Quarter Quarter Quarter Quarter
------- ------- ------- -------
Common stock price
High $48.50 $84.50 $93.18 $119.69
Low $26.10 $40.66 $61.76 $ 84.51
2003
-----------------------------------------
Predecessor
Company Successor Company
----------- ---------------------------
First Second Third Fourth
Quarter Quarter Quarter Quarter
----------- ------- ------- -------
Common stock price
High $0.14 $26.99 $30.67 $32.74
Low $0.06 $12.85 $23.35 $23.00
For the first quarter of fiscal 2003, the Predecessor Company stock was
quoted on the Pink Sheets Electronic Quotation Service maintained by the
National Quotation Bureau, Inc. Upon emergence from Chapter 11, all
then-outstanding equity securities of the Predecessor Company were cancelled,
and common stock of the Successor Company was issued.
We have not paid dividends on our Common Stock since our emergence from
Chapter 11.
5
Purchase of Equity Securities
The following table provides information about shares of Common Stock the
Company was assigned during the fourth quarter of fiscal 2004 as part of
settlement agreements resolving claims arising from our Chapter 11
reorganization. These repurchases were not made under the Company's share
repurchase program.
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 Share Program the Program
- -------------------------------------- ---------------- -------- ----------------- ---------------
October 28, 2004 to November 24, 2004 220,663 (1) $101.70 -- $96,000,000
November 25, 2004 to December 29, 2004 253,520 (2) $103.53 -- $96,000,000
December 30, 2004 to January 26, 2005 10,814 (3) $ 92.77 -- $96,000,000
(1) The Company was assigned 220,663 shares of Common Stock as part of
settlement agreements resolving claims arising from our Chapter 11
reorganization.
(2) The Company was assigned 251,340 shares (weighted-average price of
$103.53 per share) of Common Stock as part of settlement agreements resolving
claims arising from our Chapter 11 reorganization; in addition the Company was
assigned 2,180 shares (weighted-average price of $102.91 per share) of Common
Stock for payment of withholding taxes related to the vesting of restricted
stock.
(3) The Company was assigned 10,814 shares (weighted-average price of
$92.77 per share) of Common Stock as part of settlement agreements resolving
claims arising from our Chapter 11 reorganization.
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 Board of Directors increased the existing share repurchase
authorization to $100 million of Common Stock and broadened the scope of future
repurchases to include the repurchase of shares in furtherance of general
corporate purposes. The share repurchase program does not have a termination
date. As of January 28, 2004, we had repurchased approximately $4 million of
Common Stock. No shares were repurchased in fiscal 2004 as part of the share
repurchase program.
6
Item 6. Selected Financial Data
The table below summarizes the Successor Company's and Predecessor
Company's recent financial information. The data set forth below should be read
in conjunction with "Management's Discussion and Analysis of Financial Condition
and Results of Operations" and the Company's consolidated financial statements
and notes thereto.
Successor Company Predecessor Company
-------------------------- ----------------------------------------------
39-Weeks 13-Weeks Fiscal
Fiscal Ended Ended -----------------------------
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) 2004 January 28, 2004 April 30, 2003 2002 2001 2000
- -------------------------------------------- ------- ---------------- -------------- ------- ------- -------
SUMMARY OF OPERATIONS
Total sales (1) $19,701 $17,072 $6,181 $29,352 $34,180 $35,027
Comparable sales %(2) (11.0%) (9.5%) (3.2%) (10.1%) (0.1%) 1.1%
Income (loss) from continuing operations (3) 1,106 234 (852) (2,771) (2,377) (256)
Discontinued operations -- -- (10) (448) (69) (12)
Net income (loss) (3) 1,106 234 (862) (3,219) (2,446) (268)
PER COMMON SHARE
Basic:
Continuing income (loss) $ 12.39 $ 2.61 $(1.63) $ (5.47) $ (4.81) $ (0.51)
Discontinued operations $ -- $ -- $(0.02) $ (0.89) $ (0.14) $ (0.02)
Net income (loss) $ 12.39 $ 2.61 $(1.65) $ (6.36) $ (4.95) $ (0.53)
Diluted: (4)
Continuing income (loss) $ 11.00 $ 2.51 $(1.63) $ (5.47) $ (4.81) $ (0.51)
Discontinued operations $ -- $ -- $(0.02) $ (0.89) $ (0.14) $ (0.02)
Net income (loss) $ 11.00 $ 2.51 $(1.65) $ (6.36) $ (4.95) $ (0.53)
Successor Company Predecessor Company
------------------------ ---------------------------
Book value per common share $50.39 $24.64 $19.45 $ (0.58) $ 6.42 $ 12.09
FINANCIAL DATA
Total assets $8,651 $6,074 $6,660 $11,238 $14,183 $14,815
Long-term debt (5) 91 76 59 -- 330 2,084
Long-term capital lease obligations 276 374 415 623 857 943
Trust convertible preferred securities -- -- -- 646 889 887
Capital expenditures (Predecessor Company for
the 13-weeks ended April 30, 2003) 230 108 4 252 1,385 1,089
Number of Stores 1,480 1,511 1,513 1,829 2,114 2,105
(1) Our fiscal year ends on the last Wednesday in January. Fiscal 2000
consisted of 53 weeks.
(2) Comparable store sales for fiscal 2000 are based on the 52-weeks ended
January 24, 2001.
(3) Results include the following non-comparable items: in fiscal 2004, a $946
million net gain on sales of assets; in the 39-weeks ended January 28,
2004, an $89 million net gain on sales of assets; in the 13-weeks ended
April 30, 2003, a $47 million charge for accelerated depreciation on
unimpaired assets to be disposed of following store closings, a $10 million
credit as a result of a change in the estimated expenses for the 2002 cost
reduction initiatives; in fiscal 2002, $1,019 million for inventory
write-downs in conjunction with accelerated mark-downs due to store
closings, $533 million for asset impairments, $50 million for cost
reduction initiatives, and $33 million for other items; in fiscal 2001,
$827 million for asset impairments, $163 million for supply chain
restructuring, $97 million for the restructuring/impairment of
BlueLight.com, and $23 million for Voluntary Early Retirement
Program/Severance; and in fiscal 2000, $712 million for strategic
initiatives.
(4) Consistent with the requirements of Statement of Financial Accounting
Standards No. 128, "Earnings per Share," certain stock options and
restricted stock were excluded from the calculation of diluted earnings per
share as they were anti-dilutive. The convertible note was excluded from
the calculation of diluted earnings per share for the 39-weeks ended
January 28, 2004. Options to purchase common stock, restricted stock and
Trust convertible preferred securities were excluded from the calculation
of diluted earnings per share for the 13-weeks ended April, 30, 2003,
fiscal years 2002, 2001, and 2000. Upon emergence, all then-outstanding
equity securities of the Predecessor Company and the Trust convertible
preferred securities were cancelled.
(5) For fiscal years 2002 and 2001 long-term debt does not include liabilities
classified as subject to compromise.
7
MANAGEMENT DISCUSSION AND ANALYSIS
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION
This Form 10-K, 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, as amended,
that reflect, when made, Kmart's current views with respect to current events
and financial performance. The words "believe," "expect," "anticipate,"
"project," and similar expressions, among others, generally identify
"forward-looking statements," which articulate our position as of the date the
statement was made. 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.
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.
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; the successful
integration of Kmart's and Sears' business and operations if the merger is
approved by the shareholders; 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; 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 contracts,
including leases, that are critical to its operations; Kmart's ability to
develop a market niche; regulatory and legal developments; general economic
conditions; changes in consumer confidence, tastes, preferences and spending;
the availability and level of consumer debt; the possibility that new business
and strategic options will be identified, potentially including selective
acquisitions, dispositions, restructurings, joint ventures and partnerships;
trade restrictions, tariffs, and other factors potentially affecting the ability
to find qualified vendors and access products in an efficient manner; the
outcome of pending legal proceedings; social and political conditions such as
war, political unrest and terrorism or natural disasters; the possibility of
negative investment returns in Kmart's pension plan; changes in interest rates;
other factors affecting business beyond Kmart's control; the effect of
seasonable buying patterns, which are difficult to forecast with certainty; and
Kmart's ability to attract, motivate and/or retain key executives and
associates. Additional factors that could cause Kmart's results to differ
materially in connection with the pending business combination with Sears,
Roebuck and Co. can be found in Sears Holding Corporation's Registration
Statement on Form S-4 (Registration No. 333-120954) filed with the SEC and
available at the SEC's Internet site www.sec.gov.
EXECUTIVE SUMMARY
Management Overview
In fiscal 2004, Kmart focused on continuing to improve the customer store
experience, providing quality products at attractive pricing, and enhancing its
service culture. By improving our logistics and allocation process, Kmart
allowed its stores to provide particular customers with a more customized
merchandise offering. We plan to continue building on existing customer
relationships, to attract customers back who left during bankruptcy, and to
offer an experience that will bring new customers to Kmart. Kmart seeks to
further develop its apparel and home offerings based on its design and sourcing
capabilities. Management believes that focusing its merchandising and marketing
approach on quality and differentiated products will build customer loyalty and
further differentiate Kmart stores from those of competitors.
8
MANAGEMENT DISCUSSION AND ANALYSIS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
Kmart has identified and begun to execute several financial, merchandising
and operational initiatives that are defined as critical to its future success.
Financial initiatives
- Maintaining a strong liquidity position
- Focusing on generating profitable sales growth
- Sustaining positive cash flow from operations on a long-term basis
- Operating within the framework of its financial covenants
Merchandising initiatives
- Re-merchandising to improve market basket
- Differentiating Kmart from competitors by offering exclusive brands
and tailoring merchandise assortments to serve the unique needs of
customers in local markets
Operational initiatives
- Improving relations with its vendors and business partners
- Establishing a customer and service driven culture throughout the
organization
As we continue to execute these initiatives, we will ensure that we remain
consistent with our core strategic goals.
Establish Profitability
Upon bankruptcy emergence, Kmart sought to eliminate unprofitable sales,
reduce excess inventory, and improve the customer experience. Kmart took actions
to reduce an over reliance on unprofitable promotional events and ineffective
advertising spend. The Company also eliminated excess inventories in backrooms
of stores that required significant store labor to manage. The Company required
that each store develop a plan for 2004 that was profitable and to take
appropriate actions to meet those individual store goals. We will continue to
test advertising and promotional programs which are designed to drive both
incremental sales and demonstrate the improvement in our shopping experience for
both new and existing customers.
Profitable growth
Kmart is a large discount retailer with fiscal 2004 revenues of
approximately $20 billion. Kmart has focused on maximizing shareholder value by
continuing to focus on driving profitable sales, controlling costs, streamlining
overhead and increasing asset productivity. Kmart has experienced a decrease in
market share in part due to store closings and the elimination of unprofitable
sales while competitors, such as Target and Wal-Mart, have continued to open new
stores. Kmart expects this trend to continue due to its limited growth plans as
it focuses on building the appropriate return on capital and return on sales to
enhance margins. We will continue to evaluate the results of our recently
initiated store remodel program. To date, such programs have been conducted on a
limited number of stores to enable us to objectively monitor and analyze the
results and to modify the program in order to maximize the return.
Refine competitive positioning
The retail business is a highly competitive industry, particularly in the
discount retail sector. Kmart has several major competitors on a national level
and many competitors on a local and regional level along with Internet and
catalog businesses, which handle similar lines of merchandise. Kmart continues
to invest in private label offerings from home decor to apparel for women, men
and children. Kmart continues to offer exclusive brands, including Martha
Stewart, Jaclyn Smith, Thalia, and Joe Boxer. In addition, success in this
competitive market is based on factors such as price, quality, product
assortment and convenience. Kmart has made steady improvements in these areas
with its disciplined high/low pricing strategy, revised product mix and more
locally focused store assortments. We will continue to look for opportunities to
extend the product lines of our proprietary brands, where appropriate, and to
expand our selection of new proprietary or national brands.
9
MANAGEMENT DISCUSSION AND ANALYSIS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
Significant cash flow generation
Kmart has achieved positive profitability and generated favorable cash
flow. The Company's strong cash flow can be attributed to initiatives that
focused on (i) profitable transactions; (ii) lower markdowns through better
"buys"/improved sell-thru; (iii) improved distribution productivity; (iv) shrink
improvement; and (v) in-source pantry. These initiatives have enabled Kmart to
realize improvements in margin trends and cost reductions. We will continue to
focus on improving profitability in every aspect of the business.
MERGER WITH SEARS, ROEBUCK AND CO.
On November 17, 2004, Kmart and Sears, Roebuck and Co. ("Sears") announced
a business combination pursuant to an Agreement and Plan of Merger, dated as of
November 16, 2004 (the "Merger Agreement"). The combined company will be a new
retail company named Sears Holdings Corporation ("Holdings"). Upon the
consummation of the merger, which is subject to shareholder approval and other
conditions, Kmart and Sears will become wholly-owned subsidiaries of Holdings.
Holdings is expected to be the third largest retailer in the United States,
initially with approximately $55 billion in annual revenues and with
approximately 3,800 full-line and specialty retail stores in the United States
and Canada.
Under the terms of the Merger Agreement, Kmart shareholders will receive
one share of Holdings common stock for each Kmart share owned. Sears
shareholders have the right to elect $50 in cash or 0.5 of a share of Holdings
for each Sears share. Sears shareholder elections will be prorated to ensure
that in the aggregate 55 percent of Sears shares are converted into Holdings
shares and 45 percent of Sears shares are converted to cash. An aggregate of
approximately 61 million shares of Holdings common stock will be issued and
approximately $5 billion in cash will be paid in consideration for (i) all
outstanding common stock of Sears based upon the proration provisions set forth
above, and the exchange ratio of 0.5 of a share of Holdings common stock for one
share of Sears common stock and (ii) all outstanding stock options of Sears.
Approximately 95 million shares of Holdings common stock will be issued in
exchange for all outstanding common stock of Kmart based on the one-for-one
exchange ratio. As a result of the merger, the former shareholders of Kmart will
have an approximate 63% interest in Holdings (assuming the exercise of certain
options) and the former shareholders of Sears will have an approximate 37%
interest in Holdings.
The merger will be treated as a purchase business combination for
accounting purposes, and Sears' assets acquired and liabilities assumed will be
recorded at their fair values.
The benefits of the business combination will generate an estimated $500
million of annualized cost and revenue synergies to be fully realized by the end
of the third year after closing. However, such synergies will be partially
offset by merger-related integration and restructuring expenses. Holdings has
not made any integration decisions and, accordingly, the amounts of
merger-related integration costs have not been determined.
In several circumstances involving a change in a board's recommendation in
favor of the merger agreement or a third party acquisition proposal, Kmart may
become obligated to pay up to $380 million in termination fees, and Sears may be
obligated to pay up to $400 million in termination fees. In addition, if Sears
stockholders do not approve the merger agreement, Sears must reimburse Kmart for
all costs and expenses incurred by Kmart in connection with the merger agreement
up to $10 million.
ESL and its affiliates will beneficially own between approximately 40% and
44% of Holdings common stock, including options to purchase approximately 6.5
million shares of Holdings common stock, assuming that approximately 156 million
shares of Holdings common stock will be issued in the merger. The actual
ownership percentage will depend on the actual number of shares of Holdings
common stock that are issued in the merger and the elections that Sears
stockholders make. Prior to the merger, ESL and its affiliates beneficially own
approximately 14% of the outstanding shares of Sears common stock.
Holdings common stock will be traded on the NASDAQ Stock Market under the
symbol "SHLD."
10
MANAGEMENT DISCUSSION AND ANALYSIS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
Emergence from Chapter 11 Bankruptcy Protection
On the May 6, 2003, Kmart Corporation (the "Predecessor Company") emerged
from Chapter 11 as a subsidiary of Kmart Holding Corporation. The Predecessor
Company's emergence was pursuant to the terms of the Plan of Reorganization,
which received formal endorsement of the statutory creditors' committee and, as
modified, was confirmed by the United States Bankruptcy Court for the Northern
District of Illinois (the "Court") on April 23, 2003.
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 investment was made pursuant to an Investment Agreement dated January
24, 2003, as amended. The Plan Investors and their affiliates received
approximately 32 million shares of the Successor Company's 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. ESL was also granted an option to purchase, prior to
May 6, 2005, 6.6 million new shares of Common Stock at a price of $13 per share.
A portion of that option was assigned to Third Avenue. In addition, we issued a
9%, $60 million principal convertible note ("the Note") to affiliates of ESL,
which was convertible to equity at a price equal to $10 per share at any time at
the option of the holder prior to May 2006. On January 31, 2005 affiliates of
ESL converted the Note and accrued and unpaid interest into approximately 6.27
million shares of Common Stock, see Note 9 in Item 8 of this Form 10-K.
ESL and its affiliates beneficially own over 50% of the Common Stock,
including shares obtainable upon exercise of options.
In connection with emergence from Chapter 11, we reflected the terms of the
Plan of Reorganization in our consolidated financial statements applying the
terms of the American Institute of Certified Public Accountants Statement of
Position 90-7, "Financial Reporting by Entities in Reorganization Under the
Bankruptcy Code" ("SOP 90-7") with respect to financial reporting upon emergence
from Chapter 11 ("Fresh-Start accounting"). Upon applying Fresh-Start
accounting, a new reporting entity (the Successor Company) is deemed to be
created and the recorded amounts of assets and liabilities are adjusted to
reflect their estimated fair values. 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 Annual
Report on Form 10-K, references to the 13-weeks ended April 30, 2003 and prior
fiscal 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.
APPLICATION OF CRITICAL ACCOUNTING POLICIES
Our significant accounting policies are described more fully in Note 3 in
Item 8 of this Form 10-K. 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. Although the use
of estimates is pervasive throughout our financial statements, we consider an
accounting estimate to be critical if:
- It requires assumptions to be made about matters that were highly
uncertain at the time the estimate was made, and
- Changes in the estimate that are reasonably likely to occur from
period to period or different estimates that could have been
selected would have a material effect on our financial condition,
cash flow or results of operations.
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.
11
MANAGEMENT DISCUSSION AND ANALYSIS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
Management has discussed the development and selection of these critical
accounting estimates with the Audit Committee of our Board of Directors and the
Audit Committee has reviewed the disclosure presented below relating to the
selection of these estimates.
In addition, there are other accounting estimates within our financial
statements that require estimation, but are not deemed to be critical. These
include allowances for doubtful accounts receivable, long-lived asset
impairments, legal reserves, and reserves for store closings and other
management actions. Although not significant in recent years, changes in
estimates used in these and other items could have a significant effect on our
consolidated financial statements.
The following is a summary of our most critical estimates.
VALUATION OF INVENTORY
Our inventories are valued at the lower of cost or market determined
primarily using the retail inventory method ("RIM") on a FIFO basis. RIM is an
averaging method that is widely used in the retail industry due to its
practicality. To determine inventory cost under RIM, inventory at its retail
selling value is segregated into groupings of merchandise having similar
characteristics, which are then converted to a cost basis by applying specific
average cost factors for each grouping of merchandise. Cost factors represent
the average cost-to-retail ratio for each merchandise group based upon the
fiscal year purchase activity for each store location. Accordingly, a
significant assumption under the retail method is that inventory in each group
is similar in terms of its cost-to-retail relationship and has similar turnover
rates. Management monitors the content of merchandise in these groupings to
prevent distortions that would have a material effect on inventory valuation.
RIM inherently requires management judgment and certain estimates that may
significantly effect the ending inventory valuation as well as gross margin.
Among others, two of the most significant estimates are permanent, or clearance
markdowns used to clear unproductive or slow-moving inventory and shrinkage.
Amounts are charged to Cost of sales, buying and occupancy at the time the
retail value of inventory is reduced through the use of permanent markdowns.
Factors considered in the determination of permanent markdowns include:
current and anticipated demand, customer preferences, age of the merchandise,
fashion trends and weather conditions. In addition, inventory is also evaluated
against corporate pre-determined historical markdown cadences. When a decision
is made to permanently markdown merchandise, the resulting gross margin
reduction is recognized in the period the markdown is recorded. The timing of
the decision, particularly surrounding the balance sheet date, can have a
significant effect on the results of operations.
Shrinkage is estimated as a percentage of sales for the period from the
last physical inventory date to the end of the fiscal year. Physical inventories
are taken at least annually for all stores on a staggered basis throughout the
year and inventory records are adjusted accordingly. The shrinkage rate from the
most recent physical inventory, in combination with historical experience, is
used as the standard for the shrinkage accrual following the physical inventory.
SELF INSURANCE RESERVES
We self-insure or retain a portion of the exposure for losses related to
workers compensation, health care benefits and general liability costs. General
liability costs relate primarily to litigation that arises from store
operations. Self-insurance reserves include actuarial estimates of both claims
filed carried at their expected ultimate settlement value and claims incurred
but not yet reported. Our estimated claim amounts are discounted using a rate
that approximates the duration of our portfolio.
Reserves are actuarially determined based upon the development of
historical losses to their ultimate levels over time, actual paid claims data,
and lag time for claims reporting. These projections are subject to a high
degree of variability based upon future inflation rates, litigation trends,
legal interpretations, benefit level changes and claims settlement patterns,
including the effect of the bankruptcy proceedings. Overall reserves can change
based upon the selection of the appropriate discount rate, and may vary based on
different actuarial valuation techniques utilized.
Reserves for estimated self-insurance liabilities were $470 million as of
January 26, 2005 and are included in Accrued expenses and other liabilities and
Other long-term liabilities in the Consolidated Balance Sheets. Expenses for
fiscal year ended January 26, 2005 totaled $284 million and were included in
Selling, general and administrative expenses in the Consolidated Statements of
Operations.
12
MANAGEMENT DISCUSSION AND ANALYSIS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
As part of the selection of the appropriate estimate for these reserves the
actuaries determine an appropriate range of values that could be anticipated for
these liabilities. Had management recorded reserves to either the high end or
the low end of the ranges, these liabilities would have been $52 million higher
or $34 million lower than amounts currently recorded.
PENSION ACCOUNTING
The fundamental components of pension accounting consist of the
compensation cost of benefits paid, the interest costs from deferring the
payment of these benefits, and the results of investing assets to fund the
pension benefit obligation. Pension benefits are earned by employees ratably
over their years of service. In our case, effective January 31, 1996, our
pension plans were frozen, and associates no longer earn additional benefits
under the plans, therefore there are no assumptions related to future
compensation costs.
Our actuarial valuations utilize key assumptions including discount rates
and expected returns on plan assets. We are required to consider current market
conditions, including changes in interest rates and plan asset investment
returns, in determining these assumptions. Actuarial assumptions may differ
materially from actual results due to changing market and economic conditions,
changes in investment strategies and higher or lower withdrawal rates or longer
or shorter life spans of participants. The discount rate and expected return on
plan assets used for the January 26, 2005 actuarial valuation were 5.75 percent
and 8 percent, respectively. A quarter percentage point change in the discount
rate would affect Kmart's pension expense by approximately $1 million on a
pre-tax basis. A quarter percentage point change in the expected long-term rate
of return would affect Kmart's pension expense by approximately $4 million on a
pre-tax basis.
DEFERRED TAXES
Kmart accounts for income taxes in accordance with Statement of Financial
Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes" ("SFAS No.
109") which requires that deferred tax assets and liabilities be recognized
using enacted tax rates for the effect of temporary differences between the
financial reporting and tax bases of recorded assets and liabilities. SFAS No.
109 also requires that deferred tax assets be reduced by a valuation allowance
if it is more likely than not that some portion of or all of the deferred tax
asset will not be realized.
During fiscal year 2004, we utilized $380 million of pre-emergence deferred
tax assets and, accordingly, recorded an adjustment to Capital in excess of par
value. Given the Company's actual level of profitability in fiscal 2004 and
forecasted levels in fiscal 2005 through 2007, management believes that a
portion of the remaining 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 $775 million in fiscal 2004 to
reflect its estimated utilization through the end of fiscal 2007. In accordance
with SOP 90-7, the reversal of the valuation allowance was recorded to Capital
in excess of par value. The Company will continue to assess the likelihood of
realization of its pre-emergence net deferred tax assets and will 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.
13
MANAGEMENT DISCUSSION AND ANALYSIS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
RESULTS OF OPERATIONS
As previously discussed, due to the application of Fresh-Start accounting,
the reported historical financial statements of the Predecessor Company for
periods prior to May 1, 2003 generally are not comparable to those of the
Successor Company. Therefore, the Results of Operations and the Liquidity and
Financial Condition of the Successor Company have not been combined with those
of the Predecessor Company in this Management's Discussion and Analysis.
The following table is presented solely to complement management's
discussion and analysis of results of operations.
PREDECESSOR
SUCCESSOR COMPANY COMPANY
---------------------------------------------------- --------------
39-WEEKS ENDED 39-WEEKS ENDED 13-WEEKS ENDED 13-WEEKS ENDED
(dollars in millions) JANUARY 26, 2005 JANUARY 28, 2004 APRIL 28, 2004 APRIL 30, 2003
- --------------------- ---------------- ---------------- -------------- --------------
Sales $15,086 $17,072 $4,615 $6,181
Cost of sales, buying and occupancy 11,192 13,084 3,478 4,762
------- ------- ------ ------
Gross margin 3,894 3,988 1,137 1,419
Selling, general and administrative expenses 3,152 3,581 1,004 1,421
Net gain on sales of assets (914) (89) (32) --
Restructuring, impairment and other charges -- -- -- 37
------- ------- ------ ------
Operating income (loss) 1,656 496 165 (39)
Interest expense, net 80 127 28 57
Bankruptcy related recoveries (52) (4) (7) --
Equity income in unconsolidated subsidiaries -- (5) (3) (7)
Reorganization items, net -- -- -- 769
------- ------- ------ ------
Income (loss) from continuing operations
before income taxes 1,628 378 147 (858)
Provision for (benefit from) income taxes 613 144 56 (6)
------- ------- ------ ------
Income (loss) from continuing operations 1,015 234 91 (852)
Discontinued operations -- -- -- (10)
------- ------- ------ ------
Net income (loss) $ 1,015 $ 234 $ 91 $ (862)
======= ======= ====== ======
39-WEEKS ENDED JANUARY 26, 2005 COMPARED TO 39-WEEKS ENDED JANUARY 28, 2004
SAME-STORE SALES AND TOTAL SALES decreased 10.4% and 11.6%, respectively,
for the 39-weeks ended January 26, 2005 as compared to the 39-weeks ended
January 28, 2004. Same-store sales include sales of all open stores that have
been open for greater than 13 full months. Factors contributing to the decline
in same store and total sales included reductions in promotional events and
promotional advertising in our circulars, soft customer demand for apparel and
increased competition at certain store locations. During the fourth quarter of
the current fiscal year, our most critical sales period, same-store sales
declined by 4.5%, which represents a significant improvement compared to the two
preceding quarters, in which the decline was 12.8% and 14.9%, respectively.
GROSS MARGIN decreased $94 million to $3.89 billion, for the 39-weeks ended
January 26, 2005, from $3.99 billion for the 39-weeks ended January 28, 2004.
Gross margin, as a percentage of sales (gross margin rate), increased to 25.8%
for the 39-weeks ended January 26, 2005, from 23.4% for the 39-weeks ended
January 28, 2004. Improvements in product margin favorably contributed 270 basis
points to the increase in gross margin rate during the current period, primarily
due to favorable markon, reductions in markdowns on clearance items and
improvement in store shrinkage. Improvements in shrinkage at our distribution
centers as a result of our improved inventory management and supply chain
operations favorably contributed 63 basis points to our gross margin rate in the
current period.
14
MANAGEMENT DISCUSSION AND ANALYSIS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES ("SG&A") decreased $429
million for the 39-weeks ended January 26, 2005 to $3.15 billion, or 20.9% of
sales, from $3.58 billion, or 21.0% of sales, for the 39-weeks ended January 28,
2004. The primary reason for the decline in SG&A is due to reductions of $263
million in store payroll and related benefits in the current period as a result
of increased operating efficiencies and reduced sales volume at our stores.
Reductions in expenses for our weekly and mid-week circular advertising,
partially offset by an increase in our electronic media advertising contributed
$69 million to the decrease in SG&A in the current period. In addition, we
experienced a reduction of $54 million to SG&A in the current period related to
improved workers compensation costs.
OPERATING INCOME for the 39-weeks ended January 26, 2005 was $1.66 billion
or 11.0% of sales, as compared to $496 million, or 2.9% of sales, for the same
period of the prior year. Adjusted operating income for the 39-weeks ended
January 26, 2005 was $742 million, or 4.9% of sales, as compared to $407
million, or 2.4% of sales, for the same period in the prior year. Adjusted
operating income for the 39-weeks ended January 26, 2005 and January 28, 2004
exclude $914 million and $89 million of gain on sales of assets, respectively,
primarily related to the previously announced transactions with Home Depot and
Sears; see Note 5 - Real Estate and Property Transactions in Item 8 of this Form
10-K. See below for a discussion of adjusted operating income as a non-GAAP
measure. The increase in adjusted operating income was due to the decrease in
SG&A, net of the decrease in gross margin, as noted above.
INTEREST EXPENSE, NET for the 39-weeks ended January 26, 2005 and January
28, 2004 was $80 million and $127 million, respectively. The reduction in
interest expense was mainly due to an increase of $23 million in interest income
in the current year compared to the same period in the prior year. Interest
income increased due to an increase in our average cash and cash equivalents
balance and an improvement on the rate of return due to improved interest rates.
In the current period we also experienced a decline in debt discount accretion
and interest on our capital leases of $15 million and $8 million, respectively.
The EFFECTIVE INCOME TAX rate was 37.7% for the 39-weeks ended January 26,
2005 and 38.1% for the 39-weeks ended January 28, 2004; see Note 16 - Income
Taxes in Item 8 of this Form 10-K 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 for the 13-weeks ended April 28, 2004 as
compared to the 13-weeks ended April 30, 2003 decreased $684 million or 12.9%
and $1.57 billion or 25.3%, respectively. 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. Approximately $854 million
of the decrease in total sales is due to the closure of 316 stores in the first
quarter of fiscal 2003, of which 250 stores were included in continuing
operations. The remaining decrease in total sales is primarily attributable to
the decrease in same-store sales.
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. Reduced
depreciation, as a result of the write-off of long-lived assets in conjunction
with the application of Fresh-Start accounting favorably affected the gross
margin rate by 54 basis points in the current quarter.
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. Contributing to the decline was a reduction in
advertising expenses in the current period of $93 million, reduced payroll and
related expenses in our open stores of $62 million and reduced depreciation as a
result of the write-off of long-lived assets in conjunction with the application
of Fresh-Start accounting of $86 million. SG&A included $146 million related to
store closures during the 13-weeks ended April 30, 2003, as discussed above.
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 gain 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.
15
MANAGEMENT DISCUSSION AND ANALYSIS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
INTEREST EXPENSE, NET for the 13-weeks ended April 28, 2004 and April 30,
2003 was $28 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 38.1% and (0.7%) for the 13-weeks ended
April 28, 2004 and April 30, 2003, respectively; see Note 16 - Income Taxes for
a more detailed discussion.
FISCAL 2004
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.
TOTAL SALES were $19.70 billion in fiscal 2004. Same-store sales decreased
11.0%. Reductions in promotions and advertising including the frequency of
mid-week circulars, soft apparel demand and increased competition have affected
same-store and total sales.
GROSS MARGIN was $5.03 billion or 25.5% of sales in fiscal 2004. A
reduction in clearance markdowns, favorable markon and improvements in shrink
favorably affected the gross margin rate in the current period.
SG&A was $4.16 billion or 21.1% of sales in fiscal 2004. Reduced payroll
and related expenses at our stores, a reduction in advertising, lower
depreciation as a result of the write-off of long-lived assets in conjunction
with Fresh-Start accounting and improved workers compensation costs favorably
affected SG&A in the current year.
OPERATING INCOME was $1.82 billion or 9.2% of sales in fiscal 2004.
Adjusted operating income was $875 million or 4.4% of sales in fiscal 2004.
Adjusted operating income excludes a gain of $946 million on sales of assets,
primarily related to the previously announced transactions with Home Depot and
Sears; see Note 5 - Real Estate and Property Transactions in Item 8 of this Form
10-K. See below for a discussion of adjusted operating income as a non-GAAP
measure. Adjusted operating income was favorably affected by the improvements in
the gross margin rate and SG&A, as discussed above.
INTEREST EXPENSE, NET was $108 million in fiscal 2004. Interest income of
$38 million earned on our cash and cash equivalents favorably affected interest
expense, net. In the current year, we recognized $9 million of debt discount
accretion and $34 million of amortization of debt issuance costs, $23 million of
which was accelerated in conjunction with actions taken to reduce the size,
amend and restate and finally to terminate our credit facility. Interest expense
also includes $50 million of interest expense recorded for the accretion of
obligations at net present value.
The EFFECTIVE INCOME TAX RATE was 37.7% in fiscal 2004; see Note 16 -
Income Taxes in Item 8 of this Form 10-K for a more detailed discussion.
16
MANAGEMENT DISCUSSION AND ANALYSIS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
The following table is presented solely to complement management's
discussion and analysis of results of operations.
SUCCESSOR
COMPANY PREDECESSOR COMPANY
---------------- --------------------------------------------------
39-WEEKS ENDED 39-WEEKS ENDED 13-WEEKS ENDED 13-WEEKS ENDED
(dollars in millions) JANUARY 28, 2004 JANUARY 29, 2003 APRIL 30, 2003 MAY 1, 2002
- --------------------- ---------------- ---------------- -------------- --------------
Sales $17,072 $22,171 $6,181 $ 7,181
Cost of sales, buying and occupancy 13,084 18,323 4,762 6,519
------- ------- ------ -------
Gross margin 3,988 3,848 1,419 662
Selling, general and administrative expenses 3,581 4,572 1,421 1,670
Net (gain) loss on sales of assets (89) 5 -- --
Restructuring, impairment and other charges -- 574 37 --
------- ------- ------ -------
Operating income (loss) 496 (1,303) (39) (1,008)
Interest expense, net 127 122 57 33
Bankruptcy related recoveries (4) -- -- --
Equity income in unconsolidated subsidiaries (5) (29) (7) (5)
Reorganization items, net -- 112 769 251
------- ------- ------ -------
Income (loss) from continuing operations
before income taxes 378 (1,508) (858) (1,287)
Provision for (benefit from) income taxes 144 (12) (6) (12)
------- ------- ------ -------
Income (loss) from continuing operations 234 (1,496) (852) (1,275)
Discontinued operations -- (281) (10) (167)
------- ------- ------ -------
Net income (loss) $ 234 $(1,777) $ (862) $(1,442)
======= ======= ====== =======
39-WEEKS ENDED JANUARY 28, 2004 COMPARED TO 39-WEEKS ENDED JANUARY 29, 2003
SAME-STORE SALES AND TOTAL SALES decreased 9.5% and 23.0%, respectively,
for the 39-weeks ended January 28, 2004 as compared to the 39-weeks ended
January 29, 2003. The decrease in same-store sales is due primarily to several
Company-wide promotional events occurring in fiscal 2002 along with a reduction
in advertising, including the frequency of mid-week circulars in fiscal 2003.
The decrease in total sales is attributable to the decrease in same-store sales
and the closure of 316 stores during the first quarter of fiscal 2003.
GROSS MARGIN increased $140 million to $3.99 billion, for the 39-weeks
ended January 28, 2004, from $3.85 billion for the 39-weeks ended January 29,
2003. Gross margin, as a percentage of sales, increased to 23.4% for the
39-weeks ended January 28, 2004, from 17.4% for the 39-weeks ended January 29,
2003. The gross margin rate in the previous period was negatively affected by
inventory markdowns of $498 million, primarily related to our fiscal 2003 store
closings. The markdowns were charged to Cost of sales, buying and occupancy in
the fourth quarter of fiscal 2002 when the decision to close the stores was
made. Also favorably affecting gross margin was a decrease in distribution
costs, lower depreciation expense resulting from impairment charges taken while
operating in bankruptcy and as a result of the write-off of long-lived assets in
conjunction with the application of Fresh-Start accounting, less inventory
shrinkage, supplier cost reductions and an improved sales mix as a result of a
decrease in promotional activity as referenced in the sales summary above. Gross
margin also benefited from the reclassification of co-op advertising recoveries
from SG&A to Cost of sales, buying and occupancy beginning in the fourth quarter
of fiscal 2002 in accordance with Emerging Issues Task Force ("EITF") Issue No.
02-16, "Accounting by a Customer (Including a Reseller) for Certain
Consideration Received from a Vendor" ("EITF 02-16"). These improvements in the
gross margin rate were partially offset by the effect of clearance markdowns.
17
MANAGEMENT DISCUSSION AND ANALYSIS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
SG&A, which includes advertising costs (net of co-op recoveries of $199
million in 2002) decreased $991 million for the 39-weeks ended January 28, 2004
to $3.58 billion, or 21.0% of sales, from $4.57 billion, or 20.6% of sales, for
the 39-weeks ended January 29, 2003. The decrease in SG&A was primarily due to
the reduction of our store base after closing 316 stores during the first
quarter of fiscal 2003, as well as a decrease in payroll and other related
expenses from corporate headquarters' cost reduction initiatives. In addition,
lower depreciation expense resulted from impairment charges taken while
operating in bankruptcy and the write-off of long-lived assets in conjunction
with Fresh-Start accounting combined with a decrease in advertising expense
contributed to the improvement in SG&A. Collectively, these reductions were
partially offset by the effect of the reclassification of co-op advertising
recoveries, as discussed above.
OPERATING INCOME for the 39-weeks ended January 28, 2004 was $496 million
or 2.9% of sales, as compared to a loss of $1.30 billion, or (5.9%) of sales,
for the same period of fiscal 2002. The improvement from the comparable period
in the prior year was primarily due to the decrease in SG&A and the increase in
gross margin in the current period as discussed above, a charge of $574 million
in the 39-weeks ended January 29, 2003 to Restructuring, impairment and other
charges and net gain on sales of assets of $89 million in the current period.
INTEREST EXPENSE, NET for the 39-weeks ended January 28, 2004 and January
29, 2003 was $127 million and $122 million, respectively. The increase in
interest expense was due primarily to the accretion of $37 million for
obligations recorded at net present value and $22 million of debt discount
amortization recognized on the beneficial conversion feature of our Note. In
December 2003, we voluntarily reduced the size of our $2 billion credit
agreement to $1.5 billion to reduce the overall cost of the facility. In
conjunction with this action, we accelerated the amortization of $12 million of
the associated debt issuance costs. This expense is included in Interest
expense, net for the 39-weeks ended January 28, 2004. Interest expense is net of
interest income of $10 million and $3 million for the 39-weeks ended January 28,
2004 and January 29, 2003, respectively.
The EFFECTIVE INCOME TAX rate was 38.1% and (0.8%) for the 39-weeks ended
January 28, 2004 and January 29, 2003, respectively. The Predecessor Company did
not record a provision for income taxes in fiscal 2002 due to the Company's net
loss and uncertainty surrounding future utilization of net operating losses. As
such, tax benefits recorded during fiscal 2002 related primarily to an Internal
Revenue Code provision allowing for the 10-year carryback of certain losses, and
refunds resulting from the Job Creation and Worker Assistance Act of 2002. The
benefit recognized for these items in fiscal 2002 was partially offset by
expense paid to foreign jurisdictions.
13-WEEKS ENDED APRIL 30, 2003 COMPARED TO 13-WEEKS ENDED MAY 1, 2002
SAME-STORE SALES AND TOTAL SALES decreased 3.2% and 13.9%, respectively,
for the 13-weeks ended April 30, 2003 as compared to the 13-weeks ended May 1,
2002. The decrease in same-store sales was primarily due to sluggish retail
sales as a result of consumer concerns over the war with Iraq, general economic
factors and unseasonable weather conditions. The decrease in total sales was
attributable to the decrease in same-store sales and the closure of 283 stores
during the second quarter of fiscal 2002.
GROSS MARGIN increased $757 million to $1.42 billion, for the 13-weeks
ended April 30, 2003, from $662 million for the 13-weeks ended May 1, 2002.
Gross margin, as a percentage of sales, increased to 23.0% for the 13-weeks
ended April 30, 2003, from 9.2% for the 13-weeks ended May 1, 2002. The increase
in gross margin was primarily related to a charge of $625 million recorded in
the first quarter of fiscal 2002 in conjunction with the store closing
liquidation sales. Also favorably affecting gross margin was the higher gross
margin rate realized during store closing liquidation sales, a decrease in the
sale of food and consumables, which carry lower margins, and a decrease in
promotional markdowns. The affect of these items was partially offset by higher
clearance markdowns.
SG&A, which includes advertising costs (net of co-op recoveries of $67
million in fiscal 2002) decreased $249 million for the 13-weeks ended April 30,
2003 to $1.42 billion, or 23.0% of sales, from $1.67 billion, or 23.3% of sales,
for the 13-weeks ended May 1, 2002. The decrease in SG&A was primarily the
result of the closure of 283 stores in the second quarter of fiscal 2002 and
lower payroll and other related expenses in the first quarter of fiscal 2003
stemming from corporate headquarters cost reduction initiatives. In addition,
SG&A was favorably affected by a decrease in utility expenses and electronic
media advertising, and lower depreciation expense as a result of the impairment
charge recorded in the fourth quarter of fiscal 2002. Offsetting the positive
affect of these items was an increase in pension and workers' compensation
expense and the previously discussed reclassification of co-op advertising
recoveries.
18
MANAGEMENT DISCUSSION AND ANALYSIS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
OPERATING LOSS for the 13-weeks ended April 30, 2003 was $39 million, or
(0.6%) of sales, as compared to a loss of $1.01 billion, or (14.0%) of sales,
for the same period of the previous year. The decrease in operating loss was
primarily due to the 2002 charge for accelerated inventory markdowns of $625
million and the decrease in SG&A as previously discussed.
INTEREST EXPENSE, NET for the 13-weeks ended April 30, 2003 and May 1, 2002
was $57 million and $33 million, respectively. In connection with our emergence
from Chapter 11, we accelerated $12 million of the amortization of debt
issuances costs related to the Court-approved $2 billion debtor-in-possession
financing facility ("DIP Credit Facility") and recognized the expense in the
13-weeks ended April, 30, 2003. Interest at the stated contractual amount on
unsecured debt that was not charged to earnings for the 13-weeks ended April 30,
2003 and May 1, 2002 was $67 million and $69 million, respectively. Interest
expense is net of interest income of $1 million for each of the 13-weeks ended
April 30, 2003 and May 1, 2002.
The EFFECTIVE INCOME TAX rate was (0.7%) and (0.9%) for the 13-weeks ended
April 30, 2003 and May 1, 2002, respectively; see Note 16 - Income Taxes in
Item 8 of this Form 10-K for a more detailed discussion.
NON-GAAP MEASURES
Adjusted operating income is a non-GAAP measure. The Company has provided
this non-GAAP measure as we believe the significant gain on sales of assets
realized in fiscal 2004 do not reflect the results from our core business, and
they distort the ability to assess the quality of our earnings. This non-GAAP
measure provides a more meaningful comparison of our ongoing results and helps
facilitate an analysis of the Company's operating performance. In addition,
management excludes the effect of these gains when assessing the Company's
results for the period. This non-GAAP financial measure should be evaluated in
conjunction with, and is not a substitute for, GAAP financial measures.
Following is a reconciliation of adjusted results to GAAP results:
FISCAL YEAR 39-WEEKS ENDED 39-WEEKS ENDED 13-WEEKS ENDED FISCAL YEAR
(dollars in millions) 2004 JANUARY 26, 2005 JANUARY 28, 2004 APRIL 30, 2003 2002
- --------------------- ----------- ---------------- ---------------- -------------- -----------
Adjusted operating income (loss) $ 875 $ 742 $407 $(39) $(2,306)
Gain (loss) on sales of assets 946 914 89 -- (5)
------ ------ ---- ---- -------
GAAP operating income (loss) $1,821 $1,656 $496 $(39) $(2,311)
====== ====== ==== ==== =======
LIQUIDITY AND FINANCIAL CONDITION
Kmart
Since our emergence from Chapter 11, we have consistently improved our
liquidity, increasing our cash balance from April 30, 2003 of $1.2 billion to
$3.4 billion as of January 26, 2005. Main factors contributing to our cash
increase have been positive cash flows from operations of $1.8 billion and
proceeds from asset sales of $744 million. In addition, our significant cash and
cash equivalent balance provided us the ability to terminate the Credit Facility
(defined below) in January 2005, as further discussed below.
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.
Holdings
Upon the consummation of our merger with Sears, approximately $5 billion of
the combined company's cash will be used to pay cash consideration to Sears'
shareholders who elect to receive cash in lieu of stock or who have received a
prorated portion of the merger allocation of 55% stock, 45% cash. In addition, a
$4.0 billion revolving credit facility agreement will become effective and
available, as further discussed below. This credit facility will be available
for five years to fund working capital, capital expenditures, acquisitions and
other general corporate purposes.
19
MANAGEMENT DISCUSSION AND ANALYSIS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
We anticipate Holdings near-term use of liquidity to include: working
capital needs for seasonal inventory purchases, capital expenditures relating to
the conversion of Kmart stores to Sears stores, other working capital
requirements and, depending on market conditions, the possible retirement of
commercial paper. Additionally, Kmart is anticipating contributing approximately
$240 million in cash payments to its pension plan in fiscal 2005. It is
anticipated Holdings will satisfy these working capital requirements by
utilizing its cash flows from operations, cash and cash equivalents and
availability under the $4.0 billion revolving credit facility. However, Holdings
liquidity and financial covenants could be adversely affected by significant
negative sales trends, tightening of credit extended by Sears' and Kmart's
vendors, the inability to access the $4.0 billion revolving credit facility
and/or the impact of actual results which differ materially from those
projected.
In addition to near-term capital requirements, we expect Holdings long-term
liquidity requirements to include payments on Sears' debt, lease payments,
pension obligations and royalty license fees. Sears' term debt matures
periodically from 2005 though 2043. Kmart and Sears have substantial operating
and capital lease commitments over the next 5 years. Conversion of Kmart stores
to Sears stores and the potential for acquisition of real estate of leased
locations will also require additional capital. Achievement of long-term
liquidity requirements will be dependent on Holdings ability to generate cash
flows from operations, optimize its capital structure, generate returns on
pension plan assets and monetize non-core or unproductive assets. This
achievement will also depend on the outcome of material litigation, the effect
of material acquisitions and the realization of expected revenue synergies and
expense reductions from the merger.
LETTER OF CREDIT AGREEMENT
During fiscal 2004, the Company entered into a letter of credit agreement
(the "LC Agreement") with a commitment amount of up to $600 million. Standby
letters of credit issued under the LC Agreement bear interest at 0.20% per
annum. No interest is charged for trade letters of credit issued under the LC
Agreement; however, we are required to pay a fee on the cash collateral in
excess of the outstanding letters of credit equal to 0.125% per annum.
Under the terms of the LC Agreement, the Company has the ability to post
either cash or inventory as collateral. The cash collateral account is subject
to a pledge and security agreement pursuant to which the Company must maintain
cash in an amount equal to 100.5% of the face value of letters of credit
outstanding under the LC Agreement. Electing inventory would result in
incremental costs under the LC Agreement, and as of January 26, 2005, this
election has not been made. The Company has $323 million of cash posted as
collateral as of January 26, 2005. This cash is classified as Cash and cash
equivalents in the accompanying Consolidated Balance Sheet due to our ability to
post inventory as collateral at any time at our discretion.
The LC Agreement contains customary covenants, including covenants that
restrict our ability to incur or create liens on collateralized assets, and
sell, transfer, assign or otherwise dispose of any collateralized assets.
Failure to satisfy these covenants would result in an event of default that
could result in our inability to issue new letters of credit. As of January 26,
2005, and in all periods since inception of the LC Agreement, we have been in
compliance with all covenants of the LC Agreement.
CASH COLLATERAL
During fiscal 2004, we have replaced letters of credit used as collateral
for certain self-insurance programs with cash collateral which reduced fees paid
by the Company with respect to the letters of credit. We continue to classify
the cash collateral as Cash and cash equivalents due to our ability to convert
the cash to letters of credit at any time at our discretion. As of January 26,
2005, $261 million of cash was posted as collateral for our self-insurance
programs.
CREDIT FACILITY
Our credit agreement (the "Credit Facility") was an $800 million revolving
credit facility with an equivalent letter of credit sub-limit. In fiscal 2004,
we reduced the size, amended and restated our Credit Facility, and effective
January 3, 2005, we voluntarily terminated the Credit Facility. In conjunction
with these actions we accelerated the amortization of $23 million in associated
debt issuance costs. Since its issuance, we only used the Credit Facility to
support outstanding letters of credit.
20
MANAGEMENT DISCUSSION AND ANALYSIS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
CASH FLOWS
Operating activities provided net cash of $1,068 million in fiscal 2004.
Net income after gains on sales of assets after-tax of $579 and bankruptcy
related items after-tax of $37 million provided $490 million of operating cash
flow in the current year. This increase from earnings was due primarily to the
decrease in our SG&A expenses of $846 million; see Results of Operations for a
detailed explanation. Cash flows were also positively affected by improvements
in working capital, including incremental accounts payable due to improved terms
with our vendors and timing of receipts. Net cash provided for the 39-weeks
ended January 28, 2004 of $736 million was primarily driven by the reduction of
merchandise inventories of $1.2 billion on a same-store basis. Also net income,
excluding non-cash operating activities, provided $326 million in operating cash
flow. These items were partially offset by payments of $481 million for
bankruptcy exit costs and reorganization items. Net cash provided by operating
activities for the 13-weeks ended April 30, 2003 of $576 million was primarily
driven by a decrease in inventory of $480 million due to store liquidation sales
and improved inventory management, partially offset by a decrease in accounts
payable. Net cash provided by operating activities for fiscal 2002 of $88
million was affected by decreased payments on accounts payable due to the stay
of pre-petition liabilities following the Predecessor Company's filing for
protection under Chapter 11.
Net cash provided by investing activities was $332 million in fiscal 2004
due largely to proceeds of $444 million from the sale of owned and assignment of
leased properties to Sears and Home Depot (as defined below). We also received
$118 million of proceeds from the sale of real and personal property not
considered essential to our core operations. See Note 5 - Real Estate and
Property Transactions in Item 8 of this Form 10-K for a more detailed discussion
of these transactions. In fiscal 2004, we spent $124 million on the purchase of
31 previously leased properties. We also incurred costs of $106 million for
necessary capital expenditures, including $75 million for additions or
betterments to our stores or distribution centers. Net cash provided by
investing activities for the 39-weeks ended January 28, 2004 of $74 million was
due primarily to the sale of properties and other assets of $182 million,
partially offset by $108 million of costs incurred predominantly related to the
purchase of 17 stores and one distribution center that were previously leased
and capital expenditures for store maintenance. Net cash provided for the
13-weeks ended April 30, 2003 of $60 million was the result of proceeds of $64
million from the sale of four Kmart owned store locations and the sale of
furniture and fixtures from closed store locations. Net cash used for fiscal
2002 of $223 million was primarily due to capital expenditures for store
improvements.
Net cash used for financing activities was $53 million in fiscal 2004 due
to payments on capital lease obligations and mortgages payable. In addition, our
non-cash financing activity included the receipt of $88 million in treasury
stock as part of settlement agreements with past providers of our surety bonds
and critical vendor claims. See Note 4 - Emergence from Chapter 11 Bankruptcy
Protection and Fresh-Start Accounting in Item 8 of this Form 10-K for a more
detailed description. For the 39-weeks ended January 28, 2004, financing
activities provided $46 million. In this period, the Company received proceeds
of $140 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 upon emergence from Chapter 11. The positive effect of these items was
partially offset by payments made for other financing arrangements, including
capital lease obligations and mortgages on properties we own. Net cash used
during the 13-weeks ended April 30, 2003 of $17 million was primarily due to
payments on debt and capital lease obligations. Net cash used in fiscal 2002 of
$497 million was due primarily to the repayment of the DIP Credit Facility and
payments on capital leases.
The Company has a share repurchase program with authorization to repurchase
$100 million in Common Stock. At January 26, 2005, 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.
21
MANAGEMENT DISCUSSION AND ANALYSIS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
In fiscal 2004, the Company contribution to the plans was approximately $11
million. The minimum funding requirement for 2005 is $4 million; however the
Company intends to make a $240 million voluntary contribution to the pension
plan in fiscal 2005.
REAL ESTATE TRANSACTIONS
Home Depot U.S.A., Inc.
During fiscal 2004, the Company entered into multiple agreements with Home
Depot U.S.A., Inc. (a subsidiary of The Home Depot, Inc.) ("Home Depot") to sell
four properties and assign 14 properties for an aggregate purchase price of $271
million. Pursuant to 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. The Company completed the assignment of
13 of the remaining properties in the third quarter of fiscal 2004, resulting in
proceeds to the Company of $200 million in cash, and a gain of $198 million. We
closed on the final property during the fourth quarter, resulting in additional
proceeds of $12 million in cash and a gain of $12 million.
Sears, Roebuck and Co.
On September 29, 2004, the Company agreed to sell four owned properties,
assign 45 leased properties and lease one owned store to Sears for a total
purchase price of approximately $576 million. The Company received 30% of the
purchase price in September 2004, upon closing, and recognized a gain on the
transaction of $599 million. Under the original terms of the Asset Purchase
Agreement for this transaction, the remaining 70% of the purchase price is to be
received when Sears occupies the properties, which was originally scheduled to
be no later than April 15, 2005. The parties intend to amend the Asset Purchase
Agreement to provide that such occupancy delivery dates, and payment dates, for
certain of the stores will be later than April 15, 2005, which will affect the
amount and timing of the Company's receipt of cash. The receivable for the
remaining purchase price of $403 million is included in Accounts receivable, net
in our Consolidated Balance Sheet at January 26, 2005.
HOLDINGS CREDIT FACILITY
On February 22, 2005, Holdings entered into a $4.0 billion revolving credit
facility agreement. The credit facility will become effective only upon
consummation of the business combination between Kmart and Sears, which is
subject to shareholder approval and other conditions, and is expected to occur
in March 2005.
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 the Chapter 11 proceedings. For the 13-weeks ended April 30,
2003 and fiscal year 2002, the Predecessor Company recorded special charges of
$42 million and $1.63 billion, respectively. For a comprehensive discussion see
Note 22 in Item 8 of this Form 10-K.
REORGANIZATION ITEMS, NET
Reorganization items represent amounts the Predecessor Company incurred as
a result of Chapter 11, and are presented separately in the accompanying
Consolidated Statements of Operations as required by SOP 90-7. The Predecessor
Company recorded $769 million and $363 million for the 13-weeks ended April 30,
2003 and fiscal year 2002, respectively, for reorganization items. The net
increase in Reorganization items for the 13-weeks ended April 30, 2003 as
compared to fiscal 2002, is primarily due to the settlement with Fleming
Corporation of its $1.5 billion claim against the Predecessor Company for $385
million, expense of $200 million for estimated claims for rejected executory
contracts and the charge of $158 million for store closings in fiscal 2003,
partially offset by the charge of $185 million for store closings in fiscal
2002. For a comprehensive discussion see Note 23 in Item 8 of this Form 10-K.
22
MANAGEMENT DISCUSSION AND ANALYSIS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
DISCONTINUED OPERATIONS
The Company applied the provisions of SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets," to the stores sold in fiscal 2004,
and determined that none of the stores met the criteria to be accounted for as
discontinued operations.
During the first quarter of fiscal 2003 and the second quarter of fiscal
2002, the Predecessor Company closed 316 and 283 stores, respectively. Of the
total store closings 121 met the criteria for discontinued operations. For a
comprehensive discussion see Note 21 in Item 8 of this Form 10-K.
Of the 599 stores that were closed in fiscal years 2003 and 2002, 478 are
included in continuing operations, as they did not meet the criteria for
discontinued operations. For the 13-weeks ended April 30, 2003, 250 of the 316
stores closed were accounted for in continuing operations. Total sales, gross
margin and SG&A for these 250 stores were $854 million, $301 million and $146
million, respectively. For fiscal 2002, total sales, gross margin and SG&A for
the 478 closed stores that were reported in continuing operations were $4.95
billion, $890 million and $1.02 billion, respectively.
CONTRACTUAL OBLIGATIONS AND OTHER COMMERCIAL COMMITMENTS
Information concerning our obligations and commitments to make future
payments under contracts such as debt and lease agreements, and under contingent
commitments is aggregated in the following tables.
PAYMENTS DUE BY PERIOD
--------------------------------------------------------------
CONTRACTUAL OBLIGATIONS (DOLLARS IN MILLIONS) TOTAL WITHIN 1 YEAR 2-3 YEARS 4-5 YEARS AFTER 5 YEARS
- --------------------------------------------- ------ ------------- --------- --------- -------------
Operating leases $4,397 $ 451 $ 820 $ 679 $2,447
Purchase obligations 1,311 1,307 4 - --
Capital lease obligations 750 103 150 129 368
Royalty license fees 304 96 171 37 --
Pension funding obligations 979 4 558 417 --
Long-term debt 112 4 69 11 28
------ ------ ------ ------ ------
Total contractual cash obligations $7,853 $1,965 $1,772 $1,273 $2,843
====== ====== ====== ====== ======
AMOUNT OF COMMITMENT EXPIRATION PER PERIOD
-------------------------------------------------------------
OTHER COMMERCIAL COMMITMENTS (DOLLARS IN MILLIONS) TOTAL WITHIN 1 YEAR 2-3 YEARS 4-5 YEARS AFTER 5 YEARS
- -------------------------------------------------- ----- ------------- --------- --------- -------------
Standby letters of credit $156 $156 $-- $-- $--
Trade letters of credit 166 166 -- -- --
---- ---- --- --- ---
Total commercial commitments $322 $322 $-- $-- $--
==== ==== === === ===
Purchase obligations consist of services and goods the Company is committed
to purchasing in the ordinary course of business, primarily merchandise
inventories. Purchase obligations do not include contracts the Company can
terminate without cause, on 30 to 60 days notice, with little or no penalty to
the Company.
We pay royalties under various merchandise license agreements, which are
generally based on sales of products covered under these agreements. We
currently have license agreements for which we pay royalties to use the Thalia
Sodi, Jaclyn Smith, Joe Boxer, Martha Stewart Everyday, and Route 66 trademark.
Royalty license fees represent the minimum we are obligated to pay, regardless
of sales, as guaranteed royalties under our various merchandise license
agreements. If sales for products included in these agreements exceed certain
thresholds, we would be obligated to pay more than the minimum guaranteed.
23
MANAGEMENT DISCUSSION AND ANALYSIS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
OTHER MATTERS
LAWSUITS, INVESTIGATIONS AND OTHER CONTINGENT LIABILITIES
We are a party to 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 the Successor Company upon emergence from Chapter
11 or relates to a time period occurring after the Petition Date, the Successor
Company shall be responsible for any damages which may result. In addition,
certain contracts allow for damage provisions or other repayments as a result of
our termination of the contracts. For a comprehensive discussion see Note 24 in
Item 8 of this Form 10-K.
OTHER
On March 2, 2004, Footstar, Inc. ("FTS") and its direct and indirect
subsidiaries, including the 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. Kmart is a party to a master agreement with FTS that
provides FTS with a non-transferable, exclusive right and license to operate the
footwear departments in Kmart stores. Subsidiaries of Meldisco, substantially
all of which are 49% owned by Kmart and 51% owned by FTS, operate the footwear
departments pursuant to license agreements between those subsidiaries and Kmart.
On August 12, 2004, FTS filed a motion with the bankruptcy court to assume
the master agreement and the license agreements. On September 30, 2004, the
Company objected to that motion, and also filed a separate motion to terminate
the master agreement and the license agreements because of various defaults by
FTS under the master agreement. On February 16, 2005, the bankruptcy court
overruled one of the Company's objections to assumption of the master agreement.
The bankruptcy court has yet to rule on the Company's several other grounds for
objecting to assumption and moving to terminate the master agreement. Should the
bankruptcy court overrule the Company's objection in its entirety and permit FTS
to assume the master agreement and the license agreements, FTS must cure all
past defaults under those agreements. On July 26, 2004, the Company filed a
proof of claim in the FTS bankruptcy case for an amount in excess of our
recorded receivable of $24 million. The Company believes the cure amount may be
substantially in excess of $24 million. FTS asserts that the amount required to
cure past defaults is not more than $19 million, and that such amount should be
reduced by overpayments FTS alleges it made to the Company for certain fees. If
no resolution is achieved consensually with FTS with respect to the assumption
of the master agreement, the license agreements and the cure amount, and the
bankruptcy court permits FTS to assume the master agreement and the license
agreements, the cure amount will be determined by the bankruptcy court.
FTS filed a proposed plan of reorganization with the bankruptcy court on
November 12, 2004. Kmart's results, with respect to the footwear master
agreement, may be affected by whether (i) FTS is authorized by the bankruptcy
court to assume the master agreement and the license agreements, obtains
bankruptcy court approval of its plan of reorganization and successfully emerges
from bankruptcy; (ii) FTS is able to successfully manage its business in the
future and achieve the results projected in its plan of reorganization; or (iii)
Kmart's motion to terminate the master and license agreements is granted or FTS
fails to obtain bankruptcy court approval of its plan of reorganization, which
would cause Kmart to pursue alternative arrangements including potentially
sourcing footwear merchandise directly.
The Capital One and Capital Factors lawsuits, each more fully described in
Note 24 in Item 8 of this Form 10-K, together have the potential to have a
material favorable effect on our financial statements. At the current time the
ultimate amount of recovery on each of these matters cannot be determined and
any individual recovery may not have a material effect on our financial
statements.
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 issuers of pre-petition bonds.
On February 11, 2005, the Company filed an amendment to our Annual Report
on Form 10-K for the year ended January 28, 2004. The Company also amended our
10-Q's for the three periods subsequent to January 28, 2004. Such amendments
reflect the recognition of an embedded beneficial conversion feature of our
convertible note issued upon emergence from bankruptcy. Amounts restated in our
amended filings have been reflected within this Annual Report on Form 10-K for
the year ended January 26, 2005.
24
MANAGEMENT DISCUSSION AND ANALYSIS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
Merger Litigation
Following the announcement of the proposed merger with Sears on November
17, 2004, several actions have been filed purporting to challenge the merger, as
follows:
Three cases, styled William Fischer v. Sears, Roebuck and Co., et al. (Case
No. 04 CH 19137), City of Dania Beach Police & Firefighters Retirement System v.
Sears, Roebuck and Co. et al. (Case No. 04 CH 19548) and Central Laborers
Pension Fund v. Sears, Roebuck and Co. et al. (Case No. 04 CH 19435), have been
filed in the Circuit Court of Cook County, Illinois, Chancery Division. These
cases assert claims on behalf of a purported class of Sears stockholders against
Sears and certain of its officers and directors, together with Kmart, Edward S.
Lampert, William C. Crowley and other affiliated entities, related to an alleged
breach of fiduciary duty in connection with the mergers. The plaintiffs allege
that the merger favors interested defendants by awarding them disproportionate
benefits, and that the defendants failed to take appropriate steps to maximize
the value of a merger transaction for Sears stockholders. The complaints seek
provisional and permanent injunctive relief; the Fischer complaint also seeks
damages. The cases have been reassigned to a single judge and the plaintiffs
have filed a consolidated and amended complaint. On February 1, 2005, the court
granted the defendants motion to stay or dismiss these Illinois actions in favor
of the pending New York action discussed immediately below. Accordingly, these
actions are stayed pending resolution of the New York actions discussed below.
Plaintiffs have filed a notice of appeal of the stay order to the Appellate
Court of Illinois - First District.
Two cases, styled Gershon Chanowitz, et al. v. Hall Adams, Jr., et al.
(Index No. 04/603903) and Nathan Krantman v. William Bax, et al. (index
04/603889), have been filed in the Supreme Court of the State of New York, New
York County. On February 15, 2005 the Court ordered that the two cases be
consolidated as a single action. On February 16, 2005, the plaintiff's filed a
superceding consolidated Amended Class Action Complaint. The consolidated
complaint asserts claims on behalf of a purported class of Sears stockholders
against Sears and certain of its officers and directors for breach of fiduciary
duty in connection with the mergers on the grounds that the defendants allegedly
failed to take appropriate steps to maximize the value of a merger transaction
for Sears stockholders. Plaintiffs also have named Kmart, Edward S. Lampert, and
ESL Investments, Inc. as defendants on the ground that they aided and abetted
the alleged breaches of fiduciary duty. Additionally, the plaintiffs claim that
the defendants have made insufficient and misleading disclosures in connection
with the mergers. The complaint seeks provisional and permanent injunctive
relief, as well as damages. Also, on February 16, 2005, the plaintiffs filed an
order to show cause seeking expedited discovery about the appraisal of Sears'
real estate. A briefing schedule on the motion has not yet been set. On February
25, 2005, Defendants filed a motion to dismiss the complaint.
The lawsuits are in their preliminary stages, and it is impossible to
predict their outcome at this time. Kmart intends to defend itself vigorously in
respect of the claims asserted against it.
STORE ACTIVITY
During fiscal 2004, the Company purchased 31 previously leased store
locations; sold owned or assigned leases for 20 store locations; closed five
stores; and allowed leases for an additional six stores to expire. As of January
26, 2005, we operated 1,480 stores.
NEW ACCOUNTING PRONOUNCEMENTS
In November 2004, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 151, "Inventory Costs - an Amendment of ARB No. 43, Chapter 4" ("SFAS
No. 151"). SFAS No. 151 clarifies that abnormal amounts of idle facility
expense, freight, handling costs, and wasted materials (spoilage) should be
recognized as current-period charges. In addition, SFAS No. 151 requires the
allocation of fixed production overheads to the cost of conversion be based on
the normal capacity of the production facilities. SFAS No. 151 is effective for
fiscal years beginning after June 15, 2005. We do not anticipate any effect on
the Company upon adoption of SFAS No. 151.
In December 2004, the FASB issued SFAS No. 123 (revised 2004), "Share-Based
Payment" ("SFAS No. 123(R)"). SFAS 123(R) establishes standards for the
accounting for share-based payment transactions in which an entity received
employee services in exchange for either equity instruments of the entity or
liabilities that are based on the fair value of the Company's equity instruments
or that may be settled by the issuance of such equity instruments. SFAS 123(R)
requires all share-based payments to employees, including grants of employee
stock options, to be recognized in the income statement based on the fair value
at grant date. There was no effect to the Company upon the adoption of SFAS No.
123(R) as our current accounting for stock-based compensation conforms to this
requirement.
25
MANAGEMENT DISCUSSION AND ANALYSIS - (CONTINUED)
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
We have reviewed all new applicable guidance and do not deem any other new
standards to have a significant effect on the Company's financial statements.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
At January 26, 2005, 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.
26
Item 8. Financial Statements and Supplementary Data
The following information is submitted pursuant to the requirements of Item 8:
Page
----
Consolidated Statements of Operations
Successor Company - for the year ended January 26, 2005 and
the 39-weeks ended January 28, 2004
Predecessor Company - for the 13-weeks ended April 30, 2003 and
year ended January 29, 2003........................................... 28
Consolidated Balance Sheets
Successor Company - as of January 26, 2005 and January 28, 2004.......... 29
Consolidated Statements of Cash Flows
Successor Company - for the year ended January 26, 2005 and the 39-weeks
ended January 28, 2004
Predecessor Company - for the 13-weeks ended April 30, 2003 and
year ended January 29, 2003........................................... 30
Consolidated Statements of Shareholders' Equity (Deficit)
Successor Company - for the year ended January 26, 2005 and
the 39-weeks ended January 28, 2004
Predecessor Company - for the 13-weeks ended April 30, 2003 and
year ended January 29, 2003........................................... 31
Notes to Consolidated Financial Statements............................... 32
Schedule II - Valuation and Qualifying Accounts.......................... 63
Management's Annual Report on Internal Control Over
Financial Reporting................................................... 64
Management's Responsibility for Financial Statements..................... 65
Independent Registered Public Accounting Firm Report on Internal
Controls.............................................................. 66
Reports of Independent Registered Public Accounting Firm................. 67
27
CONSOLIDATED STATEMENTS OF OPERATIONS
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
SUCCESSOR COMPANY PREDECESSOR COMPANY
------------------------------ ----------------------------
FISCAL YEAR 39-WEEKS ENDED 13-WEEKS ENDED FISCAL YEAR
2004 JANUARY 28, 2004 APRIL 30, 2003 2002
----------- ---------------- -------------- -----------
Sales $19,701 $17,072 $6,181 $29,352
Cost of sales, buying and occupancy 14,670 13,084 4,762 24,842
------- ------- ------ -------
Gross margin 5,031 3,988 1,419 4,510
Selling, general and administrative expenses 4,156 3,581 1,421 6,242
Net (gain) loss on sales of assets (946) (89) -- 5
Restructuring, impairment and other charges -- -- 37 574
------- ------- ------ -------
Operating income (loss) 1,821 496 (39) (2,311)
Interest expense, net 108 127 57 155
Bankruptcy-related recoveries (59) (4) -- --
Equity income in unconsolidated subsidiaries (3) (5) (7) (34)
Reorganization items, net -- -- 769 363
------- ------- ------ -------
Income (loss) from continuing operations before income taxes 1,775 378 (858) (2,795)
Provision for (benefit from) income taxes 669 144 (6) (24)
------- ------- ------ -------
Income (loss) from continuing operations 1,106 234 (852) (2,771)
Discontinued operations (net of income taxes of $0) -- -- (10) (448)
------- ------- ------ -------
Net income (loss) $ 1,106 $ 234 $ (862) $(3,219)
======= ======= ====== =======
Basic income (loss) per common share from continuing operations $ 12.39 $ 2.61 $(1.63) $ (5.47)
Discontinued operations -- -- (0.02) (0.89)
------- ------- ------ -------
Basic net income (loss) per common share $ 12.39 $ 2.61 $(1.65) $ (6.36)
======= ======= ====== =======
Diluted income (loss) per common share from continuing operations $ 11.00 $ 2.51 $(1.63) $ (5.47)
Discontinued operations -- -- (0.02) (0.89)
------- ------- ------ -------
Diluted net income (loss) per common share $ 11.00 $ 2.51 $(1.65) $ (6.36)
======= ======= ====== =======
Basic weighted average shares (millions) 89.3 89.6 522.7 506.4
Diluted weighted average shares (millions) 101.4 93.3 522.7 506.4
See accompanying Notes to Consolidated Financial Statements
28
CONSOLIDATED BALANCE SHEETS
(DOLLARS IN MILLIONS EXCEPT SHARE DATA)
JANUARY 26, 2005 JANUARY 28, 2004
---------------- ----------------
ASSETS
CURRENT ASSETS
Cash and cash equivalents $3,435 $2,088
Merchandise inventories 3,281 3,238
Accounts receivable, net 646 301
Other current assets 179 184
------ ------
TOTAL CURRENT ASSETS 7,541 5,811
Property and equipment, net 315 153
Deferred tax asset 726 33
Other assets and deferred charges 69 77
------ ------
TOTAL ASSETS $8,651 $6,074
====== ======
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES
Mortgages payable due within one year $ 4 $ 4
Accounts payable 1,092 820
Accrued expenses and other liabilities 717 671
Taxes other than income taxes 273 281
------ ------
TOTAL CURRENT LIABILITIES 2,086 1,776
LONG-TERM LIABILITIES
Long-term debt and mortgages payable 91 76
Capital lease obligations 276 374
Pension obligations 1,004 873
Unfavorable operating leases 294 342
Other long-term liabilities 431 424
------ ------
TOTAL LIABILITIES 4,182 3,865
SHAREHOLDERS' EQUITY
Preferred stock 20,000,000 shares authorized; no shares outstanding -- --
Common stock $0.01 par value, 500,000,000 shares authorized;
88,693,006 and 89,633,760 shares issued, respectively 1 1
Treasury stock, at cost (86) (1)
Capital in excess of par value 3,291 1,974
Retained earnings 1,340 234
Accumulated other comprehensive (loss) income (77) 1
------ ------
TOTAL SHAREHOLDERS' EQUITY 4,469 2,209
------ ------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $8,651 $6,074
====== ======
See accompanying Notes to Consolidated Financial Statements
29
CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN MILLIONS)
SUCCESSOR COMPANY PREDECESSOR COMPANY
------------------------------ -----------------------------
39-WEEKS 13-WEEKS
FISCAL YEAR ENDED ENDED FISCAL YEAR
2004 JANUARY 28, 2004 APRIL 30, 2003 2002
----------- ---------------- -------------- ------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss) $1,106 $ 234 $ (862) $(3,219)
Adjustments to reconcile net income (loss) to net cash
provided by operating activities:
Depreciation and amortization 69 53 177 737
Store closings inventory charges 14 -- -- --
Net (gain) loss on sales of assets (946) (89) -- 5
Net gain on bankruptcy-related settlements (59) (4) -- --
Deferred income taxes 597 137 -- --
Equity income in unconsolidated subsidiaries (3) (5) (7) (34)
Restructuring, impairments and other charges -- -- 44 2,036
Reorganization items, net -- -- 769 363
Net cash received from bankruptcy-related settlements 10 4 -- --
Dividends received from Meldisco 3 -- 36 45
Cash used for store closings and other charges -- (15) (64) (134)
Cash used for payments of exit costs and other
reorganization items -- (481) (19) (135)
Change in:
Merchandise inventories (57) 1,193 480 (168)
Accounts receivable 44 86 114 68
Accounts payable 272 (340) (117) 401
Taxes payable 77 (197) (16) 23
Other assets 53 34 9 33
Other liabilities (112) 126 32 67
------ ------ ------ -------
NET CASH PROVIDED BY OPERATING ACTIVITIES 1,068 736 576 88
------ ------ ------ -------
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from sales of assets 562 182 64 29
Capital expenditures (230) (108) (4) (252)
------ ------ ------ -------
NET CASH PROVIDED BY (USED FOR) INVESTING ACTIVITIES 332 74 60 (223)
------ ------ ------ -------
CASH FLOWS FROM FINANCING ACTIVITIES
Payments on capital lease obligations (49) (75) (16) (94)
Payments on debt (4) (37) (1) (31)
Debt issuance costs -- (48) -- (42)
Fees paid to Plan Investors -- (13) -- --
Purchase of treasury stock -- (4) -- --
Issuance of common shares -- 140 -- --
Proceeds from issuance of debt -- 83 -- --
Net payments for DIP Credit Facility -- -- -- (330)
------ ------ ------ -------
NET CASH (USED FOR) PROVIDED BY FINANCING ACTIVITIES (53) 46 (17) (497)
------ ------ ------ -------
NET CHANGE IN CASH AND CASH EQUIVALENTS 1,347 856 619 (632)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 2,088 1,232 613 1,245
------ ------ ------ -------
CASH AND CASH EQUIVALENTS, END OF PERIOD $3,435 $2,088 $1,232 $ 613
====== ====== ====== =======
SUPPLEMENTAL DISCLOSURE ABOUT NONCASH INVESTING AND
FINANCING ACTIVITIES:
Bankruptcy related settlements resulting in the
receipt of treasury stock $ 88 $ -- $ -- $ --
====== ====== ====== =======
Sale of owned and assignment of leased properties $ 403 $ -- $ -- $ --
====== ====== ====== =======
Issuances of common stock for convertible preferred
securities $ -- $ -- $ -- $ 244
====== ====== ====== =======
See accompanying Notes to Consolidated Financial Statements
30
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (DEFICIT)
(DOLLARS AND SHARES IN MILLIONS)
CAPITAL RETAINED ACCUMULATED
IN EXCESS EARNINGS/ OTHER
NUMBER COMMON TREASURY OF PAR (ACCUMULATED COMPREHENSIVE
OF SHARES STOCK STOCK VALUE DEFICIT) INCOME (LOSS) TOTAL
--------- ------ -------- --------- ------------ ------------- -------
BALANCE AT JANUARY 30, 2002 - PREDECESSOR
COMPANY 503 $ 503 $ -- $ 1,695 $ 1,384 $ (352) $ 3,230
Comprehensive Loss
Net loss -- -- -- -- (3,219) -- (3,219)
Additional minimum pension liability
adjustment -- -- -- -- -- (554) (554)
Market value adjustment for investments -- -- -- -- -- (1) (1)
-------
TOTAL COMPREHENSIVE LOSS (3,774)
Conversion of preferred securities 17 17 -- 227 -- -- 244
Cancellation of restricted stock (1) (1) -- -- -- -- (1)
---- ----- ---- ------- ------- ------ -------
BALANCE AT JANUARY 29, 2003 - PREDECESSOR
COMPANY 519 519 -- 1,922 (1,835) (907) (301)
Comprehensive Loss
Net loss excluding Plan of Reorganization
and Fresh-Start Accounting Adjustments -- -- -- -- (855) -- (855)
-------
TOTAL COMPREHENSIVE LOSS (855)
Conversion of preferred securities 18 18 -- 241 -- -- 259
---- ----- ---- ------- ------- ------ -------
BALANCE PRIOR TO APPLICATION OF FRESH-START
ACCOUNTING 537 537 -- 2,163 (2,690) (907) (897)
Adjust pension plan to fair market value -- -- -- -- -- (94) (94)
Cancellation of Predecessor Company equity
and application of Fresh-Start accounting (537) (537) -- (2,163) 2,690 1,001 991
Capitalization of Successor Company 90 1 -- 1,743 -- -- 1,744
---- ----- ---- ------- ------- ------ -------
BALANCE AT APRIL 30, 2003 - SUCCESSOR COMPANY 90 1 -- 1,743 -- -- 1,744
Comprehensive Income
Net income -- -- -- -- 234 -- 234
Market value adjustment for investments -- -- -- -- -- 1 1
-------
TOTAL COMPREHENSIVE INCOME 235
Unearned compensation -- -- 3 (3) -- -- --
Pre-petition tax settlements/valuation
reserve adjustments -- -- -- 233 -- -- 233
Purchase of treasury stock -- -- (4) -- -- -- (4)
Other -- -- -- 1 -- -- 1
---- ----- ---- ------- ------- ------ -------
BALANCE AT JANUARY 28, 2004 - SUCCESSOR
COMPANY 90 1 (1) 1,974 234 1 2,209
Comprehensive Income
Net income -- -- -- -- 1,106 -- 1,106
Minimum pension liability adjustment, net of
tax -- -- -- -- -- (77) (77)
Market value adjustment for investments -- -- -- -- -- (1) (1)
-------
TOTAL COMPREHENSIVE INCOME 1,028
Unearned compensation -- -- 4 2 -- -- 6
Pre-petition tax settlements/valuation reserve
adjustments -- -- -- 1,297 -- -- 1,297
Bankruptcy related settlement agreements (1) -- (88) 18 -- -- (70)
Other -- -- (1) -- -- -- (1)
---- ----- ---- ------- ------- ------ -------
BALANCE AT JANUARY 26, 2005 - SUCCESSOR
COMPANY 89 $ 1 $(86) $ 3,291 $ 1,340 $ (77) $ 4,469
==== ===== ==== ======= ======= ====== =======
See accompanying Notes to Consolidated Financial Statements
31
NOTES TO 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 1,480 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 Consolidated Financial Statements have been prepared in conformity
with accounting principles generally accepted in the United States of America on
a consistent basis applying certain estimates and judgments based upon currently
available information and management's view of current conditions and
circumstances. On this basis, we believe that these financial statements
reasonably present the financial position and results of operations of Kmart
Holding Corporation. Certain prior period amounts have been reclassified to
conform to the current year 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
Consolidated Statements of Operations. See Note 4 - Emergence from Chapter 11
Bankruptcy Protection and Fresh-Start Accounting for a more detailed discussion
of the Company's Chapter 11 proceedings.
2) MERGER WITH SEARS, ROEBUCK AND CO.
On November 17, 2004, Kmart and Sears, Roebuck and Co. ("Sears") announced
a business combination pursuant to an Agreement and Plan of Merger, dated as of
November 16, 2004 (the "Merger Agreement"). The combined company will be a new
retail company named Sears Holdings Corporation ("Holdings"). Upon the
consummation of the merger, which is subject to shareholder approval and other
conditions, Kmart and Sears will become wholly-owned subsidiaries of Holdings.
Holdings is expected to be the third largest retailer in the United States,
initially with approximately $55 billion in annual revenues and with
approximately 3,800 full-line and specialty retail stores in the United States
and Canada.
Under the terms of the Merger Agreement, Kmart shareholders will receive
one share of Holdings common stock for each Kmart share owned. Sears
shareholders have the right to elect $50 in cash or 0.5 of a share of Holdings
for each Sears share. Sears shareholder elections will be prorated to ensure
that in the aggregate 55 percent of Sears shares are converted into Holdings
shares and 45 percent of Sears shares are converted to cash. An aggregate of
approximately 61 million shares of Holdings common stock will be issued and
approximately $5 billion in cash will be paid in consideration for (i) all
outstanding common stock of Sears based upon the proration provisions set forth
above, and the exchange ratio of 0.5 of a share of Holdings common stock for one
share of Sears common stock and (ii) all outstanding stock options of Sears.
Approximately 95 million shares of Holdings common stock will be issued in
exchange for all outstanding common stock of Kmart based on the one-for-one
exchange ratio. As a result of the merger, the former shareholders of Kmart will
have an approximate 63% interest in Holdings (assuming the exercise of certain
options) and the former shareholders of Sears will have an approximate 37%
interest in Holdings.
The merger will be treated as a purchase business combination for
accounting purposes, and Sears' assets acquired and liabilities assumed will be
recorded at their fair values.
In several circumstances involving a change in a board's recommendation in
favor of the merger agreement or a third party acquisition proposal, Kmart may
become obligated to pay up to $380 million in termination fees, and Sears may be
obligated to pay up to $400 million in termination fees. In addition, if Sears
stockholders do not approve the merger agreement, Sears must reimburse Kmart for
all costs and expenses incurred by Kmart in connection with the merger agreement
up to $10 million.
32
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
ESL Investments, Inc. ("ESL") and its affiliates will beneficially own
between approximately 40% and 44% of Holdings common stock, including options to
purchase approximately 6.5 million shares of Holdings common stock, assuming
that approximately 156 million shares of Holdings common stock will be issued in
the merger. The actual ownership percentage will depend on the actual number of
shares of Holdings common stock that are issued in the merger and the elections
that Sears stockholders make. Prior to the merger, ESL and its affiliates
beneficially own approximately 14% of the outstanding shares of Sears common
stock.
Holdings common stock will be traded on the NASDAQ Stock Market under the
symbol "SHLD."
3) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Operations: Kmart operates discount department stores located in
49 states, Puerto Rico, the U.S. Virgin Islands and Guam and through its
e-commerce shopping site, www.kmart.com. We have one operating segment that
comprises our retail business.
Basis of Consolidation: The Consolidated Financial Statements include all
majority-owned subsidiaries in which we exercise control. Investments in which
we exercise significant influence, but which we do not control (generally 20% to
50% ownership interest), are accounted for under the equity method of
accounting. All material intercompany transactions and balances have been
eliminated.
Cash: Cash and cash equivalents include money market funds and all
highly-liquid investments with maturities of three months or less. Included are
temporary investments of $3.3 billion and $1.9 billion at January 26, 2005 and
January 28, 2004, respectively.
Merchandise Inventories: Merchandise inventories are stated at the lower of
cost or market, primarily under the retail inventory accounting method using the
first-in, first-out (FIFO) basis. The Predecessor Company method of accounting
for merchandise inventories was the last-in, first-out (LIFO) method. In
connection with Fresh-Start accounting (defined in Note 4 - Emergence from
Chapter 11 Bankruptcy Protection and Fresh-Start Accounting), we have elected
the FIFO method of accounting for merchandise inventories. We believe that this
change provides a better matching of expenses and revenues given falling product
costs that have resulted in the value of merchandise inventories under the LIFO
method approximating replacement cost on a FIFO basis. As part of the provisions
of Fresh-Start accounting, we did not restate our financial statements for prior
periods for the change in accounting method.
The Predecessor Company recorded a LIFO credit of $25 million and $79
million to decrease the LIFO reserve in the 13-weeks ended April, 30, 2003 and
fiscal 2002, respectively.
Allowance for Doubtful Accounts: The Company provides an allowance for
doubtful accounts based on historical experience and on a specific
identification basis. Allowances for doubtful accounts on accounts receivable
balances were $40 million and $78 million as of January 26, 2005 and January 28,
2004, respectively.
Property and Equipment: Property and equipment are recorded at cost.
Additions and betterments are capitalized and include expenditures that
materially extend the useful lives of existing facilities and equipment.
Maintenance and repairs that do not materially improve or extend the lives of
the respective assets are expensed as incurred.
Long-lived Assets: Long-lived assets consist primarily of land, buildings,
furniture, fixtures and equipment and leasehold improvements. It is our policy
to review our long-lived assets for possible impairment whenever events or
circumstances indicate that the carrying amount of an asset may not be
recoverable and annually when no such event has occurred. We review assets held
and used on a store-level basis, which is the lowest level of assets for which
there are identifiable cash flows. An impairment of long-lived assets exists
when future undiscounted cash flows are less than an asset groups' carrying
value over the estimated remaining useful life of the store. Impairment is
measured as the difference between carrying value and fair market value. Fair
market value is based on appraised value or estimated sales values of similar
assets in recent transactions. Assets to be disposed of are reported at the
lower of carrying amount or fair value less the cost to sell.
Capitalized Software Costs: Costs associated with the acquisition or
development of software for internal use are capitalized and amortized using the
straight-line method over the expected useful life of the software, which ranges
from 3 to 7 years.
33
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
Depreciation and Amortization: Depreciation and amortization, including
depreciation of property held under capital leases, are computed based upon the
estimated useful lives of the respective assets using the straight-line method
for financial statement purposes, and accelerated methods for tax purposes. The
range of lives are generally 25 to 50 years for buildings, 3 to 20 years for
furniture, fixtures and equipment, and 3 to 7 years for computer systems and
computer equipment. Leasehold improvement lives can vary from the remaining life
of the existing term of a lease up to a maximum of 25 years.
Credit Risk: Financial instruments which potentially subject us to
concentration of credit risk consist principally of temporary cash investments
and accounts receivable. We place our cash and cash equivalents in
investment-grade, short-term instruments with high quality financial
institutions and, by policy, limit the amount of credit exposure in any one
financial instrument. We perform ongoing credit evaluations of our customers'
financial condition and generally, require no collateral from our customers.
Financial Instruments: Cash and cash equivalents, accounts receivable,
trade accounts payable, credit facilities and accrued liabilities are reflected
in our financial statements at cost, which approximates fair value due to the
short-term nature of these instruments. The fair value of our debt is discussed
in Note 9 - Long-Term Debt and Mortgages Payable.
Derivative Instruments and Hedging Activities: We do not engage in hedging
transactions or invest in derivative instruments.
Self-insurance: We self-insure or retain a portion of the exposure for
losses related to workers compensation, health care benefits and general
liability costs. It is our policy to record our self-insurance reserves, as
determined actuarially, based upon claims filed and an estimate of claims
incurred but not yet reported.
Revenue Recognition: We recognize revenue from the sale of merchandise at
the time the merchandise is sold, net of anticipated returns. We defer the
recognition of layaway sales and profit until the period the merchandise is
delivered to the customer. Our deferred revenue is recorded in Accrued expenses
and other liabilities in the accompanying Consolidated Balance Sheets.
Cost of Sales, Buying and Occupancy: Cost of sales, buying and occupancy
includes the cost of merchandise, freight charges, distribution expenses,
including receiving costs, inspection costs and warehousing costs, store
occupancy and inventory procurement expenses.
Vendor Rebates and Allowances: Payments from vendors in the form of buy
downs, volume or other purchase discounts that are evidenced by signed
agreements are reflected in the carrying value of the merchandise inventories
when earned and as a component of Cost of sales, buying and occupancy as the
merchandise is sold. Up-front consideration received from vendors linked to
purchases or other commitments is initially deferred and amortized ratably to
Cost of sales, buying and occupancy over the life of the contract or as
performance of the activities specified by the vendor to earn the fee is
completed. Upon the adoption of Emerging Issues Task Force ("EITF") Issue No.
02-16, "Accounting by a Customer (Including a Reseller) for Certain
Consideration Received from a Vendor" ("EITF 02-16") in the fourth quarter of
fiscal 2002, we began classifying co-op advertising credits as a reduction to
Cost of sales, buying and occupancy. Prior to the adoption of EITF 02-16, these
costs were classified as a reduction to advertising expense in Selling, general
and administrative expenses ("SG&A").
Pre-Opening Costs: The costs of start-up activities are expensed in the
period in which they occur.
Advertising Costs: Advertising costs are expensed as incurred and amounted
to $446 million, $429 million, $182 million and $625 million for fiscal 2004,
the 39-weeks ended January 28, 2004, the 13-weeks ended April 30, 2003 and
fiscal 2002, respectively. These costs are included in SG&A in the accompanying
Consolidated Statements of Operations. Advertising costs are net of co-op
recoveries from vendors of $266 million in fiscal 2002. Fiscal 2004 and 2003
co-op recoveries are classified in Cost of sales, buying & occupancy in
accordance with EITF 02-16 as noted above.
Income Taxes: Deferred income taxes are provided for temporary differences
between financial statement and taxable income. We accrue U.S. and foreign taxes
payable on our pro rata share of the earnings of subsidiaries, except with
respect to earnings that are intended to be permanently reinvested, or expected
to be distributed free of additional tax by operation of relevant statutes
currently in effect, and by utilization of available tax credits and deductions.
The Predecessor Company initially recorded a full valuation allowance against
net deferred tax assets in accordance SFAS No. 109, "Accounting for Income
Taxes" ("SFAS No. 109"), as realization of such assets in future years was
uncertain. Adequacy of the valuation allowance is reevaluated periodically based
on the expected timing of utilization of the related assets and the likelihood
of future taxable income. See Note 16 - Income Taxes.
34
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
Stock-based Compensation: In fiscal 2003, we voluntarily elected to account
for stock-based compensation using the fair value method on a prospective basis
as permitted by SFAS No. 148, "Accounting for Stock-Based Compensation -
Transition and Disclosure, an Amendment of FASB Statement No. 123" ("SFAS No.
148"). The effect of the election was not material to the results of operations
for any period presented.
Prior to the adoption of SFAS No. 148, stock options were accounted for
using the intrinsic value method in accordance with Accounting Principles Board
Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB No. 25") and
related 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, the pro
forma effects of recognizing compensation income (expense) on net loss and loss
per share, had the Predecessor Company applied the fair value method of
accounting for stock options is as follows:
Predecessor Company
----------------------------
13-Weeks Ended Fiscal Year
(dollars in millions, except per share data) April 30, 2003 2002
- -------------------------------------------- -------------- -----------
Net loss, as reported $ (862) $(3,219)
Deduct: Total stock-based employee compensation
income (expense) determined under the fair value
based method for all awards, net of related tax effects 38 (14)
------ -------
Pro forma net loss $ (824) $(3,233)
====== =======
Basic/diluted loss per share:
As reported $(1.65) $ (6.36)
====== =======
Pro forma $(1.58) $ (6.39)
====== =======
All outstanding stock options of the Predecessor Company were cancelled in
accordance with the Plan of Reorganization.
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.
Earnings (Loss) 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 effect of restricted stock
when dilutive.
A reconciliation of basic average common shares outstanding to diluted
average common shares outstanding for fiscal year 2004 and the 39-weeks ended
January 28, 2004 is as follows:
Successor Company
------------------------------
Fiscal Year 39-Weeks Ended
(in millions) 2004 January 28, 2004
- ------------- ----------- ----------------
Basic weighted average shares 89.3 89.6
Dilutive effect of stock options 6.1 3.7
9% convertible note 6.0 --
----- ----
Diluted weighted average shares 101.4 93.3
===== ====
Basic weighted average shares includes approximately 9.3 million shares in
fiscal year 2004 and 18.6 million shares in the 39-weeks ended January 28, 2004
reserved for the issuance to Class 5 claimholders pursuant to the Plan of
Reorganization. See Note 4 - Emergence from Chapter 11 Bankruptcy Protection and
Fresh-Start Accounting.
35
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
A reconciliation of net income per basic earnings per share to diluted
earnings per share for fiscal year 2004 and the 39-weeks ended January 28, 2004
is as follows:
Successor Company
------------------------------
Fiscal Year 39-Weeks Ended
(dollars in millions) 2004 January 28, 2004
- --------------------- ----------- ----------------
Net income available to common shareholders $1,106 $234
Interest and accretion of debt discount on 9% convertible note, net of tax 9 --
------ ----
Income available to common shareholders with assumed conversions $1,115 $234
====== ====
Approximately 150,000 stock options and 51,000 shares of restricted stock
were excluded from the calculation of diluted earnings per share for fiscal 2004
as they were anti-dilutive. The convertible note was excluded from the
calculation of diluted earnings per share for the 39-weeks ended January 28,
2004 as it was anti-dilutive.
All common stock equivalents of the Predecessor Company were excluded from
the calculation of diluted earnings per share for the 13-weeks ended April 30,
2003 and fiscal year 2002 as they were anti-dilutive. Upon emergence from
bankruptcy, all common stock equivalents of the Predecessor Company were
cancelled.
Use of Estimates: The preparation of the Consolidated Financial Statements
in conformity with accounting principles generally accepted in the United States
of America requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities and disclosure of contingent assets
and liabilities at the date of the financial statements and the reported amounts
of revenues and expenses during the reporting period. Significant estimates are
required as part of inventory valuation, allowance for doubtful accounts,
restructuring charges, long-lived asset impairments, self-insurance reserves,
pension benefits, legal reserves, and valuation allowances on deferred income
taxes. Actual amounts could differ from those estimates.
Reclassifications: Certain reclassifications of prior period amounts have
been made to conform to the current period presentation.
New Accounting Pronouncements: In November 2004, the Financial Accounting
Standards Board ("FASB") issued SFAS No. 151, "Inventory Costs - an Amendment of
ARB No. 43, Chapter 4" ("SFAS No. 151"). SFAS No. 151 clarifies that abnormal
amounts of idle facility expense, freight, handling costs, and wasted materials
(spoilage) should be recognized as current-period charges. In addition, SFAS No.
151 requires the allocation of fixed production overheads to the cost of
conversion be based on the normal capacity of the production facilities. SFAS
No. 151 is effective for fiscal years beginning after June 15, 2005. We do not
anticipate any effect on the Company upon adoption of SFAS No. 151.
In December 2004, the FASB issued SFAS No. 123 (revised 2004), "Share-Based
Payment" ("SFAS No. 123(R)"). SFAS 123(R) requires all share-based payments to
employees, including grants of employee stock options, to be recognized in the
income statement based on the fair value at grant date. There was no effect to
the Company upon the adoption of SFAS No. 123(R) as our current accounting for
stock-based compensation conforms to this requirement. See Stock-Based
Compensation above.
We have reviewed all new applicable guidance and do not deem any other new
standards to have a significant effect on the Company's financial statements.
4) 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 ("Kmart," "we," "us," "our"
or the "Successor Company"). Kmart is the nation's third largest discount
retailer.
36
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
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.
Plan Investors
At the time of emergence, 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%, $60
million principal convertible note ("the Note") to affiliates of ESL, which was
convertible to equity at a price equal to $10 per share at any time at the
option of the holder prior to May 2006. On January 31, 2005 affiliates of ESL
converted the Note and accrued interest into approximately 6.27 million shares
of Common Stock; see Note 9 - Long-Term Debt and Mortgages Payable. 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"). Upon
applying the criteria of Emerging Issues Task Force Issue No. 00-27,
"Application of Issue No. 98-5 to Certain Convertible Instruments" ("EITF
00-27"), the Company allocated the proceeds received from the Plan Investors,
net of expenses, of $187 million to the Note, Common Stock and stock options
based on their relative fair values. An effective conversion price was then
calculated and used to measure the intrinsic value of the embedded conversion
feature. The resulting discount of $49 million reduced the initial carrying
amount of the Note to $11 million, with a corresponding increase in Capital in
excess of par value. The debt discount was amortized to interest expense over
one year using the effective interest method through December 2003, at which
time the Plan Investors elected to extend the term of the Note an additional two
years through May 6, 2006. The remaining debt discount as of December 2003 is
being recognized over the additional two year term or until such time that the
Note is converted into Common Stock.
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 our former Chief Executive Officer. All shares were
issued without registration under the Securities Act of 1933, as amended (the
"Securities Act") in reliance on the provisions of Section 1145 of the
Bankruptcy Code and Section 4(2) of the Securities Act. 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.
37
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
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 emergence from
Chapter 11 ("Fresh-start accounting"). Upon applying Fresh-Start accounting, a
new reporting entity (the Successor Company) is deemed to be created and the
recorded amounts of assets and liabilities are adjusted to reflect their
estimated fair values. 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 Annual Report on Form
10-K, 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.
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 was highly dependent upon achieving the future financial
results set forth in the projections as well as the realization of certain other
assumptions which were 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 accompanying
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.
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 22.6 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
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 Class 5 claim settlements is 20 percent of the total shares
distributed. 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 an additional 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 April 1, 2005.
38
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
In fiscal 2004, we entered into settlement agreements with past providers
of our surety bonds to resolve all issues in connection with their pre-petition
claims. In accordance with the terms of the settlement agreements, Kmart assumed
responsibility for the future obligations under the bonds issued with respect to
the Predecessor Company's workers' compensation insurance program and was
assigned the Class 5 claims against the Company. The Class 5 claim assignments
resulted in our receipt of 640,099 shares of Common Stock in fiscal 2004, which
represents 80% of the claims. The remaining portion of the claims will be
received upon the final settlement of all Class 5 claims, as noted above. In
connection with the assumption of these obligations, the Company recorded $18
million to Capital in excess of par value in the accompanying Consolidated
Balance Sheet in fiscal 2004.
Bankruptcy-Related Recoveries
In fiscal 2004 and the 39-weeks ended January 28, 2004, we recognized
recoveries of $59 million and $4 million, respectively, from vendors who had
received cash payments for pre-petition obligations (critical vendor claims) or
preference payments. See Note 24 - Commitments and Contingencies for a more
detailed discussion of the critical vendor claims lawsuit.
5) REAL ESTATE AND PROPERTY TRANSACTIONS
During fiscal 2004, the Company entered into multiple agreements with Home
Depot U.S.A., Inc. (a subsidiary of The Home Depot, Inc.) ("Home Depot") to sell
four properties and assign 14 leased properties for an aggregate purchase price
of $271 million. Pursuant to 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. The Company completed the
assignment of 13 of the remaining properties in the third quarter of fiscal
2004, resulting in proceeds to the Company of $200 million in cash, and a gain
of $198 million. We closed on the final property during the fourth quarter,
resulting in additional proceeds of $12 million in cash and a gain of $12
million.
Sears, Roebuck and Co.
On September 29, 2004, the Company agreed to sell four owned properties,
assign 45 leased properties and lease one owned store to Sears for a total
purchase price of approximately $576 million. The Company received 30% of the
purchase price in September 2004, upon closing, and recognized a gain on the
transaction of $599 million. Under the original terms of the Asset Purchase
Agreement for this transaction, the remaining 70% of the purchase price is to be
received when Sears occupies the properties, which was originally scheduled to
be no later than April 15, 2005. The parties intend to amend the Asset Purchase
Agreement to provide that such occupancy delivery dates, and payment dates, for
certain of the stores will be later than April 15, 2005, which will affect the
amount and timing of the Company's receipt of cash. The receivable for the
remaining purchase price of $403 million is included in Accounts receivable, net
in our Consolidated Balance Sheet at January 26, 2005.
Other
In fiscal 2004 the Company also sold certain other assets resulting in a
net gain of $94 million. Included within this gain was $18 million related to
the sale of the Company's Trinidad subsidiary and its associated property, $22
million related to the sale of owned or assignment of leased properties, $12
million related to the sale of the Company's corporate airplanes and $42 million
was from sales of other real and personal property.
During the 39-weeks ended January 28, 2004 the Company executed certain
real estate transactions, resulting in a net gain of $89 million. Approximately
$56 million of the gain was the result of the assignment of four operating
leases and $22 million was from the sale of two owned properties. The remaining
net gain of $11 million was from sales of other various property and equipment.
Included in these real estate transactions is the sale of $27 million in
fiscal 2004 and $104 million in the 39-weeks ended January 28, 2004 of property
held for sale, for a net gain of $1 million and $4 million, respectively.
Property held for sale was $25 million at January 26, 2005 and $56 million at
January 28, 2004 and is included in Other current assets in the accompanying
Consolidated Balance Sheets.
During fiscal 2004 and the 39-weeks ended January 28, 2004, we purchased 31
and 18 previously-leased operating properties for $124 million and $51 million,
respectively.
39
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
6) PROPERTY AND EQUIPMENT
January 26, January 28,
(dollars in millions) 2005 2004
- --------------------- ----------- -----------
Land $ 59 $ 22
Buildings 86 27
Leasehold improvements 80 29
Furniture, fixtures and equipment 109 67
Work in progress 13 14
---- ----
347 159
Less:
Accumulated depreciation and amortization (32) (6)
---- ----
Total $315 $153
==== ====
Depreciation expense on property and equipment for fiscal 2004, the
39-weeks ended January 28, 2004, the 13-weeks ended April 30, 2003 and fiscal
2002 was $27 million, $6 million, $191 million and $728 million, respectively.
The following table provides a breakdown of the number of stores leased
compared to owned as of January 26, 2005 and January 28, 2004:
January 26, January 28,
2005 2004
----------- -----------
Number of Kmart stores owned 157 135
Number of Kmart stores leased 1,323 1,376
----- -----
Total 1,480 1,511
===== =====
7) ACCRUED EXPENSES AND OTHER LIABILITIES
Accrued expenses and other liabilities included in the accompanying
Consolidated Balance Sheets consist of the following:
January 26, January 28,
(dollars in millions) 2005 2004
- --------------------- ----------- -----------
Accrued payroll and related liabilities $215 $222
Accrued expenses 162 155
Income taxes payable 103 37
Current portion of workers compensation and general liability 97 101
Current portion of capital lease obligations 41 47
Gift certificates 25 29
Other liabilities 74 80
---- ----
Total $717 $671
==== ====
40
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
8) OTHER LONG-TERM LIABILITIES
Other long-term liabilities included in the accompanying Consolidated
Balance Sheets consist of the following:
January 26, January 28,
(dollars in millions) 2005 2004
- --------------------- ----------- -----------
Workers compensation reserve $289 $230
Public liability reserve 60 47
Priority tax 16 95
Other 66 52
---- ----
Total $431 $424
==== ====
9) LONG-TERM DEBT AND MORTGAGES PAYABLE
Fiscal Year Interest January 26, January 28,
(dollars in millions) Maturity Rates 2005 2004
- --------------------- ----------- ------------ ----------- -----------
Convertible subordinated notes, net 2006 9.00% $43 $ 33
Mortgages payable 2005-2017 7.53% - 9.83% 52 47
--- -----
Total 95 80
Less current portion of mortgages payable 4 4
--- -----
Long-term debt and mortgages payable $91 $ 76
=== =====
Letter of Credit Agreement
During fiscal 2004, the Company entered into a letter of credit agreement
(the "LC Agreement") with a commitment amount of up to $600 million. Standby
letters of credit issued under the LC Agreement bear interest at 0.20% per
annum. No interest is charged for trade letters of credit issued under the LC
Agreement; however, we are required to pay a fee on the cash collateral in
excess of the outstanding letters of credit equal to 0.125% per annum.
Under the terms of the LC Agreement, the Company has the ability to post
either cash or inventory as collateral. The cash collateral account is subject
to a pledge and security agreement pursuant to which the Company must maintain
cash in an amount equal to 100.5% of the face value of letters of credit
outstanding under the LC Agreement. Electing inventory would result in
incremental costs under the LC Agreement, and as of January 26, 2005, this
election has not been made. The Company has $323 million of cash posted as
collateral as of January 26, 2005. This cash is classified as Cash and cash
equivalents in the accompanying Consolidated Balance Sheet due to our ability to
post inventory as collateral at any time at our discretion.
The LC Agreement contains customary covenants, including covenants that
restrict our ability to incur or create liens on collateralized assets, and
sell, transfer, assign or otherwise dispose of any collateralized assets.
Failure to satisfy these covenants would result in an event of default that
could result in our inability to issue new letters of credit. As of January 26,
2005, and in all periods since inception of the LC Agreement, we have been in
compliance with all covenants of the LC Agreement.
Cash Collateral
During fiscal 2004, we have replaced letters of credit used as collateral
for certain self-insurance programs with cash collateral which reduced fees paid
by the Company with respect to the letters of credit. We continue to classify
the cash collateral as Cash and cash equivalents due to our ability to convert
the cash to letters of credit at any time at our discretion. As of January 26,
2005, $261 million of cash was posted as collateral for our self-insurance
programs.
Credit Facility
Our credit agreement (the "Credit Facility") was an $800 million revolving
credit facility with an equivalent letter of credit sub-limit. In fiscal 2004,
we reduced the size, amended and restated our Credit Facility, and we
voluntarily terminated the Credit Facility effective January 3, 2005. In
conjunction with these actions we accelerated the amortization of $23 million in
associated debt issuance costs. Since its issuance, we only used the Credit
Facility to support outstanding letters of credit.
41
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
Interest
Successor Company Predecessor Company
------------------------------ ----------------------------
Fiscal Year 39-Weeks Ended 13-Weeks Ended Fiscal Year
(dollars in millions) 2004 January 28, 2004 April 30, 2003 2002
- --------------------- ----------- ---------------- -------------- -----------
Components of Interest Expense, Net
Interest expense $ 53 $ 53 $21 $112
Accretion of obligations at net present value 50 37 -- --
Amortization of debt issuance costs 34 25 37 47
Accretion of debt discount on 9% convertible note 9 22 -- --
Interest income (38) (10) (1) (4)
---- ---- --- ----
Interest expense, net $108 $127 $57 $155
==== ==== === ====
Cash paid for interest was $52 million, $52 million, $19 million and $95
million for fiscal 2004, the 39-weeks ended January 28, 2004, the 13-weeks ended
April 30, 2003 and fiscal 2002, respectively.
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 and
accordingly, 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 on certain pre-petition debt, including
convertible preferred securities, totaled $67 million and $271 million for the
13-weeks ended April 30, 2003 and fiscal year 2002, respectively.
Other
The contractual principal maturities of long-term debt for the five years
subsequent to fiscal 2004 are: 2005 - $4 million; 2006 - $64 million; 2007 - $5
million; 2008 - $5 million; 2009 - $6 million and 2010 and later - $28 million.
The estimated fair value of the convertible notes at January 26, 2005 and
January 28, 2004 was $542 million and $169 million, respectively. The estimated
fair market value was based on the closing market price for our Common Stock on
the balance sheet date. The estimated fair value of our mortgages payable
approximated carrying value for all periods presented.
Subsequent Event
On January 31, 2005, ESL and its affiliates converted, in accordance with
the terms of the convertible notes, all of the outstanding 9% convertible
subordinated notes of Kmart into an aggregate of 6,269,998 shares of Kmart
common stock, plus cash in lieu of fractional shares, and, in consideration of
such early conversion, received an aggregate payment from Kmart of $3.3 million
in cash. The cash payment is approximately equivalent to the discounted
after-tax cost of the future interest payments that would have otherwise been
paid by Kmart to ESL and its affiliates in the absence of the early conversion.
42
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
10) LEASES
We conduct our operations primarily in leased facilities. Our store leases
are generally for terms of 25 years with multiple five-year renewal options that
allow us the option to extend the life of the lease up to 50 years beyond the
initial non-cancelable term. In certain Kmart leased facilities, selling space
has been sublet or licensed to other retailers, including Olan Mills, Inc. and
the Meldisco subsidiaries of Footstar, Inc. ("FTS").
Minimum Lease
Commitments
--------------------
As of January 26, 2005 (dollars in millions) Capital Operating
- -------------------------------------------- -------- ---------
Fiscal Year:
2005 $ 103 $ 451
2006 80 429
2007 70 391
2008 66 358
2009 63 321
Later years 368 2,447
---- ------
Total minimum lease payments 750 4,397
Less - minimum sublease income (919)
------
Net minimum lease payments $3,478
======
Less:
Estimated executory costs (246)
Interest at a weighted average rate of 9.6% (187)
----
317
Less current portion of capital lease obligations (41)
----
Capital lease obligations $ 276
====
In connection with the application of Fresh-Start accounting we recorded a
liability of $390 million representing the net present value of unfavorable
lease terms for operating leases. This amount was determined based upon a third
party appraisal. As of January 26, 2005 and January 28, 2004 the liability
balance was $318 million and $367 million, respectively.
Successor Company Predecessor Company
------------------------------ ----------------------------
Fiscal Year 39-Weeks Ended 13-Weeks Ended Fiscal Year
Rent Expense (dollars in millions) 2004 January 28, 2004 April 30, 2003 2002
- ---------------------------------- ----------- ---------------- -------------- -----------
Minimum rentals $ 526 $ 402 $141 $ 694
Percentage rentals 10 17 6 30
Less-sublease rentals (146) (125) (54) (229)
----- ----- ---- -----
Total $ 390 $ 294 $ 93 $ 495
===== ===== ==== =====
11) INVESTMENTS IN AFFILIATED COMPANIES
On March 2, 2004, Footstar, Inc. ("FTS") and its direct and indirect
subsidiaries, including the 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. Kmart is a party to a master agreement with FTS that
provides FTS with a non-transferable, exclusive right and license to operate the
footwear departments in Kmart stores. Subsidiaries of Meldisco, substantially
all of which are 49% owned by Kmart and 51% owned by FTS, operate the footwear
departments pursuant to license agreements between those subsidiaries and Kmart.
43
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
On August 12, 2004, FTS filed a motion with the bankruptcy court to assume
the master agreement and the license agreements. On September 30, 2004, the
Company objected to that motion, and also filed a separate motion to terminate
the master agreement and the license agreements because of various defaults by
FTS under the master agreement. On February 16, 2005, the bankruptcy court
overruled one of the Company's objections to assumption of the master agreement.
The bankruptcy court has yet to rule on the Company's several other grounds for
objecting to assumption and moving to terminate the master agreement. Should the
bankruptcy court overrule the Company's objection in its entirety and permit FTS
to assume the master agreement and the license agreements, FTS must cure all
past defaults under those agreements. On July 26, 2004, the Company filed a
proof of claim in the FTS bankruptcy case for an amount in excess of our
recorded receivable of $24 million. The Company believes the cure amount may be
substantially in excess of $24 million. FTS asserts that the amount required to
cure past defaults is not more than $19 million, and that such amount should be
reduced by overpayments FTS alleges it made to the Company for certain fees. If
no resolution is achieved consensually with FTS with respect to the assumption
of the master agreement, the license agreements and the cure amount, and the
bankruptcy court permits FTS to assume the master agreement and the license
agreements, the cure amount will be determined by the bankruptcy court.
FTS filed a proposed plan of reorganization with the bankruptcy court on
November 12, 2004. Kmart's results, with respect to the footwear master
agreement, may be affected by whether (i) FTS is authorized by the bankruptcy
court to assume the master agreement and the license agreements, obtains
bankruptcy court approval of its plan of reorganization and successfully emerges
from bankruptcy; (ii) FTS is able to successfully manage its business in the
future and achieve the results projected in its plan of reorganization; or (iii)
Kmart's motion to terminate the master and license agreements is granted or FTS
fails to obtain bankruptcy court approval of its plan of reorganization, which
would cause Kmart to pursue alternative arrangements including potentially
sourcing footwear merchandise directly.
In September 2004, FTS restated six years of its consolidated financial
statements for fiscal years 1997 through 2002. These restatements have not had a
significant effect on our previously reported equity income derived from our
investment in the Meldisco subsidiaries. FTS has yet to file audited financial
statements and periodic reports for fiscal years 2003 and 2004.
We have received preliminary financial results from FTS for fiscal years
2003 and 2004. These statements provide the basis of our estimate of equity
income as presented in our Consolidated Statements of Operations for the
Meldisco subsidiaries with which we do business. FTS has allocated certain of
its reorganization and other costs to the Meldisco entities. These charges have
adversely affected the financial performance of these businesses. We disagree
with FTS' approach and have notified FTS of our position. As a result, our
equity earnings for fiscal 2004 do not reflect our 49% share of the net losses
generated by the Meldisco subsidiaries in fiscal 2004.
For fiscal 2004, the 39-weeks ended January 28, 2004, the 13-weeks ended
April 30, 2003 and fiscal 2002, Meldisco had net sales of $752 million, $629
million, $246 million and $1,134 million, respectively.
The table below lists the fees, rental and equity income earned from
Meldisco, dividend payments received from Meldisco, and unremitted equity
earnings from our minority ownership in Meldisco for fiscal 2004, the 39-weeks
ended January 26, 2005, the 13-weeks ended April 30, 2003 and fiscal year 2002,
respectively.
Successor Company Predecessor Company
------------------------------ ----------------------------
Fiscal Year 39-Weeks Ended 13-Weeks Ended Fiscal Year
(dollars in millions) 2004 January 28, 2004 April 30, 2003 2002
- --------------------- ----------- ---------------- -------------- -----------
Income earned $121 $109 $49 $216
Dividend payments received 3 -- 36 45
Unremitted equity earnings 15 12 7 34
As of January 26, 2005, ESL had a 9.9% ownership in the common stock of
FTS.
12) TREASURY STOCK
The Company has a share repurchase program with authorization to repurchase
$100 million of Common Stock. In fiscal 2003, we repurchased 128,400 shares of
Common Stock for grants of stock based compensation (weighted-average price of
$28.87 per share) at a cost of approximately $4 million. There were no
repurchases of Common Stock in fiscal 2004 under the share repurchase program.
44
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
In fiscal years 2004 and 2003 we repurchased 18,476 and 26,889 shares
(weighted-average price of $40.64 and $25.68 per share), respectively, of Common
Stock relating to withholding taxes for certain former associates that were part
of the Class 5 claimholders distribution, see Note 4 - Emergence from Chapter 11
Bankruptcy Protection and Fresh-Start Accounting.
During fiscal 2004, we were assigned 990,791 shares of common stock
(weighted average price of $88.96 per share) with an approximate value of $88
million. These assignments were the result of settlement agreements resolving
claims arising from our Chapter 11 reorganization; see Note 4 - Emergence from
Chapter 11 Bankruptcy Protection and Fresh-Start Accounting.
There were 984,503 and 43,749 shares in treasury as of January 26, 2005 and
January 28, 2004, respectively.
13) STOCK-BASED COMPENSATION
Stock Options
The Company accounts for stock-based compensation using the fair value
method.
On October 18, 2004, the Company's new President and Chief Executive
Officer, Aylwin B. Lewis, was granted 150,000 options to purchase shares of
Common Stock with a grant price of $88.62 per share, subject to shareholder
approval. This grant vests in installments over 4.25 years from the grant date
and we will recognize compensation expense of approximately $6 million during
this same period. The options expire 10 years from the date of grant.
During fiscal 2003, approximately 1.7 million options to purchase shares of
Common Stock were granted, of which 151,738 options were cancelled during the
same year. The weighted average grant price of the options was $13.33. Upon the
departure of our former President and Chief Executive Officer, Julian C. Day, in
October 2004, the vesting period for 778,880 of these stock options was
accelerated and 389,439 of these stock options were cancelled, as required by
the terms of his nonqualified stock option agreement, as amended, with the
Company. The accelerated vesting resulted in $2 million of compensation cost to
be recognized during the third quarter of fiscal 2004. The fair value of the
1,168,321 vested options of Julian C. Day as of January 26, 2005 was
approximately $106 million.
The fair value of each option grant is estimated on the date of grant using
the Black-Scholes option pricing model, which requires the input of highly
subjective assumptions including expected price volatility. The assumptions used
for grants in fiscal year 2004 and the 39-weeks ended January 28, 2004 are as
follows:
Successor Company
------------------------------
Fiscal Year 39-Weeks Ended
2004 January 28, 2004
----------- ----------------
Expected life (years) 5 5
Expected volatility 46% 45%
Risk-free interest rate 3.18% 2.76%
Weighted average fair value
of options at grant date $88.62 $13.33
No stock options were granted in the 13-weeks ended April 30, 2003 and
fiscal 2002.
Total compensation expense related to stock options was $4 million in
fiscal 2004 and $1 million in the 39-weeks ended January 28, 2004. There was no
compensation expense for stock options in the 13-weeks ended April 30, 2003 and
fiscal 2002 as the Predecessor Company accounted for stock options under APB No.
25, which did not require the recognition of expense for the fair value of
stock-based compensation. See Note 3 - Summary of Significant Accounting
Policies.
45
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
The following table summarizes the status of the stock options outstanding
as of January 26, 2005, January 28, 2004 and January 29, 2003:
Successor Company Predecessor Company
--------------------------------------------------- ------------------------
2004 2003 2002
------------------------ ------------------------ ------------------------
(shares in thousands) Shares Option Price Shares Option Price Shares Option Price
- --------------------- ------ --------------- ------ --------------- ------- --------------
Outstanding 1,557 $10.00 - $20.00 -- 59,973 $4.86 - $26.03
Granted 150 $88.62 1,709 $10.00 - $20.00 --
Exercised -- -- --
Cancelled/Forfeited (389) $10.00 - $20.00 (152) $10.00 - $20.00 (15,088) $4.86 - $26.03
------ ------ -------
Outstanding 1,318 $10.00 - $88.62 1,557 $10.00 - $20.00 44,885 $4.86 - $24.06
Exercisable 1,168 $10.00 - $20.00 -- 38,638 $4.86 - $24.06
Available for Grant n/a n/a 32,944
All outstanding stock options of the Predecessor Company were cancelled in
accordance with the Plan of Reorganization.
The following table summarizes information about the Company's stock
options as of January 26, 2005:
Options Outstanding Options Exercisable
---------------------------------------------- ---------------------------------
Number of Shares Weighted Average Weighted Number of Shares Weighted
Range of Exercise Outstanding Remaining Life Average Outstanding Average
Price (in thousands) (Years) Price (in thousands) Exercise Price
- ----------------- ---------------- ---------------- -------- ---------------- --------------
$10.00 - $20.00 1,168 8.3 $13.33 1,168 $13.33
$88.62 - $88.62 150 9.8 $88.62 -- $ --
----- -----
1,318 8.4 $21.90 1,168 $13.33
===== =====
Restricted Stock
We account for restricted stock grants as fixed awards, and record deferred
employee compensation to Capital in excess of par value. During fiscal year
2004, we granted 82,842 shares of restricted stock at a weighted average price
of $66.39 per share. During the 39-weeks ended January 28, 2004 we granted
111,540 shares of restricted stock at a weighted average price of $26.90 per
share.
Total compensation expense related to restricted stock was $2 million in
fiscal 2004. There was no compensation expense for restricted stock in the
39-weeks ended January 28, 2004, the 13-weeks ended April 30, 2003 or fiscal
2002. As of January 26, 2005, remaining deferred employee compensation on all
outstanding restricted stock is $6 million and is being amortized to
compensation expense on a straight-line basis over the vesting period of three
to four years.
14) COMPREHENSIVE INCOME (LOSS) AND ACCUMULATED OTHER COMPREHENSIVE INCOME
(LOSS)
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. Fiscal
2004 comprehensive income includes a minimum pension liability adjustment of $77
million, net of tax of $49 million. During fiscal year 2004 we sold
available-for-sale equity securities and in conjunction with these sales,
reduced accumulated other comprehensive income by $1 million. For the 39-weeks
ended January 28, 2004, we recorded an adjustment to shareholders' equity in
accordance with SFAS No. 115, "Accounting for Certain Investments in Debt and
Equity Securities," of $1 million to increase the value of our investment in
certain equity securities to current market value.
46
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
Accumulated Other Comprehensive Income (Loss)
The following table summarizes the components of Accumulated other
comprehensive income (loss):
Predecessor
Successor Company Company
------------------------------------- -----------
January 26, January 28, April 30, January 29,
(dollars in millions) 2005 2004 2003 2003
- --------------------- ----------- ----------- --------- -----------
Minimum pension liability, net of tax $(77) $-- $ (906) $(906)
Market value adjustment for investments -- 1 (1) (1)
Adjust pension to fair market value -- -- (94) --
Cancellation of Predecessor Company equity
and application of fresh-start accounting -- -- 1,001 --
---- --- ------ -----
Accumulated other comprehensive (loss) income $(77) $ 1 $ -- $(907)
==== === ====== =====
The Accumulated other comprehensive loss of the Predecessor Company was
eliminated through the application of Fresh-Start accounting at April 30, 2003;
see Note 4 - Emergence from Chapter 11 Bankruptcy Protection and Fresh-Start
Accounting.
15) BARTER TRANSACTIONS
In fiscal 2004, we entered into barter transactions for advertising
services with The WB Television Network ("The WB") and E! Entertainment
Television, Inc. ("E!"). We promoted The WB in a significant number of our
television, newspaper and other advertising expenditures during the third
quarter of fiscal 2004. In return, we received advertising on certain television
shows of The WB. We promoted E! in our print advertising from August 2004
through November 2004, and we received apparel promotions on the E! News Live
show for a comparable period.
We recognize barter revenue in accordance with EITF No. 99-17, "Accounting
for Advertising Barter Transactions" ("EITF 99-17"). In accordance with EITF
99-17, the fair value of these barter arrangements was not determinable and
therefore the revenue and expenses were not recognized in our Consolidated
Statements of Operations.
16) INCOME TAXES
(dollars in millions)
Successor Company Predecessor Company
------------------------------ ----------------------------
Fiscal Year 39-Weeks Ended 13-Weeks Ended Fiscal Year
Income (Loss) Before Income Taxes 2004 January 28, 2004 April 30, 2003 2002
- --------------------------------- ----------- ---------------- -------------- -----------
U.S. $1,744 $364 $(851) $(2,779)
Foreign 31 14 (7) (16)
------ ---- ----- -------
Total $1,775 $378 $(858) $(2,795)
====== ==== ===== =======
Income Tax Expense (Benefit)
Current:
Federal $ 49 $ 4 $ (6) $ (20)
State and local 16 2 -- 3
Foreign 7 1 -- (7)
------ ---- ----- -------
72 7 (6) (24)
------ ---- ----- -------
Deferred:
Federal 531 120 -- --
State and local 66 17 -- --
------ ---- ----- -------
597 137 -- --
------ ---- ----- -------
Total $ 669 $144 $ (6) $ (24)
====== ==== ===== =======
47
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
Successor Company Predecessor Company
------------------------------ ----------------------------
Fiscal Year 39-Weeks Ended 13-Weeks Ended Fiscal Year
Effective Tax Rate Reconciliation 2004 January 28, 2004 April 30, 2003 2002
- --------------------------------- ----------- ---------------- -------------- -----------
Federal income tax rate 35.0% 35.0% (35.0%) (35.0%)
State and local taxes,
net of federal tax benefit 3.0% 3.0% (1.1%) (1.0%)
Tax credits (0.2%) (0.5%) (0.1%) (0.2%)
Equity in net income
of affiliated companies (0.1%) (0.4%) (0.2%) (0.2%)
Valuation allowance --% --% 34.5% 34.3%
Other --% 1.0% 1.2% 1.2%
---- ---- ----- -----
37.7% 38.1% (0.7%) (0.9%)
==== ==== ===== =====
Successor Company
-------------------------
Deferred Tax Assets January 26, January 28,
and Liabilities (dollars in millions) 2005 2004
- ------------------------------------- ----------- -----------
Deferred tax assets:
Federal benefit for state and foreign taxes $ 37 $ 17
Accruals and other liabilities 408 625
Property and equipment 918 1,378
Capital leases 111 147
Store closings -- 2
Credit carryforwards 1 236
NOL carryforwards 214 1,470
State deferred taxes 312 259
Other 129 123
------- -------
Total deferred tax assets 2,130 4,257
Valuation allowance (1,249) (2,351)
------- -------
Net deferred tax asset 881 1,906
Deferred tax liabilities:
Inventory 9 187
Deferred gains 116 --
Cancellation of indebtedness -- 1,654
Other 1 16
------- -------
Total deferred tax liabilities 126 1,857
------- -------
Net deferred tax asset $ 755 $ 49
======= =======
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 or fiscal year 2002. Given the Company's
actual level of profitability in fiscal 2004 and forecasted levels in fiscal
2005 through 2007, 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
$775 million in fiscal 2004 to reflect its estimated utilization through the end
of fiscal 2007. The Company will continue to assess the likelihood of
realization of its pre-emergence net deferred tax assets and will 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 on pre-emergence deferred tax assets is recorded as a
direct credit to Capital in excess of par value with no effect on the Company's
earnings or cash flows.
48
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
During fiscal year 2004 and the 39-weeks ended January 28, 2004, we
utilized $380 million and $203 million, respectively, of pre-emergence deferred
tax assets. Such utilization reduced the valuation allowance previously
established. During fiscal years 2004 and 2003, we reduced our reserves for
Predecessor Company income tax liabilities by $56 million and $30 million,
respectively, primarily due to favorable claims settlements. In fiscal 2004, the
Company also received a tax benefit of $67 million relating to certain Class 5
and 6 pre-petition claims paid with equity. In accordance with SOP 90-7,
subsequent to emergence from Chapter 11, any benefit realized from the reduction
of the pre-emergence valuation allowance or any benefit realized from an
adjustment to pre-confirmation income tax liabilities shall be recorded as an
addition to Capital in excess of par value, not as income to the Company. We
recorded these adjustments to Capital in excess of par value in our Consolidated
Balance Sheets.
We recorded a provision for taxes of $669 million and $144 million in
fiscal year 2004 and the 39-weeks ended January 28, 2004, respectively. Tax
benefits recorded during the 13-weeks ended April 30, 2003 and fiscal year 2002
related primarily to an Internal Revenue Code provision allowing for the 10-year
carryback of certain losses, and refunds resulting from the Job Creation and
Worker Assistance Act of 2002. The benefit recognized in fiscal 2002 was
partially offset by expense paid to foreign jurisdictions.
In connection with the reorganization, the Company realized income from the
cancellation of certain indebtedness. Although this income was not taxable, as
it resulted from reorganization under the Bankruptcy Code, the Company was
required to reduce certain of its tax attributes (net operating loss (NOL)
carryforwards by $3,743 million, general business credit carryforwards by $45
million, AMT credit carryforwards by $111 million and basis of certain assets by
$902 million) in an amount equal to the cancellation of indebtedness.
The reorganization of the Company on the Effective Date resulted in an
ownership change under section 382 of the Internal Revenue Code and accordingly,
the use of any of the Company's NOL carryforwards and tax credits generated
prior to the ownership change, as well as certain subsequently recognized
"built-in" losses, if any, existing as of the date of the ownership change that
are not reduced pursuant to the provisions discussed above, will be subject to
an overall annual limitation of $79 million.
At January 26, 2005, we have unused NOL carryforwards of approximately $509
million. The federal tax benefits of these NOL carryforwards will expire in
2021, 2022 and 2023 and the state tax benefits will predominantly expire between
2016 and 2023.
During fiscal 2004, the Internal Revenue Service completed its examination
of Kmart's federal income tax returns through fiscal 2001. We recorded an income
tax receivable of $6 million and in accordance with SOP 90-7; we recorded the
related income tax benefit as an addition to Capital in excess of par value.
Cash paid for income taxes was $6 million in fiscal 2004. Cash received for
income taxes was $1 million, $2 million and $31 million for the 39-weeks ended
January 28, 2004, the 13-weeks ended April 30, 2003, and fiscal 2002,
respectively.
17) PENSION PLANS AND OTHER POST-RETIREMENT BENEFITS
Prior to 1996, the Predecessor Company had a tax-qualified and a
non-qualified defined benefit pension plan, which covered eligible associates
who met certain requirements of age, length of service, and hours worked per
year. Effective January 31, 1996, the pension plans were frozen, and associates
no longer earn additional benefits under the plans.
49
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
Qualified Plan
The following tables summarize the net periodic expense (benefit), change
in benefit obligation, change in plan assets and funded status for our qualified
employee pension plan.
Successor Company Predecessor Company
------------------------------ ----------------------------
Fiscal Year 39-Weeks Ended 13-Weeks Ended Fiscal Year
(dollars in millions) 2004 January 28, 2004 April 30, 2003 2002
- --------------------- ----------- ---------------- -------------- -----------
Components of Net Periodic (Benefit)/Expense
Interest costs $ 154 $114 $ 38 $ 148
Expected return on plan assets (138) (94) (33) (174)
Net loss recognition -- -- 18 14
Amortization of unrecognized transition asset -- -- (2) (8)
----- ---- ---- -----
Net periodic expense (benefit) $ 16 $ 20 $ 21 $ (20)
===== ==== ==== =====
Successor Company
-------------------------
January 26, January 28,
(dollars in millions) 2005 2004
- --------------------- ----------- -----------
Change in benefit obligation:
Benefit obligation at beginning of period $2,605 $2,501
Interest costs 154 114
Actuarial loss 114 88
Benefits paid including VERP (130) (98)
------ ------
Benefit obligation at end of period $2,743 $2,605
====== ======
Change in plan assets:
Fair value of plan assets at beginning of period $1,787 $1,647
Actual return on plan assets 71 238
Employer contributions 11 --
Benefits paid including VERP (130) (98)
------ ------
Fair value of plan assets at end of period $1,739 $1,787
====== ======
January 26, January 28,
2005 2004
----------- -----------
Funded status $(1,004) $(818)
Unrecognized net loss/(gain) 126 (55)
------- -----
Pension liability (878) (873)
Accumulated other comprehensive income (126) --
------- -----
Accrued liability recognized in the Consolidated Balance Sheets $(1,004) $(873)
======= =====
The projected benefit obligation is equal to the accumulated benefit
obligation for all periods presented.
50
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
Actuarial assumptions used to determine plan obligations and net cost for
our qualified employee pension plan are as follows:
January 26, January 28,
2005 2004
----------- -----------
Disclosure assumptions
For determining benefit obligations at period end:
Discount rate 5.75% 6.00%
For determining net periodic cost for period:
Discount rate 6.00% 6.25%
Expected return on plan assets 8.00% 8.00%
Measurement date 1/31/2005 2/1/2004
The investment goals of Kmart Corporation Employees Pension Plans are to
invest in a mix of assets that will generate, over the long term, a minimum
annualized real return of 5%, an absolute annualized return that ranks in the
top third of a universe of defined benefit plan returns, and exceeds its market
benchmark return by 0.5% on a net-of-fee basis. The strategic asset mix for the
Plan is 45% in the fixed income asset class, 45% in the equity asset class and
10% in the hedge fund asset class, but may vary within 5 percent above or below
each such target allocation. The allocation among these asset classes is
controlled by the Finance Committee, which receives recommendations from the
Company's Employee Benefit Plans Investment Committee.
Plan assets were invested in the following classes of securities (none of
which were securities of the Company):
Weighted-average plan asset allocation:
January 26, January 28,
Asset category 2005 2004
- -------------- ----------- -----------
Equity securities 42% 48%
Fixed income and debt securities 44% 42%
Hedge funds/other 14% 10%
--- ---
Total 100% 100%
=== ===
To reduce the volatility of returns, the reliance upon any one investment
manager, and the dependence of any one investment manager upon Kmart's account,
the equity funds are deployed in a manner such that no external equity manager,
except for passive index fund or enhanced index fund managers, will have more
than 20% of the total assets of the Pension Plan, and the funds placed with any
manager will not represent more than 20% of the tax-exempt assets managed by the
manager, except for small capitalization equity managers. Additionally, except
for passive index fund or enhanced index fund managers, in no event will more
than $400 million be invested with any one investment manager. We believe that
the selection of equity managers with different management styles and different
investment criteria collectively will provide adequate diversification for the
Pension Plan. Therefore, it will not be necessary for individual investment
managers to be concerned with diversification outside their asset class or
investment style.
In order to select the assumptions for the expected return on plan assets,
the expected return, variance, and correlation of return with other asset
classes are determined for each class of assets in which the plan is invested.
That information is combined with the target asset allocation to create a
distribution of expected returns. The assumption falls within the best estimate
range. The best estimate range is the range in which it is reasonably
anticipated that the actual results are more likely to fall than not.
The Company's policy is to fund the pension plans at or above the minimum
required by law. In fiscal 2004, the Company made approximately $11 million in
contributions to the plans. Contributions to the plans were not required during
fiscal years 2003 or 2002. The minimum funding requirement for 2005 is $4
million; however the Company intends to make a $240 million voluntary
contribution to the pension plan in fiscal 2005.
51
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
A summary of expected benefit payments is as follows:
Pension
(dollars in millions) Plans
- --------------------- -------
Fiscal Year
2005 $ 124
2006 125
2007 126
2008 129
2009 132
2010-2014 740
------
$1,376
======
Other
The non-qualified plan is for certain current and former associates of the
Company. The Plan is funded as benefits are paid. The benefit obligation was $2
million at January 26, 2005 and January 28, 2004 and is included in the
accompanying Consolidated Balance Sheets. The projected benefit obligation is
equal to the accumulated benefit obligation for all periods presented.
Full-time associates who have worked 10 years and who have retired after
age 55 have the option of participation in Kmart's medical plan until age 65.
The plan is contributory, with retiree contributions adjusted annually. The
accounting for the plan anticipates future cost-sharing changes that are
consistent with our expressed intent to increase the retiree contribution rate
annually. The accrued post-retirement benefit costs were $2 million and $3
million as of January 26, 2005 and January 28, 2004, respectively.
18) RETIREMENT SAVINGS PLANS
The Retirement Savings Plans provide that associates of Kmart who have
completed 1,000 hours of service within a twelve month period can invest from 1%
to 25% of their earnings in their choice of various investments. For each dollar
the participant contributes up to 6% of earnings, we contribute an additional 50
cents, which is invested in available investment funds offered by the Plans, as
elected by each participant.
Total expense related to the Retirement Savings Plans was $19 million in
fiscal year 2004, $9 million for the 39-weeks ended January 28, 2004, $8 million
for the 13-weeks ended April 30, 2003 and $31 million in fiscal year 2002.
19) RELATED PARTY DISCLOSURE
The Company's Board of Directors has delegated authority to invest the
Company's surplus cash to Edward Lampert, subject to various 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 the Company's 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.
52
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
During 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. During fiscal 2003, the Company
hired certain employees of ESL. William C. Crowley assumed the position of
Senior Vice President, Finance at the Company to assist primarily with financial
matters while continuing in his role as President and Chief Operating Officer of
ESL and as a Director of Kmart Holding Corporation. ESL's Vice President -
Research, assumed the role of Vice President - Real Estate for the Company.
On January 31, 2005, Kmart entered into an agreement with Holdings and
certain affiliates of ESL.
Pursuant to this agreement, ESL affiliates converted, in accordance with
the terms of the notes, all of the outstanding 9.00% convertible subordinated
notes of Kmart into an aggregate of 6,269,998 shares of Kmart common stock, plus
cash in lieu of fractional shares, and, in consideration of such early
conversion, received an aggregate payment from Kmart of $3.3 million in cash.
This cash payment is approximately equivalent to the discounted, after-tax cost
of the future interest payments that would have otherwise been paid by Kmart to
the ESL affiliates in the absence of the early conversion.
This agreement also provides that the options to acquire shares of common
stock of Kmart, which were issued pursuant to the Investment Agreement will be
exchanged for options to acquire the same number of share of common stock of
Holdings at the same exercise price upon consummation of the mergers involving
Kmart and Sears. The Holdings options will have the same terms and conditions as
the Kmart options issued pursuant to the Investment Agreement and will expire,
in accordance with their terms, on May 6, 2005.
This agreement was approved by Kmart's Audit Committee, as contemplated by
the rules of the NASDAQ Stock Market for related party transactions, as well as
by Kmart's Board of Directors.
20) CORPORATE COST REDUCTIONS AND TERMINATION BENEFITS
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 were based on
employees' years of service and job grade, aggregating $6 million were paid to
affected employees primarily through the end of calendar year 2004. We are also
continuing efforts to reduce other corporate non-payroll expenses.
Upon the resignation of our former President and Chief Executive Officer,
he received a $2 million severance payment, pro-rata portions of his annual and
Long Term Incentive Plan bonuses and accelerated vesting of 778,880 stock
options, all as required by various agreements with the Company. In conjunction
with these actions, we incurred compensation expense of $5 million in the third
quarter of fiscal 2004, which is recorded in SG&A in our Consolidated Statement
of Operations for the year ended January 26, 2005.
21) DISCONTINUED OPERATIONS
On January 28, 2003, the Court approved the closure of 326 stores located
in 40 states, which number was later reduced to 316. Shortly after receiving
Court approval, the Predecessor Company commenced store closing sales which were
completed by April 13, 2003.
On March 20, 2002, the Court approved the closure of 283 stores. All the
stores were closed as of June 2, 2002.
SFAS No. 144 "Accounting for the Impairment or Disposal of Long-Lived
Assets," ("SFAS No. 144") requires closed stores to be classified as
discontinued operations when the operations and cash flows of the stores have
been (or will be) eliminated from ongoing operations and the company no longer
has any significant continuing involvement in the operations associated with the
stores after closure. Based on these criteria, we identified a small number of
stores closed in fiscal 2002 that met the criteria for discontinued operations;
however, in management's opinion they were not considered material to our
consolidated results of operations and were not separately presented. Upon
closure of the 316 stores in fiscal 2003, which included a substantial exit of
the state of Texas, we reevaluated the 283 stores that were closed in fiscal
2002 and the 316 stores closed in fiscal 2003 to identify stores that should be
accounted for as discontinued operations. This analysis resulted in a total of
121 stores identified as meeting the criteria for discontinued operations
treatment for all periods presented in our Consolidated Statements of
Operations, comprised of 66 of the 316 stores closed in fiscal 2003 and 55 of
the 283 stores closed in fiscal 2002. The table below sets forth the components
of the net loss for the discontinued operations for the 13-weeks ended April 30,
2003 and fiscal year 2002.
53
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
13-Weeks Ended Fiscal Year
(dollars in millions) April 30, 2003 2002
- --------------------- -------------- -----------
Sales $232 $1,410
Cost of sales, buying and occupancy 150 1,416
---- ------
Gross margin 82 (6)
Selling, general and administrative expenses 43 297
Restructurings, impairments and other charges 5 165
Reorganization items, net 44 23
---- ------
Discontinued operations from 2002 and 2003 store closings (10) (491)
Previous discontinued operations -- 43
---- ------
Discontinued operations, net of tax $(10) $ (448)
==== ======
In connection with the Predecessor Company's bankruptcy filing, the
Predecessor Company recorded primarily non-cash credits in fiscal 2002 of $43
million for the reduction of existing lease obligations for previously reported
discontinued operations for owned subsidiaries, due to the rejection of such
leases, to the amount of the allowed claim under the Bankruptcy Code. The fiscal
2002 amounts also include income related to the recovery of claims through the
bankruptcy of the Hechinger Company.
The Company applied the provisions of SFAS No. 144 to the stores sold
during fiscal 2004 and determined that none of the stores met the criteria to be
accounted for as discontinued operations.
22) 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 the Chapter 11 proceedings. Also, in accordance with SFAS
No. 144, the Predecessor Company recorded impairment charges in fiscal 2002. The
effect of these actions on the 13-weeks ended April 30, 2003 and fiscal year
2002 are summarized below.
2002 Markdowns for Inventory Liquidation
During fiscal 2002, the Predecessor Company recorded charges aggregating
$1.26 billion related to inventory that was liquidated at the 316 stores that
were closed during the first quarter of fiscal 2003 and the 283 stores that were
closed in the second quarter of fiscal 2002. Of the charge, $1.02 billion is
included in Cost of sales, buying and occupancy and $237 million is included in
Discontinued operations in the accompanying Consolidated Statements of
Operations.
Of the charge, $779 million was recorded to write-down inventory to its
estimated selling value in connection with the liquidation sales in the closing
stores. During the liquidation sales for the 283 stores closed in the second
quarter of fiscal 2002, the actual markdowns required to liquidate the inventory
were lower than expected. As a result, a credit of $36 million was recorded to
adjust the original estimate. In addition, $193 million of liquidator fees and
expenses were incurred as a result of the disposition of the inventory.
The remaining $320 million was recorded as acceleration of markdowns on
approximately 107,000 stock keeping units ("SKUs"), the majority of which were
transferred from the remaining open stores to the 283 closed stores and included
in the liquidation sales. The liquidation of these SKUs required higher
markdowns than anticipated, and accordingly, additional markdowns of $54 million
were recorded in the second quarter of 2002 in addition to the $266 million
original estimate.
Long-lived Asset Impairments
During fiscal 2002, a non-cash charge of $695 million was recorded in
accordance with SFAS No. 144 for long-lived assets in the 316 closed store
locations. Of the charge, $533 million is included in Restructuring, impairment
and other charges and $162 million is included in Discontinued operations in the
accompanying Consolidated Statements of Operations.
54
NOTES TO 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 at the corporate headquarters and
positions nationally that provided corporate support. As a result of the job
eliminations, a charge of $50 million was recorded in fiscal 2002, which was
later reduced by $10 million in the 13-weeks ended April 30, 2003 as a result of
a change in the estimated expenses. An additional $50 million was incurred
related to the severance plan provisions of the Predecessor Company's KERP, in
accordance with SFAS No. 112, "Employers' Accounting for Postemployment
Benefits". These items are included in the line Restructuring, impairment and
other charges in the accompanying Consolidated Statements of Operations.
Supply Chain Operations
Approximately $9 million of accelerated depreciation related to operating
software the Predecessor Company anticipated replacing in its distribution
centers was recorded in fiscal 2002 of which $7 million and $2 million were
included in Cost of sales, buying and occupancy and SG&A, respectively, before
the replacement initiative was suspended and the remaining net book value of
assets was depreciated over the original useful lives.
Restructuring of BlueLight.com
In fiscal 2002, the Predecessor Company reduced the reserves established in
fiscal 2001 for BlueLight.com contract terminations by $6 million based on
revised estimates for the remaining obligations. All charges related to the
impairment of the investment and restructuring of BlueLight.com are included in
the line Restructuring, impairment and other charges in the Consolidated
Statements of Operations.
Other
Accelerated Depreciation
The Predecessor Company recorded $52 million and $30 million during the
13-weeks ended April, 30, 2003 and fiscal year 2002, respectively, for
accelerated depreciation on unimpaired assets to be disposed of following the
316 and 283 store closings. The $30 million recorded in fiscal 2002 is included
in the line Cost of sales, buying and occupancy in the Consolidated Statements
of Operations. Of the $52 million recorded in the 13-weeks ended April 30, 2003,
$47 million is included in Restructurings, impairments and other charges and $5
million is included in Discontinued operations in the Consolidated Statements of
Operations.
Reserve Activity
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 Consolidated Statements of Operations. In
addition, the Predecessor Company reclassified $181 million of capital lease
obligations to the closed store reserve. The reserve for estimated costs was
recorded in accordance with SFAS No. 146, "Accounting for Costs Associated with
Exit or Disposal Activities."
As a result of the decision to close the 283 stores, the Predecessor
Company recorded net charges of $207 million during fiscal 2002, of which $22
million is included in Discontinued operations and the remaining $185 million is
included in Reorganization items, net in the Consolidated Statements of
Operations. In addition, the Predecessor Company reclassified $144 million of
capital lease obligations to the closed store reserve. The reserve for estimated
costs was recorded in accordance with EITF Issue No. 94-3, "Liability
Recognition for Certain Employee Termination Benefits and Other Costs to Exit an
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 4 - 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.
55
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
The following table provides information regarding reserve activity:
2003 2002 2002 2001 2001 2000
Store Employee Store Supply BlueLight Strategic
(dollars in millions) Closings Severance Closings Chain .com Actions
- --------------------- -------- --------- -------- ------ --------- ---------
Balance as of January 30, 2002 $ -- $ -- $ -- $11 $18 $98
Additions charged to operations -- 101 228 1 -- --
Reclassifications -- -- 140 -- -- --
---- ---- ---- --- --- ---
Total additions -- 101 368 1 -- --
Reductions:
Cash payments:
Lease obligations -- -- 11 -- 1 2
Employee costs -- 31 -- 5 -- --
Contractual obligations -- -- -- -- 1 --
Non-cash reductions:
Adjustments -- -- 21 -- 6 1
Pre-petition liability settlements -- 1 42 5 4 --
---- ---- ---- --- --- ---
Balance as of January 29, 2003 -- 69 294 2 6 95
Additions charged to operations 214 7 -- -- -- --
Reclassifications 181 -- -- -- -- --
---- ---- ---- --- --- ---
Total additions 395 7 -- -- -- --
Reductions:
Cash payments for employee costs -- 40 -- -- -- --
Non-cash reductions:
Discharge of liabilities 395 -- 294 2 6 95
Adjustments -- -- -- -- -- --
---- ---- ---- --- --- ---
Balance as of April 30, 2003 $ -- $ 36 $ -- $-- $-- $--
==== ==== ==== === === ===
Restructuring reserves related to the fiscal 2002 employee severance
program of $36 million were assumed by the Successor Company. During fiscal
2004, we made payments of $1 million and non-cash reductions of $3 million to
this reserve. We made $28 million in payments and recorded non-cash reductions
of $4 million to the reserve during the 39-weeks ended January 28, 2004. As of
January 26, 2005 and January 28, 2004 the liability for the 2002 employee
severance program was zero and $4 million, respectively.
23) 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
accompanying Consolidated Statements of Operations as required by SOP 90-7.
Predecessor Company
----------------------------
13-Weeks Ended Fiscal Year
(dollars in millions) April 30, 2003 2002
- --------------------- -------------- -----------
Gain on extinguishment of debt $(5,642) $ --
Revaluation of assets and liabilities 5,642 --
Fleming settlement 385 --
Estimated claims for rejected executory contracts 200 --
2003 store closings 158 --
2002 store closings -- 185
Other 26 178
------- ----
Reorganization items, net $ 769 $363
======= ====
56
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
The following paragraphs provide additional information relating to costs
that were reported in the line Reorganization items, net in our Consolidated
Statements of Operations for all periods presented:
Gain on extinguishment of debt/Revaluation of assets and liabilities
See Note 4 - 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.
Fleming settlement
On February 3, 2003, the Predecessor Company announced that it had
terminated the supply relationship with Fleming Corporation ("Fleming") by means
of a rejection of the 2001 contract through the 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 4 - Emergence from Chapter 11 Bankruptcy
Protection and Fresh-Start Accounting.
2003 store closings
As discussed in Note 22 - Special Charges, the Predecessor Company recorded
a charge of $214 million for lease terminations and other costs associated with
the 316 stores closed in fiscal 2003. Of the charge, $158 million is included in
Reorganization items, net in the Consolidated Statements of Operations, and the
remaining $56 million is included in Discontinued operations.
2002 store closings
As discussed in Note 22 - Special Charges, the Predecessor Company recorded
net charges of $207 million associated with the 283 stores closed in fiscal
2002. Of the charge, $185 million is included in Reorganization items, net in
the Consolidated Statements of Operations and the remaining $22 million is
included in Discontinued 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 Employees Retention Program ("KERP"), a gain of $17 million for the sale of
pharmacy lists for closed stores, income of $65 million for lease auction
proceeds related to the fiscal years 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.
For fiscal 2002, the Predecessor Company recorded employee costs of $143
million relating to the KERP, professional fees of $112 million, $51 million of
expense to revise its estimated pre-petition obligation for general liability
claims, a gain of $100 million for the settlement of pre-petition liabilities,
income of $27 million for lease auction proceeds related to the 2002 closed
stores, a gain of $14 million for the sale of pharmacy lists and net expenses of
$13 million for other miscellaneous reorganization items.
57
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)
24) COMMITMENTS AND CONTINGENCIES
Contingent Liabilities
The Predecessor Company had (i) guaranteed obligations for real property
leases of certain Debtors and certain of its former subsidiaries, including, but
not limited to, The Sports Authority, Inc., OfficeMax, Inc. and Borders Group,
Inc., some of which leases were assigned pre-petition; (ii) contingent
liabilities under real property leases assigned by the Predecessor Company
pre-petition; and (iii) guaranteed indebtedness of other parties related to
certain leased properties financed by industrial revenue bonds. To the extent
not expressly assumed or reinstated under the Plan of Reorganization, these
guarantees were discharged subject to pre-petition claims administration, and to
the extent expressly assumed or reinstated, such guarantees are not considered
to have a material adverse effect on the Successor Company's financial position
or results of operations.
Fair Labor Standards Litigation
There is an increasing trend of high profile class action litigation,
particularly in the retail industry, against employers of large numbers of
people which allege violations of the FLSA. Other companies against which these
cases have been filed have paid significant settlements and/or had significant
judgments entered against them. Kmart has a large employee base; however, no
FLSA class actions against Kmart have yet been certified.
Securities Action Litigation
Since February 21, 2002, five separate purported class actions have been
filed on behalf of purchasers of the Predecessor Company's common stock. The
initial complaints were filed in the United States District Court for the
Eastern District of Michigan on behalf of purchasers of common stock between May
17, 2001 and January 22, 2002, inclusive, and named Charles C. Conaway, former
Chief Executive Officer and Chairman of the Board of the Predecessor Company as
the sole defendant. On September 19, 2003, these complaints were dismissed with
prejudice.
On July 31, 2002, attorneys for plaintiffs in the then pending class action
lawsuits filed a class proof of claim in the Court (the "Class Proof of Claim")
on behalf of the plaintiffs and all purchasers of the Predecessor Company's
common stock between May 17, 2001 and January 22, 2002, inclusive. The Class
Proof of Claim, which is asserted against the Debtors, reserved the right to
identify additional claimants or members of the class group in the future. In
support of the Class Proof of Claim, the claimants rely on the above-referenced
class actions filed against the parties. The claimants state that the grounds
for liability are alleged damages for violations of federal securities laws,
including the Securities Exchange Act of 1934, in connection with the purchase
or acquisition of the Predecessor Company's common stock by the claimants during
the class period. The Class Proof of Claim alleges that the Debtors are liable
to the claimants for damages in a sum not presently determinable but believed to
be not less than $700 million in the aggregate, plus interest, costs and allowed
attorneys' fees. Kmart has objected to this claim. Assuming that the decision to
dismiss the purported action is upheld, Kmart will seek to have the Class Proof
of Claim expunged.
On April 26, 2002, a lawsuit was filed in the United States District Court
for the Eastern District of Michigan ("District Court") on behalf of three
limited partnerships (the "Softbank Funds") that purchased stock of
Bluelight.com, a subsidiary of the Predecessor Company, naming Charles C.
Conaway, as former CEO and Chairman of the Board of the Predecessor Company, as
the sole defendant. The Predecessor Company was not a defendant in this
litigation. The complaint alleges that Mr. Conaway breached his fiduciary duty,
took certain actions and made certain misrepresentations that induced plaintiffs
to exchange their Bluelight.com stock for the Predecessor Company's stock and
prevented plaintiffs from realizing the market value of their stock. The
complaint also alleges violations of Section 10(b) of the Securities Exchange
Act of 1934, Rule 10b-5 promulgated thereunder and Section 410 of the Michigan
Uniform Securities Act. On January 16, 2003, the District Court dismissed the
complaint. On February 14, 2003, a lawsuit was filed by the Softbank Funds
against Mr. Conaway in the Circuit Court of Cook County, Illinois ("Cook County
Circuit Court"). This lawsuit seeks $33 million from the defendant for alleged
breach of fiduciary duty in connection with the failure of the Predecessor
Company to cause the registration of the plaintiffs' shares of the Predecessor
Company's common stock to become effective. This claim is essentially the same
as count I of the District Court lawsuit that was dismissed on January 16, 2003.
On June 26, 2003, the Cook County Circuit Court dismissed the complaint without
prejudice. The Softbank Funds filed a First Amended Complaint seeking $33
million from Mr. Conaway and a motion for Voluntary Dismissal of the Complaint
on July 25, 2003. On August 4, 2003, the Cook County Circuit Court dismissed the
First Amended Complaint without prejudice. On July 31, 2003, the Softbank Funds
filed a Petition for Discovery Before Suit to Identify Responsible Persons (the
"Petition") against Conaway and other parties (but not Kmart) involved in the
Bluelight.com transaction. In response to the Petition, the Cook County Circuit
Court entered an order allowing limited discovery by the Softbank Funds pursuant
to an agreement as to the scope of the pre-suit discovery agreed to by the
parties served with the Petition.
58
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)
On May 2, 2002, the Softbank Funds filed proofs of claim with the Court in
an aggregate amount equal to $56 million. This claim has been expunged.
The foregoing actions, which were brought by or on behalf of holders of
common stock of the Predecessor Company and are referred to as "Securities
Actions" under the Plan of Reorganization, were brought against persons other
than the Company and, therefore, were not extinguished upon emergence from
Chapter 11. Accordingly, to the extent that any awards are granted to the
respective plaintiffs under these actions and a claim is allowed against the
Predecessor Company under the proofs of claim previously filed with the Court,
the allowed claim, to the extent not covered by insurance, will be addressed and
treated solely in accordance with the Plan of Reorganization. They would be
treated as Class 10 subordinated securities claims and would be entitled to the
same Plan of Reorganization distribution as are afforded to holders of other
allowed Class 10 claims (the theory being that indemnified claims based on
securities litigation enjoy no greater rights than the securities litigation
claims themselves). Under the Plan of Reorganization, Kmart estimates that the
holders of allowed Class 10 claims (who do not receive a recovery from the
lawsuit relating to the Class Proof of Claim) will receive a payment in cash
equal to 2.5% of the proceeds realized by the Creditor Trust through prosecution
of the various trust claims (an amount which has yet to be determined with
finality). Except as noted above, the foregoing actions relate to periods
occurring prior to the Petition Date. Any obligations which we may have with
respect to a claim for indemnification by any of the defendants will be governed
by the terms of the Plan of Reorganization.
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 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. Mediation was held on December 10,
2004, which did not settle the case. However, telephonic settlement discussions
are continuing and further discovery activity has been suspended. If settlement
is not reached, discovery is expected to begin in March, 2005.
Other and Routine Actions
Kmart is a defendant in a pre-petition putative nationwide class action
pending in Colorado relating to proper access to facilities for the disabled
under the Americans with Disabilities Act ("ADA"). The Colorado class action is
pending in the United States District Court in Denver, Colorado. The parties are
awaiting the court's decision on class certification and responsibility for
attorney fees. At this time, the likelihood of a material unfavorable outcome is
not considered probable. We have experienced an increase in ADA public
accommodation lawsuits filed against Kmart stores since emergence from
bankruptcy.
On November 7, 2003, the Company filed suit in the United States District
Court for the Eastern District of Michigan, which was later dismissed and
refiled in the Oakland County Circuit Court (State of Michigan), against Capital
One Bank, Capital One, F.S.B., and Capital One Services, Inc. (collectively,
"Capital One"). The complaint, as amended, alleges breach of contract, tortious
interference with business relationships, misappropriation of a trade secret,
trademark infringement, and a violation of the Michigan Consumer Protection Act,
which claims arise 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. Capital One has filed a
motion to dismiss a hearing on that motion has not been scheduled. Trial is
currently set for June 20, 2005. Discovery is proceeding.
On November 18, 2003, the Creditor Trust filed suit in the Oakland County
(Michigan) Circuit Court against six former executives of the Predecessor
Company (the "Officer Defendants") and PricewaterhouseCoopers LLP, the
Predecessor Company's independent auditor. The allegations against the Officer
Defendants include, among other things, violations of their fiduciary duty,
their duty of good faith and loyalty, and their duty of care, and breach of
contract related to the Officer Defendants' employment agreements with the
Predecessor Company. Allegations against PricewaterhouseCoopers LLP include,
among other things, breach of duty of care owed to the Predecessor Company and
breach of contract arising out of consulting agreements between
PricewaterhouseCoopers LLP and the Predecessor Company. Kmart is not a defendant
in this litigation. PricewaterhouseCoopers removed the case to the Bankruptcy
Court for the Eastern District of Michigan seeking to have the case transferred
to the Bankruptcy Court for the Northern District of Illinois. The Creditor
Trust filed a motion to remand the case back to the Oakland County Circuit Court
which was granted. The claims against the former executives were order to
binding arbitration by the Oakland County Circuit Court based on the terms of
the employment agreements.
59
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)
The Creditor Trust has also filed complaints in the Court against four of
the Predecessor Company's former executives to recover amounts paid out as
retention loans. The amount in controversy is approximately $2.15 million. The
former executives filed Counterclaims/Third Party Complaints against the
Creditor Trust and Kmart Corporation requesting that the Court set-off whatever
contractual severance they were entitled to against the retention loan proceeds
that the Creditor Trust was trying to recover. Kmart has filed motions to
dismiss the Counterclaims. The Court has not yet ruled on these motions.
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. The Seventh Circuit upheld the decision of the
District Court. Critical vendors sought a rehearing by the Seventh Circuit,
which was denied and filed petitions for Writ of Certiorari to the Supreme Court
which were also denied.
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 recently 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. To date, Kmart has settled 505 critical vendor claims for a total
recovery to the Company of $34 million in cash and claim assignments.
The Company became aware of reporting violations of the Emergency Planning
and Community Right to Know Act ("EPCRA") and other environmental regulations at
our distribution centers. Subsequently, we completed a comprehensive
environmental audit of each distribution center and have submitted the required
reports to the United States Environmental Protection Agency. At the current
time, we cannot, with reasonable certainty, estimate the penalty that may be
imposed, but are working closely with the Environmental Protection Agency to
resolve this matter.
We have submitted documentation to the Environmental Protection Agency and
are in the process of implementing a comprehensive environmental program at the
Distribution Centers. We have complied fully with the Environmental Protection
Agency on this matter are awaiting final resolution.
On September 24, 2004, the Company filed suit against i2 Technologies, Inc.
("i2") and two of its senior executives in the District Court for Dallas County,
Texas. The suit alleges fraud, breach of contract and rescission arising out of
the September 29, 2000 contract between Kmart and i2 for software licenses,
software development and consulting work, valued at approximately $42.5 million
(the "Contract"). Kmart is seeking monetary damages. After entering into the
Contract, Kmart experienced tremendous difficulty in integrating the new
software, notwithstanding i2's representations that integration would not be an
issue. Kmart also discovered that several of the software component packages it
had purchased did not exist. Additionally, Kmart spent approximately $10 million
for consulting services associated with the nonexistent or nonfunctioning i2
software. Only one of the 13 programs purchased by Kmart was usable, and is
still being used by Kmart. Discovery has begun, but is at a very early stage.
Trial has been set for March 2006.
We are a party to a substantial number of other claims, lawsuits and
pending actions which are routine and incidental to our business. To the extent
that any claim relates to a contract which was assumed by us when we emerged or
relates to a time period occurring after the Petition Date, the Successor
Company shall be responsible for any damages which may result. In addition,
certain contracts allow for damage provisions or other repayments as a result of
our termination of the contracts.
We assess the likelihood of potential losses on an ongoing basis, and when
they are considered probable and reasonably estimable, we record an estimate of
the ultimate outcome. If there is no single point estimate of loss that is
considered more likely than others, an amount representing the low end of the
range of possible outcomes is recorded. Our balance sheet as of January 26, 2005
only reflects potential losses for which the Successor Company may have ultimate
responsibility.
60
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)
Investigative Matters
Prior to emergence, the Predecessor Company had been provided with copies
of anonymous letters that were sent to the SEC, the Predecessor Company's
independent auditors, directors, legal counsel and others, expressing concern
with respect to various matters. The letters purported to be sent by certain of
our employees. The letters were referred to the Predecessor Company's Audit
Committee of the Board of Directors, which engaged outside counsel to review and
investigate the matters set forth in the letters. We are cooperating with the
SEC and the United States Attorney's office for the Eastern District of Michigan
with respect to the investigations of these matters. The staff of the SEC has
expressed concerns about and is investigating the manner in which we recorded
vendor allowances before the change in accounting principles at the end of
fiscal 2001 and about the disclosure of certain events bearing on the
Predecessor Company's liquidity in the fall of 2001. The U.S. Attorney for the
Eastern District of Michigan also is undertaking an inquiry into these matters.
A detailed discussion of the investigation and stewardship review, as well as
the results of such investigation and review, is contained in the Disclosure
Statement, which we filed as Exhibit 2.2 to our Current Report on Form 8-K dated
March 7, 2003.
After consultation with the statutory committees in the Chapter 11
proceedings, the Predecessor Company determined that the Creditor Trust was the
preferred available mechanism for resolving any legal claims that the Company
might have based on information from these investigations. As part of the Plan
of Reorganization, the trustee of the Creditor Trust is charged with
responsibility for determining which claims to pursue and, thereafter,
litigating such claims. As discussed above, the Creditor Trust has begun
litigation against former officers based on information from these
investigations.
Merger Litigation
Following the announcement of the proposed merger with Sears on November
17, 2004, several actions have been filed purporting to challenge the merger, as
follows:
Three cases, styled William Fischer v. Sears, Roebuck and Co., et al. (Case
No. 04 CH 19137), City of Dania Beach Police & Firefighters Retirement System v.
Sears, Roebuck and Co. et al. (Case No. 04 CH 19548) and Central Laborers
Pension Fund v. Sears, Roebuck and Co. et al. (Case No. 04 CH 19435), have been
filed in the Circuit Court of Cook County, Illinois, Chancery Division. These
cases assert claims on behalf of a purported class of Sears stockholders against
Sears and certain of its officers and directors, together with Kmart, Edward S.
Lampert, William C. Crowley and other affiliated entities, related to an alleged
breach of fiduciary duty in connection with the mergers. The plaintiffs allege
that the merger favors interested defendants by awarding them disproportionate
benefits, and that the defendants failed to take appropriate steps to maximize
the value of a merger transaction for Sears stockholders. The complaints seek
provisional and permanent injunctive relief; the Fischer complaint also seeks
damages. The cases have been reassigned to a single judge and the plaintiffs
have filed a consolidated and amended complaint. On February 1, 2005, the court
granted the defendants motion to stay or dismiss these Illinois actions in favor
of the pending New York action discussed immediately below. Accordingly, these
actions are stayed pending resolution of the New York actions discussed below.
Plaintiffs have filed a notice of appeal of the stay order to the Appellate
Court of Illinois - First District.
Two cases, styled Gershon Chanowitz, et al. v. Hall Adams, Jr., et al.
(Index No. 04/603903) and Nathan Krantman v. William Bax, et al. (index
04/603889), have been filed in the Supreme Court of the State of New York, New
York County. On February 15, 2005 the Court ordered that the two cases be
consolidated as a single action. On February 16, 2005, the plaintiff's filed a
superceding consolidated Amended Class Action Complaint. The consolidated
complaint asserts claims on behalf of a purported class of Sears stockholders
against Sears and certain of its officers and directors for breach of fiduciary
duty in connection with the mergers on the grounds that the defendants allegedly
failed to take appropriate steps to maximize the value of a merger transaction
for Sears stockholders. Plaintiffs also have named Kmart, Edward S. Lampert, and
ESL Investments, Inc. as defendants on the ground that they aided and abetted
the alleged breaches of fiduciary duty. Additionally, the plaintiffs claim that
the defendants have made insufficient and misleading disclosures in connection
with the mergers. The complaint seeks provisional and permanent injunctive
relief, as well as damages. Also, on February 16, 2005, the plaintiffs filed an
order to show cause seeking expedited discovery about the appraisal of Sears'
real estate. A briefing schedule on the motion has not yet been set. On February
25, 2005, the defendants filed a motion to dismiss the complaint.
The lawsuits are in their preliminary stages, and it is impossible to
predict their outcome at this time. Kmart intends to defend itself vigorously in
respect of the claims asserted against it.
61
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)
25) QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
2004
-------------------------------------
Successor Company
-------------------------------------
First Second Third Fourth
(dollars in millions, except per share data) Quarter Quarter Quarter Quarter
- -------------------------------------------- ------- ------- ------- -------
Sales $4,615 $4,785 $4,392 $5,909
Cost of sales, buying and occupancy $3,478 $3,543 $3,247 $4,402
Selling, general and administrative expenses $1,004 $1,039 $1,043 $1,070
Net income $ 91 $ 154 $ 552 $ 309
Basic net income per share $ 1.02 $ 1.72 $ 6.19 $ 3.48
Diluted net income per share $ 0.94 $ 1.54 $ 5.45 $ 3.09
2003
-----------------------------------------
Predecessor
Company Successor Company
----------- ---------------------------
First Second Third Fourth
(dollars in millions, except per share data) Quarter Quarter Quarter Quarter
- -------------------------------------------- ----------- ------- ------- -------
Sales $6,181 $5,652 $5,092 $6,328
Cost of sales, buying and occupancy $4,762 $4,419 $3,925 $4,740
Selling, general and administrative expenses $1,421 $1,225 $1,179 $1,177
Net income (loss) $ (862) $ (8) $ (28) $ 270
Basic net income (loss) per share $(1.65) $(0.09) $(0.31) $ 3.02
Diluted net income (loss) per share $(1.65) $(0.09) $(0.31) $ 2.78
Quarterly Items:
Earnings per share amounts for each quarter are required to be computed
independently and may not equal the amount computed for the total year.
In the fourth quarter of fiscal 2004 the Company recognized gains of $35
million and $46 million on sales of assets and recoveries from bankruptcy
related settlements, respectively; see Note 4 - Emergence from Chapter 11
Bankruptcy Protection and Fresh-Start Accounting. In the third quarter and
second quarter of fiscal 2004 the Company recognized $807 million and $72
million, respectively, from gain on sales of assets primarily related to the
previously announced transactions with Sears and Home Depot.
In the fourth quarter of fiscal 2003 the Company executed certain real
estate transactions, resulting in a net gain of $86 million. Approximately $56
million of this gain was the result of the assignment of four operating leases,
and $22 million of the gain was due to the sale of two owned properties. The
remaining net gain of $8 million was from the sale of other various property and
equipment.
62
Kmart Holding Corporation
Schedule II - Valuation and Qualifying Accounts
Fiscal Year 2004, 39-Weeks Ended January 28, 2004,
13-Weeks Ended April 30, 2003 and Fiscal Year 2002
(Dollars in millions)
Additions Additions
Balance at charged to charged to Balance at
beginning of cost, expenses, other end of
Description period revenues accounts Deductions period
- ----------- ------------ --------------- ---------- ---------- ----------
Allowance for Doubtful Accounts:
Successor Company
-----------------
Fiscal 2004 $ 78 $ 64 $ -- $ 102(1) $ 40
39-weeks ended January 28, 2004 80 96 -- 98(1) 78
Predecessor Company
-------------------
13-weeks ended April 30, 2003 67 61 -- 48(1) 80
Fiscal 2002 49 102 -- 84(1) 67
Allowance for Deferred Tax Assets:
Successor Company
-----------------
Fiscal 2004 $2,351 $ 53 $ -- $1,155(2) $1,249
39-weeks ended January 28, 2004 2,789 -- -- 438(3) 2,351
Predecessor Company
-------------------
13-weeks ended April 30, 2003 2,348 611 -- 170(4) 2,789
Fiscal 2002 1,032 1,122 194(5) -- 2,348
(1) Charges to the account are for the purposes for which the reserves
were created.
(2) In fiscal 2004 we utilized $380 million of pre-emergence deferred tax
assets. Such utilization reduced the valuation allowance previously
established. In fiscal 2004, the valuation allowance was further
reduced by $775 million based on the estimated utilization of deferred
tax assets through the end of fiscal 2007. In accordance with SOP
90-7, we recorded all of these adjustments to Capital in excess of par
value.
(3) For the 39-weeks ended January 28, 2004 we utilized $203 million of
pre-emergence deferred tax assets. Such utilization reduced the
valuation allowance previously established. During this same period,
the net pre-emergence deferred taxes were reduced by $235 million and
a correlating offset to the previously established valuation allowance
was required. In accordance with SOP 90-7, we recorded all of these
adjustments to Capital in excess of par value.
(4) The valuation allowance was decreased by $170 million due to the
adjustment of assets and liabilities to fair market value during
fresh-start accounting at April 30, 2003. This adjustment was credited
to Capital in excess of par value.
(5) The charge represents the valuation allowance on the deferred tax
benefit relating to the minimum pension liability adjustment.
63
MANAGEMENT'S ANNUAL REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
March 9, 2005
To the Stockholders of Kmart Holding Corporation,
The management of Kmart Holding Corporation ("Kmart") is responsible for the
preparation, integrity, objectivity and fair presentation of the financial
statements and other financial information presented in this report. The
financial statements have been prepared in conformity with accounting principles
generally accepted in the United States of America and reflect the effects of
certain judgments and estimates made by management.
Management is also responsible for establishing and maintaining adequate
internal control over financial reporting. The internal control system over
financial reporting is designed to provide reasonable assurance to Kmart's
management and board of directors regarding the preparation, integrity,
objectivity and fair presentation of the financial statements and other
financial information presented in this report.
Management assessed the effectiveness of Kmart's internal control over financial
reporting as of January 26, 2005. In making our assessment, management used the
criteria set forth in the Internal Control - Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission (COSO). Our
assessment included the documentation and understanding of our internal control
over financial reporting. We have evaluated the design effectiveness and tested
the operating effectiveness of internal controls to form our conclusion.
Because of its inherent limitations, including the possibility of human error
and the circumvention or overriding of controls, internal control over financial
reporting may not prevent or detect misstatements. Also, projections of any
evaluation of effectiveness to future periods are subject to the risk that
controls may become inadequate because of changes in conditions, or that the
degree of compliance with the policies or procedures may deteriorate.
Based on this assessment, we conclude that, as of January 26, 2005, the
Company's internal control over financial reporting is effective to provide
reasonable assurance that our financial statements are fairly presented in
conformity with generally accepted accounting principles.
In addition, Kmart's internal auditors advise management of the results of their
audits and make recommendations to improve the system of internal control over
financial reporting. Management evaluates the audit recommendations and takes
appropriate action.
BDO Seidman, LLP, independent registered public accounting firm, has reported on
management's assertion with respect to the effectiveness of our internal control
over financial reporting as of January 26, 2005, as stated in their report
included herein. The independent registered public accounting firm advises
management of the results of their audit and makes recommendations to improve
the system of internal control over financial reporting. Management evaluates
the audit recommendations and takes appropriate action.
/s/ Aylwin B. Lewis
- ----------------------------------------
Aylwin B. Lewis
President and Chief Executive Officer
/s/ James D. Donlon, III
- ----------------------------------------
James D. Donlon, III
Senior Vice President, Chief Financial Officer
64
MANAGEMENT'S RESPONSIBILITY
FOR FINANCIAL STATEMENTS
Management is responsible for the preparation and integrity of our
consolidated financial statements and other information appearing in this
report. These financial statements have been prepared in conformity with
accounting principles generally accepted in the United States of America on a
consistent basis applying certain estimates and judgments based upon currently
available information and management's view of current conditions and
circumstances. On this basis, we believe that these financial statements
reasonably present the financial position and results of operations of Kmart
Holding Corporation.
We maintain comprehensive systems of internal controls designed to provide
reasonable assurance that assets are safeguarded and transactions are executed
in accordance with established procedures. The concept of reasonable assurance
is based upon recognition that the cost of the controls should not exceed the
benefit derived. We believe our systems of internal controls provide this
reasonable assurance. We continually review, improve and modify these systems of
controls in response to changes in our business conditions and operations and to
recommendations made by our internal audit department and the external auditors.
We have adopted a code of conduct to guide our management in the continued
observance of high ethical standards of honesty, integrity, and fairness in the
conduct of business and in accordance with the law. Compliance with the
guidelines and standards is periodically reviewed and is acknowledged by all
management associates.
The firm of BDO Seidman, LLP, independent registered public accountants was
engaged to render a professional opinion on our consolidated financial
statements for the fiscal year ended January 26, 2005 and the 39-weeks ended
January 28, 2004. Their report contains an opinion based on their audit, which
was made in accordance with auditing standards of the Public Company Accounting
Oversight Board (United States) and procedures which they believed were
sufficient to provide reasonable assurance that the consolidated financial
statements, considered in their entirety, are not misleading and do not contain
material errors. The financial statements for the 13-weeks ended April 30, 2003
and fiscal year ended January 29, 2003, were audited by other auditors whose
report expressed an unqualified opinion for the 13-weeks ended April 30, 2003
and an unqualified opinion with an emphasis on going concern for the year ended
January 29, 2003. The going concern emphasis was due to our filing of the
voluntary petition for reorganization under Chapter 11 of the United States
Bankruptcy Code on January 22, 2002. This emphasis was removed in the opinion
rendered for the 13-weeks ended April 30, 2003 in connection with our emergence
from bankruptcy on May 6, 2003 and improved liquidity position.
Our Board of Directors has an Audit Committee consisting solely of
independent directors. The duties of the Audit Committee include keeping
informed of the financial condition of Kmart and reviewing our financial
policies and procedures, our internal accounting controls, and the objectivity
of our financial reporting. Both our independent accountants and the internal
auditors have free access to the Audit Committee and meet with the Audit
Committee periodically, with and without management present.
/s/ Aylwin B. Lewis
- ----------------------------------------------
Aylwin B. Lewis
President and Chief Executive Officer
/s/ James D. Donlon, III
- ----------------------------------------------
James D. Donlon, III
Senior Vice President, Chief Financial Officer
65
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM -- BDO SEIDMAN, LLP
Board of Directors and Stockholders
Kmart Holding Corporation
Troy, Michigan
We have audited management's assessment, included in the accompanying
Management's Report on Internal Control over Financial Reporting, that Kmart
Holding Corporation and subsidiaries (Successor Company) maintained effective
internal control over financial reporting as of January 26, 2005 based on
criteria established in Internal Control--Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission (COSO). Kmart
Holding Corporation and subsidiaries' (Successor Company) management is
responsible for maintaining effective internal control over financial reporting
and for its assessment of the effectiveness of internal control over financial
reporting. Our responsibility is to express an opinion on management's
assessment and an opinion on the effectiveness of the company's internal control
over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether
effective internal control over financial reporting was maintained in all
material respects. Our audit included obtaining an understanding of internal
control over financial reporting, evaluating management's assessment, testing
and evaluating the design and operating effectiveness of internal control, and
performing such other procedures as we considered necessary in the
circumstances. We believe that our audit provides a reasonable basis for our
opinion.
A company's internal control over financial reporting is a process
designed to provide reasonable assurance regarding the reliability of financial
reporting and the preparation of financial statements for external purposes in
accordance with generally accepted accounting principles. A company's internal
control over financial reporting includes those policies and procedures that (1)
pertain to the maintenance of records that, in reasonable detail, accurately and
fairly reflect the transactions and dispositions of the assets of the company;
(2) provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company's
assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial
reporting may not prevent or detect misstatements. Also, projections of any
evaluation of effectiveness to future periods are subject to the risk that
controls may become inadequate because of changes in conditions, or that the
degree of compliance with the policies or procedures may deteriorate.
In our opinion, management's assessment that Kmart Holding Corporation
and subsidiaries (Successor Company) maintained effective internal control over
financial reporting as of January 26, 2005, is fairly stated, in all material
respects, based on criteria established in Internal Control--Integrated
Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO). Also in our opinion, Kmart Holding Corporation and
subsidiaries (Successor Company) maintained, in all material respects, effective
internal control over financial reporting as of January 26, 2005, based on
criteria established in Internal Control--Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We have also audited, in accordance with the standards of the Public
Company Accounting Oversight Board (United States), the consolidated balance
sheets of Kmart Holding Corporation and subsidiaries (Successor Company) as of
January 26, 2005 and January 28, 2004, and the related consolidated statements
of operations, shareholders' equity, and cash flows for the year ended January
26, 2005 and the 39-weeks ended January 28, 2004, and our report dated March 4,
2005 expressed an unqualified opinion thereon.
BDO Seidman, LLP
Troy, Michigan
March 4, 2005
66
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM - BDO SEIDMAN, LLP
Board of Directors and Stockholders
Kmart Holding Corporation
Troy, Michigan
We have audited the accompanying consolidated balance sheets of Kmart
Holding Corporation and subsidiaries (Successor Company) as of January 26, 2005
and January 28, 2004 and the related consolidated statements of operations,
shareholders' equity, and cash flows for the year ended January 26, 2005 and the
39-weeks ended January 28, 2004. We have also audited the schedule, listed in
the accompanying index, for the year ended January 26, 2005 and the 39-weeks
ended January 28, 2004. These financial statements and schedule are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether the
financial statements and schedule are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements and schedule. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall presentation of the financial
statements and schedule. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Kmart
Holding Corporation and subsidiaries (Successor Company) at January 26, 2005 and
January 28, 2004, and the results of their operations and their cash flows for
the year ended January 26, 2005 and the 39-weeks ended January 28, 2004, in
conformity with accounting principles generally accepted in the United States of
America.
Also, in our opinion, the schedule for the year ended January 26, 2005 and
39-weeks ended January 28, 2004, presents fairly, in all material respects, the
information set forth therein.
We also have audited, in accordance with the standards of the Public
Company Accounting Oversight Board (United States), the effectiveness of Kmart
Holding Corporation and subsidiaries (Successor Company) internal control over
financial reporting as of January 26, 2005, based on criteria established in
Internal Control - Integrated Framework issued by The Committee of Sponsoring
Organizations of the Treadway Commission (COSO) and our report dated March 4,
2005 expressed an unqualified opinion thereon.
/s/ BDO Seidman, LLP
BDO Seidman, LLP
Troy, Michigan
March 4, 2005
67
REPORT OF INDEPENDENT AUDITORS - PRICEWATERHOUSECOOPERS LLP
To the Shareholders and
Board of Directors of
Kmart Holding Corporation:
In our opinion, the accompanying consolidated statements of operations, of
shareholders' equity (deficit) and of cash flows from January 30, 2003 to April
30, 2003, and for the year ended January 29, 2003 of Kmart Holding Corporation
and its subsidiaries (Predecessor Company) present fairly, in all material
respects, the results of their operations and their cash flows for the period
from January 30, 2003 to April 30, 2003, and for the year ended January 29, 2003
in conformity with accounting principles generally accepted in the United States
of America. In addition, in our opinion, the accompanying financial statement
schedule presents fairly, in all material respects, the information set forth
therein for the period from January 30, 2003 to April 30, 2003, and for the year
ended January 29, 2003, when read in conjunction with the related consolidated
financial statements. These financial statements and financial statement
schedule are the responsibility of the Company's management; our responsibility
is to express an opinion on these financial statements and financial statement
schedule based on our audits. We conducted our audits of these statements in
accordance with standards of the Public Company Accounting Oversight Board
(United States). Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements, assessing
the accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
As discussed in Note 4 to the consolidated financial statements, the Company
filed a petition on January 22, 2002 with the United States Bankruptcy Court for
the Northern District of Illinois for reorganization under the provisions of
Chapter 11 of the Bankruptcy Code. The Company's Amended Plan of Reorganization
was substantially consummated on April 23, 2003 and the Company emerged from
bankruptcy on May 6, 2003. In connection with its emergence from bankruptcy, the
Company adopted fresh start accounting.
/s/ PricewaterhouseCoopers LLP
PricewaterhouseCoopers LLP
Detroit, Michigan
August 8, 2003
68
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
None.
Item 9A. Controls and Procedures
Under the supervision of, and with the participation of our management,
including our principal executive officer and principal 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 principal executive officer and principal financial
officer concluded that, as of the Evaluation Date, our disclosure controls and
procedures were effective in ensuring that (i) information required to be
disclosed by the Company in the reports that it files or submits under the
Exchange Act is recorded, processed, summarized and reported, within the time
periods specified in the SEC's rules and forms and (ii) information required to
be disclosed by the Company in the reports that it files or submits under the
Exchange Act is accumulated and communicated to the Company's management,
including its principal executives and principal financial officers, or persons
performing similar functions as appropriate to allow timely decisions regarding
required disclosure.
No changes in the Company's internal control over financial reporting 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.
See Management's Annual Report On Internal Control Over Financial Reporting
and the Attestation Report of the Registered Public Accounting Firm included in
Item 8 of this Form 10-K.
PART III
Item 10. Directors and Executive Officers of the Registrant
DIRECTORS
EDWARD S. LAMPERT, 42, Chairman of our Board of Directors, is the Chairman and
Chief Executive Officer of ESL Investments, Inc. based in Greenwich,
Connecticut, which he founded in April 1988. Prior to founding ESL, Mr. Lampert
worked for Goldman, Sachs & Co. for a number of years. Mr. Lampert has a
bachelor's degree from Yale University. Mr. Lampert serves on the Board of
Directors of AutoNation, Inc. and AutoZone, Inc.
E. DAVID COOLIDGE III, 61, is the Vice Chairman of William Blair & Company, a
privately owned investment banking firm. He served as its Vice Chairman since
2003 and as Chief Executive Officer from 1995 until January 2004. Mr. Coolidge
has been at William Blair for 35 years, including 17 years as head of the
Corporate Finance division. Mr. Coolidge is a graduate of Williams College and
has an MBA from the Harvard Business School. He is a trustee of the University
of Chicago, Williams College and Rush University Medical Center. He serves on
the Advisory Board of the Kellogg Graduate School of Management. Mr. Coolidge
serves on the Board of Directors of Coverall Services and Duluth Trading Co.
WILLIAM C. CROWLEY, 47, is the Senior Vice President, Finance of Kmart. Mr.
Crowley has served as an Officer of the Company since 2003. Mr. Crowley also
serves as the President and Chief Operating Officer of ESL Investments, Inc.
Prior to joining ESL in 1999, he was a Managing Director in the Merger and
Acquisitions Department of Goldman, Sachs & Co. Mr. Crowley has a bachelor's
degree and a JD from Yale University, and a master's degree from Oxford
University. Mr. Crowley serves on the Board of Directors of AutoNation, Inc.
JULIAN C. DAY, 52, is the former President and Chief Executive Officer of Kmart.
Prior to joining Kmart as President and Chief Operating Officer in March of
2002, he served as Chief Operating Officer of Sears, Roebuck and Co. and was
Executive Vice President and Chief Financial Officer of Safeway, Inc. Mr. Day
holds undergraduate and master's degrees from Oxford University and an MBA from
the London Business School. He serves on the Board of Directors of Petco Animal
Supplies, Inc.
WILLIAM S. FOSS, 65, is a California-based attorney with extensive experience in
the retail industry. He served as Senior Vice President and General Counsel of
the Selective Distribution Group of LVMH Moet Hennessy Louis Vuitton, the
Paris-based luxury goods company, from 1998 through 2001. Prior to that, he was
Senior Vice President and General Counsel at DFS Group Limited, the world's
largest duty free retailing company. He previously served as Assistant General
Counsel at Crown Zellerbach Corporation. Mr. Foss received a bachelor's degree
from Dartmouth College and graduated from Rutgers University Law School.
69
AYLWIN B. LEWIS, 50, is the President and Chief Executive Officer of Kmart.
Prior to joining Kmart in October 2004, he served as President, Chief
Multi-Branding and Operating Officer of YUM! Brands, Inc. Mr. Lewis spent 13
years at YUM! and was in the restaurant industry for 26 years. Mr. Lewis holds
dual bachelor degrees from the University of Houston in both Business Management
and English Literature and an MBA from the University of Houston. He serves on
the Board of Directors of Halliburton Company and The Walt Disney Company.
STEVEN T. MNUCHIN, 42, is Chairman and Co-Chief Executive Officer of Dune
Capital Management LP and a member of the Management Committee. Prior to this,
he was CEO of SFM Capital Management LP (a Soros Fund Management LLC affiliate
and investment advisor to Soros Credit and SFM Capital). He also served as a
member of the Management Committee of Soros Fund Management LLC. Prior to SFM,
he served as Vice Chairman of ESL Investments. Prior to ESL, Mr. Mnuchin spent
17 years at Goldman Sachs where he had broad-based management and investment
responsibilities. Mr. Mnuchin was an Executive Vice President, the firm's Chief
Information Officer, and a member of the firm's Management Committee. He was
responsible for overseeing the Technology Division, global e-commerce, and
technology strategy. Mr. Mnuchin was also a member of the Fixed Income Currency
Commodity Division's Operating Committee. Mr. Mnuchin has a bachelor's degree
from Yale University. He is a member of the Yale Development Board, Riverdale
Country School Board, Hirshhorn Museum and Sculpture Garden Board, Whitney
Museum of American Art Board, and a Trustee of the OCD Foundation.
ANN N. REESE, 52, co-founded the Center for Adoption Policy in New York in 2001
and serves as its Executive Director. Prior to co-founding the Center, Ms. Reese
held a number of senior corporate positions. Ms. Reese served as a Principal
with Clayton, Dubilier & Rice, a private equity investment firm in 1999 and
2000. From 1995 to 1998, she was Executive Vice President and Chief Financial
Officer of ITT Corp. She also served as the Treasurer and Assistant Treasurer of
ITT Corp. She began her career at Bankers Trust, and held various treasury
positions at Union Carbide and Mobil Oil. Ms. Reese has a bachelor's degree from
the University of Pennsylvania and an MBA from New York University. Ms. Reese
serves on the Board of Directors of Xerox Corporation, Jones Apparel Group, and
Merrill Lynch.
BRANDON G. STRANZL, 30, is the Managing Member of TBGS Investments, LLC, which
is the General Partner of TBGS Partners, LP, a private limited partnership
focused on value investing. Mr. Stranzl formed TBGS Investments, LLC in May
2004. Prior to the formation of TBGS Investments, LLC, Mr. Stranzl was a Member
of Third Avenue Management LLC, where he was a Portfolio Manager for the Third
Avenue Special Situations Fund LP. Prior to joining Third Avenue in 2002, Mr.
Stranzl worked for Morgan Stanley Investment Management, where he focused on
high yield and distressed investments, beginning in 1999. Earlier in his career,
from 1997 to 1999, he worked for Fidelity Investments. Mr. Stranzl received a
bachelor's degree from Vassar College. He is a Chartered Financial Analyst and a
member of the New York Society of Security Analysts.
THOMAS J. TISCH, 50, has been the Managing Partner of Four Partners, a private
investment firm, since 1992. He is a trustee of the Manhattan Institute, New
York University Medical Center and Brown University. Mr. Tisch received a
bachelor's degree from Brown University and a JD from New York University. Mr.
Tisch serves on the Board of Directors of Anteon International Corp.
OFFICERS
KAREN A. AUSTIN, 43, Senior Vice President, Chief Information Officer. Ms.
Austin has been with the Company since 1984. She previously served as Vice
President, IT Applications from 2001 to 2002 and as Divisional Vice President,
Supply Chain Applications from 1999 to 2001.
JAMES E. DEFEBAUGH IV, 50, Senior Vice President, Chief Legal Officer. Mr.
Defebaugh has been with the Company since 1983. He previously served as Senior
Vice President, Chief Compliance Officer and Secretary during 2002 and 2003,
Vice President, Associate General Counsel and Secretary during 2001 and 2002,
Vice President and Secretary during 2000 and 2001, and Vice President, Legal in
1999.
JAMES D. DONLON III, 58, Senior Vice President, Chief Financial Officer. Mr.
Donlon joined the Company in January 2004. He spent 25 years at Daimler Chrysler
Corporation, retiring from there in 2003 after serving as Controller from 1992
to 1993, Vice President and Controller from 1993 to 1998 and Senior Vice
President & Controller from 1998 to 2003.
JAMES F. GOOCH, 37, Vice President, Controller. Mr. Gooch has been with the
Company since 1996. He previously served as Vice President, Treasurer, Financial
Planning & Analysis from March 2003 to September 2004, Vice President, Financial
Planning & Analysis from March 2002 to March 2003, Divisional Vice President -
Financial Planning & Analysis from November 2001 to March 2002, Assistant
Treasurer from April to November 2001 and Divisional Vice President -
Merchandise Finance from April 1999 to November 2001.
JOHN D. GOODMAN, 40, Senior Vice President, Chief Apparel Officer. Mr. Goodman
joined the Company in December 2003. He previously served as a Senior Vice
President from October 2001 to November 2003 and Vice President from March 2000
to October 2001 with Gap, Inc., and as Divisional Merchandise Manager/Senior
Director at Banana Republic from 1998 to 2000.
70
PAUL GUYARDO, 43, Senior Vice President, Chief Marketing Officer. Mr. Guyardo
joined the Company in March 2004. He previously served as Executive Vice
President of Television & Marketing for the Home Shopping Network from 1996 to
2004. Mr. Guyardo serves on the National Advisory Council at Northwestern
University, and the Board of Directors of Starlight/Starbright Children's
Foundation.
W. BRUCE JOHNSON, 53, Senior Vice President, Supply Chain and Operations. Mr.
Johnson joined the Company in October 2003. He previously served as Director,
Organization and Systems for Carrefour S.A. from March 1998 to October 2003.
JAMES P. MIXON, 60, Senior Vice President, Logistics. Mr. Mixon was previously
employed with the Company as Senior Vice President, Logistics from June 1997 to
October 2000. He served as Executive Vice President of The Return Exchange from
June 2001 to May 2002. He returned to the Company as Senior Vice President,
Logistics in May 2002.
ALLEN R. RAVAS, 49, Vice President, Treasurer, Financial Planning & Analysis.
Mr. Ravas has been with the Company since 1997. He previously served as Vice
President, Merchandise Controller from 2002 to September 2004, Divisional Vice
President, Merchandise Finance from 1999 to 2002 and Divisional Vice President,
Logistics Finance from 1997 to 1999.
DENE L. ROGERS, 44, Senior Vice President, Stores. Mr. Rogers joined the Company
in October 2003 as the head of Store Operations and was promoted to his current
role in June 2004. He previously served as Senior Vice President, Planning, New
Products and Development for Starwood Hotels and Resorts Worldwide, Inc. from
2001 to 2003 and Vice President, Business Development at General Electric
Capital Corporation from 1998 to 2001.
LISA SCHULTZ, 50, Senior Vice President, Chief Creative Officer. Ms. Schultz
joined the Company in September 2003. She previously served as Executive Vice
President Product Development and Design from 1987 to 2001 for Gap, Inc.
DAVID R. WHIPPLE, 51, Senior Vice President, Associate Resources. Mr. Whipple
joined the Company in June 2004. He previously served as Chief Human Resources
Officer from 2000-2004 for U.S. Food Service and Executive Vice President Human
Resources from 1995-2000 for Tops Markets, Inc.
SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Section 16(a) of the Exchange Act of 1934 requires the Company's directors
and officers to file reports of ownership and changes in ownership with respect
to the securities of the Company with the Securities and Exchange Commission and
to furnish copies of these reports to the Company. Based on a review of these
reports and written representations from the Company's directors and officers
regarding the necessity of filing a report, the Company believes that during
fiscal 2004 all filing requirements were met on a timely basis.
CODE OF ETHICS
The Company has long maintained a Code of Conduct that applies to all Kmart
associates, including our Chief Executive Officer, Chief Financial Officer, and
Principal Accounting Officer. We have posted our Code of Conduct in the
Corporate Governance section of our corporate website, www.kmart.com.
CORPORATE GOVERNANCE PRACTICES
The Board of Directors of the Company (the "Board") is committed to
effective corporate governance. The Board has approved and adopted Corporate
Governance Guidelines that provide the framework for governance of the Company.
The Corporate Governance Committee reviews and assesses the Corporate Governance
Guidelines annually and recommends changes to the Board as appropriate. The
Corporate Governance Guidelines, along with the charters of all Board
committees, the Company's Code of Business Conduct and the Company's Standards
of Conduct for Directors are available on our website at www.kmart.com under the
heading "About Kmart." Among other things, the Corporate Governance Guidelines
provide that:
- A majority of the members of the Board, and all members of the Board's
committees, must be independent Directors to the extent required by
applicable listing standards.
- Directors have the opportunity to meet regularly in executive session,
without management present.
- The Board and its committees have the power to engage independent
legal, financial or other advisors as deemed necessary, without
consulting or obtaining the approval of the Company's officers in
advance.
- The Board conducts an annual evaluation to assess whether it and its
committees are functioning effectively.
71
DIRECTOR INDEPENDENCE
A majority of the Directors on the Board of Directors are independent. The
Board has determined that each of the following Directors is an "independent
director" as defined in the listing standards of the NASDAQ Stock Market, Inc.
("NASDAQ"):
E. David Coolidge
William S. Foss
Edward S. Lampert
Steven T. Mnuchin
Ann N. Reese
Brandon G. Stranzl
Thomas J. Tisch
The Board of Directors has also determined that all members of the Audit
Committee meet additional, heightened independence criteria applicable to audit
committee members under the NASDAQ listing standards. The Board of Directors has
further determined that Ann N. Reese, the chair of the Audit Committee, E. David
Coolidge and Brandon G. Stranzl are "audit committee financial experts" as
defined in Item 401(h) of Regulation S-K promulgated by the SEC.
NASDAQ listing standards exempt "controlled companies" from NASDAQ's
requirements relating to the independence of the board, and the independence of
directors who participate in the director nomination and executive compensation
processes, in recognition of the fact that majority shareholders have the right
to select directors and control certain key decisions, such as executive officer
compensation, by virtue of their ownership rights. The Company qualifies as a
controlled company within the meaning of NASDAQ's listing standards because more
than 50% of the Company's voting power is held by ESL Investments, Inc. and its
affiliates ("ESL"). However, the Company has a majority of independent Directors
on its Board, and, under NASDAQ listing standards, the nominating and
compensation committees are independent.
COMMITTEES OF THE BOARD OF DIRECTORS
The Board has standing committees for Audit, Compensation, Corporate Governance
and Finance.
The table below reflects the membership for each committee in fiscal 2004.
Corporate
Audit Compensation Governance Finance
----- ------------ ---------- -------
E. Lampert X* X*
E. Coolidge X
W. Crowley X
J. Day X
W. Foss X
A. Lewis
S. Mnuchin X* X
A. Reese X* X
B. Stranzl X
T. Tisch X X
* Chair
Each committee operates under a written charter. The charters are available
on our corporate website, www.kmart.com under the heading "About Kmart."
72
Item 11. Executive Compensation
SUMMARY COMPENSATION TABLE
The following table sets forth information concerning the annual and long
term compensation paid to Aylwin B. Lewis, our Chief Executive Officer, Julian
C. Day, our former Chief Executive Officer, and the four other most highly
compensated executive officers for fiscal 2004 (the "Named Executive Officers").
Long Term Compensation
Annual Compensation Awards
----------------------------------------- ------------------------
Other Restricted
Annual Stock Securities All Other
Compensation Awards Underlying Compensation
NAME AND PRINCIPAL POSITION Year Salary ($) Bonus ($) (1) ($) (2) ($) (3) Options (4) ($) (5)
- --------------------------- ---- ---------- ------------- ------------ ---------- ----------- ------------
A. LEWIS
PRESIDENT AND CEO (6) 2004 $ 291,668 -- $ 17,624 $4,622,086 150,000 --
J. DAY
FORMER PRESIDENT
AND CEO (7) 2004 $ 712,500 $1,000,000 -- -- -- $2,003,365
2003 $1,000,000 $1,000,000 $ 2,754 -- 1,557,760 $ 1,692
2002 $ 643,123 $2,275,000 $778,494 -- -- $ 75,917
W. B. JOHNSON
SVP, SUPPLY CHAIN &
OPERATIONS (8) 2004 $ 650,000 $ 166,339 $215,906 -- -- $ 1,911
2003 $ 197,083 -- $ 88,966 $ 507,282 -- $ 338
H. LUEKEN
SVP, GENERAL
COUNSEL AND
SECRETARY (9) 2004 $ 450,000 $ 343,750 $ 17,483 -- -- $ 475,936
2003 $ 325,673 -- $ 72,955 $ 507,282 -- $ 25,232
J. MIXON
SVP, LOGISTICS 2004 $ 400,000 $ 180,000 -- -- -- $ 2,956
2003 $ 400,210 $ 180,000 -- -- -- $ 1,870
2002 $ 280,556 $ 80,000 $151,872 -- -- $ 779
L. SCHULTZ
SVP, CHIEF CREATIVE
OFFICER (10) 2004 $ 500,000 $ 176,528 -- -- -- $ 1,193
2003 $ 206,731 -- -- $ 507,282 -- $ 188
(1) Mr. Day, Mr. Johnson, Mr. Lueken, Mr. Mixon and Ms. Schultz received their
bonuses under the Company's Annual Bonus Plan.
(2) The dollar amounts under "Other Annual Compensation" include: Reimbursement
of Housing and Temporary Living Costs plus associated tax gross-up - Mr.
Lewis- $17,624 (2004); Mr. Day- $2,754 (2003), $154,438 (2002); Mr.
Johnson- $215,906 (2004), $88,966 (2003); Mr. Lueken - $17,483 (2004),
$72,955 (2003); Mr. Mixon - $148,872 (2002);
(3) Restricted stock cannot be sold or otherwise transferred by the Named
Executive Officer until such restrictions lapse. Restricted stock is valued
at the average high low price on the date of grant.
73
On January 26, 2005, the Named Executive Officers owned the number of
restricted shares set forth below. The market value is based on the closing
price of $90.33 for Kmart stock on that date.
W.B.
A. Lewis J. Day Johnson H. Lueken J. Mixon L. Schultz
---------- ------ ---------- ---------- -------- ----------
Number 50,781 -- 17,109 11,406 -- 17,109
of
Shares
Market $4,587,048 -- $1,545,456 $1,030,303 -- $1,545,456
Value
Kmart does not currently pay dividends on its common stock.
The following restricted stock grants reflected in the table vest or will
vest, in whole or in part, in under three years from the date of grant:
On October 18, 2004, in connection with his employment with the Company,
Mr. Lewis was granted 50,781 shares of restricted stock that will vest as of the
later of (i) the last day of the first Fiscal Year, of Fiscal Years 2005 through
2008, during which certain performance goals are met and (ii) the last day of
Fiscal Years 2005, 2006, 2007 and 2008, in the case of the first, second, third
and fourth installments, respectively. Mr. Lewis's restricted stock grant is
subject to shareholder approval.
On September 3, 2003, in connection with their employment with the Company,
Mr. Johnson, Mr. Lueken and Ms. Schultz were granted 17,109 shares of restricted
stock. The shares will vest with respect to those granted to Mr. Johnson and Ms.
Schultz in equal installments on 12:01 a.m. on the date after the end of fiscal
years 2004, 2005, and 2006. Mr. Lueken's shares would have vested in equal
installments on September 4, 2005 and September 4, 2006. Pursuant to Mr.
Lueken's separation agreement with the Company, vesting for one tranche of
restricted shares was accelerated and one tranche was forfeited.
(4) Mr. Lewis's options are subject to shareholder approval. Mr. Lewis was the
only employee of Kmart to receive options in fiscal 2004. Mr. Day was the
only employee of Kmart to receive options in fiscal 2003.
(5) The dollar amounts (for fiscal year 2004) set forth under "All Other
Compensation" include: Value of Life Insurance Premiums - Mr. Day -
$3,365; Mr. Johnson - $1,911; Mr. Lueken - $477; Ms. Schultz - $1,193; Mr.
Mixon - $2,956; Severance Payout - Mr. Day - $2,000,000; Value upon
vesting of Restricted Stock - Mr. Lueken - $475,459.
(6) Mr. Lewis's employment with Kmart commenced on October 18, 2004.
(7) Mr. Day's employment with Kmart ceased on October 18, 2004.
(8) Mr. Johnson became an executive officer of Kmart on September 3, 2003.
(9) Mr. Lueken's employment with Kmart ceased on January 31, 2005.
(10) Ms. Schultz became an executive officer of Kmart on September 2, 2003.
The following table provides information about stock option grants in 2004.
OPTION GRANTS IN LAST FISCAL YEAR
Percent of
Number of Total
Securities Options
Underlying Granted to Market
Options Employees Exercise Price Potential Realizable Value Assumed
Granted in Fiscal Price on Date Expiration at Annual Rates of Stock Price
Name (#) Year ($/Sh) of Grant Date Appreciation for Option Term
- ----------- ---------- ---------- -------- -------- ---------- ----------------------------------
5% ($) 10% ($)
A. Lewis(1) 150,000 100% $88.62 $88.62 10/18/2014 8,946,298 22,119,365
J. Day -- -- -- -- -- --
W. Johnson -- -- -- -- -- --
H. Lueken -- -- -- -- -- --
J. Mixon -- -- -- -- -- --
L. Schultz -- -- -- -- -- --
(1) Subject to shareholder approval.
74
AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR
AND FISCAL YEAR-END OPTION VALUES
Number of Securities Value of Unexercised
Underlying Unexercised In-the-Money Options at
Shares Options at Fiscal Year Fiscal Year End ($)
Acquired on Value End (#) Exercisable/Unexercisable
Name Exercise(#) Realized ($) Exercisable/Unexercisable (1)
- ---- ----------- ------------ ------------------------- -------------------------
A. Lewis -- -- 0/150,000(2) 0/$256,500
J. Day -- -- 1,168,321/0 $89,956,826/0
W. Johnson -- -- -- --
H. Lueken -- -- -- --
J. Mixon -- -- -- --
L. Schultz -- -- -- --
(1) The value of the unexercised in-the-money options are based on the
closing market price of $90.33 as of January 26, 2005, the Company's
fiscal year end.
(2) Subject to shareholder approval.
LONG TERM INCENTIVE PLAN -- AWARDS IN THE LAST FISCAL YEAR
The table below shows the contingent target awards established for the
Named Executive Officers with respect to Long Term Incentive Plan awards ("LTIP
Awards") issued under the Kmart Holding Corporation Long Term Incentive Plan for
the 2004-2006 performance period. Amounts available for LTIP Awards to executive
officers are contingent upon achievement of certain levels of earnings before
income, taxes, depreciation and amortization ("EBITDA"). The target amount is
based on each participant's annual salary and target bonus.
Estimated Future Payouts under
Performance or Other Period until Non-Stock Price-Based Plans
Name Maturation or Payout Target ($)
- ------------- --------------------------------- ------------------------------
A. Lewis -- --
J. Day (1) 10/19/04 $ 479,053
W. Johnson 1/29/04 - 1/31/07 $1,137,500
H. Lueken (2) 2/1/05 $ 725,000
J. Mixon -- --
L. Schultz 1/29/04 - 1/31/07 $ 875,000
(1) Mr. Day will receive a cash payment if the Company's cumulative EBITDA
for the entire performance period (1/29/04 - 1/31/07) is met.
(2) In accordance with the Separation Agreement between Mr. Lueken and the
Company, he received in lieu of any outstanding Long Term Incentive
Awards a $750,000 cash lump sum payment.
ANNUAL BOARD COMPENSATION
Only non-employee Directors are compensated for serving as Directors of the
Company. Each non-employee Director receives a cash retainer of $40,000. The
Audit Committee chair receives an additional $10,000 retainer. No other Director
receives additional compensation for board service. All Directors are reimbursed
for out-of-pocket expenses incurred to attend meetings.
EXECUTIVE OFFICER EMPLOYMENT AGREEMENTS
Aylwin B. Lewis. Kmart appointed Mr. Lewis to the office of President and
Chief Executive Officer effective October 18, 2004 and, in connection with his
appointment, entered into a five-year employment agreement with Mr. Lewis as of
such date (the "Lewis Agreement").
75
Under the Lewis Agreement, Mr. Lewis will receive an annual salary of not
less than $1,000,000; an annual bonus opportunity with a target amount equal to
his annual salary; relocation benefits and other employee benefits and
perquisites on the same basis as other senior executives of the Company, as in
effect from time to time. However, he will not participate in the Kmart Long
Term Incentive Plan. Mr. Lewis' annual bonus for the fiscal year beginning in
2004 will be based on performance from October 1, 2004 through the end of the
fiscal year and pro-rated to reflect that he will have served for only a portion
of the fiscal year.
Pursuant to the Lewis Agreement, Mr. Lewis was granted 150,000 options with
an exercise price equal to the fair market value of the underlying stock on
October 18, 2004, and restricted stock having a value, on October 18, 2004, of
$4,500,000. Subject to shareholder approval, which the Company will seek at its
special meeting of shareholders (to be held on March 24, 2005), the options and
restricted stock will vest in four installments on the last day of fiscal years
2005 through 2008, subject to his continued employment and, in the case of the
restricted stock, to a performance condition. However, if his employment is
terminated by the Company without cause or as a result of constructive
termination, the restricted stock will vest in full, options that would have
vested within 12 months of date of termination (but not less than one additional
installment) will vest; and all vested options will remain exercisable for two
years. The restricted stock will also vest upon his death or disability. In the
event that Mr. Lewis's employment is terminated by Kmart without cause (other
than because of death or disability) or by Mr. Lewis under a constructive
termination, Mr. Lewis will receive his salary and continued welfare benefits
for the lesser of three years or the remaining term of the Lewis Agreement, but
not less than 12 months, and a pro-rata portion of the annual bonus for the year
of termination.
If Mr. Lewis's employment is terminated because of his death or the
expiration of the term of his employment agreement, Mr. Lewis would be entitled
to receive accrued but unpaid salary, benefits under Kmart benefit plans and a
prorated annual bonus under our bonus program for the year in which the contract
was terminated, if a bonus was earned for that year. If Mr. Lewis's employment
is terminated due to disability, he would receive his base salary through the
date of termination, through the Company's long-term disability plan or
otherwise, an amount equal to 60% of his base salary for the period beginning on
the date of termination through his 65th birthday, and a prorated annual bonus
under our bonus program for the year in which the contract was terminated, if a
bonus was earned for that year. In addition to the items that Mr. Lewis would
receive upon termination of his employment agreement by death or by the
expiration of the contract, if Mr. Lewis's employment agreement is terminated by
Kmart without cause, or by Mr. Lewis under a constructive termination, he is
entitled to his base salary, at the rate in effect on the date of termination of
his employment payable for a period from the date of termination through the
later of (i) the third anniversary of the date of termination or, if sooner, the
last day of the Employment Term (as that is defined in the Lewis Agreement) and
(ii) the first anniversary of the date of termination.
The Lewis Agreement provides for 12-month post-termination non-competition
and non-solicitation covenants.
Julian C. Day. On October 18, 2004, the Company entered into an agreement
with Julian Day (the "Day Agreement") regarding his ceasing to serve as
President and Chief Executive Officer, which is treated as a termination without
cause under his employment agreement entered into originally in 2002, as amended
in 2003, and for purposes of his incentive compensation awards.
Upon the execution by Mr. Day of a mutual release of claims between him and
the Company, and compliance with the covenants described below, he received a
cash payment of $2,000,000 on the date when the mutual release became
irrevocable, and will receive a pro-rata portion of the annual bonus for the
2004 fiscal year, based upon Company performance for the entire year and payable
when the Company pays annual bonuses generally. In addition, as provided in his
long-term performance awards for the performance periods 2003-2006 and
2004-2007, he will receive pro-rata awards in the respective amounts of $977,974
and $479,053, if the applicable performance goals are met, payable in cash after
the end of the applicable performance periods. In addition to the first tranche
of 389,441 options granted to him in 2003 which were vested at the time of his
separation from the Company, the next two tranches of 389,441 options each
granted in 2003 became fully vested, with all such options remaining exercisable
for the next two years. Mr. Day will also receive continued welfare benefits for
two years.
Mr. Day is also subject to two-year non-competition and non-solicitation
covenants; a confidentiality covenant; and a covenant obligating him to
cooperate with the Company.
76
W. Bruce Johnson. Kmart appointed Mr. Johnson to the office of Senior Vice
President, Supply Chain and Operations effective September 3, 2003, and in
connection with his appointment, entered into an employment agreement with Mr.
Johnson (the "Johnson Agreement"). The Johnson Agreement is a three year
agreement with automatic one year renewal periods. The Johnson Agreement
provides for a base salary of $650,000, which shall be reviewed at least
annually. The Johnson Agreement also provides for an annual incentive award with
a target of 75% of his then-current salary, with the exact amount to be
determined based on the Company's performance. The Johnson Agreement awarded Mr.
Johnson $500,000 in restricted stock for entering the Johnson Agreement. Mr.
Johnson is also eligible to participate in the Company's Long Term Incentive
Plan. Awards under this Plan are contingent upon the Company's achievement of
certain EBITDA levels. For the period 1/29/04 -1/31/07, Mr. Johnson is eligible
to receive an award of up to $1,137,500. In addition, the Company agreed to
reimburse Mr. Johnson for reasonable personal financial (including tax)
counseling and for certain expenses related to his relocation.
If Mr. Johnson's employment is terminated because of his death or the
expiration of the term of his employment agreement, Mr. Johnson would be
entitled to receive accrued but unpaid salary, benefits under Kmart benefit
plans and a prorated annual bonus under our bonus program for the year in which
the contract was terminated, if a bonus was earned for that year. He would also
be entitled to the balance of any award earned but not yet paid, under the
Company's long term incentive plan. If Mr. Johnson's employment is terminated
due to disability, he would receive his base salary through the date of
termination, through the Company's long-term disability plan or otherwise, an
amount equal to 60% of his base salary for the period beginning on the date of
termination through his 65th birthday, and a prorated annual bonus under our
bonus program for the year in which the contract was terminated, if a bonus was
earned for that year. In addition to the items that Mr. Johnson would receive
upon termination of his employment agreement by death or by the expiration of
the contract, if Mr. Johnson's employment agreement is terminated by Kmart
without cause, or by Mr. Johnson under a constructive termination, he is
entitled to severance payments equal to his monthly base pay for one year,
except that such severance payments shall be reduced to the extent that he earns
fees, salary or wages from a subsequent employer, and a continuation of his
benefits for a one year period. The Johnson Agreement further provides for
12-month post-termination non-competition and non-solicitation covenants.
Harold W. Lueken. On January 26, 2005, the Company entered into a
separation agreement (the "Lueken Agreement") with Harold W. Lueken, Senior Vice
President, General Counsel and Secretary of Kmart. Under the terms of the Lueken
Agreement, Mr. Lueken remained an employee of Kmart through January 31, 2005 and
receives certain benefits through that date and for one year thereafter.
Pursuant to the Lueken Agreement, Mr. Lueken will receive a lump sum payment of
$750,000 in lieu of any amounts owed to him under the Company's Long Term
Incentive Plan. He will also receive his base salary for one year commencing on
the effective date of the Agreement, subject to certain reductions, and will be
eligible for his 2004 annual bonus. In addition, 5,703 shares of restricted
stock of the Company previously granted to Mr. Lueken will vest and become free
of transfer restrictions and the remaining unvested shares of restricted stock
will be forfeited on the effective date of the Agreement.
Lisa Schultz. Kmart appointed Ms. Schultz to the office of Senior Vice
President, Chief Creative Officer effective September 2, 2003, and in connection
with her appointment, entered into an employment agreement with Ms. Schultz (the
"Schultz Agreement"). The Schultz Agreement is a three year agreement with
automatic one year renewal periods. The Schultz Agreement provides for a base
salary of $500,000 which shall be reviewed at least annually. The Schultz
Agreement also provides for an annual incentive award with a target of 75% of
her then-current salary, with the exact amount to be determined based on the
Company's performance. The Schultz Agreement awarded Ms. Schultz $500,000 in
restricted stock for entering the Schultz Agreement. Ms. Schultz is also
eligible to participate in the Company's Long Term Incentive Plan. Awards under
this Plan are contingent upon the Company's achievement of certain EBITDA
levels. For the period 1/29/04 -1/31/07, Ms. Schultz is eligible to receive an
award of up to $875,000. In addition, the Company agreed to reimburse Ms,
Schultz for reasonable personal financial (including tax) counseling.
If Ms. Schultz's employment is terminated because of her death or the
expiration of the term of the Schultz Agreement, Ms. Schultz would be entitled
to receive accrued but unpaid salary, benefits under Kmart benefit plans and a
prorated annual bonus under our bonus program for the year in which the contract
was terminated, if a bonus was earned for that year. She would also be entitled
to the balance of any award earned but not yet paid, under the Company's long
term incentive plan. If Ms. Schultz's employment is terminated due to
disability, she would receive that base salary through the date of termination,
through the Company's long-term disability plan or otherwise, an amount equal to
60% of her base salary for the period beginning on the date of termination
through her 65th birthday, and a prorated annual bonus under our bonus program
for the year in which the contract was terminated, if a bonus was earned for
that year. In addition to the items that Ms. Schultz would receive upon
termination of her employment agreement by death or by the expiration of the
Schultz Agreement, if the Schultz Agreement is terminated by Kmart without
cause, or by Ms. Schultz under a constructive termination, or upon expiration of
the Schultz Agreement she is entitled to severance payments equal to her monthly
base pay for one year, except that such severance payments shall be reduced to
the extent that she earns fees, salary or wages from a subsequent employer, and
a continuation of her benefits for a one year period. The Schultz Agreement
further provides for 12-month post-termination non-competition and
non-solicitation covenants.
77
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
None of the members of the Board's Compensation Committee during Fiscal
2004 is or has been an officer or employee of the Company. During Fiscal 2004,
no Kmart executive officer served on the compensation committee (or equivalent)
or the board of directors of another entity whose executive officer(s) served on
Kmart's Compensation Committee or Board. Information about transactions between
the Company and its directors is set forth under "Certain Relationships and
Transactions."
Item 12. Security Ownership of Certain Beneficial Owners and Management
EQUITY COMPENSATION PLAN INFORMATION
The following table reflects information about the securities authorized
for issuance under the Company's equity compensation plans as of January 26,
2005.
(c) Number of securities
remaining available for
(a) Number of securities future issuance under
to be issued upon (b) Weighted-average equity compensation
exercise of outstanding exercise price of plans (excluding
options, warrants and outstanding options, securities reflected in
Plan Category rights warrants and rights column (a))
- --------------------- ------------------------ -------------------- ------------------------
Equity compensation 0 0 0
plans approved by
security holders
Equity compensation 1,168,321 $13.33 0
plans not approved by
security holders
TOTAL 1,168,321/0 $13.33 0
SECURITY OWNERSHIP OF MANAGEMENT AND BOARD MEMBERS
The following table sets forth information with respect to the beneficial
ownership of our Common Stock as of February 22, 2005 by:
each Named Executive Officer;
each of our Directors; and
all Executive Officers and Directors as a group.
The percentage calculations are based the shares of common stock issued and
outstanding as of February 22, 2005, except that information for Edward S.
Lampert and ESL Investments, Inc. is based on the Schedule 13 D/A dated February
1, 2005. Shares of common stock subject to options that are currently
exercisable or exercisable within 60 days after February 22, 2005 are deemed to
be outstanding and to be beneficially owned by the person holding the options
for the purpose of computing the percentage ownership of that person, but are
not treated as outstanding for the purpose of computing the percentage ownership
of any other person. Unless otherwise noted, each person or group identified
possesses sole voting and investment power with respect to the shares indicated,
subject to applicable community property laws.
The address of the beneficial owners is: c/o Kmart Holding Corporation,
3100 W. Big Beaver Road, Troy, Michigan 48084.
78
OPTIONS AND NOTES
EXERCISABLE WITHIN 60
NAME OF BENEFICIAL OWNERS COMMON STOCK (1) DAYS PERCENT OF CLASS
- ----------------------------------- ---------------- --------------------- ----------------
E. Coolidge 10,000 0 *
W. Crowley 0 0 *
J. Day 0 1,168,321 1.13%
W. Foss 2,000 0 *
W. Johnson 3,776 0 *
E. Lampert (2) 48,303,424 6,475,300 53.69%
A. Lewis 0 0 *
J. Mixon 0 0 *
S. Mnuchin 0 0 *
A. Reese 5,000 0 *
L. Schultz 7,703 0 *
B. Stranzl 0 0 *
T. Tisch (3) 1,079,302 0 1.06%
Directors & Executive Officers as a
group (22 persons)
49,420,967 7,643,621 55.93%
* Less than 1%
(1) This does not include restricted stock not yet vested.
(2) Mr. Lampert is deemed to beneficially own the shares of ESL Investments,
Inc. and certain of its affiliates. His ownership percentage is based on
the Schedule 13D/A dated February 1, 2005.
(3) Excludes 3,237,906 shares owned by Andrew H. Tisch, Daniel R. Tisch and
James S. Tisch, brothers of Mr. Thomas J. Tisch, or by trusts of which they
are the managing trustees and beneficiaries, in respect of which Mr. Tisch
has no pecuniary interest.
Item 13. Certain Relationships and Related Transactions
The Chairman of our Board of Directors, Edward S. Lampert, is also the
founder of ESL Investments, Inc., affiliates of which are our single largest
shareholder group. Mr. Lampert beneficially owns 53.69% of our common stock
because of this relationship. Mr. William C. Crowley, a director of the Company
and our Senior Vice President, Finance, is also continuing in his current role
as President and Chief Operating Officer of ESL Investments, Inc.
The Company's Board of Directors has delegated authority to invest the
Company's surplus cash to Edward Lampert, subject to various 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.
79
Further, to clarify the expectations that the Board of Directors has with
respect to the investment of the Company's 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.
On January 31, 2005, Kmart entered into an agreement with Holdings, ESL
Partners, L.P., ESL Investors, L.L.C., ESL Institutional Partners, L.P. and CRK
Partners II, L.P. (the foregoing entities other than Kmart and Holdings,
collectively the "ESL Companies"). The ESL Companies are controlled, directly or
indirectly, by ESL Investments, Inc., which in turn is controlled by Edward S.
Lampert. Pursuant to the agreement, the ESL Companies converted, in accordance
with the terms of the notes, all of the outstanding 9.00% convertible
subordinated notes of Kmart into an aggregate of 6,269,998 shares of Kmart
common stock, plus cash in lieu of fractional shares, and, in consideration of
such conversion, received an aggregate payment from Kmart of $3.3 million in
cash. This cash payment is approximately equivalent to the discounted, after-tax
cost of the future interest payments that would have otherwise been paid by
Kmart to the ESL Companies in the absence of the conversion (calculated by
multiplying the present value of such interest payments by one less an assumed
effective tax rate for Kmart).
The agreement also provides that the options to acquire shares of common
stock of Kmart which were issued pursuant to an Investment Agreement, dated as
of January 24, 2003, as amended, among ESL Investments, Inc. and Third Avenue
Trust, on behalf of its investment series, will be exchanged for options to
acquire the same number of shares of common stock of Holdings at the same
exercise price upon consummation of the merger with Sears. The Holdings options
will have the same terms and conditions as the Kmart Options and will expire, in
accordance with their terms, on May 6, 2005.
The Agreement was approved by Kmart's Audit Committee, as contemplated by
the rules of the NASDAQ Stock Market for related party transactions, as well as
by Kmart's Board of Directors.
For a discussion of certain other Related Transactions, see Note 2 - Merger
with Sears, Roebuck and Co. in Item 8 of this Form 10-K.
Item 14. Principal Accounting Fees and Services
INDEPENDENT AUDITOR FEES
We have elected to disclose fees billed to us by both BDO Seidman, LLP and
PricewaterhouseCoopers LLP for fiscal year 2003. Fees for the 13-weeks ended
April 30, 2003 were incurred by Kmart Corporation.
AUDIT FEES
The aggregate fees billed by BDO Seidman, LLP for professional services
rendered for the audit of our Annual Financial Statements for the year-ended
January 26, 2005 and for the review of the Financial Statements included in the
Company's Quarterly Report on Form 10-Q for that period were $1,599,879. The
aggregate fees billed by BDO Seidman, LLP for professional services rendered for
the audit of our Annual Financial Statements for the 39-weeks ended January 28,
2004 and for the review of the Financial Statements included in the Company's
Quarterly Report on Form 10-Q for that period were $1,337,131.
The aggregate fees billed by PricewaterhouseCoopers LLP for professional
services rendered for the audit of our Annual Financial Statements for the
13-weeks ended April 30, 2003 and for the reviews of the Financial Statements
included in the Company's Quarterly Reports on Form 10-Q, for the period May 1,
2003 through October 8, 2003, were $1,169,900.
AUDIT-RELATED FEES
The aggregate fees billed by BDO Seidman, LLP for professional services
rendered for audit-related services for the year-ended January 26, 2005 were
$249,000. Audit-related services include fees incurred in connection with the
Form S-4 filed for the merger with Sears.
80
The aggregate fees billed by BDO Seidman, LLP for professional services
rendered for audit-related services related to the period commencing October 8,
2003 through January 28, 2004 were $19,900.
The aggregate fees billed by PricewaterhouseCoopers LLP for professional
services rendered for audit-related services for the period commencing January
30, 2003 through October 8, 2003 were $64,000.
TAX FEES
There were no fees billed by BDO Seidman, LLP for professional tax services
rendered for fiscal year 2004 and for the period commencing October 8, 2003
through January 28, 2004.
The aggregate fees billed by PricewaterhouseCoopers LLP for professional
services rendered for tax services for the period commencing January 30, 2003
through October 8, 2003 were $988,554.
ALL OTHER FEES
The were no fees billed by BDO Seidman, LLP for services rendered to the
Company, other than the services described above under "Audit Fees," and
"Audit-Related Fees".
The aggregate fees billed by BDO Seidman, LLP for services rendered to the
Company, other than the services described above under "Audit Fees," and
"Audit-Related Fees" for fiscal year 2003 were $58,000.
AUDIT COMMITTEE PRE-APPROVAL POLICIES AND PROCEDURES
The Audit Committee has established a policy requiring its pre-approval of
all audit and permissible non-audit services provided by the independent
auditor. The policy provides for the pre-approval of particular types of
services and provides specific cost limits for each such service on an annual
basis. The policy requires pre-approval on a case-by-case basis of all other
permitted services. In determining whether to pre-approve services, the Audit
Committee considers whether such services are consistent with the rules of the
SEC on auditor independence. The Audit Committee delegates to its Chair the
authority to address any requests for pre-approval of services between Audit
Committee meetings, and the Chair reports any pre-approval decisions to the
Audit Committee at its next scheduled meeting. Consistent with applicable law,
the policy prohibits the Audit Committee from delegating to management the Audit
Committee's responsibility to pre-approve permitted services.
PART IV
Item 15. Exhibits, Financial Statement Schedules
(a) The following documents are filed as part of this report:
1. Financial Statements
Financial statements filed as part of this Form 10-K are listed under Part II,
Item 8.
2. Financial Statement Schedules
Financial statement schedules filed as part of this Form 10-K are listed under
Part II, Item 8.
The separate financial statements and summarized financial information of
majority-owned subsidiaries not consolidated and of 50% or less owned persons
have been omitted because they are not required pursuant to conditions set forth
in Rules 3-09 and 1-02(w) of Regulation S-X.
All other schedules have been omitted because they are not required under the
instructions contained in Regulation S-X because the information called for is
contained in the financial statements and notes thereto.
3. Exhibits
The following documents are filed as part of this report or are incorporated by
reference to exhibits previously filed with the SEC.
Exhibit 1.1 - Amended and Restated Certificate of Incorporation of Kmart Holding
Corporation (previously filed as Exhibit 1.1 to the Company's Quarterly Report
on Form 10-Q, for the period ended April 30, 2003, and incorporated herein by
reference)
81
Exhibit 1.2 - By-Laws of Kmart Holding Corporation (previously filed as Exhibit
1.2 to the Company's Quarterly Report on Form 10-Q, for the period ended April
30, 2003, and incorporated herein by reference)
Exhibit 2.1 - Agreement and Plan of Merger, dated as of November 16, 2004, by
and among Kmart Holding Corporation, Sears, Roebuck and Co., Sears Holdings
Corporation, Kmart Acquisition Corp. and Sears Acquisition Corp. (incorporated
by reference to Annex A to the joint proxy statement - prospectus in Part I of
the Sears Holdings Corporation's Registration Statement on Form S-4, file No.
333-120954, filed on December 2, 2004)
Exhibit 2.2 - Joinder Agreement, dated as of January 27, 2005, by and among
Sears Holdings Corporation, Kmart Acquisition Corp., Sears Acquisition Corp.,
Kmart Holding Corporation and Sears, Roebuck and Co., (incorporated by reference
to Exhibit 2.2 of Sears Holdings Corporation's Amendment No. 2 to the
Registration Statement on Form S-4, file No. 333-120954, filed on January 31,
2005)
Exhibit 4.1 - Investment Agreement (previously filed as Exhibit 4.1 to the
Predecessor Company's Current Report on Form 8-K, dated January 24, 2003, and
incorporated herein by reference)
Exhibit 4.2 - Amendment to Investment Agreement, dated as of February 21, 2003
(previously filed as Exhibit 4.9 to the Predecessor Company's Annual Report on
Form 10-K, dated January 29, 2003, and incorporated herein by reference)
Exhibit 4.3 - 9% Convertible Subordinated Note issued by Kmart Holding
Corporation to CRK Partners, L.P. (previously filed as Exhibit 4.1 to the
Company's Quarterly Report on Form 10-Q, for the period ended April 30, 2003,
and incorporated herein by reference)
Exhibit 4.4 - 9% Convertible Subordinated Note issued by Kmart Holding
Corporation to CRK Partners II, L.P. (previously filed as Exhibit 4.2 to the
Company's Quarterly Report on Form 10-Q, for the period ended April 30, 2003,
and incorporated herein by reference)
Exhibit 4.5 - 9% Convertible Subordinated Note issued by Kmart Holding
Corporation to ESL Institutional Partners, L.P. (previously filed as Exhibit 4.3
to the Company's Quarterly Report on Form 10-Q, for the period ended April 30,
2003, and incorporated herein by reference)
Exhibit 4.6 - 9% Convertible Subordinated Note issued by Kmart Holding
Corporation to ESL Investors, L.L.C. (previously filed as Exhibit 4.4 to the
Company's Quarterly Report on Form 10-Q, for the period ended April 30, 2003,
and incorporated herein by reference)
Exhibit 4.7 - Registration Rights Agreement, dated May 6, 2003, by and among
Kmart Holding Corporation, ESL Investments, Inc. and Third Avenue Trust, on
behalf of certain of its investment series. (previously filed as Exhibit 4.5 to
the Company's Quarterly Report on Form 10-Q, for the period ended April 30,
2003, and incorporated herein by reference)
Exhibit 4.8 - Guarantee Agreement, dated May 6, 2003, by and among Kmart
Corporation, CRK Partners, L.P., CRK Partners II, L.P., ESL Institutional
Partners, L.P. and ESL Investors L.L.C. (previously filed as Exhibit 4.6 to the
Company's Quarterly Report on Form 10-Q, for the period ended April 30, 2003,
and incorporated herein by reference)
Exhibit 4.9 - Kmart Creditor Trust Agreement, dated as of April 30, 2003, by and
among Kmart Corporation, the other Affiliated Debtors party thereto and Douglas
J. Smith, as Trustee. (previously filed as Exhibit 4.7 to the Company's
Quarterly Report on Form 10-Q, for the period ended April 30, 2003, and
incorporated herein by reference)
Exhibit 4.10 - First Amendment to Kmart Creditor Trust Agreement, dated as of
May 6, 2003, by and among Kmart Corporation, the other Affiliated Debtors party
thereto and Douglas J. Smith, as Trustee. (previously filed as Exhibit 4.8 to
the Company's Quarterly Report on Form 10-Q, for the period ended April 30,
2003, and incorporated herein by reference)
Exhibit 10.1 - Credit Agreement, dated as of May 6, 2003, among Kmart
Corporation, as Borrower, the other Credit Parties signatory thereto, as Credit
Parties, the Lenders signatory thereto, from time to time, as Lenders, and
General Electric Capital Corporation, as Administrative Agent, Co-Collateral
Agent and Lender, GECC Capital Markets Group, Inc., as Co-Lead Arranger and
Co-Book Runner, Fleet Retail Finance Inc., as Co-Syndication Agent,
Co-Collateral Agent and Lender Fleet Securities, Inc., as Co-Lead Arranger and
Co-Book Runner, Bank of America, N.A., as Co-Syndication Agent and Lender, Banc
of America Securities LLC, as Co-Lead Arranger and Co-Book Runner, GMAC
Commercial Finance LLC, as Co-Documentation Agent and Foothill Capital
Corporation, as Co-Documentation Agent (previously filed as Exhibit 10.1 to the
Company's Quarterly Report on Form 10-Q, for the period ended April 30, 2003,
and incorporated herein by reference)
82
Exhibit 10.2 - Assignment and Assumption Agreement, dated as of May 6, 2003,
between Kmart Holding Corporation and Kmart Corporation assigning Julian C.
Day's Employment Agreement to Kmart Holding Corporation (previously filed as
Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q, for the period
ended April 30, 2003, and incorporated herein by reference)
Exhibit 10.3 - Kmart Holding Corporation Nonqualified Stock Option Agreement
between Kmart Holding Corporation and Julian C. Day (previously filed as Exhibit
10.3 to the Company's Quarterly Report on Form 10-Q, for the period ended April
30, 2003, and incorporated herein by reference)
Exhibit 10.4 - Employment Agreement, dated as of May 6, 2003, between Kmart
Management Corporation and Harold W. Lueken. (previously filed as Exhibit 10.4
to the Company's Quarterly Report on Form 10-Q, for the period ended April 30,
2003, and incorporated herein by reference)
Exhibit 10.5 - Michael T. Macik Separation Agreement. (previously filed as
Exhibit 10.5 to the Company's Quarterly Report on Form 10-Q, for the period
ended April 30, 2003, and incorporated herein by reference)
Exhibit 10.6 - Letter Agreement to Credit Agreement (previously filed as Exhibit
10.1 to the Company's Quarterly Report on Form 10-Q, for the period ended July
30, 2003, and incorporated herein by reference)
Exhibit 10.7 - Kmart Holding Corporation Annual Incentive Bonus Plan (previously
filed as Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q, for the
period ended July 30, 2003, and incorporated herein by reference)
Exhibit 10.8 - First Amendment to Credit Agreement (previously filed as Exhibit
10.3 to the Company's Quarterly Report on Form 10-Q, for the period ended July
30, 2003, and incorporated herein by reference)
Exhibit 10.9 - Employment Agreement, dated as of September 15, 2003, between
Kmart Management Corporation and Bruce Johnson (previously filed as Exhibit 10.1
to the Company's Quarterly Report on Form 10-Q, for the period ended October 29,
2003, and incorporated herein by reference)
Exhibit 10.10 - Employment Agreement dated as of September 3, 2003, between
Kmart Management Corporation and Janet L. Kelly (previously filed as Exhibit
10.2 to the Company's Quarterly Report on Form 10-Q, for the period ended
October 29, 2003, and incorporated herein by reference)
Exhibit 10.11 - Employment Agreement dated as of September 3, 2003, between
Kmart Management Corporation and Lisa Schultz (previously filed as Exhibit 10.3
to the Company's Quarterly Report on Form 10-Q, for the period ended October 29,
2003, and incorporated herein by reference)
Exhibit 10.12 - Kmart Management Corporation Restricted Stock Agreement with
Bruce Johnson (previously filed as Exhibit 10.4 to the Company's Quarterly
Report on Form 10-Q, for the period ended October 29, 2003, and incorporated
herein by reference)
Exhibit 10.13 - Kmart Management Corporation Restricted Stock Agreement with
Janet L. Kelly (previously filed as Exhibit 10.5 to the Company's Quarterly
Report on Form 10-Q, for the period ended October 29, 2003, and incorporated
herein by reference)
Exhibit 10.14 - Kmart Management Corporation Restricted Stock Agreement with
Lisa Schultz (previously filed as Exhibit 10.6 to the Company's Quarterly Report
on Form 10-Q, for the period ended October 29, 2003, and incorporated herein by
reference)
Exhibit 10.15 - Kmart Management Corporation Restricted Stock Agreement with
Harold Lueken (previously filed as Exhibit 10.7 to the Company's Quarterly
Report on Form 10-Q, for the period ended October 29, 2003, and incorporated
herein by reference)
Exhibit 10.16 - Amendment No. 1 to the May 6, 2003 Nonqualified Stock Option
Agreement between Kmart Holding Corporation and Julian C. Day (previously filed
as Exhibit 10.8 to the Company's Quarterly Report on Form 10-Q, for the period
ended October 29, 2003, and incorporated herein by reference)
Exhibit 10.17 - Form of Kmart Holding Corporation Long Term Incentive Award
Agreement (previously filed as Exhibit 10.9 to the Company's Quarterly Report on
Form 10-Q, for the period ended October 29, 2003, and incorporated herein by
reference)
Exhibit 10.18 - Amended and Restated Employment Agreement for Julian C. Day,
dated as of January 17, 2003, between Kmart Corporation and Julian C. Day
(previously filed as Exhibit 99.2 to the Predecessor Company's Current Report on
Form 8-K, dated January 17, 2003 and incorporated herein by reference)
83
Exhibit 10.19 - Employment Agreement dated as of January 1, 2004, between Kmart
Management Corporation and James D. Donlon, III (previously filed as Exhibit
10.19 to the Company's Annual Report on Form 10-K, dated March 18, 2004 and
incorporated herein by reference)
Exhibit 10.20 - Employment Agreement dated as of January 1, 2004, between Kmart
Management Corporation and John Goodman (previously filed as Exhibit 10.20 to
the Company's Annual Report on Form 10-K, dated March 18, 2004 and incorporated
herein by reference)
Exhibit 10.21 - Employment Agreement dated as of February 27, 2004, between
Kmart Management Corporation and Paul Guagliardo "Guyardo" (previously filed as
Exhibit 10.21 to the Company's Annual Report on Form 10-K, dated March 18, 2004
and incorporated herein by reference)
Exhibit 10.22 - Kmart Management Corporation Restricted Stock Agreement with
James D. Donlon, III (previously filed as Exhibit 10.22 to the Company's Annual
Report on Form 10-K, dated March 18, 2004 and incorporated herein by reference)
Exhibit 10.23 - Kmart Management Corporation Restricted Stock Agreement with
John Goodman (previously filed as Exhibit 10.23 to the Company's Annual Report
on Form 10-K, dated March 18, 2004 and incorporated herein by reference)
Exhibit 10.24 - Second Amendment to the Credit Agreement (previously filed as
Exhibit 10.24 to the Company's Annual Report on Form 10-K, dated March 18, 2004
and incorporated herein by reference)
Exhibit 10.25 - Third Amendment to the Credit Agreement (previously filed as
Exhibit 10.25 to the Company's Annual Report on Form 10-K, dated March 18, 2004
and incorporated herein by reference)
Exhibit 10.26 - Kmart Management Corporation Restricted Stock Agreement with
Paul Guagliardo "Guyardo" (filed herewith)
Exhibit 10.27 - Employment Agreement dated as of June 1, 2004, between Kmart
Management Corporation and David Whipple (previously filed as Exhibit 10.1 to
the Company's Quarter Report on Form 10-Q, for the period ended July 28, 2004,
and incorporated herein by reference)
Exhibit 10.28 - Asset Purchase Agreement dated as of June 29, 2004, between
Kmart Corporation and Sears, Roebuck and Co. (previously filed as Exhibit 10.2
to the Company's Quarter Report on Form 10-Q, for the period ended July 28,
2004, and incorporated herein by reference)
Exhibit 10.29 -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 (previously filed as Exhibit 10.3 to the Company's Quarterly
Report on Form 10-Q, for the period ended July 28, 2004, and incorporated herein
by reference)
Exhibit 10.30 - First Amendment to 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 (previously filed as Exhibit 10.3 to
the Company's Quarterly Report on Form 10-Q, for the period ended October 27,
2004, and incorporated herein by reference)
Exhibit 10.31 - Employment Agreement dated as of October 18, 2004, between Kmart
Holding Corporation and Aylwin B. Lewis (previously filed as Exhibit 10.1 to the
Company's Quarterly Report on Form 10-Q, for the period ended October 27, 2004
and incorporated herein by reference)
Exhibit 10.32 - Julian C. Day Separation Agreement, dated as of October 18, 2004
(previously filed as Exhibit 10.2 to the Company's Quarterly Report on Form
10-Q, for the period ended October 27, 2004, and incorporated herein by
reference)
Exhibit 10.33 - Credit Agreement, dated as of May 6, 2003, as amended and
restated as of October 7, 2004, among Kmart Corporation as Borrower, the other
Credit Parties signatory thereto, as Credit Parties, the Lenders signatory
thereto, from time to time, as Lenders, and General Electric Capital
Corporation, as Administrative Agent, Co-Collateral Agent and Lender, GECC
Capital Markets Group, Inc., as Co-Lead Arranger and Co-Book Runner, Fleet
Retail Finance Inc., as Syndication Agent, Co-Collateral Agent and Lender, Fleet
Securities, Inc., as Co-Lead Arranger and Co-Book Runner, GMAC Commercial
Finance LLC, as Co-Documentation Agent and Wells Fargo Foothill Inc. as
Co-Documentation Agent (previously filed as Exhibit 10.4 to the Company's
Quarterly Report on Form 10-Q, for the period ended October 27, 2004, and
incorporated herein by reference)
Exhibit 10.34 - Employment Agreement dated as of November 16, 2004, among Alan
J. Lacy, Kmart Holding Corporation and Sears, Roebuck and Co. (previously filed
as Exhibit 10.1 to the Company's Current Report on Form 8-K, dated as of
November 16, 2004, and incorporated herein by reference)
84
Exhibit 10.35 - Harold W. Lueken Separation Agreement, dated as of January 26,
2005 (filed herewith)
Exhibit 10.36 - Second Amendment to Letter of Credit Agreement, dated as of
December 23, 2004, among Kmart Corporation, Bank of America, National
Association and Fleet National Bank as issuing banks (filed herewith)
Exhibit 10.37 - Agreement, dated January 31, 2005, among Kmart Holding
Corporation, Sears Holdings Corporation, ESL Partners, L.P., ESL Investors,
L.L.C., ESL Institutional Partners, L.P. and CRK Partners II, L.P. (previously
filed as Exhibit 99.1 to the Company's Current Report on Form 8-K, dated January
31, 2005 and incorporated herein by reference)
Exhibit 10.38 - Five-Year Credit Agreement, dated as of February 22, 2005, among
Sears Holdings Corporation, and Sears Roebuck Acceptance Corp. and Kmart
Corporation as borrowers, and the banks, financial institutions and other
institutional lenders (the "Initial Lenders") listed on the signature pages
thereof, Citicorp USA, Inc. and Bank of America, N.A. as syndication agents,
Barclays Bank PLC, Lehman Commercial Paper Inc., HSBC Bank USA, Merrill Lynch
Bank USA, Morgan Stanley Bank, The Royal Bank of Scotland, PLC and Wachovia Bank
National Association as documentation agents and J.P. Morgan Securities Inc.,
Citigroup Global Markets Inc. and Banc of America Securities LLC as lead
arrangers and joint bookrunners, and JPMorgan Chase Bank, N.A., as
administrative agent for the Initial Lenders (previously filed as Exhibit 99.1
to the Company's Current Report on Form 8-K, dated February 22, 2005 and
incorporated herein by reference)
Exhibit 21 - Kmart Holding Corporation List of Significant Subsidiaries
Exhibit 23.1 - Consent of Independent Registered Public Accounting Firm
Exhibit 23.2 - Consent of Independent Registered Public Accounting Firm
Exhibit 31.1 - Certification Pursuant to Rule 13a-15(e)/15d-15(e) of the
Securities Exchange Act of 1934, as Amended
Exhibit 31.2 - Certification Pursuant to Rule 13a-15(e)/15d-15(e) of the
Securities Exchange Act of 1934, as Amended
Exhibit 32.1 - Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
Exhibit 99.1 - Support Agreement and Irrevocable Proxy, dated as of November 16,
2004, among certain affiliates of ESL Investments, Inc., Kmart Holding
Corporation and Sears, Roebuck and Co. (previously filed as Exhibit 99.1 to the
Company's Current Report on Form 8-K, dated as of November 16, 2004, and
incorporated herein by reference)
85
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized on March 9, 2005.
Each signatory hereby acknowledges and adopts the typed form of his or her
name in the electronic filing of this document with the Securities and Exchange
Commission.
Kmart Holding Corporation
By: /s/ Aylwin B. Lewis
------------------------------------------------
Aylwin B. Lewis
President and Chief Executive Officer
(Principal Executive Officer)
By: /s/ James D. Donlon, III
------------------------------------------------
James D. Donlon, III
Senior Vice President, Chief Financial Officer
(Principal Financial Officer)
By: /s/ James F. Gooch
------------------------------------------------
James F. Gooch
Vice President, Controller
(Principal Accounting Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons, on behalf of the
Registrant and in the capacities indicated, on March 9, 2005.
Each signatory hereby acknowledges and adopts the typed form of his or her
name in the electronic filing of this document with the Securities and Exchange
Commission.
/s/ Edward S. Lampert
-------------------------------------------------------
Edward S. Lampert, Chairman of the Board of Directors
/s/ E. David Coolidge, III /s/ Steven T. Mnuchin
- ------------------------------------- ----------------------------------------
E. David Coolidge, III, Director Steven T. Mnuchin, Director
/s/ William C. Crowley /s/ Ann N. Reese
- ------------------------------------- ----------------------------------------
William C. Crowley, Director Ann N. Reese, Director
/s/ Julian C. Day /s/ Brandon G. Stranzl
- ------------------------------------- ----------------------------------------
Julian C. Day, Director Brandon G. Stranzl, Director
/s/ William S. Foss /s/ Thomas J. Tisch
- ------------------------------------- ----------------------------------------
William S. Foss, Director Thomas J. Tisch, Director
/s/ Aylwin B. Lewis
- -------------------------------------
Aylwin B. Lewis, Director
86
EXHIBIT INDEX
Exhibit
Number Description
- ------- -----------
10.26 Kmart Management Corporation Restricted Stock Agreement with Paul
Guagliardo "Guayardo"
10.35 Harold W. Lueken Separation Agreement, dated as of January 26, 2005
10.36 Second Amendment to Letter of Credit Agreement, dated as of December
23, 2004, among Kmart Corporation, Bank of America, National
Association and Fleet National Bank as issuing banks
21 Kmart Holding Corporation List of Significant Subsidiaries
23.1 Consent of Independent Registered Public Accounting Firm
23.2 Consent of Independent Registered Public Accounting Firm
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