Back to GetFilings.com
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 28, 2002
Commission File Number 1-11681
FOOTSTAR, INC.
-------------
(Exact name of registrant as specified in its charter)
Delaware 22-3439443
-------------------------------- ----------
(State of incorporation) (IRS Employer Identification No.)
1 Crosfield Avenue, West Nyack, New York 10994
----------------------------------------------
(Address of principal executive offices)
Registrant's telephone number, including area code: (845) 727-6500
--------------
Securities registered pursuant to Section 12(b) of the Act:
None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock (par value $.01 per share)
----------------------------------------
(Title of Class)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes __ No X
-
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in the definitive proxy statement incorporated
by reference in Part III of this Form 10-K, or any amendment to this Form 10-K.
[ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act).
Yes X No__
-
The aggregate market value of the Common Stock held by non-affiliates of the
registrant as of July 3, 2004, was approximately $108 million.
Number of shares outstanding of Common Stock, par value $.01 per share, as of
July 31, 2004: 20,293,558.
Documents Incorporated by Reference
None
-2-
FOOTSTAR, INC.
ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
PART I ...................................................................... 5
Introductory Note ........................................................... 5
Restatement of Consolidated Financial Statements ............................ 9
Item 1. Business ........................................................... 15
General ..................................................................... 15
The Meldisco Segment ........................................................ 15
Significant Kmart Relationship .................................... 16
Merchandising ..................................................... 18
Marketing ......................................................... 18
Competitive Environment ........................................... 18
Acquisition and Disposition of the Footwear Assets of
J. Baker, the Ames Bankruptcy Proceeding ........................ 19
Other Business .................................................... 20
The Athletic Segment ........................................................ 21
Footaction ........................................................ 22
Merchandising ..................................................... 22
Marketing ......................................................... 22
Just For Feet ..................................................... 22
Merchandising ..................................................... 22
Marketing ......................................................... 22
Chief Executive Officer ..................................................... 23
Risk Factors ................................................................ 23
Trademarks and Service Marks ................................................ 30
Employees ................................................................... 30
Available Information ....................................................... 31
Item 2. Properties ......................................................... 32
Item 3. Legal Proceedings .................................................. 33
Item 4. Submission of Matters to a Vote of Security Holders ................ 34
PART II ..................................................................... 35
Item 5. Market Prices for the Registrant's Common Equity and
Related Stockholder Matters ...................................... 35
Item 6. Selected Financial Data ............................................ 36
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations ....................................... 37
Item 7A. Quantitative and Qualitative Disclosures About Market Risk ........ 66
Item 8. Financial Statements and Supplementary Data ........................ 68
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure ........................................ 69
Item 9A. Controls and Procedures ........................................... 70
PART III .................................................................... 77
Item 10. Directors and Executive Officers of the Registrant ................ 77
-3-
Item 11. Executive Compensation ............................................ 81
Item 12. Security Ownership of Certain Beneficial Owners and Management .... 90
Item 13. Certain Relationships and Related Transactions .................... 94
Item 14. Principal Accountant Fees and Services ............................ 94
PART IV ..................................................................... 95
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K ... 95
Footstar, the Footstar logo, Footaction, Shoe Zone, Just For Feet, Thom McAn,
Cobbie Cuddlers, Texas Steer, Cara Mia, Players University and Starclub are, or
were as of December 28, 2002, trademarks and/or service marks of Footstar,
Inc.'s subsidiaries or affiliates. All other trademarks mentioned are the
property of their respective owners.
-4-
PART I
INTRODUCTORY NOTE
Footstar, Inc. ("Footstar" or the "Company") is today filing this Annual Report
on Form 10-K for its fiscal year ended December 28, 2002. The Company has not
filed its Quarterly Report on Form 10-Q for the fiscal quarter ended September
28, 2002 and its Quarterly Reports on Form 10-Q for the fiscal quarters ended
March 30, 2002 and June 29, 2002 will be amended. Each of these reports, or
amended reports, as applicable, was delayed as a result of the internal
investigation, the restatement of the Company's consolidated financial
statements and the Company's operation under protection of the bankruptcy laws,
each described below. The Company intends to file these quarterly reports as
soon as practicable. In this Annual Report, words such as "today," "recently,"
"current" or "currently," or phrases such as "as of the date hereof" or "as of
the date of this report," refer to the date the Company is filing this report
with the Securities and Exchange Commission (the "SEC").
The Company's Quarterly Reports on Form 10-Q for the fiscal quarters ended March
29, 2003, June 28, 2003, and September 27, 2003, the Company's Annual Report on
Form 10-K for its fiscal year ended January 3, 2004 and its Quarterly Reports on
Form 10-Q for the fiscal quarters ended April 3, 2004 and July 3, 2004, have
also been delayed and will be prepared and filed as soon as practicable. Due to
the delay, the Company has included in this Annual Report certain unaudited
information relating to fiscal 2003, including sales, debt and inventory levels
but has not included operating profit information as the entire closing process
has not been completed.
On December 29, 2003, the New York Stock Exchange ("NYSE") suspended trading in
the common stock of the Company and, at a later date, the Company's common stock
was delisted. The NYSE stated that it decided to take these actions in view of
the overall uncertainty surrounding the Company's previously announced
restatement of its results for 1997 through 2002 and the continued delay in
fulfilling its financial statement filing requirements.
Commencing March 2, 2004 ("Petition Date"), Footstar and most of its
subsidiaries (collectively, the "Debtors") filed voluntary petitions for relief
under Chapter 11 of Title 11 of the United States Code ("Bankruptcy Code" or
"Chapter 11") in the United States Bankruptcy Court for the Southern District of
New York in White Plains ("Court"). The Chapter 11 cases are being jointly
administered under the caption "In re: Footstar, Inc., et al. Case No. 04-22350
(ASH)" (the "Chapter 11 cases"). The Debtors are currently operating their
businesses and managing their properties as debtors-in-possession pursuant to
Sections 1107(a) and 1108 of the Bankruptcy Code. As a debtor-in-possession, the
Company 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, on notice and an opportunity to be heard.
As of the Petition Date, the Company's operations were comprised of two distinct
business segments: (i) the discount and family footwear segment ("Meldisco");
and (ii) the athletic footwear and apparel segment ("Athletic"). Meldisco sells
family footwear through licensed footwear departments and wholesale
arrangements. Athletic sold athletic footwear and apparel through various retail
chains (for example, Footaction and Just For Feet), the Internet and customer
service centers.
-5-
Meldisco has operated licensed footwear departments in discount chains since
1961, and is the only major operator of licensed footwear departments in the
United States today. As of July 31, 2004, Meldisco operated licensed footwear
departments in 1,503 Kmart Corporation ("Kmart") stores, 860 Rite Aid
Corporation ("Rite Aid") stores, and licensed children's footwear departments in
26 stores operated by subsidiaries of Federated Department Stores, Inc.
("Federated"). Meldisco supplies certain retail stores, such as Wal-Mart Stores,
Inc. ("Wal-Mart") and Rite Aid stores, with family footwear on a wholesale
basis.
Prior to the Petition Date, Athletic specialized in the sale of branded athletic
footwear, apparel and accessories. Athletic used its three retail chains,
Footaction, Just For Feet, and Uprise, to conduct retail sales. Each of the
retail chains in Athletic sold footwear and apparel from all of the major
brand-name merchandisers. Athletic's Consumer Direct operations conducted sales
through the Internet and customer service centers to support the Footaction and
Just For Feet retail chains.
The Company decided to seek bankruptcy protection after management determined it
was unable to obtain necessary liquidity from its lending syndicate or
additional debt or equity financing. The Company suffered a decline in its
liquidity primarily resulting from the unprofitable results in the Athletic
Segment, the reduction in trade credit by certain Athletic vendors, unprofitable
results of operations from recent acquisitions and the effect of the Kmart
bankruptcy. Other factors included intense competition in the discount retailing
industry, unsuccessful sales and marketing initiatives and recent capital market
volatility.
As part of its initial reorganization plans, after filing for Chapter 11 the
Company closed 166 underperforming stores within the Athletic Segment: all 88
Just For Feet stores; 75 Footaction stores; and three Uprise stores. In fiscal
2002, the net sales of these now-closed stores were $378.2 million. Within the
Meldisco Segment, the Company plans to exit the footwear departments in 26
Federated stores by September 2004, has exited the footwear departments in 44
Gordmans, Inc. ("Gordmans") stores, has closed 13 Shoe Zone stores and has sold
26 Shoe Zone stores in Puerto Rico. In fiscal 2002, the net sales of these
now-closed Meldisco businesses were $24.7 million.
The Company obtained Court authority to conduct (i) store closing sales at 75
Footaction locations and (ii) going out of business sales at all of the Debtors'
88 Just For Feet locations. In connection therewith, the Company employed Hilco
Merchant Resources LLC to act as the Company's liquidation agent to maximize the
value of the inventory at these stores.
With respect to the leases related to these stores (and a handful of additional
leases related to the Meldisco business), the Company employed Abacus Advisors
Group LLC and a joint venture group to mitigate potential lease rejection damage
claims arising thereunder. The aggregate potential landlord claims for these 175
leases was estimated to be $71.2 million prior to mitigation. As of July 31,
2004, the Company has mitigated $18.9 million of potential claims, resulting in
a remaining potential obligation to landlord creditors of approximately $52.3
million.
After the Petition Date, the Company received indications of significant
interest from potential acquirers of the remaining 353 Footaction retail stores
comprising the Athletic Segment. The Company determined that a sale of the
scaled-down Athletic Segment was the best way to maximize the value of that
business. This decision was driven in part by the absence of a commitment from
NIKE USA, Inc., the largest supplier of the Athletic Segment, to supply the
Athletic Segment for more than a limited period of time in accordance with past
business practices. Accordingly, the Company decided to establish an orderly
sale process for the remaining Footaction retail stores.
-6-
On March 26, 2004, the Company filed a motion seeking Court approval to conduct
an auction accepting all types of bids with respect to its Athletic Segment,
including, but not limited to, going concern bids, liquidation bids, lease
purchase bids, and any combination of the foregoing. On April 6, 2004, the Court
established procedures for the sale (the "Procedures Order").
On April 21, 2004, the Company received Court approval to sell to certain
affiliates of Foot Locker, Inc. (collectively "Foot Locker") 349 of the
remaining Footaction stores (including all lease rights and inventory at these
stores), along with the remaining inventory from the other four remaining
Footaction stores. Effective May 2, 2004, these assets were sold to Foot Locker
for $225.0 million in cash, subject to adjustment. Approximately $13.0 million
of the sale price was placed in escrow with respect to 14 store locations which
were leased on a month-to-month basis. During the year following the closing of
the sale, if Foot Locker enters into a new lease for any of these store
locations, the escrow amount relating to that location shall be paid to the
Company. The escrow amount relating to any location for which Foot Locker has
not entered into a new lease within one year after the closing shall be paid to
Foot Locker, thereby reducing the purchase price by such amount.
The estimated gain on the sale of the Athletic Segment, including the effect of
the closing of the 166 underperforming stores, is approximately $28.0 million.
The $28.0 million will increase by the amount of the escrowed cash that is
released to the Company.
In the initial stages of the Chapter 11 cases, the Company sought to streamline
its Meldisco business. In July 2004, the Company sold 26 of its Shoe Zone stores
located in Puerto Rico to Novus, Inc. for approximately $5.5 million in cash.
The estimated loss on the sale of Shoe Zone, including the cost of closing
stores not sold, was approximately $9.0 million. As a result of the Company's
continued analysis of both the Athletic and Meldisco businesses, the Company
determined that the Uprise chain, which was comprised of three stores, and six
of its Shoe Zone stores located in the United States were underperforming and
required immediate liquidation to maximize the value of the merchandise therein.
The Company obtained authority to conduct store closing, going out of business,
or similar sales at the Uprise and Shoe Zone stores. Because of the small number
of stores involved, the Company did not require the assistance of a liquidating
agent to assist with the disposition of the merchandise.
In July 2004, the Company exited the footwear departments in the 44 Gordmans
stores and plans to exit the footwear departments in the 26 Federated stores by
September 2004. The estimated cost of exiting the footwear departments of
Federated and Gordmans is approximately $7.0 million.
Under the Procedures Order, the Company pursued the sale of certain other
assets, including its distribution centers. The Company began soliciting offers
for its distribution centers in Mira Loma, California ("Mira Loma") and Gaffney,
South Carolina ("Gaffney"). The Company sold Mira Loma to Thrifty Oil Co.
("Thrifty") for approximately $28.0 million. Pursuant to the terms of the
pertinent sale documents, Thrifty has leased Mira Loma to FMI International LLC,
a logistics provider, which has agreed to provide the Company with warehousing
and distribution services for Meldisco for the next eight years under an
operating lease agreement. The sale of Mira Loma closed on July 22, 2004 and
resulted in a loss of approximately $20.0 million. On August 20, 2004, the
Company announced that it had entered into an agreement to sell Gaffney to
Automated Distribution Systems, L.P., a logistics provider, for approximately
$15.1 million. This sale is subject to certain closing conditions and Court
approval. The estimated loss on the sale of Gaffney is approximately $3.0
million.
-7-
Effective March 4, 2004, the Company entered into a Debtor-in-Possession Credit
Agreement ("DIP Credit Agreement") with a syndicate of lenders co-led by Fleet
National Bank ("Fleet") and GECC Capital Markets Group, Inc. ("GECC"). The DIP
Credit Agreement provided a secured credit facility consisting of revolving
loans of up to $240.0 million (including a sub-limit of $75.0 million for
letters of credit) and a term loan of $60.0 million. The DIP Credit Agreement
had a term of two years.
As a result of the recent aforementioned sales and other restructuring
activities, the DIP Credit Agreement was amended on May 11, 2004 to, among other
things, reduce the amount of DIP financing available to reflect the operating
needs of the Company's smaller business base. By Court order dated July 22,
2004, the Debtors further amended the DIP Credit Agreement to also provide for
financing upon emergence from Chapter 11 (as so amended, the "DIP and Exit
Facility"). Under the DIP and Exit Facility, the Company will have access to up
to $100.0 million of secured DIP financing, including a sub-limit for letters of
credit, subject to a borrowing base formula based upon inventory and accounts
receivable. Upon emergence from Chapter 11, the Company may, at its option,
convert the DIP and Exit Facility to post-emergence financing ("Exit Facility"),
which will provide for up to $160.0 million in revolving commitments, including
a sub-limit for letters of credit. Borrowings under the DIP and Exit Facility
will bear interest at Fleet's prime rate plus 0.0% to 0.5% or LIBOR plus 1.75%
to 2.50%, at the Company's option, with the applicable margin based on excess
availability levels.
The DIP and Exit Facility has a term not to exceed five years from the Petition
Date, including the period during which the Company operates as a
debtor-in-possession. The Exit Facility term will be three years, as long as the
DIP lending period does not exceed two years. As of July 31, 2004, there were no
loans outstanding under the DIP and Exit Facility.
Pursuant to Court orders, the Debtors have been authorized to pay certain
pre-petition operating liabilities incurred in the ordinary course of business
and reject certain of its pre-petition obligations. The Debtors have notified
all known pre-petition creditors of the establishment of a bar date by which
creditors must file a proof of claim. Differences between liability amounts
recorded by the Debtors and claims filed by creditors will be reconciled and, if
necessary, the Court will make a final determination of allowable claims. The
Debtors will continue to evaluate the amount of its pre-petition liabilities on
an ongoing basis and recognize any additional liabilities, which may be
material.
Under the Bankruptcy Code, the Company has the ability to reject executory
contracts, including leases, subject to the approval of the Court and certain
other conditions. Parties affected by the rejection of a contract may file
claims against the Company in the Court in accordance with the Bankruptcy Code.
The Company expects that as a result of its rejection of additional executory
contracts, including leases of nonresidential real property, additional claims
will be filed. Under the Bankruptcy Code, the Company may choose to assume
executory contracts subject to the approval of the Court and certain other
conditions, including the Company's cure of all prior defaults, including
liabilities thereunder arising prior to the Petition Date. The Company expects
-8-
that the assumption of additional executory contracts and unexpired leases may
convert liabilities currently shown on its consolidated financial statements as
subject to compromise into non-contingent, post-petition liabilities. Due to the
uncertain nature of many of the potential claims, which have been or may be
asserted against the Company, the Company is unable to project the magnitude of
such claims with any degree of certainty. The Company has incurred, and will
continue to incur, significant costs associated with the Chapter 11 cases.
In order to exit Chapter 11 successfully, the Company will need to propose and
obtain Court confirmation of a Chapter 11 plan that satisfies the requirements
of the Bankruptcy Code. The Bankruptcy Code provides the Company with the
exclusive right to propose a Chapter 11 plan for a period of 120 days from the
Petition Date. The Court has extended the Company's period of exclusivity
through September 28, 2004. At this time, it is not possible to predict
accurately the effect of the Chapter 11 cases on the Company's business,
creditors or stockholders or when the Company may emerge from Chapter 11, if at
all. The Company's future results depend on the timely and successful
confirmation and implementation of a Chapter 11 plan.
As detailed above, the Company has sold or is in the process of consummating the
sale of all of the assets of Athletic. The Meldisco business is the Company's
sole remaining business. The Company's sale of discount family footwear at Kmart
stores currently generates over 90% of Meldisco's revenues. The Company's
relationship with Kmart is governed by (i) the Master License Agreement with
Kmart and (ii) the certain sub-agreements governing the operation of footwear
departments in each of Kmart's stores. Absent these revenues from the footwear
departments, the Debtors cannot continue to operate and any reorganization of
the Company depends upon their continued ability to generate revenues through
the sale of footwear at Kmart stores. Accordingly, on August 12, 2004, the
Company filed a motion to assume the Master License Agreement and the
sub-agreements. A preliminary hearing with respect to this assumption will take
place in early September 2004, with a hearing on the merits to occur sometime
thereafter.
As described below, certain financial information included in this Annual Report
has been restated. The consolidated financial statements referred to on page F-1
and included in this report have been audited by the Company's Independent
Registered Public Accounting Firm, KPMG LLP. The Consolidated Balance Sheet as
of December 29, 2001 and the Consolidated Statements of Operations,
Shareholders' Equity and Cash Flows for fiscal years 2000 and 2001 have been
restated. While the consolidated restated financial information for fiscal years
1998 and 1999 included in this report is unaudited, these periods are restated
on a basis that is consistent with the restatement of the Company's consolidated
financial statements for fiscal years 2000 and 2001, and the consolidated
financial statements for fiscal 2002.
RESTATEMENT OF CONSOLIDATED FINANCIAL STATEMENTS
Since 1997, the Company has operated a Shared Services Center in Texas. The
Shared Services Center administers accounts payable, loss prevention, payroll,
benefits, store accounting and inventory control for all segments of Footstar.
Through 2002, the Shared Services Center processed approximately 100,000
invoices and $1 billion of payments to vendors annually. The accounts payable
systems for each segment have varied over the years as a result of the Company's
acquisitions and the specific business requirements of the segments.
-9-
On November 13, 2002, the Company announced that management had discovered
discrepancies in the reporting of its accounts payable balances. As a result of
this discovery, the Company determined that certain processes and systems
designed to prevent or capture exceptions were not functioning as intended.
These process and system issues primarily involved the reconciliation and
processing of accounts payable transactions, in both the Athletic and Meldisco
Segments, and in the processing of transactions during the conversion and
transition of Just For Feet's systems in fiscal 2000 (i.e., the failure to
record receipts at Just For Feet) and related understatements of expenses from
inventory losses (shrink expense). For additional details, see "The
Investigation".
Prior to the Company's November 13, 2002 announcement, the Company notified the
Staff of the SEC concerning the discovery of the accounting discrepancies. The
SEC began a regulatory proceeding captioned, In the Matter of Footstar, Inc.,
MNY-7122, including an investigation into the facts and circumstances giving
rise to the restatement. On November 25, 2003, the SEC issued an Order Directing
Private Investigation and Designating Officers to Take Testimony, in that
regulatory proceeding. The Company has been and intends to continue cooperating
fully with the SEC. The Company cannot predict the outcome of this proceeding.
In the procurement-to-payment cycle, the Company employs computer systems for
ordering, receipt, inventory, accounts payable, three-way matching, payment, and
general ledger accounting. For the Meldisco Segment, merchandise is ordered
using a purchase order management system (the "POM system"), which was
internally developed for the Meldisco buying team and has been in use since well
before 1996. Receipt of merchandise is tracked and recorded in a warehouse
management system (the "WM system"), purchased in 1996. This WM system was not
installed as originally intended by the Company's management, due to design
issues encountered with the system provider. As a result, the Company has, at
times, utilized certain manual procedures to interface the systems. Meldisco's
inventory stock ledger system was licensed from the JDA Software Group, Inc. in
1998 ("JDA system"). For Meldisco, the three-way match of domestic purchase
order-to-receipt-to-invoice is done using the POM system; payments by wire
transfer are made using the POM system, and payments by check are made using a
general ledger system which was licensed from Lawson Associates, Inc., d/b/a/
Lawson Software in 1997 ("Lawson GL system").
The Athletic Segment, like the Meldisco Segment, used the POM system for
creating purchase orders, the WM system for receiving merchandise, and the
Lawson GL system for the general ledger. However, for the Athletic Segment, the
inventory stock ledger, accounts payable, three-way matching and payments were
all processed using a stock ledger system licensed from NSB Retail Systems PLC,
which had been used by the Footstar businesses since before their spinoff from
Melville Corporation and by Just For Feet since 2000. Before the Company
acquired Just For Feet in March 2000, and during a period of approximately four
months after that acquisition, Just For Feet used a stock ledger system licensed
from Island Pacific Software Corporation that the Company had purchased as part
of the Just For Feet acquisition.
To function properly, these different systems must transfer accurate data from
one to another. The interface also must be correctly synchronized so that data
cannot be misinterpreted because of timing differences among system cutoffs.
-10-
Flaws in systems interfaces are generally detected during periodic
reconciliations of the balances of one system to another. The principal
reconciliation performed regularly by the Company was between the merchandise
accounts payable sub-systems, the JDA system at the Meldisco Segment, the STS
system at the Athletic Segment, and the Lawson GL system at both segments.
The POM system was not originally designed to process financial transactions and
had been customized by the Company to handle accounts payable, three-way
matching and some payments. The JDA system was installed in 1998 and has been
significantly customized so that subsequent versions of that system could not
easily be installed at Meldisco.
In August 2002, in an effort to improve internal controls, management shifted
reporting responsibilities so that the Shared Services Center began reporting to
the Company's Controller rather than to the Chief Information Officer. Late in
October 2002, in a further effort to improve internal controls, management moved
the preparation of monthly reconciliations of the merchandise accounts payable
sub-systems to the general ledger from the Shared Services Center to the
Corporate accounting group in New York. Subsequent to the transfer, the
Corporate accounting group detected significant discrepancies in the basic
reconciliation procedures that were followed in the Shared Services Center.
These discrepancies were communicated to the Company's senior management team,
the Audit Committee of the Board of Directors, the full Board of Directors,
internal auditors from Deloitte & Touche LLP and independent auditors from KPMG
LLP.
An investigation was conducted, under the oversight of the Audit Committee.
Based on the findings of the investigation, the Company has restated its
consolidated financial statements for fiscal year 1997 through the first half of
fiscal year 2002.
The restatement reduced earnings by an aggregate of $47.4 million pre-minority
interest and pre-taxes (or $27.7 million after minority interests and taxes)
over the five-and-one-half-year period from the beginning of fiscal year 1997
through June 29, 2002. Of the $47.4 million in pre-minority interest and pre-tax
reduction in earnings, $46.1 million related to accounts payable adjustments.
The remaining $1.3 million reflects the net of various adjustments disclosed
under the caption "Management's Discussion and Analysis of Financial Condition
and Results of Operations", and are primarily accounting adjustments affecting
inventory, fixed assets, accrued expenses, minority interests and consolidation
elimination entries. The Company concluded that vendors had been paid in full
during the five-and-one-half-year period, as the restatements related to
adjusting the general ledger and not the detailed vendor payable subledger. The
restatement resulted in an increase to cost of sales and certain selling,
general and administrative expenses as well as an increase in the reported
general ledger accounts payable balance.
The investigation and the financial impact of the restatement on the Company are
described below. For a discussion of the actions taken by the Company to
remediate areas of weakness identified during the investigation and the
restatement, see "Controls and Procedures".
-11-
THE INVESTIGATION
Beginning in November 2002, an investigation into accounting misstatements
identified in the Company's previously filed consolidated financial statements
was conducted under the oversight of the Audit Committee of the Board of
Directors. During the nearly two year investigation, restatement corrections
totaling $47.4 million (pre-tax and pre-adjustments to minority interests) were
identified. While the Company's restatement encompassed a wide range of matters,
the principal findings of the investigation related to three accounting issues:
(1) the understatement of cost of goods sold and the understatement of selling,
general and administrative expenses relating to incorrect write-offs of accounts
payable ($35.8 million); (2) the failure to appropriately estimate the
liquidation value of inventory obtained in connection with the acquisition of
Just For Feet and the resulting overstatement of the profitability of the sale
of that inventory ($5.9 million inappropriate increase to income, which nets to
$3.8 million after reflecting other purchase accounting allocation adjustments);
and (3) the overstatement of profits resulting from the failure to properly
record certain inventory receipts following the acquisition of Just For Feet
($10.3 million.) The net effect of all other restatement adjustments was a $2.5
million increase in pre-tax income.
The Company's Audit Committee initially retained the law firm of Latham &
Watkins LLP ("L&W") to assist with the investigation and the related regulatory
proceeding commenced by the SEC. At the same time, the Company retained L&W to
represent it in the derivative action and purported class action lawsuits that
were filed after the Company's November 13, 2002 announcement. L&W retained
forensic accountants, Navigant Consulting, to assist in its investigation and
delivered a preliminary report to the Audit Committee in January 2003 and a
further report in April 2003, which focused principally on the accounts payable
issue and certain other issues that arose in the course of the investigation.
The initial investigation identified instances where certain members of the
Company's senior management caused manual entries to be improperly made to
write-off certain payables and correspondingly reduced certain operating
expenses such as losses of inventory relating to such items as theft, loss in
shipment, etc. (shrink expense) and also inappropriately to offset unrelated
items, such as unrecoverable receivables. Not only were these manual entries
improper, they were also taken inconsistently into income following no
established policies and procedures. In addition, the initial investigation
identified significant deficiencies in the Company's internal controls and
procedures, computer systems and organizational structure, as well as instances
in which some members of management and finance-related employees devoted
insufficient resources and attention to accounting issues.
After reviewing the findings of the initial investigation and discussing the
issues raised by the findings with its independent auditors, the Audit Committee
determined that a further and broader investigation was warranted into areas
beyond those raised in the restatement process to assess the accuracy and
completeness of the Company's consolidated financial statements. The Audit
Committee retained the law firm of Richards Spears Kibbe & Orbe LLP ("RSKO"),
which had no previous relationship with the Company or its management, to
conduct this additional investigation, while L&W continued to represent the
Company in connection with litigation and regulatory matters. RSKO was also
assisted by forensic accountants, Navigant Consulting. Although the additional
investigation required more time, the Audit Committee believed it was necessary
to help ensure that the investigation and restatement would be accurate and
complete.
-12-
The RSKO investigation confirmed that certain members of the Company's senior
management caused manual entries to be improperly made to write-off certain
payables and correspondingly reduced certain operating expenses, such as losses
of inventory relating to such items as theft, loss in shipment, etc. (shrink
expense) and to also inappropriately offset unrelated items, such as
unrecoverable receivables.
With respect to the Company's acquisition of Just For Feet in 2000, the RSKO
investigation found that the Company did not perform a detailed analysis in
determining the estimate of the fair market value of inventories acquired. As a
result, the original purchase price allocation was incorrect. By the end of the
third quarter in 2000, the Company determined that the sale of the acquired
inventory exceeded the estimate by $5.9 million. Rather than readjusting the
purchase price allocation, certain members of senior management allowed the
Company to record the $5.9 million excess as a reduction of cost of sales,
thereby overstating in 2000 the profitability of Just For Feet by this amount.
In addition, since the reason for the increased profitability was not disclosed,
it appeared that the Just For Feet acquisition was more profitable than it
actually had been.
Also in 2000, certain members of senior management caused the Company to record
incorrect entries to the consolidated income statement related to what was then
described as "positive shrink" or an unexpected increase in Just For Feet
inventory. This $10.3 million increase in inventory was noted during a series of
physical inventory counts, and was taken into income without being properly
investigated or disclosed and contributed to the overstatement, in 2000, of the
profitability of the Just For Feet acquisition by $10.3 million. The
investigation found these amounts primarily related to "drop shipments"
(shipments from vendors directly to stores) not recorded in the Company's
inventory and accounts payable records. The invoices related to this inventory
were paid by the Company. The failure to record the receipt of inventory and the
related accounts payable resulted in unusual gains when the inventory was
counted.
The RSKO investigation also found that some members of senior management and
finance-related employees devoted insufficient attention and resources to
ensuring accurate accounting and financial reporting and did not communicate
adequately to the Company's internal auditors, independent external auditors,
the Audit Committee and the Board of Directors, which caused the problems
arising from the deficiencies in the Company's internal controls and procedures
not to be identified. In addition, the RSKO investigation identified that there
was a failure by the Company's senior management to establish an appropriate
control environment, and there were significant deficiencies in the Company's
internal controls and procedures resulting from numerous causes, including
inadequate staffing, insufficient quality and training of personnel and
inadequate systems and systems interfaces. As a result of the investigations,
the Company has made significant personnel and policy changes, including the
discharge of several financial employees and the separation of employment of its
Chief Executive Officer, J.M. Robinson, on September 12, 2003. In addition, the
Company has established the position of Senior Vice President Financial Planning
and Control, which reports directly to the Chief Executive Officer on all
matters related to the preparation of the Company's consolidated financial
statements.
Based on the findings of the investigation and the overall results of the
restatement process, the Company has implemented an Internal Process and
Controls Plan (formerly the "Remediation Plan") to improve the Company's
internal controls and procedures, address the systems and personnel issues
raised in the course of the restatement and help ensure a corporate culture that
emphasizes the importance of accurate financial reporting. The Internal Process
and Controls Plan has addressed the Company's control environment, organization
and staffing, policies, procedures and documentation, and information systems.
For a further discussion of the steps the Company has taken to address these
issues, see "Controls and Procedures".
-13-
The investigation resulted in the Company restating its Consolidated Financial
Statements for the fiscal years 1997 through 2001 and the six month period ended
June 29, 2002. The cumulative impact of the restatement reduced earnings by
$47.4 million over the five-and-one-half year period and reduced the Company's
consolidated retained earnings as of June 29, 2002 by $28.2 million, inclusive
of $0.5 million related to the recognition of certain retirement benefits.
Additional information relating to the financial impact of the restatement is
discussed in Item 7 "Management's Discussion and Analysis of Financial
Conditions and Results of Operations."
On December 29, 2003, the NYSE suspended trading in the common stock of the
Company and, at a later date, the Company's common stock was delisted. The NYSE
stated that it decided to take these actions in view of the overall uncertainty
surrounding the Company's previously announced restatement of its results for
1997 through 2002 and the continued delay in fulfilling its financial statement
filing requirements.
-14-
ITEM 1. BUSINESS
GENERAL
Footstar is a holding company in which its businesses are operated through its
subsidiaries. The Company is principally a specialty retailer conducting
business through its Meldisco Segment and, prior to its sale to Foot Locker on
May 2, 2004, its Athletic Segment. Meldisco sells family footwear through
licensed footwear departments and wholesale arrangements. Athletic sold athletic
footwear and apparel through various retail chains (for example, Footaction and
Just For Feet), the Internet and customer service centers. The financial
information concerning industry segments and geographical areas is set forth in
Note 32 of "Notes to Consolidated Financial Statements."
The Company was organized in Delaware in March 1996. Footstar became a publicly
traded company on October 12, 1996 when Melville Corporation, as part of its
overall restructuring, distributed Footstar's outstanding common stock to the
Melville stockholders.
See "Introductory Note" for a description of certain important events which
occurred subsequent to December 28, 2002, including Footstar's Chapter 11
filing, the planned exit from the footwear departments of Federated and the exit
from the Gordmans stores and the closing and sale of the Shoe Zone stores within
the Meldisco Segment and the closing of certain stores and the sale of all
remaining stores within the Athletic Segment.
THE MELDISCO SEGMENT
Meldisco sells family footwear through licensed footwear departments and
wholesale arrangements. Meldisco has operated licensed footwear departments in
discount chains since 1961 and is the only major operator of licensed footwear
departments in the United States today.
As of December 28, 2002, Meldisco operated licensed footwear departments in
1,832 Kmart stores, in 3,367 Rite Aid drugstores, in 190 stores whose footwear
department licenses were acquired from J. Baker, Inc. ("J. Baker"), in 40
Gordmans stores, and in children's footwear departments in 66 stores operated by
Federated. As of July 31, 2004, Meldisco operated licensed footwear departments
in 1,503 Kmart stores, in 860 Rite Aid drugstores, and in children's footwear
departments in 26 Federated stores. In October 2002, Meldisco began selling
family footwear on a wholesale basis to Wal-Mart and, in April 2003, the
licensed footwear agreement between the Company and Rite Aid changed to a
wholesale arrangement covering approximately 2,500 Rite Aid drugstores located
in the eastern half of the United States. As of December 28, 2002, Meldisco also
operated Shoe Zone, a chain of stand-alone family footwear retail stores, that
sold quality leather and value-priced fashion footwear, including the
Company-owned Thom McAn and Cara Mia brands.
Meldisco's core licensed footwear operation sells family footwear and
lower-priced basic and seasonal footwear in Kmart and Rite Aid stores and, as of
December 28, 2002, its "better" licensed business sold branded and other
higher-end footwear in department and specialty stores, including Gordmans and
certain Federated stores. In its licensed footwear departments, Meldisco
generally sells a wide variety of family footwear, including men's, women's and
children's dress, casual and athletic footwear, work shoes and slippers.
-15-
Meldisco had pursued a strategy to increase its licensed footwear business with
other retail outlets since 2001. In February 2001, Meldisco acquired from J.
Baker 13 new license agreements with retailers covering over 1,000 licensed
footwear departments, but subsequently exited these businesses as none of them
performed as expected. See "Acquisition and Disposition of the Footwear Assets
of J. Baker; the Ames Bankruptcy Proceeding" . In August 2001, Meldisco expanded
its business in the Rite Aid stores from those located primarily in the western
portion of the United States to include Rite Aid's operations in the eastern
portion of the United States. In January 2002, the Company announced new
licensed footwear department agreements with subsidiaries of Federated and with
Gordmans. See "Introductory Note" for a description of Footstar's exit from the
footwear departments of Federated and Gordmans stores.
The Company operated 20 Shoe Zone stores as of December 28, 2002 and no Shoe
Zone stores as of July 31, 2004. These family footwear stores featured a
selection of fashion accessories, including belts, handbags and wallets. See
"Introductory Note" for a description of Footstar's sale of Shoe Zone stores.
In October 2002, Meldisco began supplying Thom McAn family footwear on a
wholesale basis to 300 Wal-Mart stores. In February 2003, the Company expanded
its arrangement with Wal-Mart to supply Thom McAn family footwear on a wholesale
basis to up to 1,500 Wal-Mart stores in the United States. As of July 31, 2004,
the Company was supplying Thom McAn family footwear to 1,547 Wal-Mart stores in
the United States and Puerto Rico. Wal-Mart is not contractually obligated to
continue its existing level of purchases from the Company or to expand the Thom
McAn line into any of its other stores.
SIGNIFICANT KMART RELATIONSHIP
Footstar operates licensed footwear departments in every Kmart store in the
United States, the U.S. Virgin Islands, Puerto Rico and Guam, through
subsidiaries ("Shoemart Subsidiaries") that own the inventory and are
responsible for staffing the footwear departments. Kmart owns a 49% equity
interest in each of the Shoemart Subsidiaries, with the exception of 29 Shoemart
Subsidiaries in which the Company has a 100% equity interest as of July 31,
2004. Meldisco has operated licensed footwear departments in Kmart stores since
1961. The licensed footwear departments in Kmart have historically provided a
significant portion of Footstar's total sales and profits.
The Company's arrangement with Kmart is governed by a Master License Agreement
effective as of July 1, 1995, as amended ("Master License Agreement"). The
Master License Agreement provides the Company with the non-transferable,
exclusive right and license to operate a footwear department in every Kmart
store. The initial term of the Master License Agreement expires on July 1, 2012,
and is renewable for 15 year terms upon mutual agreement, unless terminated
earlier as provided in the agreement. The Master License Agreement is subject to
certain performance standards that are primarily based upon sales volumes. The
majority of the fees in the Kmart arrangement are based on sales, with some
additional payments based on profits.
From January 22, 2002 through May 6, 2003, Kmart operated under the protection
of Chapter 11 of the U.S. Bankruptcy Code. During the first six months of 2002,
Kmart closed 283 under-performing stores. During the first four months of 2003,
Kmart closed an additional 319 under-performing stores. In June 2004 and August
2004, Kmart announced the sale of an additional 54 and 18 stores to other
retailers, respectively.
-16-
The business relationship between Meldisco and Kmart is extremely important to
the Company, particularly now that the Company has exited all of its Athletic
Segment businesses and some of its other Meldisco businesses. The loss of
Meldisco's Kmart operations, a significant reduction in customer traffic in
Kmart stores, or the closing of a significant number of additional Kmart stores
would have a material adverse effect on the Company. The Master License
Agreement and the license agreements for particular Kmart stores allow the
parties to terminate those agreements under specified circumstances. The initial
term of the Master License Agreement expires July 1, 2012, and is renewable
thereafter for 15-year terms upon mutual agreement, unless terminated as
follows:
o At least four years prior to the end of the applicable term or renewal
term, either party may give the other party written notice of its
intent to either renew the agreement ("Renewal Notice") or to
terminate the agreement ("Termination Notice") at the end of the
applicable term or renewal term.
o If either party gives Renewal Notice to the other, the agreement shall
renew for a 15 year renewal term commencing on the day following the
end of the applicable term or renewal term, unless, within 60 days of
receipt of Renewal Notice, the receiving party responds with written
notice of its intent to terminate the agreement (in which latter case
the agreement shall terminate at the end of the applicable term or
renewal term.)
o If either party gives Termination Notice to the other, the agreement
terminates at the end of the applicable term or renewal term.
o If neither party gives the other Renewal Notice or Termination Notice,
the applicable term or renewal term will be extended for a period
ending on the date four years following either party's written notice
to the other of its intent to terminate.
Under the Master License Agreement, Kmart may audit the books and records of the
Shoemart Subsidiaries. In addition, the Company may audit the deductions taken
by Kmart from the weekly sales proceeds. These audits for fiscal years 1999 -
2003 are in process. Under the bankruptcy claims procedures, Kmart has filed a
claim of approximately $58.0 million related to the period 1999 to 2003. Of this
amount, approximately $25.0 million relates to claims for fiscal 2002 and prior.
The Company has accrued approximately $10.0 million as of December 28, 2002. The
remaining claim of $33.0 million relates to fiscal 2003. Of this amount
approximately $24.0 million relates to excess rent and minority interest
distributions of which the Company has recorded $18.0 million in fiscal 2003.
The Company believes that, upon reconciliation, its recorded amounts will be
adequate, but there can be no assurances and any material changes in this
reconciliation could have a material adverse effect on the Company.
For further information regarding the impact of the Kmart store closings, the
Company's relationship with Kmart and the Master License Agreement, see
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Significant Kmart Relationship," and Notes 2, 6 and 7 of Notes to
Consolidated Financial Statements.
-17-
MERCHANDISING
Meldisco's merchandising strategy is focused on building upon its position in
family footwear. The essence of this strategy is to satisfy Meldisco's customers
with high in-stock availability of its footwear products and a wide selection of
well-known national brands such as Thom McAn and Cobbie Cuddlers (which are
Company-owned) and Everlast.
In its licensed footwear operations, Meldisco seeks to attract non-footwear
shoppers into the footwear departments from other areas of the stores. To this
end, Meldisco consistently offers selected high-quality footwear at prices
significantly lower than those at which comparable merchandise is sold. These
branded products are also intended to differentiate Meldisco merchandise from
that of its competitors. Brands currently available at Meldisco's operations
include Thom McAn, Cobbie Cuddlers and Texas Steer (which are Company-owned) and
Everlast, Route 66, Thalia and Joe Boxer. Meldisco conducts consumer research on
an ongoing basis to gauge new opportunities for brand extensions and to
determine price and positioning of new brands. The Company's strategy is to
leverage its expertise in branded products to expand its sales in existing
licensed departments as well as in its wholesale operations.
Meldisco's traditional strength has been in quality leather footwear under its
Thom McAn brand, as well as seasonal, work, value-priced athletic, women's
casual and children's shoes. Meldisco builds on its strength in these segments
by focusing on customer satisfaction. Meldisco's "narrow and deep" merchandising
strategy and its merchandise planning systems are designed to ensure that each
store is well stocked in product lines that are particularly popular with
Meldisco's core customers. Meldisco's demand-driven merchandise replenishment
system has been designed to permit inventory management at the store, style and
size levels.
MARKETING
Meldisco believes that the typical footwear customer in its leased footwear
departments in Kmart generally resembles the average Kmart softlines shopper: a
25 to 49 year-old mother with children, who is employed at least part-time, has
at least one child under the age of 18 and reports a total annual household
income between $25,000 and $65,000. Meldisco's marketing initiatives are
designed to support its overall business strategy of increasing purchases among
traditional footwear shoppers, as well as the growing customer segments that
include African Americans and Hispanics.
Meldisco's marketing strategy in its Kmart footwear departments is designed to
convey to prospective customers that Kmart carries the right value combination
of brands, product selection, quality, comfort and price to make Kmart footwear
departments their footwear destination of choice. This message is communicated
primarily through weekly advertising in newspaper inserts and in-store
presentations. Meldisco pays Kmart a sales promotion fee, which Kmart applies
toward footwear advertisements in the Kmart weekly newspaper inserts, a
publication which had a weekly circulation of approximately 45 million as of
July 31, 2004.
COMPETITIVE ENVIRONMENT
The family footwear business, where the highest percentage of Meldisco's
business is concentrated, is highly competitive. Competition is concentrated
among a limited number of retailers and discount department stores, including
Kmart, Wal-Mart, Payless ShoeSource, Kohl's and Target, with a number of
traditional off-price and value retailers such as Shoe Carnival, Famous Footwear
and Rack Room also selling lower-priced footwear. Many of the Company's
competitors have grown more rapidly and have substantially greater financial and
marketing resources than the Company. The Company relies on the high consumer
acceptance of Meldisco's brands, particularly Thom McAn, to provide a
competitive advantage and has extended distribution of the brand into Wal-Mart
stores.
-18-
ACQUISITION AND DISPOSITION OF THE FOOTWEAR ASSETS OF J. BAKER; THE AMES
BANKRUPTCY PROCEEDING
In February 2001, the Company acquired, for cash consideration of $59.0 million,
the footwear assets and related license agreements of J. Baker and its
subsidiaries in a transaction accounted for as a purchase. As of the date of the
acquisition, J. Baker operated 1,163 licensed footwear departments under 13
agreements with retail chains, including Ames Department Stores, Inc. ("Ames"),
Variety Wholesalers, Inc. and its affiliates (collectively, "Variety"), Stein
Mart, Inc. ("Stein Mart") and Spiegel, Inc. ("Spiegel"). Assets purchased
included inventory, store fixtures, trademarks and license agreements.
During the third quarter of fiscal year 2001, Ames filed a voluntary petition
for reorganization under Chapter 11 of the U.S. Bankruptcy Code. On August 14,
2002, Ames announced that, as a result of continued weak sales, it would cease
operations and close all of its 327 store locations. Footstar subsidiaries
continued to operate licensed footwear departments within Ames' stores until
October 2002 when all stores were closed.
The Company recorded a charge in the fiscal quarter ended June 29, 2002 of $9.2
million as an allowance for bad debt in connection with its pre-petition
receivable from Ames. The Company is pursuing its claim with respect to the $9.2
million through litigation. During the third quarter of fiscal year 2002, the
Company recorded restructuring, asset impairment and other charges of $14.0
million, $11.2 million of which related to costs associated with exiting the
Ames business as a result of Ames' announcement in August 2002 that it would
close its remaining stores. See Note 7 of Notes to the Consolidated Financial
Statements for additional information concerning costs associated with exiting
the Ames business.
During the second quarter of fiscal year 2002, the Company announced that it had
decided to end two unprofitable licensed footwear relationships that were part
of the J. Baker acquisition. The Company exited Variety during the second
quarter of fiscal year 2002 and ceased operating the footwear departments in
Stein Mart stores at the end of February 2003, when that contract expired. See
Note 7 to the Consolidated Financial Statements for a description of the $14.0
million in restructuring and other charges recorded in connection with this
decision.
During the third quarter of fiscal year 2002, the Company decided to exit
Spiegel and five other smaller licensed footwear relationships that were part of
the J. Baker acquisition. As of April 2003, the Company had exited substantially
all of the licensed footwear departments acquired in the J. Baker acquisition.
As of the first day of fiscal year 2002, the Company adopted Statement of
Financial Accounting Standards Board No. 142, Goodwill and Other Intangible
Assets, recording $24.3 million as a cumulative effect of a change in accounting
principle, resulting from the write-off of goodwill arising from the acquisition
of the J. Baker business.
-19-
OTHER BUSINESS
Late in 2001, Meldisco opened its first Shoe Zone store. As of December 28,
2002, there were 20 Shoe Zone stores, and as of July 31, 2004, there were no
Shoe Zone stores. The stores offered family and fashion footwear and accessories
primarily under the Company-owned Thom McAn and Cara Mia brands. The concept
targeted the fast-growing Hispanic footwear market.
In July 2002, the Meldisco Segment began operating licensed children's footwear
departments in certain stores operated by subsidiaries of Federated. The
children's footwear departments, formerly operated by Stride Rite, were
redesigned with new self-service fixtures and introduced Federated's private
children's brand, Greendog, in a range of footwear styles from athletic to
special occasion. The Company was operating children's footwear departments in
66 stores operated by subsidiaries of Federated in 15 states as of December 28,
2002.
In July 2002, Meldisco began operating licensed footwear departments in all
Gordmans stores, of which there were 40 as of December 28, 2002, predominantly
located in the Midwest. These footwear departments offered high quality,
nationally branded footwear in an open stock, self-service environment.
See "Introductory Note" for a description of Footstar's exit from the footwear
departments of Federated and Gordmans stores and the closing and sale of the
Shoe Zone stores within the Meldisco Segment.
In October 2002, Meldisco began supplying Thom McAn family footwear to 300
Wal-Mart stores in the mainland United States for a six-month test period. This
wholesale arrangement provided the Company with an opportunity to expand the
distribution of the Thom McAn brand, as well as to build a relationship with
Wal-Mart. In February 2003, the Company announced that it would supply Thom McAn
family footwear to up to 1,500 Wal-Mart stores, including the original 300
stores that began selling Thom McAn footwear in October 2002, as well as in 11
Wal-Mart stores in Puerto Rico. As of December 28, 2002, Meldisco supplied
women's shoes to 305 stores, men's shoes to 305 stores and children's shoes to
105 stores in the Wal-Mart chain. As of July 31, 2004, Meldisco supplied women's
shoes to 1,521 stores, men's shoes to 1,015 stores and children's shoes to 446
stores in the Wal-Mart chain. Wal-Mart currently operates 3,270 discount stores,
Supercenters and 578 Sam's Clubs in the United States. Wal-Mart also operates
887 stores outside the United States. The Company sells footwear to Wal-Mart
pursuant to orders placed from time to time at Wal-Mart's discretion. Wal-Mart
is not contractually obligated to continue its existing level of purchases from
the Company, or to expand the Thom McAn line into any of its other stores.
-20-
THE ATHLETIC SEGMENT
See "Introductory Note" for a description of Footstar's closing of certain
stores and sale of all remaining stores within the Athletic Segment.
The Athletic Segment specialized in the sale of branded athletic footwear,
apparel and accessories. There were significant elements of overlap between the
various businesses operated by the Athletic Segment in terms of product and
customer base. However, each business had a somewhat different core customer
niche. Footaction stores were predominantly located in malls, targeting 12 to 24
year-old fashion conscious consumers. As of December 28, 2002, Footaction
operated 459 stores. Just For Feet stores were off-mall superstores that
targeted the athletic family. As of December 28, 2002, Just For Feet operated 95
stores. Uprise was introduced as a new concept in 2002 with stores that targeted
the young suburban action-sport and fashion customer. As of December 28, 2002,
there were three Uprise stores.
The following table sets forth the approximate percentages of the Athletic
Segment's net sales attributable to footwear, apparel and accessories:
APPROXIMATE PERCENTAGES OF THE ATHLETIC SEGMENT'S NET SALES
2002 2001 2000
---- ---- ----
Footwear 84% 84% 83%
Apparel 10% 11% 11%
Accessories 6% 5% 6%
-- -- --
100% 100% 100%
==== ==== ====
With fewer Footaction stores in operation and a highly competitive environment,
fiscal year 2002 sales of the Athletic Segment declined 6.1% to $953.9 million
with a comparable store sales decrease of 3.8%.
In fiscal year 2001, the Company approved a plan (the "2001 Plan"), which
included costs related to asset impairments and lease terminations associated
with the closing of under-performing stores prior to lease expiration in the
Athletic Segment, asset impairments for additional Athletic Segment stores to be
closed when their leases expired over the next several years, inventory
write-downs to liquidate aged athletic inventory more timely, inventory
markdowns related to the stores to be closed and a reduction in the carrying
value of the former Just For Feet headquarters building in Birmingham, Alabama,
which was acquired as part of the Just For Feet acquisition in March 2000.
In the first quarter of fiscal year 2002, the Company implemented a new plan to
consolidate the operations of its athletic chains into the Athletic Segment.
This plan included combining the operations and marketing support, procurement,
real estate, finance and human resources functions of its two primary athletic
chains, Footaction and Just For Feet. The Company recorded charges in the first
quarter of fiscal year 2002 involving costs to shut down the Company's
Footaction offices in Dallas, Texas, including building exit costs and severance
costs.
These strategic actions were intended to result in increasing the
competitiveness of the Athletic Segment and strengthening the Company's
platform. The Company also believed that the elimination of under-performing
stores would increase profitability, improve operating cash flows and allow
management to concentrate on the most profitable areas of the business.
-21-
FOOTACTION
Footaction, which opened its first store in 1976, was a specialty retailer of
branded athletic footwear, apparel and related accessories. Footaction's stores
were located predominantly in enclosed regional malls anchored by major
department stores, as well as in select street and strip mall locations, which
allowed Footaction to take advantage of high customer traffic. As of December
28, 2002, Footaction operated 459 stores in 41 states, Puerto Rico and the U.S.
Virgin Islands.
MERCHANDISING
Footaction sought to be the first to offer the most current and innovative, as
well as exclusive, "street-inspired" athletic footwear and apparel to its target
customer group. Footaction monitored product trends to help identify styles
which were or might become popular. Footaction carried the leading athletic and
sport fashion footwear and apparel brands, including Nike, Reebok, And 1,
Adidas, K-Swiss, Lugz, New Balance, Converse, Fila, Puma, Saucony, Timberland,
Enyce, Sean Jean and Majestic.
Footaction sought to differentiate itself from other branded athletic footwear
and apparel retailers by increasing consumer awareness and name recognition of
Footaction and establishing in the minds of its target customer group the
perception that Footaction was the first to offer the latest styles. As part of
this strategy, Footaction obtained from some of its vendors exclusive styles,
color variations and designs of their products, the sales of which represented
approximately 54% of Footaction's footwear business during fiscal year 2002.
MARKETING
Footaction's core customers were teens and young adults aged 12 to 24. The
Company believed that Footaction's secondary customers, the 25 to 49 year-olds
and the 11 year-olds and under, added a stable business base and the prospects
for multiple sales. Footaction focused its mass media advertising on core
customers in the 12 to 24 year-old age group. A large percentage of the cost of
such advertising was offset by vendor co-operative advertising allowances.
JUST FOR FEET
On March 7, 2000, the Company acquired, for cash consideration of $64.2 million,
from Just For Feet, Inc. and its subsidiaries, 79 Just For Feet superstores and
certain other assets that had been operating under the protection of the U.S.
Bankruptcy Court. The stores, which were primarily located in the southern half
of the United States, offered a broad product selection of branded athletic
footwear and apparel at competitive prices. Just For Feet's target customers
were members of an athletic family. Just For Feet was an operator of
large-format superstores, specializing in brand-name athletic and outdoor
footwear and apparel. Just For Feet, which began with a single mall-based store
in 1977, opened its first superstore in 1988 and, since that time, had focused
on developing and refining its superstore concept. The Company re-launched the
chain in 2000 following the acquisition. During fiscal year 2002, the Company
opened 8 new stores and closed 1 store. As of December 28, 2002, Just For Feet
operated 95 off-mall superstores.
-22-
MERCHANDISING
Just For Feet distinguished its stores by offering a larger selection of
brand-name athletic and outdoor footwear in terms of styles, sizes and price
points than any of its competitors. Concurrently, it also sought to offer value
through strong promotions and the "Zone", a self-service section with every day
low pricing. The average store was 15,000 to 20,000 square-feet, and had
approximately three to four times the selling space of leading mall-based
specialty athletic footwear retailers. This large-store format enabled each Just
For Feet superstore to offer a broad selection of name-brand athletic and
outdoor footwear.
MARKETING
Just For Feet strove to create an exciting and high-energy shopping experience
in its superstores through the use of bright colors, upbeat music, an enclosed
"half-court" basketball court for use by customers, a multi-screen video bank
and appearances by sports celebrities. Just For Feet used television, radio and
print advertising to generate customer store traffic. Print advertisements and
promotional circulars were published in local newspapers. In addition, Just For
Feet had the "Frequent Feet" loyalty program with incentives for multiple
purchases.
CHIEF EXECUTIVE OFFICER
Effective September 12, 2003, J.M. Robinson was terminated as Chairman,
President and Chief Executive Officer of the Company as a result of the
investigation of the restatement. Neele E. Stearns, Jr., a member of the Board
of Directors and the then Chairman of the Audit Committee, was appointed
Chairman and Chief Executive Officer on an interim basis. Mr. Stearns served as
Interim Chairman and Chief Executive Officer until January 18, 2004 and
currently serves as the Company's Interim Vice Chairman.
On January 19, 2004, Dale W. Hilpert was appointed Chairman and Chief Executive
Officer of the Company. Prior to joining Footstar, Mr. Hilpert spent two years
as Chief Executive Officer of Williams-Sonoma, Inc. In 1995, he joined Foot
Locker where he was Chairman and CEO. Prior to that, he spent 17 years at May
Department Stores serving in senior management positions, including Chairman and
CEO of its Payless ShoeSource division.
RISK FACTORS
Set forth below are certain important risks and uncertainties that could
adversely affect the Company's results of operations or financial condition and
cause its actual results to differ materially from those expressed in
forward-looking statements made by the Company or its management. See
"Forward-Looking Statements" in Item 7 for additional risk factors.
-23-
IF THE COMPANY IS UNABLE TO SUCCESSFULLY REORGANIZE ITS CAPITAL STRUCTURE AND
OPERATIONS AND IMPLEMENT ITS BUSINESS PLAN THROUGH THE CHAPTER 11 PROCESS, THE
COMPANY MAY NEVER EMERGE FROM BANKRUPTCY AND MAY BE REQUIRED TO LIQUIDATE ITS
ASSETS.
Commencing March 2, 2004, the Company and most of its subsidiaries filed
voluntary petitions for relief under Chapter 11 of the Bankruptcy Code. Risk
factors involving the Chapter 11 filing include, but are not limited to, the
following:
o The commencement of the Chapter 11 cases may adversely affect the
Company's business. The Company believes that any such adverse effects
may worsen if confirmation of the plan is protracted.
o There can be no assurance that the Company will develop a plan of
reorganization or, even if it does, there can be no assurance that the
Court will confirm the Company's plan of reorganization.
o There can be no assurance regarding any adverse actions that creditors
or equity holders of the Company or other parties in interest in the
Chapter 11 cases may take that may have the effect of preventing or
unduly delaying confirmation of the plan of reorganization, if any.
o There can be no assurance as to the overall long-term viability of the
Company's operational reorganization and financial restructuring plan.
o There can be no assurance as to the Company's ability to maintain
sufficient financing sources to fund its plan of reorganization and
meet future obligations.
o The Company may be unable to retain top management and other key
personnel through the process of reorganization.
In addition, the uncertainty regarding the eventual outcome of the Company's
restructuring, and the effect of other unknown adverse factors, could threaten
the Company's existence as a going concern. Continuing on a going concern basis
is dependent upon, among other things, the success and Court approval of the
Company's Chapter 11 plan, maintaining the support of key vendors, retaining key
personnel along with financial, business, and other factors, many of which are
beyond the Company's control.
-24-
MELDISCO IS THE COMPANY'S ONLY CONTINUING BUSINESS AND SUBSTANTIALLY ALL OF THE
COMPANY'S CONTINUING NET SALES AND PROFITS RESULT FROM MELDISCO'S BUSINESS
RELATIONSHIP WITH KMART, WHICH EMERGED FROM BANKRUPTCY PROCEEDINGS IN MAY 2003.
KMART STORE CLOSINGS AND REDUCED TRAFFIC IN THE REMAINING KMART STORES HAS HAD,
AND CONTINUES TO HAVE, A NEGATIVE EFFECT ON SALES AND PROFITS OF THE MELDISCO
SEGMENT. A FURTHER MATERIAL REDUCTION IN THE NUMBER OF KMART STORES OR A
TERMINATION OF THIS RELATIONSHIP WOULD HAVE A MATERIALLY ADVERSE EFFECT ON THE
COMPANY.
The Company has exited its Athletic Segment business and certain portions of its
Meldisco business. The Company's sales in the footwear departments operated by
Meldisco in Kmart stores were $1,209.3 million in fiscal year 2001, $1,154.3
million in fiscal year 2002, and $901.4 million in fiscal year 2003, or 84%, 86%
and 89%, respectively, of Meldisco's total net sales for those periods.
From January 22, 2002 through May 6, 2003, Kmart operated under the protection
of Chapter 11. During the first six months of 2002, Kmart closed 283
under-performing stores. During the first four months of 2003, Kmart closed an
additional 319 under-performing stores. These store closings had a negative
effect on cash flows and profitability during fiscal year 2003, which the
Company expects to continue in future years. This negative cash flow effect was
partially offset by cash generated from inventory liquidations in the closed
stores during fiscal year 2003 and by lower working capital requirements that
will continue beyond fiscal year 2003. The Kmart store closings, as well as the
reduced traffic Meldisco has experienced in the footwear departments of Kmart
stores that remained open during and after the bankruptcy, have also had, and
continue to have, a negative effect on net sales and profits of the Meldisco
Segment.
In June and August 2004, Kmart announced the sale of an additional 54 and 18
stores to other retailers, respectively. If Kmart were to close a significant
number of additional stores, it would have a material adverse effect on the
Company's net sales and profits. With or without additional store closings, a
continued decline in the Company's per store sales in the remaining Kmart stores
will have a material adverse effect on the Company's net sales and profits.
Although Kmart emerged from bankruptcy on May 6, 2003, there can be no assurance
that Kmart's operations, or Meldisco's operations in the Kmart footwear
departments, will return to previous levels of sales or profitability.
The Company's agreements with Kmart are subject to certain performance standards
based primarily on sales volumes. Both the Master License Agreement and the
license agreements for particular Kmart stores allow for termination of the
agreements under certain circumstances. A termination of these agreements would
have a material adverse effect on the sales and profit of the Company.
Under the Master License Agreement, Kmart may audit the books and records of the
Shoemart Subsidiaries. In addition, the Company may audit the deductions taken
by Kmart from the weekly sales proceeds. These audits for fiscal years 1999 -
2003 are in process. Under the bankruptcy claims procedures, Kmart has filed a
claim of approximately $58.0 million related to the period 1999 to 2003. Of this
amount, approximately $25.0 million relates to claims for fiscal 2002 and prior.
The Company has accrued approximately $10.0 million as of December 28, 2002. The
remaining claim of $33.0 million relates to fiscal 2003. Of this amount
approximately $24.0 million relates to excess rent and minority interest
distributions of which the Company has recorded $18.0 million in fiscal 2003.
The Company believes that, upon reconciliation, its recorded amounts will be
adequate, but there can be no assurances and any material changes in this
reconciliation could have a material adverse effect on the Company.
-25-
THE COMPANY IS A DEFENDANT IN CERTAIN SECURITIES LITIGATION AND IS THE SUBJECT
OF AN SEC REGULATORY PROCEEDING AND CANNOT YET REASONABLY DETERMINE WHETHER ITS
INSURANCE COVERAGE IS ADEQUATE TO COVER THE CLAIMS. THE COMPANY MAY ALSO BE
SUBJECT TO ADDITIONAL LITIGATION OR REGULATORY ACTION.
On the Petition Date, the Company commenced the Chapter 11 cases by filing
petitions for relief under Chapter 11 of the Bankruptcy Code. The Company has
continued to manage its property as debtors-in-possession, subject to the
supervision of the Court and in accordance with the provisions of the Bankruptcy
Code. An immediate effect of the filing of the Chapter 11 cases was the
imposition of the automatic stay under section 362 of the Bankruptcy Code,
which, with limited exceptions, enjoins the commencement or continuation of: (i)
all collection efforts by creditors; (ii) enforcement of liens against any
assets of the Company; and (iii) litigation against the Company. However, the
automatic stay is applicable only to litigation against the Company, and not its
officers and directors. The Company may request the Court to extend the stay to
cover its officers and directors, but absent Court approval, such litigation may
proceed. Also, the automatic stay has no effect on the SEC investigation.
Prior to the Company's November 13, 2002 announcement that management had
discovered discrepancies in the reporting of its accounts payable balances, the
Company notified the staff of the SEC concerning the discovery of the accounting
discrepancies. The SEC began a regulatory proceeding captioned, In the Matter of
Footstar, Inc., MNY-7122, including an investigation into the facts and
circumstances giving rise to the restatement. On November 25, 2003, the SEC
issued an Order Directing Private Investigation and Designating Officers to Take
Testimony, in the same regulatory proceeding, authorizing an investigation and
empowering certain members of the SEC staff to take certain actions in the
course of the investigation, including requiring testimony and the production of
documents. The Company has been and intends to continue cooperating fully with
the SEC. The Company cannot predict the outcome of this proceeding.
The investigation overseen by the Audit Committee and the restatement led to a
delay in the filing of this and other SEC reports. See "Introductory Note".
Because of these delays, the Company was not in compliance with the listing
standards of the NYSE on which its common stock was listed. On December 29,
2003, the NYSE suspended trading in the common stock of the Company and, at a
later date, the Company's common stock was delisted. The NYSE stated that it
decided to take these actions in view of the overall uncertainty surrounding the
Company's previously announced restatement of its results for 1997 through 2002
and the continued delay in fulfilling its financial statement filing
requirements.
The Company and certain of its directors and officers are defendants in two
derivative suits and several purported class action lawsuits alleging violations
of federal securities laws and breaches of fiduciary duties. With Court
approval, Footstar and the relevant individual parties have mutually agreed to
resolve the claims made in both the derivative and purported class action
complaints, without any admission of liability, for the amounts of $9.2 million
and $14.3 million, respectively. See "Legal Proceedings". The parties are still
in the process of obtaining final approval of these settlements in the District
Court where the actions were brought and failure to finalize these settlements
could have a material adverse impact on the Company.
-26-
Litigation or other regulatory actions against the Company by the SEC, the NYSE
or other regulatory bodies could have a material adverse effect on the Company,
and would also have adverse secondary effects, such as negative reactions from
the Company's stockholders, creditors or vendors.
A FAILURE BY THE COMPANY TO EFFECTIVELY AND EFFICIENTLY MAINTAIN INTERNAL
CONTROLS OVER FINANCIAL REPORTING WOULD HAVE A MATERIAL ADVERSE EFFECT ON THE
COMPANY'S OPERATIONS OR FINANCIAL RESULTS.
The Company's investigation, conducted under the oversight of the Audit
Committee, found instances where certain members of management caused manual
entries to be improperly made to write-off certain liabilities with
corresponding reductions in cost of sales, certain operating expenses, and to
offset unrelated items, such as unrecoverable receivables and vendor credits
with unmatched receipts (accounts payable). With respect to the Company's
acquisition of Just For Feet in 2000, the RSKO investigation found that the
original purchase price allocation contained misstatements as a result of the
Company not utilizing all of the detailed information available at that time,
and certain members of senior management allowed incorrect entries to be made to
the Company's income statement rather than making such adjustments to the
purchase price allocation.
The investigation also found that, in addition to the specific items giving rise
to the need for the restatement, there were instances in which some members of
management and finance-related employees devoted insufficient attention and
resources to ensuring accurate accounting and financial reporting, and did not
communicate adequately to the Company's internal auditors, independent external
auditors, the Audit Committee and the Board of Directors, which caused the
problems arising from the deficiencies in the Company's internal controls and
procedures not to be identified. In addition, the investigation identified that
there was a failure by the Company's management to establish an appropriate
control environment, and there were significant deficiencies in the Company's
internal controls and procedures resulting from numerous causes, including
inadequate staffing, insufficient quality and training of personnel and
inadequate systems and systems interfaces. As a result of the investigations,
the Company has made significant personnel and policy changes. The deficiencies
described above contributed to accounting misstatements in the Company's
consolidated financial statements, which necessitated the restatements described
elsewhere in this report.
The Company has implemented an Internal Process and Controls Plan to address
areas of control weakness identified in the investigation. The Internal Process
and Controls Plan addressed the Company's control environment, organization and
staffing, policies, procedures and documentation, and information systems. The
Audit Committee of the Board of Directors periodically reviews and assesses the
effectiveness of internal controls and procedures. See "Controls and Procedures"
for a further discussion of the Internal Process and Controls Plan.
The Company is prepared to and may be required to forego sales growth or cost
savings opportunities that might threaten the maintenance of effective internal
control over financial reporting. The Company has and will incur increases in
employee levels, capital expenditures and operating expenses with respect to the
implementation of these changes. If the Company is unable to implement these
changes effectively or efficiently, it would have a material adverse effect on
the Company's operations and financial results.
-27-
DECLINES IN THE COMPANY'S SALES WILL HAVE A MAGNIFIED IMPACT ON PROFITABILITY
BECAUSE OF THE COMPANY'S FIXED COSTS.
A significant portion of the Company's operating expenses are fixed costs that
are not dependent on its sales performance, as opposed to variable costs, which
vary proportionately with sales performance. These fixed costs include the
corporate offices, fixed portion of interest expense and a substantial portion
of the Company's labor expenses. If the Company's sales continue to decline, the
Company will be unable to reduce its operating expenses proportionately.
THE COMPANY OPERATES IN THE HIGHLY COMPETITIVE FOOTWEAR RETAILING INDUSTRY.
The family footwear industry, where the highest percentage of Meldisco's
business is concentrated, is highly competitive. Competition is concentrated
among a limited number of retailers and discount department stores, including
Payless ShoeSource, Kmart, Wal-Mart, Kohl's and Target, with a number of
traditional mid-tier retailers such as Shoe Carnival, Famous Footwear and Rack
Room also selling lower-priced footwear. Many of the Company's competitors have
grown more rapidly and have substantially greater financial and marketing
resources than the Company.
If the Company is unable to respond effectively to its competitors, the
Company's operations and financial condition could be materially adversely
affected.
THE COMPANY MAY BE UNABLE TO ATTRACT AND RETAIN TALENTED PERSONNEL.
The Company's success is dependent upon its ability to attract and retain
qualified and talented individuals. The Company has instituted several retention
programs designed to retain key executives and employees. However, if the
Company is unable to attract or retain key executives and employees, including
senior management, accounting and finance, marketing, and merchandising
personnel, it could adversely affect its businesses.
THE COMPANY MUST PROVIDE CONSUMERS WITH SEASONALLY APPROPRIATE MERCHANDISE,
MAKING ITS SALES HIGHLY DEPENDENT ON SEASONAL WEATHER CONDITIONS.
If the weather conditions for a particular period vary significantly from those
typical for that period, such as an unusually cold spring like the Company
experienced in 2003, or an unusually warm winter, consumer demand for seasonally
appropriate merchandise that the Company has available in its footwear
departments will be lower, and the Company's net sales and margins will be
adversely affected. Lower sales may leave the Company with excess inventory of
its basic products and seasonally appropriate products, forcing the Company to
sell both types of its products at significantly discounted prices and, thereby,
adversely affecting its net sales and margins.
THE COMPANY MAY BE UNABLE TO ADJUST TO CONSTANTLY CHANGING FASHION TRENDS.
The Company's success depends, in large part, upon its ability to gauge the
evolving fashion tastes of its customers and to provide merchandise that
satisfies such fashion tastes in a timely manner. The retailing industry
fluctuates according to changing fashion tastes and seasons, and merchandise
usually must be ordered well in advance of the season, frequently before
consumer fashion tastes are evidenced by consumer purchases. In addition, in
order to ensure sufficient quantities of footwear in the desired size, style and
color for each season, the Company is required to maintain substantial levels of
inventory, especially prior to peak selling seasons when the Company builds up
its inventory levels.
-28-
As a result, if the Company fails to properly gauge the fashion tastes of
consumers, or to respond to changes in fashion tastes in a timely manner, this
failure could adversely affect retail and consumer acceptance of the Company's
merchandise and leave the Company with substantial unsold inventory. If that
occurs, the Company may be forced to rely on markdowns or promotional sales to
dispose of excess, slow-moving inventory, which may harm its business and
financial results.
THE FOOTWEAR RETAILING INDUSTRY IS HEAVILY INFLUENCED BY GENERAL ECONOMIC
CYCLES.
Footwear retailing is a cyclical industry that is heavily dependent upon the
overall level of consumer spending. Purchases of footwear, apparel and related
goods tend to be highly correlated with the cycles of the levels of disposable
income of the Company's customers. As a result, any substantial deterioration in
general economic conditions could have a material adverse effect on the
Company's operations and financial condition.
THERE ARE RISKS ASSOCIATED WITH THE COMPANY'S IMPORTATION OF PRODUCTS.
Approximately 90% of Meldisco's products are manufactured in China.
Substantially all of this imported merchandise is subject to customs duties and
tariffs imposed by the United States and penalties may be imposed for violations
of labor and wage standards by foreign contractors. In addition, China and other
countries in which the Company's merchandise is manufactured may, from time to
time, impose additional new quotas, tariffs, duties, taxes or other restrictions
on its merchandise or adversely change existing quotas, tariffs, duties, taxes
or other restrictions. Any such changes could adversely affect the Company's
ability to import its products and, therefore, its results of operations. Any
deterioration in the trade relationship between the United States and China,
issues regarding China's compliance with its agreements related to its entry
into the World Trade Organization, or any other disruption in the Company's
ability to import products from China could adversely affect the Company's
business, financial condition or results of operations.
Other risks inherent in sourcing products from foreign countries include
economic and political instability, social unrest and the threat of terrorism,
each of which risks could adversely affect the Company's business, financial
condition or results of operations. In addition, the Company incurs costs as a
result of security programs designed to prevent acts of terrorism such as those
imposed by government regulations and the Company's participation in the
Customs-Trade Partnership Against Terrorism implemented by the United States
Bureau of Customs and Border Protection. Significant increases in such costs
could adversely affect the Company's business, financial condition or results of
operations.
The outbreak and spread of severe acute respiratory syndrome ("SARS") in
southern China during the early part of 2003 severely curtailed travel to and
from, as well as general business activities within China. Although the
Company's ability to purchase and import its merchandise from its China-based
manufacturers was not negatively impacted during this outbreak of SARS, an
additional outbreak of SARS, Avian Flu or outbreaks of other infectious diseases
could prevent the manufacturers the Company uses from manufacturing the
Company's merchandise or hinder the Company's ability to import such
merchandise, either of which could have an adverse effect on the results of
operations of the Company.
-29-
The Company's ability to successfully import merchandise into the United States
from foreign sources is also dependent on stable labor conditions in the major
ports of the United States. Any instability or deterioration of the domestic
labor environment in these ports, such as the work stoppage at West Coast ports
in 2002, could result in increased costs, delays or disruption in merchandise
deliveries that could cause loss of revenue, damage to customer relationships
and have a material adverse effect on the Company's business operations and
financial condition.
A REDUCTION IN FOOTWEAR PURCHASES BY WAL-MART COULD ADVERSELY EFFECT THE
COMPANY'S RESULTS.
The Company's sales of footwear to Wal-Mart constitute a small but growing
portion of the Company's total net sales. Wal-Mart is not under any contractual
obligation to continue purchasing the Company's products. Should Wal-Mart
decrease or discontinue its purchases, this would adversely effect the Company's
results.
MELDISCO RELIES ON KEY VENDORS AND THIRD PARTIES TO MANUFACTURE AND DISTRIBUTE
ITS PRODUCTS.
Product sourcing in the family footwear business is driven by relationships with
foreign manufacturers. If these foreign manufacturers are unable to secure
sufficient supplies of raw materials or maintain adequate manufacturing
capacity, they may be unable to provide Meldisco with timely delivery of
products of acceptable quality. In addition, if the prices charged by these
manufacturers increase, the Company's cost of acquiring merchandise would
increase. Should the Company not be able to recover these cost increases with
increased pricing to its customers, it could have a material adverse effect on
the Company's operations and financial condition.
Meldisco also depends on third parties to transport and deliver its products. If
these third parties are unable to transport or deliver its products for any
reason, or if they increase the price of their services, including as a result
of increases in the cost of fuel, there could be a material adverse effect on
the Company's operations and financial performance.
TRADEMARKS AND SERVICE MARKS
Footstar or its subsidiaries own all rights in the United States to the marks
Thom McAn, Cobbie Cuddlers and Cara Mia for use in connection with footwear
and/or related products and services. The Company or its subsidiaries have
registered or have common law rights to over 100 trademarks and/or service marks
under which the Company markets merchandise or services. The Company either has
registered or is in the process of registering its trademarks and service marks
in foreign countries in which it operates or may operate in the future. The
Company vigorously protects its trademarks and service marks both domestically
and internationally.
EMPLOYEES
As of December 28, 2002, the Company had 18,830 employees, including 7,451 at
Meldisco, 10,458 at Athletic and 921 at the Company's corporate offices and
distribution centers. Meldisco had 3,085 full-time and 4,366 part-time employees
and Athletic had 2,294 full-time and 8,164 part-time employees.
-30-
As of July 31, 2004, the Company had 5,161 employees, including 4,867 at
Meldisco and 294 at the Company's corporate offices and distribution centers.
Meldisco had 2,157 full-time and 2,710 part-time employees.
AVAILABLE INFORMATION
The Company makes available free of charge through its web site,
www.footstar.com, all materials that the Company files electronically with the
SEC, including the Company's Annual Report on Form 10-K, Quarterly Reports on
Form 10-Q, Current Reports on Form 8-K, and amendments to those reports, filed
or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act
of 1934. During the period covered by this Form 10-K, the Company made all such
materials available through its web site as soon as reasonably practicable after
filing such materials with the SEC. As discussed in the Introductory Note of
this Annual Report on Form 10-K, certain 2002, 2003 and 2004 SEC filings have
been delayed.
You may also read and copy any materials filed by the Company with the SEC at
the SEC's Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549,
and you may obtain information on the operation of the Public Reference Room by
calling the SEC at 1-800-SEC-0330. In addition, the SEC maintains an Internet
web site, www.sec.gov, that contains reports, proxy and information statements
and other information which the Company files electronically with the SEC.
-31-
ITEM 2. PROPERTIES
- ------- ----------
Footaction had a nationwide presence. As of December 28, 2002, it operated 459
stores in 41 states, Puerto Rico and the U.S. Virgin Islands. Footaction's store
design was 3,500 square feet, while the average size of a Footaction store was
4,800 square feet. Footaction stores were all leased with a typical lease term
of 10 years. These leases called for minimum annual rents subject to periodic
adjustments, plus other charges, including a proportionate share of taxes,
insurance and common area maintenance and percentage rent based on the store's
sales volume.
Just For Feet's stores ranged from 6,000 to 33,000 square feet. Just For Feet's
average store size was 17,000 square feet. As of December 28, 2002, it operated
95 stores. Three of Just For Feet's stores were owned by the Company; the
remainder were leased, with a typical initial lease term of 15 years.
As of December 28, 2002, Meldisco operated licensed footwear departments in
5,495 stores and 20 Company-owned Shoe Zone stores. As of July 31, 2004,
Meldisco operated licensed footwear departments in 2,389 stores. The licensed
footwear departments are located in all 50 states, Guam, Puerto Rico and the
U.S. Virgin Islands. Of the licensed departments operated as of December 28,
2002 and July 31, 2004, respectively, 1,832, and 1,503 were located in Kmart
discount stores; 3,367 and 860 licensed departments were in Rite Aid drugstores;
190 and none were in stores whose footwear department licenses were acquired
from J. Baker; 40 and none were located in Gordmans stores; and 66 and 26 were
children's footwear departments located in stores operated by Federated.
Kmart and other retail host stores provide Meldisco with store space to sell
footwear in exchange for certain payments. Meldisco-operated footwear
departments in Kmart stores range from 900 to 4,400 square feet. The Gordmans
licensed footwear departments averaged 1,500 square feet, and the Federated
licensed children's footwear departments averaged 900 square feet. The Company's
Shoe Zone stores averaged 3,500 square feet.
The Company's headquarters is located in 43,000 square feet of leased office
space in West Nyack, New York. Meldisco's corporate offices are located in
129,000 square feet of owned office space in Mahwah, New Jersey. The Company
plans to move its headquarters into the Meldisco office building by the end of
2004 at lease expiration. The Athletic Segment's corporate offices were located
in approximately 63,000 square feet of leased office space in Mahwah, New
Jersey; this lease expires as of September 30, 2004. The Company's corporate tax
department is located in 3,500 square feet of leased office space in Worcester,
Massachusetts. The Company's Shared Services Center is located in 57,000 square
feet of leased office space in Dallas, Texas. The Company is currently
relocating its Shared Services Center to the Meldisco office building. This
relocation is expected to be completed by the end of 2004. The Company also
maintained approximately 8,300 square feet of leased office space in Wausau,
Wisconsin in which its direct marketing operations were primarily located; that
lease ended as of June 2004. The Company previously operated out of two owned
distribution facilities, located in Mira Loma, California, and Gaffney, South
Carolina, with a total of 1.2 million square feet. In addition, the Company
leases a 200,000 square feet distribution facility in Morrow, Georgia.
See "Introductory Note" for a discussion of the Company's disposition of its
facilities.
-32-
ITEM 3. LEGAL PROCEEDINGS
- ------- -----------------
As stated above, the Company commenced the Chapter 11 cases by filing petitions
for relief under Chapter 11 of the Bankruptcy Code. The Company has continued to
manage its property as debtors-in-possession, subject to the supervision of the
Court and in accordance with the provisions of the Bankruptcy Code. An immediate
effect of the filing of the Chapter 11 cases is the imposition of the automatic
stay under Section 362 of the Bankruptcy Code, which, with limited exceptions,
enjoins the commencement or continuation of: (i) all collection efforts by
creditors; (ii) enforcement of liens against any assets of the Company; and
(iii) litigation against the Company. However, the automatic stay is applicable
only to litigation against the Company, and not against any of its officers and
directors. The Company may request the Court to extend the stay to cover its
respective officers and directors in any litigation filed, but absent Court
approval, such litigation may proceed. The automatic stay has no effect on the
SEC investigation.
Prior to the Company's November 13, 2002 announcement that management had
discovered discrepancies in the reporting of its accounts payable balances, the
Company notified the staff of the SEC concerning the discovery of the accounting
discrepancies. Following that notification, the SEC began a regulatory
proceeding captioned, In the Matter of Footstar, Inc., MNY-7122, including an
investigation into the facts and circumstances giving rise to the restatement.
The Company has been cooperating fully with the SEC. On November 25, 2003, the
SEC issued a Formal Order, in that regulatory proceeding, authorizing an
investigation and empowering certain members of the SEC staff to take certain
actions in the course of the investigation, including requiring testimony and
the production of documents.
The fact-finding investigation authorized by the Formal Order includes
determining whether the Company and certain of its present or former directors,
officers and employees may have engaged in violations of the federal securities
laws in connection with: the purchase or sale of the securities of the Company;
required filings with the SEC; maintenance of the Company's books, records and
accounts; implementation and maintenance of internal accounting controls; making
of false or misleading statements or omissions in connection with required
audits or examinations of the Company's consolidated financial statements or the
preparation and filing of documents or reports the Company is required to file
with the SEC. The Company has been and intends to continue cooperating fully
with the SEC.
The investigation overseen by the Audit Committee, the restatement and the
Company's operation under protection of the bankruptcy laws have led to a delay
in the filing of this and other SEC reports. See "Introductory Note". Because of
these delays, the Company was not in compliance with the listing standards of
the NYSE on which its common stock was listed. On December 29, 2003, the NYSE
suspended trading in the Company's common stock and, at a later date, the
Company's common stock was delisted. The NYSE stated that it decided to take
these actions in view of the overall uncertainty surrounding the Company's
previously announced restatement of its results for 1997 through 2002 and the
continued delay in fulfilling its financial statement filing requirements.
-33-
The Company and certain of its directors and officers are defendants in two
derivative suits (consolidated into a single action as described below) and
several purported class action lawsuits (also consolidated into a single action
as described below) alleging violations of federal securities laws and breaches
of fiduciary duties. Messrs. Stearns, Day, Davies and Olshan, members of the
Company's Board of Directors, and J.M. Robinson, its former Chairman, President
and Chief Executive Officer, and Stephen Wilson, an officer of the Company, have
been named as defendants in two derivative complaints filed by individual
shareowners, one in the United States District Court for the Southern District
of New York and one in the Supreme Court of the State of New York, Rockland
County. In New York, the Supreme Court is a trial level court. The complaints
allege that these directors and officers breached their fiduciary duties to the
Company by failing to implement and maintain an adequate internal accounting
control system, seek unspecified damages against the defendants and in favor of
the Company, as well as costs and expenses associated with the litigation. These
complaints have been consolidated in a single action in the United States
District Court for the Southern District of New York captioned, Barry Lee
Bragger v. J.M. Robinson, et al., Civil Action No. 02 Civ. 9163 (SCR). With
Bankruptcy Court approval, Footstar and the relevant individual parties have
mutually agreed to resolve the claims made in the derivative complaints, without
any admission of liability, for $9.2 million, all of which will be funded with
insurance proceeds and paid to the Company. Footstar is in the process of
seeking an order from the court before which this litigation is pending
approving the resolution of such litigation and dismissing it with prejudice.
The Company and Messrs. Robinson and Wilson have also been named as defendants
in several purported shareholder class action lawsuits for alleged violations of
securities laws. These actions seek unspecified monetary damages and costs and
expenses associated with the litigation. These initial complaints allege that
beginning mid-May 2000, the Company and its officers named above misrepresented
the Company's financial performance. The cases have been consolidated into a
single action pending in the United States District Court for the Southern
District of New York, captioned, Stephen Rush v. Footstar, Inc., et al., 02 Civ.
9130 (SRC) (Consolidated).
With Bankruptcy Court approval, Footstar and the named plaintiffs have mutually
agreed to resolve the claims made in the several purported class action
lawsuits, without any admission of liability, for the amount of $14.3 million,
all of which will be funded with insurance proceeds. Footstar is in the process
of seeking approval from class members and upon such approval, seeking an order
from the court before which this litigation is pending, dismissing it with
prejudice.
The Company is involved in other legal proceedings, lawsuits and other claims
incidental to the conduct of its business and estimates of the probable costs
for resolution of these claims are accrued to the extent that they can be
reasonably estimated. These estimates are based on an analysis of potential
results, assuming a combination of litigation and settlement strategies.
However, legal proceedings are subject to significant uncertainties, the
outcomes are difficult to predict, and assumptions and strategies may change.
Consequently, except as specified above, the Company is unable to ascertain the
ultimate financial impact of any legal proceedings.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
- ------- ---------------------------------------------------
There were no matters submitted to a vote of security holders during fiscal year
2002 as no annual meeting was held.
-34-
PART II
-------
ITEM 5. MARKET PRICES FOR THE REGISTRANT'S COMMON EQUITY AND
- ------------------------------------------------------------
RELATED STOCKHOLDER MATTERS
- ---------------------------
The Company's common stock was listed on the NYSE under the trading symbol
"FTS". On December 29, 2003, the NYSE suspended trading in the common stock of
the Company and, at a later date, the Company's common stock was delisted. See
"Introductory Note". Since December 30, 2003, the Company's common stock has
been traded on the over-the-counter bulletin board ("OTCBB") under the symbol
"FTSTQ:PK". Prices shown for quarters 2001, 2002 and 2003 reflect the high and
low sales prices for the common stock for each such quarter as reported in the
consolidated transaction reporting system. Prices shown for periods during 2004
reflect the high and low bid prices for the common stick as reported on the
OTCBB System. The over-the-counter market quotations reflect inter-dealer
prices, without retail mark-up, mark-down or commission and may not necessarily
reflect actual transactions. As of July 31, 2004, the closing price of the
Company's stock was $4.95 and there were 2,594 shareholders of record.
Information concerning the market prices of the Company's common stock is set
forth below:
HIGH LOW
---- ---
2001
- -------------------------------------------- --------------------------------
First Quarter $ 49.56 $ 37.45
Second Quarter $ 40.30 $ 32.25
Third Quarter $ 39.11 $ 31.78
Fourth Quarter $ 36.70 $ 29.19
2002
- -------------------------------------------- --------------------------------
First Quarter $ 31.87 $ 22.65
Second Quarter $ 32.43 $ 23.04
Third Quarter $ 24.46 $ 7.72
Fourth Quarter $ 8.88 $ 5.00
2003
- -------------------------------------------- --------------------------------
First Quarter $ 10.00 $ 5.87
Second Quarter $ 13.39 $ 8.12
Third Quarter $ 13.56 $ 6.65
Fourth Quarter $ 7.42 $ 3.10
2004
- -------------------------------------------- --------------------------------
First Quarter $ 5.55 $ 1.26
Second Quarter $ 6.75 $ 2.15
The Company has not paid dividends at any time since it became a public company.
The DIP and Exit Facility prohibits cash dividends without lender consent.
-35-
ITEM 6. SELECTED FINANCIAL DATA
- ------- -----------------------
FIVE-YEAR HISTORICAL FINANCIAL SUMMARY
(dollars in millions)
2001(1) 2000(1) 1999(1),(2) 1998(1),(2)(3)
2002 (Restated) (Restated) (Restated) (Restated)
- --------------------------------------------------------------------------------------------------------------------
Statement of Operations Data
Net sales $2,299.9 $2,460.5 $2,236.5 $1,880.0 $1,829.1
Cost of sales 1,625.3 1,762.2 1,551.4 1,298.4 1,283.0
- --------------------------------------------------------------------------------------------------------------------
Gross profit 674.6 698.3 685.1 581.6 546.1
Store operating, selling, general
and administrative expenses 550.9 568.5 499.4 398.1 388.6
Bad debt expense - Ames Department Stores 9.2 -- -- -- --
Depreciation and amortization 57.4 47.6 39.6 34.5 33.1
Loss on investment -- -- 3.0 -- --
Restructuring, asset impairment
and other charges (reversals), net 17.7 60.6 (0.9) (4.7) 26.7
- --------------------------------------------------------------------------------------------------------------------
Operating profit 39.4 21.6 144.0 153.7 97.7
Interest expense 15.3 16.8 11.6 3.6 3.2
Interest income (1.1) (1.6) (1.4) (1.3) (2.6)
Provision (benefit) for income taxes (4) 67.3 (7.8) 38.0 49.2 31.9
Minority interests in net income 37.1 44.8 51.4 44.6 38.1
Earnings from discontinued
operations, net (5) -- -- -- 2.4 --
Cumulative effect of a change in
accounting principle(6) 24.3 -- -- -- --
- --------------------------------------------------------------------------------------------------------------------
Net (loss) income $ (103.5) $ (30.6) $ 44.4 $ 60.0 $ 27.1
- --------------------------------------------------------------------------------------------------------------------
Balance Sheet Data
Current assets:
Cash and cash equivalents $13.4 $12.5 $14.3 $31.8 $49.1
Inventories 360.9 389.5 392.1 281.9 290.6
Other 87.5 123.7 90.5 77.1 101.4
- --------------------------------------------------------------------------------------------------------------------
Total current assets 461.8 525.7 496.9 390.8 441.1
Property and equipment, net 266.7 256.2 258.5 198.7 217.3
Other assets 46.8 116.9 58.4 32.3 37.8
- --------------------------------------------------------------------------------------------------------------------
Total assets $775.3 $898.8 $813.8 $621.8 $696.2
- --------------------------------------------------------------------------------------------------------------------
Note payable 146.8 146.9 74.0 -- --
Other current liabilities 319.0 322.4 287.7 243.4 279.5
Long-term debt -- -- -- -- --
Other liabilities(7) 72.8 81.5 71.5 44.1 46.9
Minority interests in subsidiaries 61.9 70.1 78.9 73.1 67.5
- --------------------------------------------------------------------------------------------------------------------
Total liabilities 600.5 620.9 512.1 360.6 393.9
- --------------------------------------------------------------------------------------------------------------------
Shareholders' equity (7) 174.8 277.9 301.7 261.2 302.3
- --------------------------------------------------------------------------------------------------------------------
Total liabilities and equity $775.3 $898.8 $813.8 $621.8 $696.2
- --------------------------------------------------------------------------------------------------------------------
(1) Amounts in fiscal years 2001, 2000, 1999 and 1998 have been restated after
management discovered and announced it had identified certain accounting
discrepancies as described in Note 1 of Notes to Consolidated Financial
Statements.
(2) The restated financial information for fiscal years 1998 and 1999, while
unaudited, has been restated on a basis that is consistent with the
restatement of financial statements for fiscal years 2000 and 2001. A
comparison of the fiscal year 2001 Consolidated Balance Sheet and the 2001
and 2000 Consolidated Statement of Operations as originally reported and as
restated is presented in Note 1 of Notes to Consolidated Financial
Statements.
(3) Includes $2.4 million write-off of accounts payable balances to cost of
sales that were determined not to be valid payables. The Company was unable
to locate documentation to support the year in which such amounts apply. A
portion of the $2.4 million may relate to years prior to 1998.
-36-
(4) In connection with th