10-Q/A 1 k73883e10vqza.txt AMENDMENT NO. 1 TO FORM 10-Q SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q/A AMENDMENT NO. 1 X QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES --- EXCHANGE ACT OF 1934 For the quarterly period ended May 1, 2002 ----------- OR TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES --- EXCHANGE ACT OF 1934 For the transition period from ______________ to _____________ Commission File No. 1-327 ----- KMART CORPORATION (Exact name of registrant as specified in its charter) Michigan 38-0729500 -------------------------------------------------------------------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 3100 West Big Beaver Road - Troy, Michigan 48084 -------------------------------------------------------------------------------- (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code (248) 463-1000 -------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed, by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ------- ------- As of May 29, 2002, 502,686,416 shares of Common Stock of Kmart Corporation were outstanding. 1 INDEX
PART I FINANCIAL INFORMATION PAGE ------ --------------------- ---- Item 1. Financial Statements Condensed Consolidated Statements of Operations-- 4 (Unaudited) (Restated) 13 weeks ended May 1, 2002 and May 2, 2001 Condensed Consolidated Balance Sheets-- 5 (Unaudited) (Restated) May 1, 2002, May 2, 2001 and January 30, 2002 Condensed Consolidated Statements of Cash Flows-- 6 (Unaudited) (Restated) 13 weeks ended May 1, 2002 and May 2, 2001 Notes to Condensed Consolidated Financial 7 - 21 Statements (Unaudited) Item 2. Management's Discussion and Analysis of Results of 22- 35 Operations and Financial Condition Item 3. Quantitative and Qualitative Disclosures about Market Risk 36 PART II OTHER INFORMATION ------ ----------------- Item 3. Defaults Upon Senior Securities 37 Item 6. Exhibits and Reports on Form 8-K 37 Signatures 38 Certifications 39-40
2 EXPLANATORY NOTE The purpose of this Amendment No. 1 to Quarterly Report on Form 10-Q/A is to restate the unaudited financial statements of Kmart Corporation and its subsidiaries ("Kmart," "we," "us" or "our") for the 13 week period ended May 1, 2002 and prior periods presented to reflect certain adjustments identified as a result of our ongoing review of our accounting practices and procedures and to correspondingly modify related disclosures. Certain of these adjustments were identified as out-of-period adjustments during the preparation of Kmart's Quarterly Report on Form 10-Q for the third quarter ended October 30, 2002, while others were previously identified and described in our Quarterly Report on Form 10-Q for the second quarter ended July 31, 2002, filed with the Securities and Exchange Commission ("SEC") on September 16, 2002. Upon review of the aggregate impact of these adjustments, Kmart concluded that restating our historical financial statements was appropriate, because the aggregate impact was material to the current estimate of our fiscal year 2002 results. This Amendment No. 1 to our Quarterly Report on Form 10-Q/A should be read in conjunction with Amendment No. 1 to our Annual Report on Form 10-K/A for our fiscal year ended January 30, 2002, to be filed with the SEC on January 14, 2003. We have amended and restated in its entirety each Item of our Quarterly Report on Form 10-Q for the 13 week period ended May 1, 2002 to reflect these adjustments. Except as otherwise expressly noted herein, this Amendment No.1 to Quarterly Report on Form 10-Q/A does not reflect events occurring after the June 14, 2002 filing of our Quarterly Report on Form 10-Q for the 13 week period ended May 1, 2002 or modify or update the disclosures set forth in that Quarterly Report on Form 10-Q in any way, except as required to reflect the effects of the restatement of our financial statements for the 13 week periods presented or deemed necessary in connection with the completion of restated financial statements. The Items of our Quarterly Report on Form 10-Q for the 13 week period ended May 1, 2002 which are amended and restated herein are: 1. Part I, Item 1 - Financial Statements, has been restated. 2. Part I, Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations, has been revised. 3. The certifications required by Section 302 of the Sarbanes-Oxley Act of 2002 have been added. 4. The certifications required by Section 906 of the Sarbanes-Oxley Act of 2002 have been added as Exhibits. The remaining Items contained within this Amendment No. 1 to our Quarterly Report on Form 10-Q/A consist of all other Items originally contained in our Quarterly Report on Form 10-Q for the 13 week period ended May 1, 2002 in the form filed with the SEC on June 14, 2002. These remaining Items are not amended hereby, but are included for the convenience of the reader. In order to preserve the nature and character of the disclosures set forth in such Items as originally filed, except as expressly noted herein, this report continues to speak as of the date of the original filing, and we have not updated the disclosures in this report to speak as of a later date. While this report primarily relates to the historical periods covered, events may have taken place since the original filing that might have been reflected in this report if they had taken place prior to the original filing. All information contained in this Amendment No. 1 to Quarterly Report on Form 10-Q/A is subject to updating and supplementing as provided in our reports filed with the SEC subsequent to the date of the original filing of the Quarterly Report on Form 10-Q, including but not limited to our Quarterly Reports on Form 10-Q for the 13 week periods ended July 31 and October 30, 2002, respectively. 3 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) (UNAUDITED)
(AS RESTATED - SEE NOTE 1) 13 WEEKS ENDED ---------------------------- MAY 1, 2002 MAY 2, 2001 ------------- ------------ Sales $ 7,639 $ 8,337 Cost of sales, buying and occupancy 7,021 6,779 ------- ------- Gross margin 618 1,558 Selling, general and administrative expenses 1,770 1,694 Equity income (loss) in unconsolidated subsidiaries 5 (16) Charge for employee severance and Voluntary Early Retirement Program (VERP) - 23 ------- ------- Loss before interest, reorganization items, income taxes, and dividends on convertible preferred securities of subsidiary trust (1,147) (175) Interest expense, net (contractual interest for 13 weeks ended May 1, 2002 was $102) 33 83 Reorganization items, net 274 - Income tax benefit (12) (82) Dividends on convertible preferred securities of subsidiary trust, net of income taxes of $0 and $6, respectively (contractual dividend for 13 weeks ended May 1, 2002 was $18, net of tax) - 11 ------- ------- Net loss $(1,442) $ (187) ======= ======= Basic/Diluted loss per common share $ (2.87) $ (0.38) ======= ======= Basic/Diluted weighted average shares (millions) 502.9 488.5
See accompanying Notes to Condensed Consolidated Financial Statements. 4 CONDENSED CONSOLIDATED BALANCE SHEETS (DOLLARS IN MILLIONS, EXCEPT SHARE DATA) (UNAUDITED)
(AS RESTATED - SEE NOTE 1) ----------------------------------------------- MAY 1, 2002 MAY 2, 2001 JANUARY 30, 2002 ----------- ----------- ---------------- ASSETS CURRENT ASSETS Cash and cash equivalents $ 1,829 $ 415 $ 1,245 Merchandise inventories 5,255 7,315 5,796 Other current assets 597 708 800 -------- -------- -------- TOTAL CURRENT ASSETS 7,681 8,438 7,841 Property and equipment, net 5,972 6,626 6,093 Other assets and deferred charges 219 543 249 -------- -------- -------- TOTAL ASSETS $ 13,872 $ 15,607 $ 14,183 ======== ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES Long-term debt due within one year $ - $ 315 $ - Accounts payable 1,658 2,694 89 Accrued payroll and other liabilities 659 1,500 420 Taxes other than income taxes 237 245 143 -------- -------- -------- TOTAL CURRENT LIABILITIES 2,554 4,754 652 Long-term debt and notes payable - 2,448 330 Capital lease obligations 694 922 857 Other long-term liabilities 140 877 132 -------- -------- -------- TOTAL LIABILITIES NOT SUBJECT TO COMPROMISE 3,388 9,001 1,971 LIABILITIES SUBJECT TO COMPROMISE 7,805 - 8,093 Company obligated mandatorily redeemable convertible preferred securities of a subsidiary trust holding solely 7 3/4% convertible junior subordinated debentures of Kmart (redemption value $898, $898 and $898, respectively) 889 887 889 Common stock, $1 par value, 1,500,000,000 shares authorized; 502,689,273, 489,930,257 and 503,294,515 shares outstanding, respectively 503 490 503 Capital in excess of par value 1,697 1,599 1,695 (Accumulated deficit) retained earnings (410) 3,630 1,032 -------- -------- -------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 13,872 $ 15,607 $ 14,183 ======== ======== ========
See accompanying Notes to Condensed Consolidated Financial Statements. 5 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (DOLLARS IN MILLIONS) (UNAUDITED)
(AS RESTATED - SEE NOTE 1) --------------------------- 13 WEEKS ENDED --------------------------- MAY 1, 2002 MAY 2, 2001 ----------- ----------- CASH FLOWS FROM OPERATING ACTIVITIES Net loss $(1,442) $ (187) Adjustments to reconcile net loss to net cash provided by (used for) operating activities: Restructuring, impairments and other charges 776 23 Reorganization items, net 274 - Depreciation and amortization 187 200 Equity (income) loss in unconsolidated subsidiaries (5) 16 Dividends received from Meldisco 45 51 Cash used for store closings and other charges (38) (26) Changes in Operating Assets and Liabilities: Increase in inventories (109) (965) Increase in accounts payable 1,104 494 Deferred income taxes and taxes payable (9) (28) Other assets 198 202 Other liabilities 40 (38) ------- ------- Net cash provided by (used for) continuing operations 1,021 (258) Net cash used for discontinued operations (1) (20) ------- ------- NET CASH PROVIDED BY (USED FOR) OPERATING ACTIVITIES 1,020 (278) ------- ------- NET CASH PROVIDED BY REORGANIZATION ITEMS 12 - ------- ------- CASH FLOWS FROM INVESTING ACTIVITIES Capital expenditures (52) (262) Investment in BlueLight.com - (15) ------- ------- NET CASH USED FOR INVESTING ACTIVITIES (52) (277) ------- ------- CASH FLOWS FROM FINANCING ACTIVITIES Proceeds from issuance of debt - 592 Payments on debt (347) (6) Debt issuance costs (30) - Payments on capital lease obligations (19) (21) Payments of dividends on preferred securities of subsidiary trust - (18) Issuance of common shares - 22 ------- ------- NET CASH (USED FOR) PROVIDED BY FINANCING ACTIVITIES (396) 569 ------- ------- NET CHANGE IN CASH AND CASH EQUIVALENTS 584 14 CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 1,245 401 ------- ------- CASH AND CASH EQUIVALENTS, END OF PERIOD $ 1,829 $ 415 ======= =======
See accompanying Notes to Condensed Consolidated Financial Statements. 6 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) (UNAUDITED) 1. RESTATEMENT OF CURRENT AND PRIOR PERIODS As part of the review and preparation of the Quarterly Report on Form 10-Q for the third quarter ended October 30, 2002, Kmart Corporation and its subsidiaries ("Kmart," "we," "us" or "our") identified certain adjustments that were recorded out-of-period, while others were previously identified and described in our Quarterly Report on Form 10-Q for the second quarter ended July 31, 2002, filed with the Securities and Exchange Commission ("SEC") on September 16, 2002. Upon review of the aggregate impact of the new, as well as the previously disclosed and recorded adjustments, we concluded that restating our historical financial statements was appropriate because the aggregate impact was material to the current estimate of our 2002 fiscal year results. The tables below show the results of the restatements on reported results for the 13 week periods presented in this Amendment No. 1 to our Quarterly Report on Form 10-Q/A, which relate primarily to: a) Lease accrual adjustments - An understatement of historical accruals for certain leases with varying rent payments and a related understatement of historical rent expense. b) Accounts payable adjustments - A software programming error in Kmart's accounts payable system that resulted in some paid invoices awaiting a store report of delivery not being appropriately treated in our financial statements. This error, restricted to a single vendor with unique billing arrangements, resulted in an understatement of Cost of sales, buying and occupancy since 1999. c) Inventory loads - Adjustments, as previously disclosed in the Quarterly Report on Form 10-Q for the second quarter ended July 31, 2002, for certain costs formerly capitalized into inventory. Inventory included amounts added for internal purposes to analyze gross margin on a comparable basis across all business units and to optimize purchasing decisions. These amounts are commonly referred to in the retail industry as "inventory loads," and should have been eliminated for external reporting purposes to the extent the related inventory remained unsold at the end of the period. d) Vendor allowances - The premature recording, as previously disclosed in the Quarterly Report on Form 10-Q for the second quarter ended July 31, 2002, of vendor allowance transactions in fiscal year 2000 and prior fiscal years. In addition, given the restatement for the items noted above, we are adjusting these previously reported financial results for miscellaneous immaterial items that were identified and previously recorded in the ordinary course of business. These items are now being recorded in the appropriate fiscal periods. 7 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) (UNAUDITED) The summary of the effects of the restatement on the 13 weeks ended May 1, 2002 and May 2, 2001 are presented in the tables below.
13 Weeks Ended May 1, 2002 --------------------------------------------------------------------------------------------- Adjustments --------------------------------------------------------------- As Lease Accounts previously accrual payable Inventory Vendor As reported* adjustments adjustments loads allowances Other restated --------------------------------------------------------------------------------------------- Sales $7,639 $- $- $- $- $- $7,639 Cost of sales, buying and occupancy $7,016 $3 $10 ($9) ($8) $9 $7,021 --------------------------------------------------------------------------------------------- Gross margin $623 ($3) ($10) $9 $8 ($9) $ 618 Selling, general and administrative expenses $1,791 $- $- $1 $- ($22) $1,770 Operating (loss) income ($1,163) ($3) ($10) $8 $8 $13 ($1,147) Reorganization items, net $265 $- $- $- $- $9 $ 274 --------------------------------------------------------------------------------------------- Net (loss) income ($1,449) ($3) ($10) $8 $8 $4 ($1,442) ============================================================================================= Basic/Diluted (loss) earnings per common share ($2.88) $- ($0.02) $0.01 $0.01 $0.01 ($ 2.87) =============================================================================================
13 Weeks Ended May 1, 2002 --------------------------------------------------------------------------------------------- Adjustments --------------------------------------------------------------- As Lease Accounts previously accrual payable Inventory Vendor As reported** adjustments adjustments loads allowances Other restated --------------------------------------------------------------------------------------------- Sales $8,337 $- $- $- $ - $ - $8,337 Cost of sales, buying and occupancy $6,834 $1 $5 ($15) ($41) ($5) $6,779 --------------------------------------------------------------------------------------------- Gross margin $1,503 ($1) ($5) $15 $41 $5 $1,558 Selling, general and administrative expenses $1,712 $- $- $1 $ - ($19) $1,694 Operating (loss) income ($248) ($1) ($5) $14 $41 $24 ($175) (Benefit from) provision for income taxes ($109) $- ($2) $5 $15 $9 ($82) --------------------------------------------------------------------------------------------- Net (loss) income ($233) ($1) ($3) $9 $26 $15 ($187) ============================================================================================= Basic/Diluted (loss) earnings per common share ($0.48) $- $- $0.02 $0.05 $0.03 ($0.38) =============================================================================================
* - As previously reported in the Form 10-Q for the quarter ended May 1, 2002 filed on June 14, 2002. ** - As previously reported in the Form 10-Q/A for the quarter ended May 2, 2001 filed on June 12, 2002. 8 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) (UNAUDITED) The following is a summary of the effects of the restatement on our unaudited Condensed Consolidated Balance Sheets for all amounts that changed by 5% or more for the periods ended May 1, 2002, May 2, 2001 and January 30, 2002, respectively.
As previously As reported restated ------------ ------------ May 1, 2002* Other long-term liabilities $87 $140 Accumulated deficit ($188) ($410) May 2, 2001** Other assets and deferred charges $473 $543 Other long-term liabilities $828 $877 January 30, 2002*** Accounts payable $103 $89 Accrued payroll and other liabilities $378 $420 Other long-term liabilities $79 $132 Retained earnings $1,261 $1,032
* - As previously reported in the Form 10-Q for the quarter ended May 1, 2002 filed on June 14, 2002. ** - As previously reported in the Form 10-Q/A for the quarter ended May 2, 2001 filed on June 12, 2002. *** - As previously reported in the Form 10-K for the fiscal year ended January 30, 2002 filed on May 15, 2002. 2. BASIS OF PRESENTATION General These interim unaudited Condensed Consolidated Financial Statements have been prepared on a going concern basis, which assumes continuity of operations and realization of assets and satisfaction of liabilities in the ordinary course of business, and in accordance with Statement of Position 90-7 ("SOP 90-7"), "Financial Reporting by Entities in Reorganization under the Bankruptcy Code." Accordingly, all pre-petition liabilities subject to compromise have been segregated in the unaudited Condensed Consolidated Balance Sheets and classified as Liabilities subject to compromise, at the estimated amount of allowable claims. Liabilities not subject to compromise are separately classified as current and non-current. Revenues, expenses, realized gains and losses, and provisions for losses resulting from the reorganization are reported separately as Reorganization items, net in the unaudited Condensed Consolidated Statements of Operations. Cash provided by reorganization items is disclosed separately in the unaudited Condensed Consolidated Statements of Cash Flows. These interim unaudited Condensed Consolidated Financial Statements have been prepared in accordance with the rules and regulations of the SEC. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (which include normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the 13 week period ended May 1, 2002 are not necessarily indicative of the results that may be expected for the fiscal year ending January 29, 2003. These unaudited Condensed Consolidated Financial Statements should be read in conjunction with the audited Consolidated Financial Statements and the notes thereto included in Amendment No. 1 to our Annual Report on Form 10-K/A for our fiscal year ended January 30, 2002, to be filed with the SEC on January 14, 2003. 9 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) (UNAUDITED) Reclassifications Certain reclassifications of prior period financial statements have been made to conform to the current interim period presentation. 3. COMPREHENSIVE LOSS Comprehensive loss represents net loss, adjusted for the effect of other items that are recorded directly to shareholders' equity. Net loss and comprehensive loss are equivalent for all periods presented. 4. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS In May 2002, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 145, "Rescission of FASB Statements No's. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections." This Statement requires gains and losses from extinguishment of debt to be classified as an extraordinary item only if the criteria in Opinion 30 has been met. Further, lease modifications with economic effects similar to sale-leaseback transactions must be accounted for in the same manner as sale-leaseback transactions. While the technical corrections to existing pronouncements are not substantive in nature, in some instances they may change accounting practice. The provisions of this Statement related to the rescission of SFAS No. 4 and the amendment of SFAS No. 13 are effective beginning in fiscal 2003 and for transactions occurring after May 15, 2002, respectively, and are not expected to have a significant impact on our unaudited Condensed Consolidated Financial Statements. All other provisions are effective for financial statements issued on or after May 15, 2002, and did not have a significant impact on our unaudited Condensed Consolidated Financial Statements. In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement Obligations." SFAS No. 143 will be effective for Kmart beginning January 30, 2003, and it requires entities to record the fair value of a liability for an asset retirement obligation in the period in which it is a cost by increasing the carrying amount of the related long-lived asset. Over time, the liability is accreted to its present value each period, and the capitalized cost is depreciated over the useful life of the related obligation for its recorded amount or the entity incurs a gain or loss upon settlement. Because costs associated with exiting leased properties at the end of the respective lease terms are minimal, management anticipates that the adoption of SFAS No. 143 will not have a significant impact on our Consolidated Financial Statements. In June 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible Assets," effective for our fiscal year beginning January 31, 2002. The standard addresses how intangible assets that are acquired individually or with a group of other assets should be accounted for in financial statements upon their acquisition. It also addresses how goodwill and other intangible assets should be accounted for after they have been initially recognized in the financial statements. The adoption of SFAS No. 142 had no impact on our unaudited Condensed Consolidated Financial Statements. 5. PROCEEDINGS UNDER CHAPTER 11 OF THE BANKRUPTCY CODE On January 22, 2002 ("Petition Date"), Kmart and 37 of its U.S. subsidiaries (collectively, the "Debtors") filed voluntary petitions for reorganization under Chapter 11 of the federal bankruptcy laws ("Bankruptcy Code" or "Chapter 11") in the United States Bankruptcy Court for the Northern District of Illinois ("Court") under case numbers 02 B 02462 through 02 B 02499. The reorganization is being jointly administered under the caption "In re Kmart Corporation, et al. Case No. 02 B 02474." The Debtors are currently operating their business as debtors-in-possession pursuant to the Bankruptcy Code. We decided to seek judicial reorganization based upon a rapid decline in our liquidity resulting from our below-plan sales and earnings performance in the fourth quarter of the 2001 fiscal year, the evaporation of the surety bond market and erosion of supplier confidence. Other factors included intense competition in the discount retailing industry, unsuccessful sales and marketing initiatives, the continuing recession, and recent capital market volatility. As a debtor-in-possession, Kmart is authorized to continue to operate as an ongoing business, but may not engage in transactions outside the ordinary course of business without the approval of the Court, after notice and an opportunity for a hearing. 10 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) (UNAUDITED) At first day hearings held on January 22 and 25, 2002, the Court entered orders granting authority to Kmart to, among other things, pay pre-petition and post-petition employee wages, salaries, benefits and other employee obligations, to pay selected vendors and other providers for pre-petition amounts owed, and to honor customer service programs, including warranty returns, layaways and gift certificates. On January 25, 2002, the Court also gave interim approval for $1.15 billion of a $2 billion senior secured debtor-in-possession financing facility ("DIP Credit Facility") for the payment of permitted pre-petition claims, working capital needs, letters of credit and other general corporate purposes. On March 6, 2002, the Court approved the entire $2 billion DIP Credit Facility underwritten by JP Morgan Chase Bank, Fleet Retail Finance, Inc., General Electric Capital Corporation and Credit Suisse First Boston to supplement our cash flow from operations during the reorganization process. The DIP Credit Facility requires that we maintain certain financial covenants and restricts liens, indebtedness, capital expenditures, dividend payments and sales of assets. Under the Bankruptcy Code, actions to collect pre-petition indebtedness, as well as most other pending litigation, are stayed and other contractual obligations against Kmart generally may not be enforced. Absent an order of the Court, substantially all pre-petition liabilities are subject to settlement under a plan of reorganization to be voted upon by creditors and equity holders and approved by the Court. Although the Debtors expect to file a reorganization plan or plans that provide for emergence from bankruptcy in 2003 or 2004, there can be no assurance that a reorganization plan or plans will be proposed by the Debtors or confirmed by the Court, or that any such plan(s) will be consummated. As provided by the Bankruptcy Code, the Debtors initially have the exclusive right to solicit a plan of reorganization for 120 days. On April 23, 2002, the Court extended to August 7, 2002, the period in which Kmart has the exclusive right to file a plan of reorganization and extended to October 4, 2002, the period in which Kmart has the exclusive right to submit acceptances to the plan. A hearing to extend further these exclusive periods is scheduled for July 24, 2002. Further extensions may be granted by the Court. If the Debtors fail to file a plan of reorganization during such period (as such period may be extended) or if such plan is not accepted by the required number of creditors and equity holders, any party in interest may subsequently file its own plan of reorganization. A plan of reorganization must be confirmed by the Court, upon certain findings being made by the Court which are required by the Bankruptcy Code. The Court may confirm a plan notwithstanding the non-acceptance of the plan by an impaired class of creditors or equity security holders if certain requirements of the Bankruptcy Code are met. The United States Trustee has appointed an unsecured creditors committee and a financial institutions committee. In addition, the United States Trustee is in the process of appointing an equity holders committee. The official committees and their legal representatives often take positions on matters that come before the Court, and are the most likely entities with which Kmart will negotiate the terms of a plan of reorganization. There can be no assurance that these committees will support Kmart's positions in the bankruptcy proceedings or the plan of reorganization once proposed, and disagreements between Kmart and these committees could protract the bankruptcy proceedings, could negatively impact Kmart's ability to operate during bankruptcy and could delay Kmart's emergence from bankruptcy. Under the Bankruptcy Code, we may assume or reject executory contracts and unexpired leases, including our store leases, subject to the approval of the Court and our satisfaction of certain other requirements. In the event we choose to reject an executory contract or unexpired lease, parties affected by these rejections may file claims with the court-appointed claims agent as proscribed by the Bankruptcy Code and/or orders of the Court. Unless otherwise agreed, the assumption of an executory contract or unexpired lease will require Kmart to cure all prior defaults under such executory contract or lease, including all pre-petition liabilities, some of which may be significant. In this regard, we expect that liabilities that will be subject to compromise through the Chapter 11 process will arise in the future as a result of the rejection of additional executory contracts and/or unexpired leases, and from the determination of the Court (or agreement by parties in interest) of allowed claims for items that we now claim as contingent or disputed. Conversely, we would expect that the assumption of additional executory contracts may convert liabilities shown on our financial statements as subject to compromise to post-petition liabilities. Due to the uncertain nature of many of the potential claims, we are unable to project the magnitude of such claims with any degree of certainty. Kmart has incurred, and will continue to incur, significant costs associated with the reorganization. On April 15, 2002, we filed with the Court schedules of assets and liabilities and statements of financial affairs setting forth, among other things, the assets and liabilities of the Debtors as shown by our books and records, subject to the assumptions contained in certain notes filed in connection therewith. All of the schedules and statements of financial affairs are subject to further amendment or modification. We have mailed notices to all known creditors that the deadline for filing proofs of claim with the Court is July 31, 2002. Differences between amounts scheduled by Kmart and claims by creditors will be investigated and resolved in connection with our claims resolution process, and may be significant. That process will not commence until after the July 31, 2002 bar date and, in light of the number of creditors of the Debtors, may take considerable time to complete. Accordingly, the ultimate number and amount of allowed claims is not presently known. Similarly, the ultimate distribution with respect to allowed claims is not presently ascertainable. 11 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) (UNAUDITED) We have filed over 100 motions in the Chapter 11 case whereby we were granted authority or approval with respect to various items required by the Bankruptcy Code and/or necessary for our reorganization efforts. In addition to motions pertaining to store closure and real estate disposition matters, we have obtained orders providing for, among other things, (i) implementation of a key employee retention and incentive program, (ii) authorization of a second lien for vendors in connection with our secured inventory trade credit program, (iii) authorization of a settlement agreement with our sureties who support our self-insurance program and state licensing requirements, (iv) the extension of time to assume or reject leases, and (v) assumption of agreements with our key brand partners. Under the priority scheme established by the Bankruptcy Code, certain post-petition liabilities and pre-petition liabilities need to be satisfied before shareholders are entitled to receive any distribution. The ultimate recovery to creditors, trust convertible preferred securities holders and/or common shareholders, if any, will not be determined until confirmations of a plan or plans of reorganization. No assurance can be given as to what values, if any, will be ascribed in the bankruptcy proceedings to each of these constituencies. A plan of reorganization could also result in holders of Kmart common stock receiving no distribution on account of their interests and cancellation of their interests. Holders of Kmart common stock should assume that they could receive little or no value as part of a plan of reorganization. In addition, under certain conditions specified in the Bankruptcy Code, a plan of reorganization may be confirmed notwithstanding its rejection by an impaired class of creditors or equity holders and notwithstanding the fact that equity holders do not receive or retain property on account of their equity interests under the plan. In light of the foregoing, Kmart considers the value of the common stock to be highly speculative and cautions equity holders that the stock may ultimately be determined to have no value. Accordingly, Kmart urges that appropriate caution be exercised with respect to existing and future investments in the Kmart common stock or in any claims related to pre-petition liabilities and/or other Kmart securities. At this time, it is not possible to predict the effect of the Chapter 11 reorganization on our business, various creditors and security holders or when we will be able to exit Chapter 11. The ability of Kmart to continue as a going concern is predicated upon numerous issues, including our ability to achieve the following: - developing a long-term strategy and/or market niche to revitalize our business and return Kmart to profitability; - taking appropriate action to offset the negative effects that the Chapter 11 filing has had on our business, including the loss in customer traffic and the impairment of vendor relations; - operating within the framework of our DIP Credit Facility, including its limitations on capital expenditures and its financial covenants, our ability to generate cash flows from operations or seek other sources of financing and the availability of projected vendor credit terms; - attracting, motivating and/or retaining key executives and associates; and - developing and, thereafter, having confirmed by the Court, a plan of reorganization. These challenges are in addition to those operational and competitive challenges faced by Kmart in connection with our business as a discount retailer. A plan of reorganization could materially change the amounts reported in the financial statements, which do not give effect to all adjustments of the carrying value of assets or liabilities that might be necessary as a consequence of a plan of reorganization. 12 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) (UNAUDITED) 6. REORGANIZATION ITEMS, NET Reorganization items represent amounts we incurred as a result of Chapter 11 and are presented separately in the unaudited Condensed Consolidated Statements of Operations. For the 13 weeks ended May 1, 2002, the following have been recorded:
(as restated - see Note 1) --------------- 2002 store closings $228 Professional fees 38 Employee costs 26 Sale of pharmacy lists (17) Settlement of pre-petition liabilities (5) Interest income (4) Other 8 --------------- Total $274 ===============
The following paragraphs provide additional information relating to costs that were recorded in the line Reorganization items, net in our unaudited Condensed Consolidated Statement of Operations for the 13 week period ended May 1, 2002: 2002 store closings On March 20, 2002, the Court approved the closure of 283 stores. Stores were selected by evaluating the market and financial performance of every store and the terms of every lease. Candidates for closure were stores that did not meet our financial requirements for ongoing operations. As a result of our decision to close the 283 stores we charged to our closed store reserve $228 for lease terminations and other costs and reclassified $144 of capital lease obligations to the closed store reserve. The closed store reserve is included in the line Liabilities subject to compromise in our unaudited Condensed Consolidated Balance Sheet as of May 1, 2002. The reserve for estimated costs was recorded in accordance with EITF 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)" ("EITF 94-3"). During the period that the stores remain open for business, rent and other costs of operations continue to be reflected in our operating expenses. In the first quarter of fiscal 2002, there were no payments charged to the reserve, see Note 11. Professional fees In the first quarter of fiscal 2002, we recorded $38 for professional fees. Professional fees include financial, legal, real estate and valuation services directly associated with our reorganization process. Employee costs In March 2002, we received Court approval to implement our Key Employee Retention Plan ("KERP") which provides cash incentives and certain benefits to key members of our salaried management team. The KERP is expected to encourage employees to continue their employment with Kmart through the reorganization process. In the first quarter of fiscal 2002, we recorded a charge of $26 for the KERP and retention bonuses for associates in our 283 stores that were closed. There were no payments charged to the reserve during the first quarter of fiscal 2002. 13 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) (UNAUDITED) Settlement of pre-petition claims We recorded a gain of $5 representing the difference between the settlement value of certain pre-petition obligations and the amount recorded as an allowable claim. Other reorganization items We recorded a gain of $17 for the sale of pharmacy lists and $4 for interest income earned on excess cash balances. We also recorded a charge of $8 for other miscellaneous reorganization items. 7. INTEREST EXPENSE, NET Interest income of $1 is included in the line Interest expense, net in the unaudited Condensed Consolidated Statements of Operations for each of the 13 week periods ended May 1, 2002 and May 2, 2001. Interest income earned as a result of excess cash balances due to the Chapter 11 filing are recorded in the line Reorganization items, net in the unaudited Condensed Consolidated Statements of Operations, for the 13 weeks ended May 1, 2002, see Note 6. As of the Petition Date, we ceased accruing interest on unsecured pre-petition debt classified as Liabilities subject to compromise in our unaudited Condensed Consolidated Balance Sheets in accordance with SOP 90-7. Interest at the stated contractual amount on unsecured debt that was not charged to results of operations for the 13 week period ended May 1, 2002 was approximately $69. 8. LIABILITIES SUBJECT TO COMPROMISE Under bankruptcy law, actions by creditors to collect indebtedness we owe prior to the Petition Date are stayed and certain other pre-petition contractual obligations may not be enforced against the Debtors. We have received approval from the Court to pay certain pre-petition liabilities including employee salaries and wages, benefits and other employee obligations. Except for secured debt and capital lease obligations, all pre-petition liabilities have been classified as Liabilities subject to compromise in the unaudited Condensed Consolidated Balance Sheets. Adjustments to the claims may result from negotiations, payments authorized by Court order, additional rejection of executory contracts including leases, or other events. Pursuant to an order of the Court, we mailed notices to all known creditors that the deadline for filing proofs of claim with the Court is July 31, 2002. Amounts that we have recorded may be different than amounts filed by our creditors. The number and amount of allowed claims cannot be presently ascertained. 14 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) (UNAUDITED) The following table summarizes the components of the liabilities classified as Liabilities subject to compromise in our unaudited Condensed Consolidated Balance Sheets as of May 1, 2002 and as of January 30, 2002:
(as restated - (as restated - see Note 1) see Note 1) May 1, January 30, 2002 2002 ---------------- ---------------- Debt and notes payable $3,329 $3,346 Accounts payable 2,681 3,153 Closed store reserves 845 484 Other liabilities 312 454 General liability and workers compensation 301 312 Pension obligation 190 195 Taxes payable 147 149 ---------------- ---------------- Total liabilities subject to compromise $7,805 $8,093 ================ ================
Below is a reconciliation of the changes in Liabilities subject to compromise for the period from the Petition Date through May 1, 2002:
(as restated - see Note 1) Cumulative since Petition Date ---------------- Balance, Petition Date $8,585 First day court orders authorizing payment of employee wages, benefits and other employee obligations, sales and use taxes and payments to critical vendors (737) Adjustment to general liability and workers compensation accruals (174) Adjustment to closed store reserves 185 Court order authorizing payment of additional trade accounts payable (37) Gain on pre-petition liabilities (5) Other (12) ---------------- Balance, end of period $7,805 ================
9. MARKDOWNS FOR INVENTORY LIQUIDATION During the first quarter of fiscal 2002, we recorded a charge of $758 to write-down inventory to be liquidated at our 283 closing stores to net realizable value. This charge is included in Cost of sales, buying and occupancy in the accompanying unaudited Condensed Consolidated Statements of Operations. Of the charge, $384 relates to the write-down of inventory to estimated selling value in connection with liquidation sales in the 283 stores for which we received Court approval to close on March 20, 2002. The liquidation sales and store closings were completed on June 2, 2002. In addition, a charge of $266 was recorded relating to the acceleration of markdowns on approximately 107,000 stock keeping units (SKUs) of inventory items that were transferred from our remaining open stores to the 283 closing stores and included in the liquidation sales. The SKUs will no longer be carried as part of our product assortment in our remaining open stores and were reduced to estimated selling value. The remaining $108 of the charge related to liquidation fees and expenses associated with the disposition of inventory through the liquidation sales at the 283 closing stores. 15 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) (UNAUDITED) 10. EMPLOYEE SEVERANCE AND VERP During the first quarter of 2001, our workforce was reduced by 350 employees through a voluntary early retirement program ("VERP") and other employee separations. The total cost of the realignment aggregated $23 ($15, net of tax), which is included in our unaudited Condensed Consolidated Statement of Operations for the quarter ended May 2, 2001 in the line item Charge for employee severance and VERP. The charge relates to 130 employees that accepted the VERP offer, with costs aggregating $6. The remaining 220 employees were severed and given post-employment benefits including severance, outplacement services, continuation of healthcare benefits and other benefits totaling $17. Of the charge, $19 was reserved for and was paid out of our general corporate assets, including benefits for highly-compensated employees accepting the VERP offer, and the remaining $4 was paid out of the Kmart Employee Pension Plan. Our first quarter cash payments in fiscal 2001 associated with these actions were $9. 11. RESTRUCTURING RESERVE ACTIVITY The following table provides information regarding reserve activity during the 13 week periods ended May 1, 2002 and May 2, 2001, respectively, for the fiscal year 2000 strategic actions charge, the fiscal year 2001 employee severance and VERP charge, the fiscal year 2001 BlueLight.com restructuring charge, the fiscal year 2001 supply chain restructuring charge and the fiscal year 2002 store closings charge. Reserves established in connection with the fiscal 2002 store closings charge are comprised of $228 relating to lease rejections. Please refer to Amendment No. 1 to our Annual Report on Form 10-K/A for the fiscal year ended January 30, 2002, to be filed with the SEC on January 14, 2003, for a discussion of the 2001 BlueLight.com, 2001 supply chain and 2000 strategic actions charges. The liabilities aggregated $490 and $181 at May 1, 2002 and May 2, 2001, respectively.
13 Weeks Ended -------------------------------------------------------------------------- May 1, May 2, 2002 2001 ---------------------------------------------- ----------------------- 2001 2001 2000 2001 2000 2002 Store BlueLight Supply Strategic VERP/ Strategic Closings .com Chain Actions Severance Actions ------------ ----------- --------- ---------- ----------- ----------- Balance, beginning of year $ - $ 18 $ 11 $ 98 $ - $ 177 Additions charged to operations: 228 - - - 19 - Reclassifications 144 - - - - - ------------ ----------- --------- ---------- ----------- ----------- Total additions 372 - - - 19 - Reductions: Cash payments: Lease obligations - - - 3 - 6 Employee costs - - 4 - 9 - Contractual obligations - 1 - - - - ------------ ----------- --------- ---------- ----------- ----------- Balance, end of period $ 372 $ 17 $ 7 $ 95 $ 10 $ 171 ============ =========== ========= ========== =========== ===========
12. INVENTORIES AND COST OF MERCHANDISE SOLD A substantial portion of our inventory is accounted for using the last-in, first-out ("LIFO") method. Since LIFO costs can only be determined at the end of each fiscal year when inflation rates and inventory levels are finalized, estimates are used for LIFO purposes in the interim unaudited Condensed Consolidated Financial Statements. Inventories valued on LIFO at May 1, 2002, May 2, 2001 and January 30, 2002 were $269, $194 and $269 lower, respectively, than the amounts that would have been reported under the first-in, first-out method. 16 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) (UNAUDITED) 13. INVESTMENTS IN AFFILIATED RETAIL COMPANIES Meldisco For the 13 week period ended May 1, 2002, Meldisco had net sales of $307, gross profit of $139 and net income of $17. For the 13 week period ended May 2, 2001, Meldisco had net sales of $288, gross profit of $136 and net income of $18. BlueLight.com On July 31, 2001, we acquired the remaining approximate 40% interest in BlueLight.com, and BlueLight.com's operations were fully consolidated into our financial statements. For the period from February 1, 2001 to May 2, 2001, BlueLight.com had net sales of $4, gross profit of $1 and a net loss of $30. Penske On April 9, 2002, we reached an agreement with Penske Corporation, Penske Auto Centers, Inc., and Penske Auto Centers, LLC (collectively "Penske") whereby Penske and Kmart will work together to achieve an orderly wind-down of operations at auto service centers at more than 563 Kmart stores in 44 states following Penske's unilateral decision to close the business as of April 6, 2002. This matter did not have a material adverse affect on our liquidity, financial position or results of operations for the 13 weeks ended May 1, 2002. 14. LOSS PER SHARE Net loss per common share is computed as follows :
(as restated - see Note 1) 13 Weeks Ended ------------------------------- May 1, 2002 May 2, 2001 ------------- -------------- Basic/Diluted loss per common share: Net loss ($1,442) ($ 187) ============= ============== Basic/Diluted weighted average shares outstanding 502.9 488.5 Basic/Diluted loss per common share ($ 2.87) ($ 0.38) ============= ==============
We calculate loss per share in accordance with SFAS No. 128, "Earnings Per Share." In all periods presented net losses were incurred, therefore dilutive common stock equivalents were not used in the calculation of earnings per share as they would have an anti-dilutive effect. Options to purchase 54.6 million and 58.3 million shares of common stock at prices ranging from $4.86 to $26.03 and $5.34 to $26.03 were excluded from the calculations for the 13 week periods ended May 1, 2002 and May 2, 2001, respectively. The calculations also exclude the effect of trust convertible preferred securities. For the 13 week periods ended May 1, 2002 and May 2, 2001, diluted shares outstanding exclude approximately 59.9 million common shares from potential conversion of certain trust convertible preferred securities due to their anti-dilutive effect. 17 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) (UNAUDITED) 15. INCOME TAXES In the fourth quarter of fiscal 2001, we recorded a valuation allowance against our net deferred tax assets, including the tax benefits associated with the employee severance and VERP charges, in accordance with SFAS No. 109, "Accounting for Income Taxes," as realization of such assets in future years is uncertain. We have continued to maintain a valuation allowance against our net deferred tax assets, and accordingly, we have not recognized any tax benefit from our losses in fiscal 2002. The $12 tax benefit recorded in the first quarter of fiscal 2002 relates primarily to amounts now refundable to Kmart as a result of the Job Creation and Worker Assistance Act of 2002 which was enacted in the first quarter of fiscal 2002. 16. OTHER COMMITMENTS AND CONTINGENCIES Contingent Liabilities As of May 1, 2002, we had (i) guaranteed obligations for real property leases of certain current and former subsidiaries of Kmart including, but not limited to, The Sports Authority, Inc., OfficeMax, Inc. and Borders Group, Inc., some of which leases have been assigned pre-petition; (ii) contingent liability under real property leases assigned by Kmart pre-petition; and (iii) guaranteed $79 of indebtedness of other parties related to certain of our leased properties financed by industrial revenue bonds. Our rights and obligations with respect to our guarantee of leases of the former subsidiaries The Sports Authority, Inc., Office Max, Inc., and Borders Group, Inc., which are detailed below, are governed by Lease Guarantee, Indemnification and Reimbursement Agreements dated as of November 23, 1994, November 9, 1994 and May 24, 1995, respectively, as they may be amended from time to time. Kmart's contingent obligations, described above, which are not reflected in our financial statements, are dependent on the future performance by the parties whose obligations we guarantee and are subject to settlement under a plan of reorganization to be voted upon by creditors and equity holders and approved by the Court. As of May 1, 2002, our outstanding guarantees for real property leases of The Sports Authority, Inc., Office Max, Inc., and Borders Group, Inc. were as follows:
Present Value of Future Lease Gross Future Obligations @ 7% Lease Obligations ------------------ ------------------- The Sports Authority, Inc. $ 180 $ 305 Borders Group, Inc. 87 147 OfficeMax, Inc. 64 94 -------- -------- Total $ 331 $ 546 ======== ========
Bankruptcy Proceedings On the Petition Date, Kmart and 37 of its U.S. subsidiaries filed voluntary petitions for reorganization under Chapter 11 of the Bankruptcy Code in the Court. The reorganization is being jointly administered under the caption "In re Kmart Corporation, et al., case No. 02 B 02474." Included in the unaudited Condensed Consolidated Financial Statements are subsidiaries operating outside of the United States, which have not commenced Chapter 11 cases or other similar proceedings elsewhere, and are not debtors. The assets and liabilities and results of operations of such non-filing subsidiaries are not considered material to the unaudited Condensed Consolidated Financial Statements. We retain control of our assets and are authorized to operate the business as a debtor-in-possession while being subject to the jurisdiction of the Court. As of the Petition Date, most pending litigation is stayed, and absent further order of the Court, substantially all pre-petition liabilities are subject to settlement under a plan of reorganization. At this time, it is not possible to predict the outcome of the Chapter 11 cases or their effect on our business. If it is determined that the liabilities subject to compromise in the Chapter 11 cases exceed the fair value of the assets, unsecured claims may be satisfied at less than 100% of their fair value and the equity interests of our shareholders may have no value. See Note 5. 18 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) (UNAUDITED) Legal Proceedings Since February 21, 2002, five separate purported class actions have been filed on behalf of purchasers of Kmart common stock between May 17, 2001 and January 22, 2002, inclusive, naming Charles Conaway as CEO and Chairman of the Board of Kmart as the sole defendant. The complaints filed in the United States District Court for the Eastern District of Michigan allege that Mr. Conaway made material misstatements or omissions during the alleged class period that inflated the trading prices of Kmart's common stock and seek, among other things, damages under Section 10b-5 of the Securities and Exchange Act of 1934. Kmart is not a defendant in these litigations. Kmart is involved in discussions with the United States Attorney for the District of Puerto Rico regarding a criminal investigation arising out of the alleged actions of certain of our employees following the 1998 Hurricane Georges. On March 18, 2002, a purported class action was filed in the United States District Court for the Eastern District of Michigan on behalf of participants or beneficiaries of the Kmart Corporation Retirement Savings Plan against various officers and directors of Kmart alleging breach of fiduciary duty under ERISA for excessive investment in company stock; failure to provide complete and accurate information about Kmart common stock and failure to provide accurate information regarding our financial condition. Class action allegations are also made for current and former employees who participate in the Kmart Corporation Retirement Savings Plan. Kmart is not a defendant in this litigation. On April 26, 2002, a lawsuit was filed in the United States District Court for the Eastern District of Michigan on behalf of three limited partnerships that purchased stock of Bluelight.com, a subsidiary of Kmart, naming Charles C. Conaway, as CEO and Chairman of the Board of Kmart, as the sole defendant. The Complaint alleges that Mr. Conaway breached his fiduciary duty, took certain actions and made certain misrepresentations that induced plaintiffs to exchange their Bluelight.com stock for Kmart stock and prevented plaintiffs from realizing the market value of their stock. The complaint also alleges violations of Section 10b-5 of the Securities and Exchange Act of 1934 and Section 410 of the Michigan Uniform Securities Act. Kmart is not a defendant in this litigation. Kmart is a defendant in six putative class actions and one multi-plaintiff case pending in California, all relating to our classification of assistant managers and various other employees as "exempt" employees under the federal Fair Labor Standards Act and the California Labor Code and our alleged failure to pay overtime wages as required by these laws. These seven wage-and-hour cases were all filed during 2001 and are currently pending in the U.S. District Court for the Eastern District of California (Henderson v. Kmart), the U.S. District Court for the Central District of California (Gulley v. Kmart, the multi-plaintiff case, which was originally brought in state court) and the Superior Courts of the State of California for the Counties of Alameda, Los Angeles and Riverside (Panossian v. Kmart, Wallace v. Kmart, Pierce v. Kmart, Hancock v. Kmart, Pryor v. Kmart). If all of these cases were determined adversely to Kmart, the resulting damages would have a material adverse impact on our results of operations and financial condition. However, there have been no class certifications, all of the cases are stayed as a result of our bankruptcy and, based on our initial investigations, we believe that we have numerous defenses to each of these claims. As a result, we are currently unable to quantify the financial exposure of these cases. We are a party to a substantial number of other claims, lawsuits, and pending actions, most of which are routine and all of which are incidental to our business. Some matters involve claims for large amounts of damages as well as other relief. Kmart assesses the likelihood of potential losses on an ongoing basis and when they are considered probable and reasonably estimable, records an estimate of the ultimate outcome. If there is no single point estimate of loss that is considered more likely than others, an amount representing the low end of the range of possible outcomes is recorded. Although the final consequences of these proceedings are not presently determinable, in the opinion of management, they are not expected to have a material adverse effect on our liquidity, financial position or results of operations. 19 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) (UNAUDITED) In addition to the foregoing, there are numerous matters filed with the Court in our reorganization proceedings by creditors, landlords or other third parties related to our business operations or the conduct of our reorganization activities. Although none of these individual matters which have been filed to date have had or are expected to have a material adverse effect on Kmart, our ability to successfully manage the reorganization process and develop an acceptable reorganization plan could be negatively impacted by adverse determinations by the Court on certain of these matters. Investigative Matters Kmart has been provided with copies of anonymous letters sent to the SEC, our auditors, directors, legal counsel and others, expressing concern with respect to various matters. The letters purport to be sent by certain of our employees. The letters have been referred to the Audit Committee, which has engaged outside counsel to review and investigate the matters set forth in the letters. We are cooperating with the SEC and the U. S. Attorney's office for the Eastern District of Michigan with respect to the investigations of these matters. The staff of the SEC has expressed concerns with respect to the manner in which we recorded vendor allowances prior to the change in accounting principle at the end of fiscal 2001 as discussed below, as well as the Staff's intention to continue to pursue its investigation of these matters. We are cooperating with the House Committee with respect to their inquiry. Events Subsequent to Filing of Original 10-Q During the Fall of 2002 and in response to inquiries from the staff of the SEC, Kmart reviewed its historical practices for the recording of allowances prior to the adoption in the fourth quarter of fiscal year 2001 of a new accounting policy, effective February 1, 2001, for the interim financial reporting of vendor allowances. The effect of these practices relates only to Kmart's interim financial statements. See "Internal Investigation - Developments Since Filing of 2001 Form 10-K- Vendor Allowance Matters - Premature Recognition of Vendor Allowances" in the section entitled "Management's Discussion and Analysis of Results of Operations and Financial Condition" for a description of the impact of the premature recording of certain vendor allowances on Kmart's audited financial statements. For interim reporting periods in fiscal 2000 and prior, our policy was to record allowances not yet subject to a written agreement during the first three quarters of a fiscal year based upon our estimate of annual allowances ("our plan") as determined by historical experience and current understandings with our vendors. These amounts were supplemented by allowances obtained that were not contemplated in our plan ("incrementals"). During the fourth quarter of fiscal 2001, we adopted a new accounting policy, effective as of February 1, 2001, for interim financial reporting only, requiring that cost recoveries from vendors be recognized only when a formal agreement for such amount has been obtained and the underlying activity for which the amount was provided has been performed. As part of its review of allowances, the current management of Kmart observed that the total level of allowances originally recorded during the first three quarters of fiscal year 2001 appeared high, given the challenges that faced the business in fiscal year 2001 and the fact that sales failed to increase as originally contemplated in Kmart's business plan. In that regard, it was noted that had Kmart recorded allowances during the first three quarters of fiscal year 2001 at rates which corresponded to more historical rates, Kmart would have recorded fewer allowances. During the first three quarters of fiscal year 2001, Kmart characterized and recorded as incremental allowances $110, $163 and $50, respectively. Kmart selectively identified for review certain of such allowances that had been characterized and recorded as incrementals prior to the adoption of the new accounting policy. Of those reviewed, the amount of allowances which appeared to be questionable, other than those previously disclosed, were $27, $42 and $23, respectively. The questions about these allowances relate to, among other things, the failure to have appropriate signed documentation in place, the failure to have adequate records demonstrating that the allowance was collectible or the failure to otherwise comply with Kmart's historical policies. Based on the investigation, it appears that some of these allowances may have been reported in error in the quarterly financial statements. Given, however, that Kmart's review of allowances was selective, as well as the difficulties of confirming on a retroactive basis whether an incremental allowance is supplemental to the plan, Kmart cannot exclude the possibility that there may be additional incremental allowances in fiscal year 2001 which could be subject to question. Any errors, as described in the preceding paragraphs, concerning the recording of allowances that were reflected in our fiscal year 2001 interim unaudited financial statements prior to the change in accounting policy were no longer 20 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) (UNAUDITED) reflected in our restated financial statements as filed with the SEC on May 15, 2002. This results from the change in accounting policy, given that under the new accounting policy there is no longer a distinction between planned and incremental allowances, no allowances are recognized absent a formal agreement and the recording of allowances is no longer based on a plan. Key Brand Partners On March 20, 2002, the Court authorized our business relationships with several key brand partners. Motions were approved allowing Kmart to assume our license agreements with Martha Stewart Living Omnimedia, Inc. for Martha Stewart Everyday home, garden, colors, baby, kitchen, keeping and decorating products, along with candles and accessories; Jaclyn Smith G.H. Production, Inc. for Jaclyn Smith women's apparel, jewelry and accessories; Kathy Ireland World Wide, Inc. for Kathy Ireland women's apparel, accessories and exercise equipment; Disney Enterprises, Inc. for Disney apparel for infants and children; and Joe Boxer Licensing, LLC. for JOE BOXER apparel, accessories and home furnishings. On May 29, 2002, the Court authorized our business relationship with Sesame Workshop. Motions were approved allowing Kmart to assume our license agreement with Sesame Workshop for Sesame Street toys and infants and children's apparel. 21 MANAGEMENT'S DISCUSSION AND ANALYSIS (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION This Form 10-Q/A, as well as other statements or reports made by or on behalf of Kmart, may contain or may incorporate by reference material which includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 that reflect, when made, Kmart's current views with respect to current events and financial performance. Statements, other than those based on historical facts, which address activities, events or developments that we expect or anticipate may occur in the future are forward-looking statements, which are based upon a number of assumptions concerning future conditions that may ultimately prove to be inaccurate. Such forward-looking statements are and will be, as the case may be, subject to many risks, uncertainties and factors relating to Kmart's operations and business environment which may cause the actual results of Kmart to be materially different from any future results, express or implied, by such forward-looking statements. Factors that could cause actual results to differ materially from these forward-looking statements include, but are not limited to, the following: General Factors - general economic conditions, - weather conditions, including those which affect buying patterns of our customers, - marketplace demand for the products of our key brand partners, as well as the engagement of appropriate new brand partners, - changes in consumer spending and our ability to anticipate buying patterns and implement appropriate inventory strategies, - competitive pressures and other third party actions, including pressures from pricing and other promotional activities of competitors, - our ability to timely acquire desired goods in appropriate quantities and/or fulfill labor needs at planned costs, - our ability to properly monitor our inventory needs and remain in-stock, - our ability to successfully implement business strategies and otherwise execute planned changes in various aspects of the business, - regulatory and legal developments, - our ability to attract, motivate and/or retain key executives and associates, - our ability to attract and retain customers, - other factors affecting business beyond our control, Bankruptcy Related Factors - our ability to continue as a going concern, - our ability to operate pursuant to the terms of the DIP Credit Facility, - our ability to obtain Court approval with respect to motions in the Chapter 11 proceeding from time to time, - our ability to develop, confirm and consummate one or more plans of reorganization with respect to the Chapter 11 cases, - risks associated with third parties seeking and obtaining court approval to terminate or shorten the exclusivity period that we have to propose and confirm one or more plans of reorganization, for the appointment of a Chapter 11 trustee or to convert the cases to Chapter 7 cases, - our ability to offset the negative effects that the filing for reorganization under Chapter 11 has had on our business, including the loss in customer traffic and the constraints placed on available capital, - our ability to obtain and maintain normal terms with vendors and service providers, - the ability of our vendors to obtain satisfactory credit terms from factors and other financing sources, - our ability to maintain contracts, including leases, that are critical to our operations, - the potential adverse impact of the Chapter 11 cases on our liquidity or results of operations, - our ability to develop a long-term strategy and/or market niche, and - our ability to fund and execute our business plan. Consequently, all of the forward-looking statements are qualified by these cautionary statements and there can be no assurance that the results or developments anticipated will be realized or that they will have the expected effects on our business or operations. The forward-looking statements contained herein or otherwise that we make or are made on our behalf speak only as of the date of this report, or if not contained herein, as of the date when made, and we do not undertake to update these risk factors or such forward-looking statements. 22 MANAGEMENT'S DISCUSSION AND ANALYSIS - (CONTINUED) (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) Similarly, these and other factors, including the terms of any reorganization plan ultimately confirmed, can affect the value of our various pre-petition liabilities, common stock and/or other equity securities. No assurance can be given as to what values, if any, will be ascribed in the bankruptcy proceedings to each of these constituencies. A plan of reorganization could result in holders of Kmart common stock receiving no distribution on account of their interests and cancellation of their interests. Holders of Kmart common stock should assume that they could receive little or no value as part of a plan of reorganization. In addition, under certain conditions specified in the Bankruptcy Code, a plan of reorganization may be confirmed notwithstanding its rejection by an impaired class of creditors or equity holders and notwithstanding the fact that equity holders do not receive or retain property on account of their equity interests under the plan. In light of the foregoing, Kmart considers the value of the common stock to be highly speculative and cautions equity holders that the stock may ultimately be determined to have no value. Accordingly, Kmart urges that appropriate caution be exercised with respect to existing and future investments in Kmart common stock or any claims relating to pre-petition liabilities and/or other Kmart securities. The following discussion and analysis should be read in conjunction with the audited Consolidated Financial Statements and Notes to Consolidated Financial Statements in Item 8. Financial Statements and Supplementary Data, of Amendment No. 1 to our Annual Report on Form 10-K/A for our fiscal year ended January 30, 2002, to be filed with the SEC on January 14, 2003. RESTATEMENT OF CURRENT AND PRIOR PERIODS As part of the review and preparation of the Quarterly Report on Form 10-Q for the third quarter ended October 30, 2002, Kmart Corporation and its subsidiaries ("Kmart," "we," "us" or "our") identified certain adjustments that were recorded out-of-period, while others were previously identified and described in our Quarterly Report on Form 10-Q for the second quarter ended July 31, 2002, filed with the Securities Exchange Commission ("SEC") on September 16, 2002. Upon review of the aggregate impact of the new, as well as the previously disclosed and recorded adjustments, we concluded that restating our historical financial statements was appropriate because the aggregate impact was material to the current estimate of our fiscal year 2002 results. The tables below show the results of the restatements on reported results for the 13 week periods presented in this Amendment No. 1 to our Quarterly Report on Form 10-Q/A, which relate primarily to: a) Lease accrual adjustments - An understatement of historical accruals for certain leases with varying rent payments and a related understatement of historical rent expense. b) Accounts payable adjustments - A software programming error in Kmart's accounts payable system that resulted in some paid invoices awaiting a store report of delivery not being appropriately treated in our financial statements. This error, restricted to a single vendor with unique billing arrangements, resulted in an understatement of Cost of sales, buying and occupancy since 1999. c) Inventory loads - Adjustments, as previously disclosed in the Quarterly Report on Form 10-Q for the second quarter ended July 31, 2002, for certain costs formerly capitalized into inventory. Inventory included amounts added for internal purposes to analyze gross margin on a comparable basis across all business units and to optimize purchasing decisions. These amounts are commonly referred to in the retail industry as "inventory loads," and should have been eliminated for external reporting purposes to the extent the related inventory remained unsold at the end of the period. d) Vendor allowances - The premature recording, as previously disclosed in the Quarterly Report on Form 10-Q for the second quarter ended July 31, 2002 of vendor allowance transactions in fiscal year 2000 and prior fiscal years. In addition, given the restatement for the items noted above, we are adjusting previously reported financial results for miscellaneous immaterial items that were identified and previously recorded in the ordinary course of business. These items are now being recorded in the appropriate fiscal periods. 23 MANAGEMENT'S DISCUSSION AND ANALYSIS - (CONTINUED) (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) The summary of the effects of the restatement on reported results for prior fiscal periods is presented in the table below.
Impact on retained Income (Expense) earnings ----------------------------------------------------------- Fiscal Fiscal Fiscal January 30, 2001 2000 1999 1999 ----------------------------------------------------------- Lease accrual adjustments ($5) ($4) ($10) ($37) Accounts payable adjustments ($42) ($9) ($1) $- Inventory loads ($7) ($12) ($21) ($17) Vendor allowances $94 ($52) ($33) ($28) Other items $47 $39 $4 ($135) ----------------------------------------------------------- Pre-tax impact of restatement $87 ($38) ($61) ($217) (Benefit from) provision for income taxes $115 ($14) ($22) ($79) ----------------------------------------------------------- Total impact of restatement ($28) ($24) ($39) ($138) ===========================================================
The summary of the effects of the restatement on the 13 weeks ended May 1, 2002 and May 2, 2001, respectively, are presented in the tables below.
13 Weeks Ended May 1, 2002 ------------------------------------------------------------------------------------------------ Adjustments ------------------------------------------------------------------- As Lease Accounts previously accrual payable Inventory Vendor As reported* adjustments adjustments loads allowances Other restated ------------------------------------------------------------------------------------------------ Sales $7,639 $- $ - $ - $- $- $7,639 Cost of sales, buying and occupancy $7,016 $3 $10 ($9) ($8) $9 $7,021 ------------------------------------------------------------------------------------------------ Gross margin $623 ($3) ($10) $9 $8 ($9) $618 Selling, general and administrative expenses $1,791 $ - $- $1 $- ($22) $1,770 Operating (loss) income ($1,163) ($3) ($10) $8 $8 $13 ($1,147) Reorganization items, net $265 $- $- $- $- $9 $274 ------------------------------------------------------------------------------------------------ Net (loss) income ($1,449) ($3) ($10) $8 $8 $4 ($1,442) ================================================================================================ Basic/Diluted (loss) earnings per common share ($2.88) $0.00 ($0.02) $0.01 $0.01 $0.01 ($2.87) ================================================================================================
* - As previously reported in the Form 10-Q for the quarter ended May 1, 2002 filed on June 14, 2002. 24 MANAGEMENT'S DISCUSSION AND ANALYSIS - (CONTINUED) (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
13 Weeks Ended May 2, 2001 ------------------------------------------------------------------------------------------------ Adjustments ------------------------------------------------------------------- As Lease Accounts previously accrual payable Inventory Vendor As reported** adjustments adjustments loads allowances Other restated ------------------------------------------------------------------------------------------------ Sales $8,337 $- $- $- $- $- $8,337 Cost of sales, buying and occupancy $6,834 $1 $5 ($15) ($41) ($5) $6,779 ------------------------------------------------------------------------------------------------ Gross margin $1,503 ($1) ($5) $15 $41 $5 $1,558 Selling, general and administrative expenses $1,712 $- $- $1 $- ($19) $1,694 Operating (loss) income ($248) ($1) ($5) $14 $41 $24 ($175) (Benefit from) provision for Income taxes ($109) $- ($2) $5 $15 $9 ($82) ------------------------------------------------------------------------------------------------ Net (loss) income ($233) ($1) ($3) $9 $26 $15 ($187) ================================================================================================ Basic/Diluted (loss) earnings per common share ($0.48) $- $- $0.02 $0.05 $0.03 ($0.38) ================================================================================================
The following is a summary of the effects of the restatement on our unaudited Condensed Consolidated Balance Sheets for all amounts that changed by 5% or more for the periods ended May 1, 2002, May 2, 2001 and January 30, 2002, respectively.
As Previously As Reported Restated -------------- -------------- May 1, 2002* Other long-term liabilities $87 $140 Accumulated deficit ($188) ($410) May 2, 2001** Other assets and deferred charges $473 $543 Other long-term liabilities $828 $877 January 30, 2002*** Accounts payable $103 $89 Accrued payroll and other liabilities $378 $420 Other long-term liabilities $79 $132 Retained earnings $1,261 $1,032
* - As previously reported in the Form 10-Q for the quarter ended May 1, 2002 filed on June 14, 2002. ** - As previously reported in the Form 10-Q/A for the quarter ended May 2, 2001 filed on June 12, 2002. *** - As previously reported in the Form 10-K for the fiscal year ended January 30, 2002 filed on May 15, 2002. 25 MANAGEMENT'S DISCUSSION AND ANALYSIS - (CONTINUED) (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) OVERVIEW On January 22, 2002 ("Petition Date"), Kmart and 37 of its U.S. subsidiaries (collectively, the "Debtors") filed voluntary petitions for reorganization under Chapter 11 of the federal bankruptcy laws ("Bankruptcy Code" or "Chapter 11") in the United States Bankruptcy Court for the Northern District of Illinois ("Court") under case numbers 02 B 02462 through 02 B 02499. The reorganization is being jointly administered under the caption "In re Kmart Corporation, et al. Case No. 02 B 02474." Under Chapter 11, we are operating our business as a debtor-in-possession. As of the Petition Date, actions to collect pre-petition indebtedness as well as most other pending litigation, are stayed and other pre-petition contractual obligations generally may not be enforced against Kmart. In addition, under the Bankruptcy Code we may assume or reject executory contracts and unexpired leases, subject to approval of the Court and our satisfaction of certain other requirements. Parties affected by these rejections may file claims against the debtor in accordance with the reorganization process. Absent an order of the Court, substantially all pre-petition liabilities are subject to settlement under a plan of reorganization to be voted upon by creditors and equity holders and approved by the Court. There can be no assurance that a reorganization plan or plans will be proposed by the Debtors or confirmed by the Court, or that any such plan(s) will be consummated; in addition, the timing of such actions may be other than currently planned by Kmart. If the Debtors fail to file a plan of reorganization during the exclusivity period described above (as such period may be extended) or if such plan is not accepted by the required number of creditors and equity holders, any party in interest may subsequently file its own plan of reorganization. A plan of reorganization cannot become effective until confirmed by the Court, upon certain findings being made by the Court which are required by the Bankruptcy Code. The Court may confirm a plan notwithstanding the non-acceptance of the plan by an impaired class of creditors or equity security holders if certain requirements of the Bankruptcy Code are met. On March 20, 2002, the Court approved the closure of 283 stores, or approximately 13% of our 2,114 stores. Stores were selected by evaluating the market and financial performance of every store and the terms of every lease. Candidates for closure were stores that did not meet our financial requirements for ongoing operations. Renegotiating lease terms was also explored to improve store profitability and to avoid the need for closure. Shortly after receiving Court approval we commenced store closing sales, which were completed June 2, 2002. Approximately 22,000 associates were impacted by the closures. On April 4, 2002, we announced that we had contracted with firms to assist in the disposition of leases for these stores. Under the agreement, the firms will assist our internal real estate staff in identifying retailers and investors interested in an assignment and landlords interested in a termination of the leases for the closing stores. The ability of Kmart to continue as a going concern is predicated upon numerous issues, including our ability to achieve the following: - developing a long-term strategy and/or market niche to revitalize our business and return Kmart to profitability; - taking appropriate action to offset the negative effects that the Chapter 11 filing has had on our business, including the loss in customer traffic and the impairment of vendor relations; - operating within the framework of our DIP Credit Facility, including its limitations on capital expenditures, its financial covenants, our ability to generate cash flows from operations or seek other sources of financing and the availability of projected vendor credit terms; - attracting, motivating and/or retaining key executives and associates; and - developing and, thereafter, having confirmed by the Court, a plan of reorganization. These challenges are in addition to those operational and competitive challenges faced by Kmart in connection with our business as a discount retailer. See "Cautionary Statement Regarding Forward-Looking Information" above. 26 MANAGEMENT'S DISCUSSION AND ANALYSIS - (CONTINUED) (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) ANALYSIS OF OPERATIONS EXCLUDING NON-COMPARABLE ITEMS DESCRIBED BELOW The following table segregates non-comparable items from operating income as reported in the unaudited Condensed Consolidated Statements of Operations:
(as restated) ---------------------- 13 Weeks Ended ---------------------- May 1, May 2, 2002 2001 --------- --------- Sales $ 7,639 $ 8,337 Cost of sales, buying and occupancy 6,245 6,779 --------- --------- Gross margin 1,394 1,558 Selling, general and administrative 1,770 1,694 Equity income (loss) in unconsolidated subsidiaries 5 (16) --------- --------- Operating loss before non-comparable items (371) (152) Non-comparable items: Charge for employee severance and VERP - 23 Accelerated depreciation 18 - 2002 inventory markdowns 758 - --------- --------- Operating loss as reported $ (1,147) $ (175) ========= ========= Same-store sales % (8.8%) 1.9% Same-store sales %, excluding liquidation sales (11.7%) N/A
Management uses operating loss before non-comparable items, among other metrics, to measure operating performance. It supplements and is not intended to represent a measure of performance in accordance with disclosures required by accounting principles generally accepted in the United States. The following discussion and analysis excludes non-comparable items. See the table above for a reconciliation to reported amounts and the section titled Description of non-comparable items described below. Prior to the restatement, and after adjustment for non-comparable items, the previously reported amounts for gross margin, as a percentage of sales were 18.3% and 18.0% for the 13 weeks ended May 1, 2002 and May 2, 2001, respectively; Selling, general and administrative expenses ("SG&A"), as a percentage of sales, were 23.4% and 20.5% for the 13 weeks ended May 1, 2002 and May 2, 2001, respectively; and Operating loss, as a percentage of sales, were (5.1%) and (2.7%) for the 13 weeks ended May 1, 2002 and May 2, 2001, respectively. Same-store sales and total sales decreased (8.8%) and (8.4%), respectively, for the 13 weeks ended May 1, 2002. The decrease in same-store sales and total sales is primarily due to poor in-stock levels and negative customer perception due to the bankruptcy filing. Same-store sales include sales of all stores open, that have been open for greater than 13 full months. Gross margin decreased $164 to $1,394, for the 13 weeks ended May 1, 2002, from $1,558 for the 13 weeks ended May 2, 2001. The decrease in gross margin is attributable to the decrease in total sales in fiscal 2002 as compared to fiscal 2001. Gross margin, as a percentage of sales, decreased to 18.2% for the 13 weeks ended May 1, 2002, from 18.7% for the 13 week period ended May 2, 2001. The decrease in gross margin rate is attributable to decreased vendor allowances due to erosion in supplier confidence brought on by the effects of the bankruptcy filing and reduced retail pricing as a result of competitive pressures partially offset by decreased sales, as a percent of total sales, of food and consumables, which carry lower margins, and to a shift from clearance sales to regular sales. 27 MANAGEMENT'S DISCUSSION AND ANALYSIS - (CONTINUED) (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) Selling, general and administrative expenses ("SG&A"), which includes advertising costs (net of co-op recoveries of $69 in fiscal 2002 and $92 in fiscal 2001) increased $76 for the 13 weeks ended May 1, 2002 to $1,770, or 23.2% of sales, from $1,694, or 20.3% of sales, for the 13 weeks ended May 2, 2001. The increase of $76 is due primarily to severance and contractual obligations, increased bonus accruals, utility rate increases, decreased co-op recoveries due to the erosion in supplier confidence brought on by the effect of the bankruptcy filing and increased expenses for general liability claims, partially offset by the elimination of our previous year customer service bonus program for our store associates. Operating loss for the 13 weeks ended May 1, 2002 was ($371), or (4.9%) of sales, as compared to operating loss of ($152), or (1.8%) of sales, for the same period of the prior year. The increase in operating loss is attributable to lower sales, decreased gross margin rate and increased SG&A expenses as discussed above. Net interest expense for the 13 weeks ended May 1, 2002 and May 2, 2001 was $33 and $83, respectively. Included in net interest expense is interest income of $1 for the 13 weeks ended May 1, 2002 and May 2, 2001. The decrease in net interest expense is a result of our ceasing to accrue interest on unsecured pre-petition debt classified as Liabilities subject to compromise in our unaudited Condensed Consolidated Balance Sheets. Interest at the stated contractual amount on unsecured debt that was not charged to earnings for the 13 weeks ended May 1, 2002 was approximately $60. Effective income tax rate was (0.8%) and (31.8%) for the 13 weeks ended May 1, 2002 and May 2, 2001, respectively. The decrease in the effective income tax benefit rate is due to a valuation allowance established for deferred tax assets which we may not be able to utilize in future years. See Note 15 of the Notes to Condensed Consolidated Financial Statements of this Form 10-Q/A. The $12 tax benefit recorded in the first quarter of fiscal 2002 relates primarily to amounts now refundable to Kmart as a result of the Job Creation and Worker Assistance Act of 2002 which was enacted in the first quarter of fiscal 2002. LIQUIDITY AND FINANCIAL CONDITION Shortly after the Petition Date, in conjunction with our filing under Chapter 11, we entered into a $2 billion debtor-in-possession financing facility ("DIP Credit Facility"). On the Petition Date, the Court gave interim approval authorizing borrowings up to $1.15 billion of the DIP Credit Facility for the payment of certain pre-petition claims and the funding of working capital and other general operating needs. On March 6, 2002, the Court approved the entire $2 billion DIP Credit Facility. The DIP Credit Facility is a revolving credit facility under which Kmart is the borrower and the rest of the Debtors are guarantors. The DIP Credit Facility has been afforded superpriority claim status in the Chapter 11 case and is collateralized by first liens on substantially all of the Debtors' assets (subject to valid and unavoidable prepetition liens and certain other permitted liens) and provides that proceeds be used for working capital needs and other general corporate purposes. The DIP Credit Facility requires that we maintain certain financial covenants and restrict liens, indebtedness, capital expenditures, dividend payments and sale of assets. As of May 1, 2002 we were in compliance with the DIP Credit Facility financial covenants. Following the Petition Date, we have utilized cash flows from operations and the DIP Credit Facility as our primary sources of working capital. As of May 1, 2002 we had utilized $335 of the DIP Credit Facility for letters of credit issued for ongoing import purchasing operations, contractual and regulatory purposes. Total availability under the DIP Credit Facility as of May 1, 2002 is $1.56 billion. As of May 1, 2002 there were $400 and $664 borrowings outstanding under our $400 credit facility and $1.1 billion credit facility, respectively. These borrowings are included in Liabilities subject to compromise in our unaudited Condensed Consolidated Balance Sheet as of May 1, 2002. There were no borrowings outstanding under our DIP Credit Facility as of May 1, 2002. 28 MANAGEMENT'S DISCUSSION AND ANALYSIS - (CONTINUED) (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) Net cash provided by operating activities for the 13 weeks ended May 1, 2002 was $1,020 as compared to net cash used for operating activities of $278 for the same period in 2001. The increase in cash provided by operating activities as compared to the same period of the prior year was primarily the result of an increase in accounts payable, partially offset by lower net earnings, excluding non-comparable items. The increase in accounts payable is attributable to the bankruptcy filing as pre-petition indebtedness was stayed. As we have been purchasing inventory since the bankruptcy filing, we expect our accounts payable and related cash needs to return to more historical levels. Net cash used for investing activities was $52 for the 13 weeks ended May 1, 2002 compared to $277 for the same period in 2001. The decrease in cash used for investing activities was primarily due to restrictions on capital expenditures mandated by our DIP Credit Facility. Net cash used for financing activities was $396 for the 13 weeks ended May 1, 2002 compared to net cash provided by financing activities of $569 for the comparable period in 2001. The decrease in cash provided by financing activities in fiscal 2002 as compared to fiscal 2001 is primarily attributable to the bankruptcy filing. As of the Petition Date, pre-petition indebtedness was stayed resulting in substantial increases in cash balances in the first quarter of fiscal 2002. In the first quarter of fiscal 2002 we were able to pay off $347 in borrowings outstanding at fiscal year end 2001 under our credit facilities. In contrast, during the first quarter of fiscal 2001, we borrowed $592 under our $1.6 billion credit facility to finance our operations. Due to the seasonal nature of the retail industry, where merchandise sales and cash flows from operations are historically higher in the fourth quarter than any other period, a disproportionate amount of operating income and cash flows from operations is earned in the fourth quarter. Our results of operations and cash flows are primarily dependent upon the large sales volume generated during the fourth quarter of our fiscal year. Fourth quarter sales represented over 30% of total net sales in fiscal 2001. As a result, operating performance for the interim periods is not necessarily indicative of operating performance for the entire year. To support the higher seasonal sales volume we experience a seasonal inventory build in October and November and, as a result, our usage of credit lines is higher for this period of the year. We believe that our DIP Credit Facility will be adequate to support our forecasted seasonal borrowing needs. Our cash needs are satisfied through working capital generated by our business and funds available under our DIP Credit Facility. The level of cash generated by our business is dependent, in significant part, on our level of sales and the credit extended by our vendors. Since our filing for reorganization under Chapter 11, most of our vendors have resumed normal trade terms. Should, however, we experience a significant disruption of terms with our vendors, margins fail to improve, and/or the DIP Credit Facility for any reason becomes unavailable and/or actual results differ materially from those projected, our compliance with financial covenants and our cash resources could be adversely affected. This liquidity section of MD&A should be read in conjunction with the Quarterly Report on Form 10-Q for the 13 and 39 week periods ended October 30, 2002, filed with the SEC on December 23, 2002. 29 MANAGEMENT'S DISCUSSION AND ANALYSIS - (CONTINUED) (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) DESCRIPTION OF NON-COMPARABLE ITEMS During the 13 week periods ended May 1, 2002 and May 2, 2001, respectively, we have instituted certain restructuring actions to improve our operations. A more detailed description of these non-comparable items is as follows: Markdowns for inventory liquidation During the first quarter of fiscal 2002, we recorded a charge of $758 to write-down inventory to be liquidated at our 283 closing stores to net realizable value. This charge is included in Cost of sales, buying and occupancy in the accompanying unaudited Condensed Consolidated Statements of Operations. Of the charge, $384 relates to the write-down of inventory to estimated selling value in connection with liquidation sales in the 283 stores for which we received Court approval to close on March 20, 2002. The liquidation sales and store closings were completed on June 2, 2002. In addition, a charge of $266 was recorded relating to the acceleration of markdowns on approximately 107,000 stock keeping units (SKUs) of inventory items that were transferred from our remaining open stores to the 283 closing stores and included in the liquidation sales. The SKUs will no longer be carried as part of our product assortment in our remaining open stores and were reduced to estimated selling value. The remaining $108 of the charge related to liquidation fees and expenses associated with the disposition of inventory through the liquidation sales at the 283 closing stores. Accelerated depreciation On September 6, 2001, we announced that we would restructure certain aspects of our supply chain operations. Part of the restructuring included implementing new real-time distribution software across our supply chain improving product flow and efficiency. Completion of the implementation is expected by the end of the third quarter of fiscal 2003. The existing supply chain software will continue to be utilized until replaced in 2003. Depreciation has been accelerated to reflect the revised remaining useful lives. We recorded a charge of $4 in the first quarter of fiscal 2002 related to the accelerated depreciation for these assets. The charge is included in Cost of sales, buying and occupancy in the unaudited Condensed Consolidated Statements of Operations. In the fourth quarter of fiscal 2001 we recorded a non-cash charge for the impairment of long-lived assets in accordance with SFAS No. 144. Included in the charge was the write-down to fair value of long-lived assets at our 283 stores for which we received Court approval to close. Depreciation on the remaining asset values were accelerated to reflect the revised useful lives and the assets will be fully-depreciated by the end of the second quarter of fiscal 2002. We recorded a charge of $14 related to the accelerated depreciation on these assets in the first quarter of fiscal 2002. The charge is included in Cost of sales, buying and occupancy in the unaudited Condensed Consolidated Statements of Operations. Employee severance and VERP During the first quarter of 2001, our workforce was reduced by 350 employees through a voluntary early retirement program ("VERP") and other employee separations. The total cost of the realignment aggregated $23 ($15, net of tax), which is included in our unaudited Condensed Consolidated Statement of Operations for the quarter ended May 2, 2001 in the line item Charge for employee severance and VERP. The charge relates to 130 employees that accepted the VERP offer, with costs aggregating $6. The remaining 220 employees were severed and given post-employment benefits including severance, outplacement services, continuation of healthcare benefits and other benefits totaling $17. Of the charge, $19 was reserved for and was paid out of our general corporate assets, including benefits for highly-compensated employees accepting the VERP offer, and the remaining $4 was paid out of the Kmart Employee Pension Plan. Our first quarter cash payments in fiscal 2001 associated with these actions was $9. 30 MANAGEMENT'S DISCUSSION AND ANALYSIS - (CONTINUED) (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) REORGANIZATION ITEMS, NET Reorganization items represent amounts we incurred as a result of the Chapter 11 and are presented separately in the unaudited Condensed Consolidated Statements of Operations. For the 13 weeks ended May 1, 2002, the following have been recorded:
2002 store closings $ 228 Professional fees 38 Employee costs 26 Sale of pharmacy lists (17) Settlement of pre-petition liabilities (5) Interest income (4) Other 8 -------- Total $ 274 ========
The following paragraphs provide additional information relating to costs that were recorded in the line Reorganization items, net in our unaudited Consolidated Statement of Operations for the 13 week period ended May 1, 2002: 2002 store closings On March 20, 2002, the Court approved the closure of 283 stores. Stores were selected by evaluating the market and financial performance of every store and the terms of every lease. Candidates for closure were stores that did not meet our financial requirements for ongoing operations. As a result of our decision to close the 283 stores we charged to our closed store reserve $228 for lease terminations and other costs and reclassified $144 of capital lease obligations to the closed store reserve. The closed store reserve is included in the line Liabilities subject to compromise in our unaudited Condensed Consolidated Balance Sheet as of May 1, 2002. The reserve for estimated costs was recorded in accordance with EITF 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)" ("EITF 94-3"). During the period that the stores remained open for business, rent and other costs of operations continue to be reflected in our operating expenses. In the first quarter of fiscal 2002, there were no payments charged to the reserve, see Note 11. Professional fees In the first quarter of fiscal 2002, we recorded $38 for professional fees. Professional fees include financial, legal, real estate and valuation services directly associated with our reorganization process. Employee costs In March 2002, we received Court approval to implement our Key Employee Retention Plan ("KERP") which provides cash incentives and certain benefits to key members of our salaried management team. The KERP is expected to encourage employees to continue their employment with Kmart through the reorganization process. In the first quarter of fiscal 2002, we recorded a charge of $26 for the KERP and retention bonuses for associates in our 283 stores that were closed. There were no payments charged to the reserve during the first quarter of fiscal 2002. Settlement of pre-petition claims We recorded a gain of $5 representing the difference between the settlement value of certain pre-petition obligations and their recorded allowable claims. 31 MANAGEMENT'S DISCUSSION AND ANALYSIS - (CONTINUED) (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) Other reorganization items We recorded a gain of $17 for the sale of pharmacy lists and $4 for interest income earned on excess cash balances. We also recorded a charge of $8 for other miscellaneous reorganization items. INTERNAL INVESTIGATION - DEVELOPMENTS SINCE FILING OF 2001 FORM 10-K AND ORIGINAL FORM 10-Q Investigative Matters The following sets forth developments that have occurred since the filing of Kmart's Annual Report on Form 10-K for fiscal year 2001, dated May 15, 2002 (the "Original 2001 10-K") in connection with the internal investigation and related stewardship review being conducted under the supervision of the Audit Committee of the Board of Directors. As previously disclosed, following the receipt of anonymous letters, the Board of Directors had instructed that an internal investigation be undertaken under the supervision of the Audit Committee by outside legal counsel, with the assistance of independent accounting advisors. The Original 2001 10-K had reflected, as of the date of filing, the results of the investigation with respect to various accounting matters. As of the date of the filing, we believed that the investigation was complete with respect to accounting matters affecting the financial statements in the Original 2001 10-K. Set forth below is a discussion of certain matters relating to vendor allowances and inventories that have been investigated since the filing of the Original 2001 10-K. Vendor Allowance Matters Premature Recognition of Vendor Allowances Since the filing of our Original 2001 10-K we became aware of documents that indicated that there were certain vendor allowance transactions prematurely recorded in our fiscal year 2000 fourth quarter financial statements that required investigation. We also determined that such early recognition of vendor allowances occurred in other prior fiscal periods, although the impact of these transactions on our financial statements was less significant. We described the effect of these items in our Form 10-Q for the thirteen week period ended July 31, 2002 that we filed with the SEC on September 16, 2002. In addition, we recently became aware of allowances received from a vendor aggregating $14, which had previously been recognized in our fiscal year 2000 financial statements and that we have determined should more appropriately have been recognized over the five-year life of the contract that we entered into with this vendor. It is important to note that although we have conducted all procedures we deemed reasonable under the circumstances to identify and quantify vendor allowances that were prematurely recorded, and which were restated to correct and record such allowances in the appropriate period, there can be no assurance that we have captured all of such allowance transactions. Furthermore, we believe that our ability to accurately identify prematurely recorded allowance transactions diminishes with the passage of time. We have taken actions to strengthen our internal controls concerning vendor allowance transactions and we have restated our prior period financial statements for these adjustments. 2001 Interim Recognition of Allowances During the Fall of 2002 and in response to inquiries from the staff of the SEC, Kmart reviewed its historical practices for the recording of allowances prior to the adoption in the fourth quarter of fiscal year 2001 of a new accounting policy, effective February 1, 2001, for the interim financial reporting of vendor allowances. The effect of these practices relates only to Kmart's interim financial statements. For interim reporting periods in fiscal 2000 and prior, our policy was to record allowances not yet subject to a written agreement during the first three quarters of a fiscal year based upon our estimate of annual allowances ("our plan") as determined by historical experience and current understandings with our vendors. These amounts were supplemented by allowances obtained that were not contemplated in our plan ("incrementals"). During the fourth quarter of fiscal 2001, we adopted a new accounting policy, effective as of February 1, 2001, for interim financial reporting only, requiring that cost recoveries from vendors be recognized only when a formal agreement for such amount has been obtained and the underlying activity for which the amount was provided has been performed. 32 MANAGEMENT'S DISCUSSION AND ANALYSIS - (CONTINUED) (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) As part of its review of allowances, the current management of Kmart observed that the total level of allowances originally recorded during the first three quarters of fiscal year 2001 appeared high, given the challenges that faced the business in fiscal year 2001 and the fact that sales failed to increase as originally contemplated in Kmart's business plan. In that regard, it was noted that had Kmart recorded allowances during the first three quarters of fiscal year 2001 at rates which corresponded to more historical rates, Kmart would have recorded fewer allowances. During the first three quarters of fiscal year 2001, Kmart characterized and recorded as incremental allowances $110, $163 and $50, respectively. Kmart selectively identified for review certain of such allowances that had been characterized and recorded as incrementals prior to the adoption of the new accounting policy. Of those reviewed, the amount of allowances which appeared to be questionable, other than those previously disclosed, were $27, $42 and $23, respectively. The questions about these allowances relate to, among other things, the failure to have appropriate signed documentation in place, the failure to have adequate records demonstrating that the allowance was collectible or the failure to otherwise comply with Kmart's historical policies. Based on the investigation, it appears that some of these allowances may have been reported in error in the quarterly financial statements. Given, however, that Kmart's review of allowances was selective, as well as the difficulties of confirming on a retroactive basis whether an incremental allowance is supplemental to the plan, Kmart cannot exclude the possibility that there may be additional incremental allowances in fiscal year 2001 which could be subject to question. Any errors, as described in the preceding paragraphs, concerning the recording of allowances that were reflected in our fiscal year 2001 interim unaudited financial statements prior to the change in accounting policy were no longer reflected in our restated financial statements as filed with the SEC on May 15, 2002. This results from the change in accounting policy, given that under the new accounting policy there is no longer a distinction between planned and incremental allowances, no allowances are recognized absent a formal agreement and the recording of allowances is no longer based on a plan. Inventory Matters Following the filing of the Original 2001 10-K and in response to inquiries from the staff of the SEC, we have conducted an internal inventory quality review with respect to our 1999, 2000 and 2001 fiscal years. We continue to believe, following the conclusion of this review, that our inventory balances during these periods were, in all material respects, appropriately valued at the lower of cost or market and that, therefore, our financial statements require no adjustment for inventory quality matters. However, we have provided the following additional information with respect to our historical inventory markdown and reserve practices so as to enhance a reader's understanding of our financial statements as presented in Management's Discussion and Analysis in the Original 2001 10-K and to be contained in Amendment No. 1 to our Annual Report on Form 10-K/A for our fiscal year ended January 30, 2002, to be filed with the SEC on January 14, 2003. 2000 Strategic Actions Charge and Related Matters During the second quarter of fiscal year 2000, we reported a $740 charge for strategic actions including the closure of certain stores, acceleration of certain inventory reductions and redefining our information technology strategy. The $740 charge included $290 for the estimated loss on disposal for the accelerated liquidation of certain discontinued product, which was characterized in Management's Discussion and Analysis of our 2001 10-K as a "non-comparable" item. During the course of the recent internal inventory review, we analyzed the assumptions of the charge related to the accelerated liquidation of the discontinued merchandise, including historical markdown cadences, or the timing for recognizing markdowns in our financial statements, for discontinued product. In carrying out such review, current management observed that the effect of an accelerated markdown cadence, combined with certain transfer costs, approximated $156. In light of these observations with respect to accelerated markdown cadences, current management noted that approximately $134, the remaining portion of the charge, could have been viewed as an operating item and, as such, not reported as a "non-comparable" item. Similarly, current management observes that if the $134 portion of the charge had been reflected as an operating item, it could have been recorded against an existing inventory reserve. 33 MANAGEMENT'S DISCUSSION AND ANALYSIS - (CONTINUED) (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) Inventory Valuation Reserves At the end of fiscal year 1999, Kmart had designated valuation reserves related to its discontinued and aged seasonal merchandise inventories of $63, as well as general reserves existing in its LIFO provision of $158. In light of these reserves, the inventory at the end of fiscal 1999 was, in the judgment of current management, properly stated at the lower of cost or market in accordance with generally accepted accounting principles. During the fourth quarter of fiscal year 2000, the $158 general reserve that existed in our LIFO valuation was recharacterized within inventory reserves as a reserve for markdowns on discontinued and aged seasonal merchandise. During the first quarter of 2001, we changed our method of recording the effect of permanent markdowns and began to record them as a direct reduction in the carrying value of the related inventory instead of being estimated and recorded as a valuation reserve. At that time, the then existing reserves of $172 for permanent markdowns on discontinued and aged seasonal merchandise were applied directly to the marked-down merchandise. Accordingly, a permanent markdown accrual was no longer necessary. 2001 Clearance Markdowns As indicated in our Original 2001 10-K, inventory valuation is considered to be one of our critical accounting policies as significant judgments and estimates are required in determining merchandise markdowns, among other reasons. A number of factors are considered in determining the timing and amount of merchandise markdowns including rate of product sell-through, projected future demand, and market conditions and weather conditions. The timing of such decisions may have a significant effect on quarterly financial results. During our recent internal inventory review, we noted that levels of clearance markdowns in the second and third quarter of 2001 appeared low in relation to historical markdown experience apparently as a result of, among other things, decisions to minimize markdown activity and related charges in light of Kmart's then operating performance. Although current management found that inventory balances had been properly stated, in all material respects, under our policy of valuing inventory at the lower of cost or market value during each of the quarterly periods of 2001, current management noted that the fewer markdowns in the second and third quarters of 2001 served to increase reported earnings in those quarters, and increase markdowns and decrease reported earnings in the first and fourth quarters. For example, we observed that had markdowns been taken in each quarter of 2001 in a manner which, on a percentage of sales basis, corresponded to the average of the markdowns taken, on a quarterly basis, during fiscal years 1998, 1999 and 2000, excluding the effect of special events such as store closings, the level of clearance markdowns in 2001 could have been increased by $55 and $105 in the second and third quarters, respectively, and reduced by $40 and $120 in the first and fourth quarters, respectively. The actual effect, however, that a different markdown practice could have had on our quarterly net income for the full fiscal year is difficult to predict, given the numerous other factors, estimates and assumptions that would affect our results. OTHER MATTERS Contingent Liabilities As of May 1, 2002, we had (i) guaranteed obligations for real property leases of certain current and former subsidiaries of Kmart including, but not limited to, The Sports Authority, Inc., OfficeMax, Inc. and Borders Group, Inc., some of which leases have been assigned pre-petition; (ii) contingent liability under real property leases assigned by Kmart pre-petition; and (iii) guaranteed $79 of indebtedness of other parties related to certain of our leased properties financed by industrial revenue bonds. Our rights and obligations with respect to our guarantee of leases of the former subsidiaries The Sports Authority, Inc., Office Max, Inc., and Borders Group, Inc., which are detailed below, are governed by Lease Guarantee, Indemnification and Reimbursement Agreements dated as of November 23, 1994, November 9, 1994 and May 24, 1995, respectively, as they may be amended from time to time. Kmart's contingent obligations, described above, which are not reflected in our financial statements, are dependent on the future performance by the parties whose obligations we guarantee and are subject to settlement under a plan of reorganization to be voted upon by creditors and equity holders and approved by the Court. 34 MANAGEMENT'S DISCUSSION AND ANALYSIS - (CONTINUED) (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) As of May 1, 2002, our outstanding guarantees for real property leases of The Sports Authority, Inc., Office Max, Inc., and Borders Group, Inc. were as follows:
Present Value of Future Lease Gross Future Obligations @ 7% Lease Obligations --------------------- --------------------- The Sports Authority, Inc. $ 180 $ 305 Borders Group, Inc. 87 147 OfficeMax, Inc. 64 94 --------- --------- Total $ 331 $ 546 ========= =========
Key Brand Partners On March 20, 2002, the Court authorized our business relationships with several key brand partners. Motions were approved allowing Kmart to assume our license agreements with Martha Stewart Living Omnimedia, Inc. for Martha Stewart Everyday home, garden, colors, baby, kitchen, keeping and decorating products, along with candles and accessories; Jaclyn Smith G.H. Production, Inc. for Jaclyn Smith women's apparel, jewelry and accessories; Kathy Ireland World Wide, Inc. for Kathy Ireland women's apparel, accessories and exercise equipment; Disney Enterprises, Inc. for Disney apparel for infants and children; and Joe Boxer Licensing, LLC. for JOE BOXER apparel, accessories and home furnishings. On May 29, 2002, the Court authorized our business relationship with Sesame Workshop. Motions were approved allowing Kmart to assume our license agreement with Sesame Workshop for Sesame Street toys and infants and children's apparel. Our key brand partners will continue to be a key element in our merchandising and marketing initiatives. As a result, decline in the demand for our key brands or their failure to achieve or maintain broad market acceptance, could have a material effect on our results of operations. Penske On April 9, 2002, we reached an agreement with Penske Corporation, Penske Auto Centers, Inc., and Penske Auto Centers, LLC (collectively "Penske") whereby Penske and Kmart will work together to achieve an orderly wind-down of operations at auto service centers at more than 563 Kmart stores in 44 states following Penske's unilateral decision to close the business as of April 6, 2002. This matter did not have a material adverse affect on our liquidity, financial position or results of operations for the 13 weeks ended May 1, 2002. 35 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK At May 1, 2002, we did not have any derivative instruments that increased our exposure to market risks for interest rates, foreign currency rates, commodity prices or other market price risks. We do not use derivatives for speculative purposes. Currently, our exposure to market risks results primarily from changes in interest rates, principally with respect to the DIP Credit Facility, which is a variable rate financing agreement. We do not use swaps or other interest rate protection agreements to hedge this risk. 36 PART II. OTHER INFORMATION ITEM 3. DEFAULTS UPON SENIOR SECURITIES As a result of its Chapter 11 filing, Kmart has not made principal or interest payments on unsecured indebtedness incurred prior to January 22, 2002. In addition, Kmart is not permitted to pay dividends on its trust convertible preferred securities. The dividend arrearage on the trust convertible securities from December 18, 2001 through May 1, 2002 is approximately $18. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) The following exhibits are filed as a part of this report: Exhibit 99.1 - CEO Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. Exhibit 99.2 - CFO Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (b) Reports on Form 8-K: We filed the following Current Reports on Form 8-K with the SEC during the 13 weeks ended May 1, 2002: 1. March 11, 2002 - Press release dated March 8, 2002, announcing the closure of 284 under-performing stores, and the press release dated March 11, 2002, announcing the appointments and promotions of senior officers. 2. March 29, 2002 - Monthly Operating Report for the period from January 22, 2002 to February 27, 2002, as filed with the Bankruptcy Court. 3. April 22, 2002 - Monthly Operating Report for the period from February 28, 2002 to March 27, 2002, as filed with the Bankruptcy Court. 37 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. The signatory hereby acknowledges and adopts the typed form of his/her name in the electronic filing of this document with the Securities and Exchange Commission. Date: January 14, 2003 Kmart Corporation ---------------------------------------------- (Registrant) By: /s/ James B. Adamson ---------------------------------------------- James B. Adamson CHAIRMAN OF THE BOARD AND CHIEF EXECUTIVE OFFICER (Principal Executive Officer) /s/ A. A. Koch ---------------------------------------------- A. A. Koch CHIEF FINANCIAL OFFICER (Principal Financial Officer) /s/ Richard J. Noechel ---------------------------------------------- Richard J. Noechel VICE PRESIDENT AND CONTROLLER (Principal Accounting Officer) 38 CERTIFICATIONS CEO Certification I, James B. Adamson, certify that: 1. I have reviewed this quarterly report on Form 10-Q/A of Kmart Corporation; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; and 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report. Date: January 14, 2003 /s/ James B. Adamson ------------------------- James B. Adamson Chairman of the Board and Chief Executive Officer 39 CFO Certification I, Albert A. Koch, certify that: 1. I have reviewed this quarterly report on Form 10-Q/A of Kmart Corporation; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; and 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report. Date: January 14, 2003 /s/ Albert A. Koch -------------------------- Albert A. Koch Chief Financial Officer 40 EXHIBIT INDEX EXHIBIT NO. DESCRIPTION 99.1 CEO Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 99.2 CFO Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.