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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 January 3, 2004
Commission File Number 1-11681
FOOTSTAR, INC.
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(Exact name of registrant as specified in its charter)
DELAWARE 22-3439443
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(State of incorporation) (IRS Employer Identification No.)
933 MACARTHUR BLVD., MAHWAH, NEW JERSEY 07430
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(Address of principal executive offices)
Registrant's telephone number, including area code: (201) 934-2000
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)
1
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 February 26, 2005, was approximately $97.9 million.
Number of shares outstanding of common stock, par value $.01 per share, as of
February 26, 2005: 20,308,849.
DOCUMENTS INCORPORATED BY REFERENCE
None
2
FOOTSTAR, INC.
ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
PART I............................................................................................... 4
Introductory Note.................................................................................... 4
Item 1. Business..................................................................................... 10
General.............................................................................................. 10
The Meldisco Segment................................................................................. 10
Significant Kmart Relationship........................................................... 11
Merchandising............................................................................ 13
Marketing................................................................................ 13
Competitive Environment.................................................................. 13
Acquisition and Disposition of the Footwear Assets of J. Baker; the Ames Bankruptcy
Proceeding............................................................................... 14
Chief Executive Officer.............................................................................. 14
Risk Factors......................................................................................... 15
Trademarks and Service Marks......................................................................... 21
Employees............................................................................................ 21
Available Information................................................................................ 21
Item 2. Properties................................................................................... 22
Item 3. Legal Proceedings............................................................................ 23
Item 4. Submission of Matters to a Vote of Security Holders.......................................... 26
PART II.............................................................................................. 27
Item 5. Market Prices for the Registrant's Common Equity and Related Stockholder Matters............. 27
Item 6. Selected Financial Data...................................................................... 28
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations........ 29
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.................................. 56
Item 8. Financial Statements and Supplementary Data.................................................. 58
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure......... 59
Item 9A. Controls and Procedures..................................................................... 63
Item 9B. Other Information........................................................................... 65
PART III............................................................................................. 66
Item 10. Directors and Executive Officers of the Registrant.......................................... 65
Item 11. Executive Compensation...................................................................... 71
Item 12. Security Ownership of Certain Beneficial Owners and Management.............................. 80
Item 13. Certain Relationships and Related Transactions.............................................. 84
Item 14. Principal Accountant Fees and Services...................................................... 84
PART IV.............................................................................................. 85
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K............................. 85
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 January 3, 2004, trademarks and/or service marks of Footstar, Inc.'s
subsidiaries or affiliates. All other trademarks mentioned are the property of
their respective owners.
3
PART I
INTRODUCTORY NOTE
Footstar, Inc., which may be referred to as "Footstar", the "Company", "we",
"us" or "our", is today filing this Annual Report on Form 10-K for its fiscal
year ended January 3, 2004. We have not filed our Quarterly Reports on Form 10-Q
for the fiscal quarters ended March 29, 2003, June 28, 2003 and September 27,
2003. In lieu of filing such Quarterly Reports, this Form 10-K includes
summarized quarterly financial data and other material information that would
have been available in our 2003 Quarterly Reports on Form 10-Q. These reports
were delayed as a result of our internal investigation, the restatement of our
consolidated financial statements included in our previously filed fiscal 2002
Annual Report on Form 10-K and our operation under protection of the bankruptcy
laws, each described below. Similarly, we intend to include in our fiscal 2004
Annual Report on Form 10-K, which we plan to file as soon as practicable
following the filing of this 2003 Form 10-K, summarized financial data and other
material information that would have been available in our 2004 Quarterly
Reports on Form 10-Q. We also intend to file our Form 10-Q's for fiscal 2005 as
soon as practicable following the filing of our fiscal 2004 Annual Report on
Form 10-K. 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 on or about the date we are filing this report with the
Securities and Exchange Commission (the "SEC").
On November 13, 2002, we announced that management had discovered discrepancies
in the reporting of our accounts payable balances. An investigation of the
discrepancies was conducted with the oversight of the Audit Committee of the
Board of Directors and the assistance of outside legal advisors and forensic
accountants.
The investigation determined that a restatement of previously issued financial
statements over a five-and-one-half year period from the beginning of fiscal
year 1997 through June, 2002 was required. This restatement was included in our
fiscal year 2002 Annual Report on Form 10-K that was filed on September 3, 2004.
We have implemented an Internal Process and Control Plan in order that the
weaknesses identified in internal controls be remedied and we are prepared to
emerge from Chapter 11 protection in full compliance with SEC reporting
requirements and the requirements of the Sarbanes-Oxley Act of 2002
("Sarbanes-Oxley".) See Item 9A - Controls and Procedures
Prior to the Company's November 13, 2002 announcement, we notified the Staff of
the SEC concerning the discovery of the accounting discrepancies. Following that
notification, the SEC began a regulatory proceeding including an investigation
into the facts and circumstances giving rise to the restatement. The Company has
been and intends to continue cooperating fully with the SEC. We cannot predict
the outcome of this proceeding. For a further description of this and other
restatement related litigation, see "Restatement Related Litigation" under Item
3 - Legal Proceedings.
On December 29, 2003, the New York Stock Exchange ("NYSE") suspended trading in
our common stock and, at a later date, our common stock was delisted. The NYSE
stated that it decided to take these actions in view of the overall uncertainty
surrounding our previous announcement that
4
a restatement of our results for 1997 through 2002 would be required and the
continued delay in fulfilling our financial statement filing requirements.
Commencing March 2, 2004 ("Petition Date"), Footstar and substantially all 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, we
are 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, our operations were comprised of two distinct business
segments: the discount and family footwear segment ("Meldisco" or "Meldisco
Segment") and the athletic footwear and apparel segment ("Athletic" or "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), and via
catalogues and the Internet.
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 February 26, 2005, Meldisco operated licensed
footwear departments in 1,479 Kmart Corporation ("Kmart") stores and 860 Rite
Aid Corporation ("Rite Aid") stores located on the West Coast. Meldisco also
supplies certain retail stores, including stores operated by Wal-Mart Stores,
Inc. ("Wal-Mart") and Rite Aid, 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 vendors. Athletic's Consumer Direct operations conducted sales
through catalogues and the Internet to support the Footaction and Just For Feet
retail chains.
We sought bankruptcy protection after we determined we could not obtain
necessary liquidity from our lending syndicate or additional debt or equity
financing. This decline in liquidity primarily resulted from unprofitable
results in the Athletic Segment, a 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 capital market volatility.
Since the Petition Date, we have exited the Athletic Segment entirely by closing
certain underperforming stores and selling the remainder of the stores and the
other assets. Our financial statements have been restated to reflect the
Athletic Segment as a discontinued operation for all periods presented.
5
In the initial stages of the Chapter 11 cases, we sought to streamline our
Meldisco business by selling or exiting selected stores. As a result of our
continued analysis of our businesses, we determined to sell or liquidate all of
our Shoe Zone stores. We also exited the footwear departments in 44 Gordmans,
Inc. ("Gordmans") stores and the footwear departments in 87 stores operated by
subsidiaries of Federated Department Stores, Inc. ("Federated").
We have sold other assets, including our distribution centers in Mira Loma,
California ("Mira Loma") and Gaffney, South Carolina ("Gaffney"). The purchaser
of Mira Loma, Thrifty Oil Co. has leased Mira Loma to FMI International LLC, a
logistics provider, which will provide us with warehousing and distribution
services through June 30, 2012 under a receiving, warehousing and distribution
services agreement.
Effective March 4, 2004, we entered into a two year, $300.0 million senior
secured 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. The DIP Credit Agreement was subsequently amended and, as is
currently constituted (the "DIP and Exit Facility"), we have access to up to
$100.0 million of secured DIP financing, including a sub-limit for letters of
credit with availability determined by a borrowing base formula based upon
inventory and accounts receivable. Upon emergence from Chapter 11, we may, at
our option, and subject to satisfaction of certain conditions, convert the DIP
and Exit Facility to post-emergence financing (the "Exit Facility"), which will
provide for up to $160.0 million in revolving commitments, including a sub-limit
for letters of credit. The conditions include the absence of any default or
event of default, confirmation of a proposed joint plan of reorganization (the
"Plan"), which we filed with the Court on November 12, 2004 and occurrence of
all conditions related thereto, resolution of all issues related to our
assumption of the Master Agreement with Kmart effective as of July 1, 1995, as
amended ("Master Agreement"), our delivery of forward looking projections
acceptable to the lender and specified availability levels. Borrowings under the
DIP and Exit Facility bear interest at either Fleet's prime rate plus 0.0% to
0.5% or LIBOR plus 1.75% to 2.50%, at our option, with the applicable margin
based on excess availability levels. A quarterly fee of 0.3% per annum is
payable on the unutilized balance.
The DIP and Exit Facility has a total term not to exceed five years from the
Petition Date and expires upon Plan confirmation. The Exit Facility is effective
upon our emergence from bankruptcy and its term will be three years. Because
there could be a number of months between confirmation and emergence, we plan to
work with our current lenders to ensure the DIP and Exit Facility is amended to
provide financial support to us during the period from Plan confirmation to
emergence. As of February 26, 2005, there were no loans outstanding under the
DIP and Exit Facility and outstanding letters of credit thereunder totaled $20.2
million. For further information on the DIP and Exit Facility, see "Liquidity
and Capital Resources; The DIP and Exit Facility" under Item 7 - Management's
Discussion and Analysis of Financial Condition and Results of Operations.
Pursuant to Court orders, we have been authorized to pay certain pre-petition
operating liabilities incurred in the ordinary course of business and reject
certain of our pre-petition obligations. We notified all known pre-petition
creditors of the establishment of a bar date by which creditors must file a
proof of claim, which date has now passed for all creditors. Differences between
liability amounts recorded by us and claims filed by creditors are being
reconciled and, if necessary, the Court will make a final determination of
allowable claims. We continue to evaluate the amount of
6
our pre-petition liabilities on an ongoing basis and recognize any additional
liabilities, which may be material.
The following is an overview of the pre-petition claims filed against us as of
March 15, 2005:
STATUS CLAIMS (#) CLAIMS ($)
- ---------------------------------------------------------------- ---------- --------------
Total claims received from Creditors 6,296 $ 646,353,470
Claims officially withdrawn by Creditors (through Court) (46) (402,407)
Claims objected to which were subsequently expunged by the Court (358) (324,252,261)
Other Claims formally objected to(1) (2,048) (208,582,431)
Claims agreed to "As Submitted" (624) (8,760,492)
Claims still being reviewed (65) (2,206,979)
------ -------------
Claims still to be reconciled(2) 3,155 $ 102,148,900
====== =============
(1) A formal objection was filed on March 11, 2005; the Creditor's response
deadline is April 13, 2005 and the hearing on the objection is scheduled
for April 19, 2005
(2) The remaining 3,155 claims consist of:
Expenses Payable 33 $ 806,297
Real Estate 285 55,760,024
Claims Involving Litigation 31 14,786,343
Payroll Tax 140 1,150,885
Income/Sales/All Other Tax 2,666 29,645,351
----- ------------
3,155 $102,148,900
===== ============
Under the Bankruptcy Code, we have 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 us in the Court in accordance with the Bankruptcy Code. We have rejected
a number of executory contracts, and the claims made against us with respect to
those rejected contracts on or prior to March 15, 2005 are included in the
tables above. We expect that as a result of our rejection of additional
executory contracts, including leases of nonresidential real property,
additional claims will be filed. Under the Bankruptcy Code, we may choose to
assume executory contracts subject to the approval of the Court and certain
other conditions, including our payment or "cure" of all outstanding liabilities
thereunder. Due to the uncertain nature of many of the claims, which have been
or may be asserted against us, we are unable to project the total magnitude of
all such claims with any degree of certainty. We have incurred, and will
continue to incur, significant costs associated with the Chapter 11 cases.
In order to exit Chapter 11 successfully, we will need to obtain Court
confirmation of a Chapter 11 plan that satisfies the requirements of the
Bankruptcy Code. At this time, it is not possible to accurately predict the
effect of the Chapter 11 cases on our business, creditors or stockholders or
when we may emerge from Chapter 11, if at all.
On November 12, 2004, we filed the Plan with the Court. The Plan provides for an
orderly reorganization of the Company and cash distributions to impaired parties
and is subject to a vote by eligible ballot holders. Alternatively, the Plan
allows for a sale of all or substantially all of our assets and/or equity
interests in the Meldisco business, following notice and a hearing.
7
The Plan provides for some flexibility in the timing of its confirmation and our
emergence from bankruptcy. Key events that could impact this timing include
determinations by the Court on our motion to assume the Master Agreement
(including a determination of Kmart's cure claim prior to Plan confirmation).
See "Significant Kmart Relationship" under Item 7 - Management's Discussion and
Analysis of Financial Condition and Results of Operations. The Plan also
provides that we will not emerge from bankruptcy until we are current in filing
our periodic reports with the SEC.
If and when the Plan is confirmed, we expect to make an initial distribution of
cash to creditors. The amount of this initial distribution will be based upon
our cash balance remaining after payment of, or establishing reasonable reserves
for, administrative claims, cure claims to the extent applicable, priority tax
claims, secured tax claims and convenience claims as well as establishing a
working capital cash reserve of $28.0 million. As set forth in the Plan, if the
initial distribution does not exceed the lesser of $121.0 million or 85% of the
then estimated general unsecured claims, we will apply up to $21.0 million of
our working capital cash reserve to increase the initial distribution to an
amount equal to the lesser of $121.0 million or 85% of the then estimated
general unsecured claims. Balances due creditors after the initial distribution,
if any, will be paid subject to our generation of free cash flow, as defined.
Such amounts will be distributed following the first and third quarters of each
fiscal year until such obligations have been satisfied.
As we have sold or otherwise disposed of all of the assets of our Athletic
Segment, the Meldisco business is our sole remaining business and our business
relationship with Kmart is critical to Meldisco. Our sale of discount family
footwear at Kmart stores currently generates over 89% of Meldisco's revenues. If
we lose the revenues from all or a substantial number of Kmart stores, we will
not be able to continue our operations; any reorganization of the Company
depends upon our continued ability to generate revenues through the sale of
footwear at Kmart stores.
Our relationship with Kmart is governed by the Master Agreement and certain
sub-agreements governing the operation of footwear departments in each of
Kmart's stores. We have sought Court approval for us to assume those agreements
so that we can continue operating shoe departments in those stores. Kmart has
objected to our motion to assume the agreements and disputed the amount that we
claim would be required to cure defaults under the Master Agreement if we are
allowed to assume it. In addition, Kmart has sought to lift the automatic stay
which is imposed under Section 362 of the Bankruptcy Code (the "Automatic Stay")
so that it can terminate the Master Agreement. For a more complete discussion of
our relationship with Kmart and this important litigation, see "Risk Factors"
under Item 1 - Business, "Significant Kmart Relationship" under Item 7 -
Management's Discussion and Analysis of Financial Condition and Results of
Operations; and "Adversary Proceedings Involving Kmart" under Item 3 - Legal
Proceedings.
Even if we are successful in assuming the Master Agreement and sub-agreements,
we have lost and will continue to lose revenues whenever Kmart closes stores or
transfers stores to entities that are not subject to the Master Agreement.
During the first six months of 2002, while operating under the protection of
Chapter 11 of the U.S. Bankruptcy Code, Kmart closed 283 stores. Kmart closed an
additional 319 stores during the first four months of 2003. While Kmart emerged
from bankruptcy protection on May 6, 2003, we believe that Kmart has continued
and will continue to consider sales of both performing and underperforming
stores. Store sales by Kmart will adversely affect us since virtually all of the
footwear departments in those stores are operated at a profit by us.
8
In June 2004, Kmart announced the sale of 54 of its retail store locations to
Sears, Roebuck and Co. ("Sears") but agreed that Kmart would continue to operate
such stores until Sears could complete its conversion plans. Thereafter, in
November 2004, Kmart announced plans to acquire Sears (the "Sears Acquisition"),
which closed on March 24, 2005.
We received a notice from Kmart instructing us to either vacate approximately 24
of these stores or have the footwear departments relocated within the stores
while their reconfiguration to a new Sears store called Sears Essentials took
place. We believe that the Master Agreement continues to grant us the exclusive
right to operate footwear departments in those stores despite their conversion
to Sears Essentials stores. We asked the Court to find Kmart in contempt for
violation of the Automatic Stay and assess compensatory damages. Kmart replied
by arguing that the Automatic Stay did not prevent them from converting the
stores to Sears Essentials stores because our rights under the Master Agreement
to sell footwear in the stores expires upon their conversion.
Following a preliminary hearing on February 24, 2005, the Court ruled that the
Automatic Stay barred Kmart from taking any actions to remove us from the 24
stores absent a motion for relief from the Automatic Stay. Accordingly, on March
4, 2005, Kmart filed a motion seeking relief from the Automatic Stay to require
us to vacate approximately 24 stores on or before April 13, 2005 (the "Kmart
Stay Motion"). On April 6, 2005, the Court heard legal arguments concerning our
claim that we have the right to continue to operate in the converted stores and
reserved decision. Footstar and Kmart are discussing a schedule for discovery on
any factual issues relating to the Kmart Stay Motion that might remain
outstanding after the Court renders an opinion on the issues raised at the April
6, 2005 hearing. For a more complete discussion of our dispute with Kmart over
this and the related important litigation, see "Risk Factors" under Item 1 -
Business, "Significant Kmart Relationship" under Item 7 - Management's
Discussion and Analysis of Financial Condition and Results of Operations; and
"Adversary Proceedings Involving Kmart" under Item 3 - Legal Proceedings.
9
ITEM 1. BUSINESS
GENERAL
We are a holding company and operate our businesses through our subsidiaries. We
are principally a retailer conducting business through our Meldisco Segment and,
prior to our sale of certain stores to Foot Locker on May 2, 2004 and the
closing of underperforming stores, our 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), and via catalogues and the Internet.
See "Introductory Note" for a description of certain important events which
occurred subsequent to January 3, 2004, including our Chapter 11 filing, the
exit from the footwear departments of Federated and 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.
MELDISCO
Meldisco sells family footwear through licensed footwear departments and
wholesale arrangements. Meldisco has operated licensed footwear departments
since 1961 and is the only major operator of licensed footwear departments in
the United States today.
As of January 3, 2004, Meldisco operated licensed footwear departments in 1,511
Kmart stores, in 863 Rite Aid drugstores, in 44 Gordmans stores, and in
children's footwear departments in 87 stores operated by Federated. As of
February 26, 2005, Meldisco operated licensed footwear departments in 1,479
Kmart stores and in 860 Rite Aid drugstores located on the West Coast. In
October 2002, Meldisco began selling family footwear on a wholesale basis to
Wal-Mart. In April 2003, the licensed footwear agreement between the Company and
Rite Aid covering approximately 2,500 Rite Aid drugstores located in the eastern
half of the United States changed to a wholesale arrangement. As of January 3,
2004, 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
January 3, 2004, 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.
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, Inc. ("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 "Meldisco - 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
10
United States. In January 2002, we announced new licensed footwear department
agreements with Federated and Gordmans. See "Introductory Note" for a
description of our exit from the footwear departments of Federated and Gordmans
stores.
We operated 39 Shoe Zone stores as of January 3, 2004. These family footwear
stores featured a selection of fashion accessories, including belts, handbags
and wallets. See "Introductory Note" for a description of our sale or
liquidation of all of our 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, we expanded our
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 February 26,
2005, we were supplying Thom McAn family footwear to 1,562 Wal-Mart stores in
the United States and Puerto Rico. Wal-Mart is not contractually obligated to
continue its existing level of purchases from us or to expand the Thom McAn line
into any of its other stores.
Significant Kmart Relationship
The business relationship between Meldisco and Kmart is extremely important to
us. The licensed footwear departments in Kmart have historically provided a
significant portion of our total sales and profits, and comprise an even greater
percentage of our sales and profits now that we have exited all of our Athletic
Segment businesses and most of our other Meldisco businesses. The loss of
Meldisco's Kmart business, a significant further reduction in customer traffic
in Kmart stores or the closing of a significant number of Kmart stores would
have a material adverse effect on us and would likely not allow us to continue
to operate.
We operate licensed footwear departments in every Kmart store in the United
States, the U.S. Virgin Islands, Puerto Rico and Guam, through subsidiaries
("Shoemart Subsidiaries" or "Shoemart") 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 we have a 100% equity interest as of February 26, 2005.
Meldisco has operated licensed footwear departments in Kmart since 1961.
Our arrangement with Kmart is governed by the Master Agreement. The Master
Agreement provides us with the non-transferable, exclusive right and license to
operate the footwear departments in Kmart's stores. The initial term of the
Master Agreement expires on July 1, 2012, and is renewable for a 15 year term
upon mutual agreement, unless either party gives notice of termination at least
four years prior to the end of the applicable term. Certain sub-license
agreements for particular Kmart stores allow the parties to terminate those
agreements under specified circumstances.
We have sought Court approval for us to assume the Master Agreement and the
sub-agreements so that we can continue operating shoe departments in those
stores. Kmart has objected to our motion to assume the agreements and disputed
the amount that we claim will be required to cure defaults under the Master
Agreement if we are allowed to assume it. In addition, Kmart has sought to lift
the Automatic Stay so that it can terminate the Master Agreement. For a more
complete discussion of our relationship with Kmart and this important
litigation, see "Significant Kmart Relationship" under Item 7 - Management's
Discussion and Analysis of Financial Condition and Results of Operations; and
"Adversary Proceedings Involving Kmart" under Item 3 - Legal Proceedings.
11
Even if we are successful in assuming the Master Agreement and sub-agreements,
we have lost and will continue to lose revenues whenever Kmart closes stores or
transfers stores to entities that are not subject to the Master Agreement.
During the first six months of 2002, while operating under the protection of
Chapter 11 of the U.S. Bankruptcy Code, Kmart closed 283 stores. Kmart closed an
additional 319 stores during the first four months of 2003. While Kmart emerged
from bankruptcy protection on May 6, 2003, we believe that Kmart has continued
and will continue to consider sales of both performing and underperforming
stores. Store sales by Kmart will adversely effect us since virtually all of the
footwear departments in those stores are operated at a profit by us.
In June 2004, Kmart announced the sale of 54 of its retail store locations to
Sears but agreed that Kmart would continue to operate such stores until Sears
could complete its conversion plans. Thereafter, in November 2004, Kmart
announced the Sears Acquisition, which closed on March 24, 2005.
Prior to this closing, we received a notice from Kmart instructing us to either
vacate approximately 24 stores or have the footwear departments relocated within
the stores while their reconfiguration to a new Sears store called Sears
Essentials took place. We believe that the Master Agreement continues to grant
us the exclusive right to operate footwear departments in those stores despite
their conversion to Sears Essentials stores. We asked the Court to find Kmart in
contempt for violating the Automatic Stay and assess compensatory damages. Kmart
replied by arguing that the Automatic Stay did not prevent them from converting
the stores to Sears Essentials stores because our rights under the Master
Agreement to sell footwear in the stores expires upon their conversion.
Following a preliminary hearing on February 24, 2005, the Court ruled that the
Automatic Stay barred Kmart from taking any actions to remove us from the stores
absent a motion for relief from the Automatic Stay. Accordingly, on March 4,
2005, Kmart filed the Kmart Stay Motion. On April 6, 2005, the Court heard legal
arguments concerning our claim that we have the right to continue to operate in
the converted stores and reserved decision. Footstar and Kmart are discussing a
schedule for discovery on any factual issues relating to the Kmart Stay Motion
that might remain outstanding after the Court renders an opinion on the issues
raised at the April 6, 2005 hearing.
If Kmart sells stores to independent third parties (i.e., not Sears) we may lose
our right to operate footwear departments in such stores. If the Court rules in
Kmart's favor in connection with the Sears/Kmart conversion litigation, Kmart is
likely to continue to take the position pre and post-bankruptcy that we are not
entitled to sell footwear in stores that get converted to Sears Essentials or
any other name that does not include the Kmart name.
For further information regarding the impact of the Kmart store closings, our
relationship with Kmart, the Master Agreement, our dispute with Kmart over this
issue and the related important litigation, see "Significant Kmart Relationship"
under Item 7 - Management's Discussion and Analysis of Financial Condition and
Results of Operations and "Adversary Proceedings Involving Kmart" under Item 3 -
Legal Proceedings.
12
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. Our strategy is to leverage our
expertise in branded products to expand our sales in existing licensed
departments as well as in our wholesale operations.
Meldisco's traditional strength has been in quality leather footwear which it
currently offers under the 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 licensed 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 appealing to 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 44.5 million as of
February 26, 2005.
Competitive Environment
The family footwear business, where the majority of Meldisco's business is
generated, 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
13
number of traditional off-price and value retailers such as Shoe Carnival,
Famous Footwear and Rack Room also selling lower-priced footwear. Many of our
competitors have grown more rapidly and have substantially greater financial and
marketing resources than us. We rely on the high consumer acceptance of
Meldisco's brands, particularly Thom McAn, to provide a competitive advantage.
We have extended distribution of the Thom McAn brand into Wal-Mart stores.
Acquisition and Disposition of the Footwear Assets of J. Baker; the Ames
Bankruptcy Proceeding
In February 2001, we acquired, for cash consideration of $59.0 million, the
footwear assets and related license agreements of J. Baker 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 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. We continued to operate licensed footwear
departments within Ames' stores until October 2002 when all stores were closed.
We recorded a charge in fiscal year 2002 of $9.2 million as an allowance for bad
debt in connection with our receivable from Ames. We are pursuing our claim with
respect to the $9.2 million through litigation. Also during fiscal year 2002, we
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.
During fiscal year 2002, we announced that we had decided to end two
unprofitable licensed footwear relationships that were part of the J. Baker
acquisition. We exited Variety during fiscal year 2002 and ceased operating the
footwear departments in Stein Mart stores at the end of February 2003, when that
contract expired.
In addition, during fiscal year 2002, we decided to exit Spiegel and five other
smaller licensed footwear relationships that were part of the J. Baker
acquisition. As of April 2003, we had exited substantially all of the licensed
footwear departments acquired in the J. Baker acquisition.
As of the first day of fiscal year 2002, we 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.
CHIEF EXECUTIVE OFFICER
Since January 19, 2004, Dale W. Hilpert has been our Chairman and Chief
Executive Officer. Prior to joining us, 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.
14
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
our Interim Chairman and Chief Executive Officer until January 18, 2004 and
currently serves as our Interim Vice Chairman.
RISK FACTORS
Set forth below are certain important risks and uncertainties that could
adversely affect our results of operations or financial condition and cause our
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.
IF WE ARE UNABLE TO SUCCESSFULLY REORGANIZE OUR CAPITAL STRUCTURE AND OPERATIONS
AND IMPLEMENT OUR BUSINESS PLAN THROUGH THE CHAPTER 11 PROCESS, WE MAY NEVER
EMERGE FROM BANKRUPTCY AND MAY BE REQUIRED TO LIQUIDATE OUR 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:
- The Chapter 11 cases may adversely affect our business. We believe
that any such adverse effects may worsen if confirmation of the Plan
is protracted.
- There can be no assurance that the Court will confirm our Plan.
- 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.
- There can be no assurance as to the overall long-term viability of
our operational reorganization and Plan.
- There can be no assurance as to our ability to maintain sufficient
financing sources to fund our Plan and meet future obligations.
- We 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 our
restructuring, and the effect of other unknown adverse factors, could threaten
our existence as a going concern. Continuing on a going concern basis is
dependent upon, among other things, the success and Court approval of our Plan,
including the assumption of our Master Agreement with Kmart, maintaining the
support of key vendors and retaining key personnel, along with financial,
business, and other factors, many of which are beyond our control.
15
MELDISCO IS OUR ONLY CONTINUING BUSINESS AND SUBSTANTIALLY ALL OF OUR CONTINUING
NET SALES AND PROFITS RESULT FROM MELDISCO'S BUSINESS RELATIONSHIP WITH KMART.
KMART STORE CLOSINGS AND REDUCED TRAFFIC IN THE REMAINING KMART STORES HAVE HAD,
AND CONTINUE TO HAVE, A NEGATIVE EFFECT ON SALES AND PROFITS OF MELDISCO. WE ARE
CURRENTLY IN LITIGATION WITH KMART IN THE COURT OVER OUR ABILITY TO ASSUME THE
MASTER AGREEMENT. A FURTHER MATERIAL REDUCTION IN THE NUMBER OF KMART STORES OR
A TERMINATION OF THIS RELATIONSHIP WOULD HAVE A MATERIALLY ADVERSE EFFECT ON US
AND WOULD LIKELY NOT ALLOW US TO CONTINUE TO OPERATE.
We have exited our Athletic Segment business and certain portions of our
Meldisco business. Our sales in the footwear departments operated by Meldisco in
Kmart stores accounted for 89% of our sales and 69% of our profits during 2003.
We are currently in litigation with Kmart regarding numerous aspects of our
business relationship with them. Among other things, Kmart has challenged our
right to assume the Master Agreement, challenged the cure amount associated with
the assumption, and sought to have the Automatic Stay lifted so that it can
terminate the Master Agreement.
Even if we are successful in assuming the Master Agreement, we have lost and
will continue to lose revenues whenever Kmart closes stores or transfers stores
to entities that are not subject to the Master Agreement. While operating under
the protection of Chapter 11 of the U.S. Bankruptcy Code during 2002 and the
first four months of 2003, Kmart closed approximately 600 stores. Kmart has
continued, and we believe will continue, to consider sales of both performing
and underperforming stores. Store sales by Kmart will adversely effect us since
virtually all of the footwear departments in those stores are operated at a
profit by us.
In June 2004, Kmart announced the sale of 54 of its retail store locations to
Sears but agreed that Kmart would continue to operate such stores until Sears
could complete its conversion plans. Thereafter, in November 2004, Kmart
announced the Sears Acquisition which closed on March 24, 2005.
We are involved in litigation with Kmart regarding their instructions for us to
either vacate approximately 24 stores or have the footwear departments relocated
within the stores while their reconfiguration to a new Sears store called Sears
Essentials took place. While we assert that the Master Agreement continues to
grant us the exclusive right to operate footwear departments in those stores
despite the operation of the stores as Sears Essentials stores, Kmart asserts
that our rights under the Master Agreement to sell footwear in the stores
expires upon their conversion.
If Kmart sells stores to independent third parties (i.e., not Sears) we may lose
our right to operate footwear departments in such stores. If the Court rules in
Kmart's favor in connection with the Sears/Kmart conversion litigation, Kmart is
likely to continue to take the position pre and post-bankruptcy that we are not
entitled to sell footwear in stores that are operated under the Sears Essentials
name or any other name that does not include the Kmart name.
If Kmart were to close a significant number of additional stores or convert a
significant number of stores to formats in which we did not have the right to
operate, it would have a material adverse effect on our net sales and profits.
With or without additional store closings, a continued decline in
16
our per store sales in the remaining Kmart stores would have a material adverse
effect on our net sales and profits.
For further information regarding the impact of the Kmart store closings, our
relationship with Kmart, the Master Agreement, our dispute with Kmart over this
issue and the related important litigation, see "Significant Kmart Relationship"
under Item 7 - Management's Discussion and Analysis of Financial Condition and
Results of Operations; and "Adversary Proceedings Involving Kmart" under Item 3
- - Legal Proceedings.
WE ARE A DEFENDANT IN CERTAIN SECURITIES LITIGATION AND ARE THE SUBJECT OF AN
SEC REGULATORY PROCEEDING AND CANNOT YET DETERMINE WITH CERTAINTY WHETHER OUR
INSURANCE COVERAGE IS ADEQUATE TO COVER THE CLAIMS. WE MAY ALSO BE SUBJECT TO
ADDITIONAL LITIGATION OR REGULATORY ACTION.
On the Petition Date, we commenced the Chapter 11 cases by filing petitions for
relief under Chapter 11 of the Bankruptcy Code. We have continued to manage our
business and 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 which, with limited exceptions, enjoins the commencement or
continuation of all collection efforts by creditors, enforcement of liens
against any assets of the Company and litigation against us. However, the
Automatic Stay is applicable only to litigation against us, and not against our
officers and directors. We may request the Court to extend the stay to cover our
officers and directors, but absent Court approval, such litigation may proceed.
Also, the Automatic Stay has no effect on the SEC investigation.
Prior to our November 13, 2002 announcement that management had discovered
discrepancies in the reporting of our accounts payable balances, we notified the
staff of the SEC concerning the discovery of the accounting discrepancies.
Following that notification, the SEC began a regulatory proceeding including an
investigation into the facts and circumstances giving rise to the restatement.
The Company has been and intends to continue cooperating fully with the SEC. We
cannot predict the outcome of this proceeding.
The investigation overseen by the Audit Committee of the Board of Directors and
the restatement led to a delay in the filing of this and other SEC reports. See
"Introductory Note". Because of these delays, we were not in compliance with the
listing standards of the NYSE and the NYSE delisted our common stock.
The Company and certain of its directors and officers were defendants in several
purported class action lawsuits (consolidated into a single action) alleging
violations of federal securities laws and breaches of fiduciary duties. 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. See Item 3 - Legal Proceedings. We are 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.
Litigation or other regulatory actions against us by the SEC, the NYSE or other
regulatory bodies could have a material adverse effect on us, and would also
have adverse secondary effects, such as
17
negative reactions from our stockholders, creditors or vendors. For a further
description of our restatement related litigation, see "Restatement Related
Litigation" under Item 3 - Legal Proceedings.
A FAILURE BY US TO EFFECTIVELY AND EFFICIENTLY MAINTAIN INTERNAL CONTROL OVER
FINANCIAL REPORTING WOULD HAVE A MATERIAL ADVERSE EFFECT ON OUR OPERATIONS OR
FINANCIAL RESULTS.
We have implemented an Internal Process and Controls Plan to address areas of
control weakness identified in the investigation and the related restatement.
The Internal Process and Controls Plan addresses our control environment,
organization and staffing, policies, procedures and documentation, and
information systems. The Audit Committee of the Board of Directors and
management periodically review and assess the effectiveness of internal controls
and procedures. This Internal Process and Controls Plan supports our efforts to
comply with the requirements of Sarbanes-Oxley.
We are 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 may continue to incur increases in
employee levels, capital expenditures and operating expenses with respect to the
implementation of these changes. If we are unable to implement these changes
effectively or efficiently, or if we are found by our independent external
auditor not to be in compliance with the requirements of Sarbanes-Oxley, or if
we or our independent external auditor determine that we have deficiencies in
our internal control over financial reporting that constitute "significant
deficiencies" or "material weaknesses" as defined by the Public Company
Accounting Oversight Board's Audit Standard No. 2, it could have a material
adverse effect on our financial condition, results of operations or liquidity.
WE RELY ON KEY VENDORS AND THIRD PARTIES TO MANUFACTURE AND DISTRIBUTE OUR
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, our cost of acquiring merchandise would increase. Should
we not be able to recover these cost increases with increased pricing to our
customers, it could have a material adverse effect on our operations and
financial condition. In addition, if the terms under which these vendors deal
with us, including payment terms, change adversely, there could be a material
adverse impact on our operations and financial condition.
Meldisco also depends on third parties to receive, transport and deliver its
products. If these third parties are unable to perform for any reason, or if
they increase the price of their services, including but not limited to, as a
result of increases in the cost of fuel, there could be a material adverse
effect on our operations and financial performance.
18
WE MAY BE UNABLE TO ATTRACT AND RETAIN TALENTED PERSONNEL.
Our success is dependent upon our ability to attract and retain qualified and
talented individuals. We have instituted several retention programs designed to
retain key executives and employees. However, if we are unable to attract or
retain key executives and employees, including senior management, and qualified
accounting and finance, marketing, and merchandising personnel, it could
adversely affect our businesses. This risk is acute while we remain in
bankruptcy.
DECLINES IN OUR SALES WILL HAVE A MAGNIFIED IMPACT ON PROFITABILITY BECAUSE OF
OUR FIXED COSTS.
A significant portion of our operating expenses are fixed costs that are not
dependent on our sales performance, as opposed to variable costs, which vary
proportionately with sales performance. These fixed costs include the costs
associated with operating as a public company, the expense of being in
bankruptcy, and a substantial portion of our labor expenses. If our sales
continue to decline, we will be unable to reduce our operating expenses
proportionately.
THERE ARE RISKS ASSOCIATED WITH OUR IMPORTATION OF PRODUCTS.
Approximately 92% 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. Penalties may be imposed for violations of
labor and wage standards by foreign contractors. In addition, China and other
countries in which our 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 our ability to
import our products and, therefore, our 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 our ability to import products from
China could adversely affect our 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 our business, financial condition or
results of operations. In addition, we incur costs as a result of security
programs designed to prevent acts of terrorism such as those imposed by
government regulations and our 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 our
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 our ability
to purchase and import our merchandise from our 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 we use from manufacturing our merchandise or hinder our ability to
import such merchandise, either of which could have an adverse effect on our
results of operations.
19
Our 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 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 our business operations and
financial condition.
WE OPERATE IN THE HIGHLY COMPETITIVE FOOTWEAR RETAILING INDUSTRY.
The family footwear industry, where our business is now 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, Sears 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 our competitors have grown more rapidly and have substantially
greater financial and marketing resources than us.
If we are unable to respond effectively to our competitors, our operations and
financial condition could be materially adversely affected.
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 our customers. As a result, any substantial deterioration in general
economic conditions could have a material adverse effect on our operations and
financial condition.
WE MAY BE UNABLE TO ADJUST TO CONSTANTLY CHANGING FASHION TRENDS.
Our success depends, in large part, upon our ability to gauge the evolving
fashion tastes of our customers and to provide merchandise that satisfies those
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, we
are required to maintain substantial levels of inventory, especially prior to
peak selling seasons when we build up our inventory levels.
As a result, if we fail 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 our merchandise and leave us
with substantial unsold inventory. If that occurs, we may be forced to rely on
markdowns or promotional sales to dispose of excess, slow-moving inventory,
which may harm our business and financial results.
WE MUST PROVIDE CONSUMERS WITH SEASONALLY APPROPRIATE MERCHANDISE, MAKING OUR
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 we experienced in
2003, or an unusually warm winter,
20
consumer demand for seasonally appropriate merchandise that we have available in
our footwear departments will be lower, and our net sales and margins will be
adversely affected. Lower sales may leave us with excess inventory of our basic
products and seasonally appropriate products, forcing us to sell both types of
our products at significantly discounted prices and, thereby, adversely
affecting our net sales and margins.
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 in the United States to over 100 trademarks
and/or service marks under which we market 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. We vigorously protect our trademarks and service marks both domestically
and internationally.
EMPLOYEES
As of February 26, 2005, we had 4,677 employees, of which 1,591 were full-time
and 3,086 were part-time employees.
AVAILABLE INFORMATION
We make available free of charge through our web site, www.footstar.com, all
materials that we file electronically with the SEC, including our 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, we made all such materials available through our web site as soon as
reasonably practicable after filing such materials with the SEC. As discussed in
the Introductory Note, certain 2003 and 2004 SEC reports have not been filed to
date.
You may also read and copy any materials filed by us 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 we file electronically with the SEC.
21
ITEM 2. PROPERTIES
As of January 3, 2004, Meldisco operated licensed footwear departments in 2,503
stores and 39 Company-owned Shoe Zone stores. As of February 26, 2005, Meldisco
operated licensed footwear departments in 2,339 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 January 3, 2004 and February
26, 2005, respectively, 1,511 and 1,479 were located in Kmart discount stores;
863 and 860 licensed departments were in Rite Aid drugstores; 44 and none were
located in Gordmans stores; and 87 and none were located in Federated stores.
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.
Our corporate headquarters and Meldisco's corporate offices are now located in
129,000 square feet of owned office space in Mahwah, New Jersey. Our corporate
tax department is located in 3,500 square feet of leased office space in
Worcester, Massachusetts.
We no longer operated any Footaction or Just For Feet stores as of February 26,
2005. As of January 3, 2004, we operated 433 Footaction stores in 39 states and
Puerto Rico and we operated 89 Just For Feet stores. Footaction's average store
size was 4,800 square feet. Just For Feet's stores ranged from 6,000 to 33,000
square feet with an average store size of 17,000 square feet. Footaction stores
were all leased with a typical lease term of 10 years. Three of Just For Feet's
stores were owned by us; the remainder were leased, with a typical initial lease
term of 15 years.
Until the fourth quarter of 2004, our headquarters was located in 43,000 square
feet of leased office space in West Nyack, New York. Until its relocation to our
Mahwah office building during the third and fourth quarters of 2004, our Shared
Services Center was located in 57,000 square feet of leased office space in
Dallas, Texas. The Athletic Segment's corporate offices were located in
approximately 63,000 square feet of leased office space in Mahwah, New Jersey;
the lease expired as of September 30, 2004. We also maintained approximately
8,300 square feet of leased office space in Wausau, Wisconsin in which our
direct marketing operations were primarily located; that lease ended as of June
2004. We 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, we leased a 200,000 square foot distribution facility
in Morrow, Georgia; that lease ended as of January 31, 2005.
See "Introductory Note" for a discussion of our disposition of our facilities.
22
ITEM 3. LEGAL PROCEEDINGS
As stated in the "Introductory Note" above, we commenced the Chapter 11 cases by
filing petitions for relief under Chapter 11 of the Bankruptcy Code. We have
continued to manage our business 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, which, with limited exceptions, enjoins the
commencement or continuation of all collection efforts by creditors, enforcement
of liens against any assets of the Company and litigation against us. However,
the Automatic Stay is applicable only to litigation against us, and not against
any of our officers and directors. We may request the Court to extend the stay
to cover our 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.
In addition to the matters described below, we are involved in other legal
proceedings, lawsuits and other claims incidental to the conduct of our 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. These estimates also take into account that bar dates
have been established in connection with our bankruptcy proceedings. These bar
dates, all of which have passed, require that any claims relating to events that
occurred prior to our bankruptcy filing be reported in a proof of claim filed
with the Court in our bankruptcy case. 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,
we are unable to ascertain the ultimate financial impact of any legal
proceedings.
RESTATEMENT RELATED LITIGATION
Prior to our November 13, 2002 announcement that management had discovered
discrepancies in the reporting of our accounts payable balances, we 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. 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. We cannot predict the outcome of these proceedings.
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 our 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 our consolidated financial statements or the preparation and
filing of documents or reports we are required to file with the SEC. The Company
has been and intends to continue cooperating fully with the SEC.
23
The Company and certain of its directors and officers were 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, were
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
alleged that these directors and officers breached their fiduciary duties to the
Company by failing to implement and maintain an adequate internal accounting
control system, sought unspecified damages against the defendants and in favor
of the Company, as well as costs and expenses associated with the litigation.
These complaints were 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
Court approval, Footstar and the relevant individual parties mutually agreed to
resolve the claims made in the derivative complaints, without any admission of
liability, for $9.2 million, all of which has been funded with insurance
proceeds paid to the Company. An order has been issued by the court before which
this litigation was pending dismissing the matter with prejudice.
The Company and Messrs. Robinson and Wilson have 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
our 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).
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. We are 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.
ADVERSARY PROCEEDINGS INVOLVING KMART
On August 12, 2004, we filed a motion to assume the Master Agreement (the
"Assumption Motion"). On September 30, 2004, Kmart filed an objection to this
motion (the "Assumption Objection") and cross-moved to lift the Automatic Stay
to enable Kmart to terminate the Master Agreement (the "Cross-Motion").
In the Assumption Objection, Kmart argued that the Master Agreement was
non-assumable under section 365(c)(1) of the Bankruptcy Code because applicable
law rendered the Master Agreement non-assignable. In addition, Kmart argued that
the Master Agreement was non-assumable pursuant to section 365(b)(2)(D) of the
Bankruptcy Code because we had defaulted under the Master Agreement and such
defaults are incurable. Finally, Kmart disputed the amount of cure we would owe
should they be authorized to assume the Master Agreement. We contend that, as of
the Petition
24
Date, the cure amount is approximately $19.0 million, while Kmart asserts that
the cure amounts are no less than $57.8 million. In the Cross-Motion, Kmart
argued that, because the Master Agreement is non-assumable, Kmart should be
entitled to exercise a termination provision pursuant to section 365(e)(2) of
the Bankruptcy Code.
We contested the factual assertions and arguments contained in the Assumption
Objection and the Cross-Motion. Specifically, we argued that applicable
nonbankruptcy law does not prevent us from assigning the Master Agreement. In
addition, we argued that, even if applicable nonbankruptcy law prevented
assignment of the Master Agreement, section 365(c)(1) did not prevent us from
assuming the Master Agreement. Finally, we argued that section 365(b)(2)(D) did
not prevent assumption. On December 17, 2004, a hearing was held to determine
whether, as a matter of law, we can assume the Master Agreement. On February 16,
2005, the Court issued its Decision on Motion to Assume Executory Contracts (the
"Assumption Decision"). In the Assumption Decision, the Court overruled the
Assumption Objection to the extent it was based upon section 365(c)(1) of the
Bankruptcy Code. Specifically, the Court ruled that section 365(c)(1) does not
prevent assumption of the Master Agreement by us because we do not intend to
assign the Master Agreement. The Court did not resolve the issue of whether the
Master Agreement was assignable under applicable nonbankruptcy law. The Court
reserved its decision on the issue of section 365(b)(2)(D) until the completion
of discovery.
The Court has not rendered a decision on the remaining issues raised by the
Assumption Objection or the Cross-Motion. On February 28, 2005, Kmart filed its
Motion for Reargument of Decision on Motion to Assume Executory Contract (the
"Reargument Motion"). In the Reargument Motion, Kmart requested that the Court
reconsider its Assumption Decision on the grounds that controlling precedent
mandates a reversal of the Assumption Decision. We filed our response to the
Reargument Motion on March 18, 2005. The Court held a hearing on the Reargument
Motion on March 31, 2005. At this hearing, the Court reaffirmed the Assumption
Decision.
Kmart has requested additional briefing and argument before the Court with
respect to the termination of the Master Agreement pursuant to section 365(e)(2)
of the Bankruptcy Code. The hearing date on this matter has been set for April
21, 2005.
On March 17, 2005, the Court entered a scheduling order establishing a timetable
for the resolution of the remaining issues raised by the Assumption Motion, the
Assumption Objection, and the Cross-Motion. While the Court did not schedule a
final hearing date, we anticipate a final hearing will be held in July 2005.
There is no guarantee that the Court will authorize us to assume the Master
Agreement or Kmart to terminate the Master Agreement under section 365(e)(2) of
the Bankruptcy Code. Additionally, we cannot be sure what cure amounts will be
owing to Kmart whether or not the Court authorizes us to assume the Master
Agreement. See "Risk Factors" under Item 1 - Business.
In June 2004, Kmart announced the sale of 54 of its retail store locations to
Sears but agreed that Kmart would continue to operate such stores until Sears
could complete its conversion plans. Subsequently, in November 2004, Kmart
announced the Sears Acquisition, which closed on March 24, 2005. Following the
announcement of the Sears Acquisition, we received inconsistent information from
Kmart regarding its plans to convert certain of its stores to a different retail
25
format. Initially, Kmart advised us of its intent to convert approximately 25 of
the 54 stores to Sears Essentials stores, and that Kmart expected us to
discontinue operating the footwear departments in those stores. Kmart then
informed us that only 11 of these 25 stores were slated for a format conversion.
After receiving inconsistent information from Kmart regarding its plans for the
stores, we filed a motion with the Court on January 28, 2005 (the "Examination
Motion") seeking to compel Kmart to produce certain documents relating to the
proposed Sears Acquisition and Kmart's business plans relating to the operation
of footwear departments in its stores.
Shortly after we filed the Examination Motion, Kmart announced its plan to begin
the reconfiguration of some of the stores slated for conversion to a new Sears
format. We then received a notice from Kmart instructing us to either vacate
approximately 24 stores or have the footwear departments relocated within the
stores while their reconfiguration took place. We believe that the Master
Agreement continues to grant us the exclusive right to operate footwear
departments in all stores which are directly or indirectly owned by Kmart and
which at one time operated as Kmart stores, whether or not Kmart converts or
operates certain of the stores under a different discount retail name, such as
the Sears Essentials name. Accordingly, after receiving the notice from Kmart,
we filed a motion (the "Enforcement Motion") requesting that the Court adjudge
and determine Kmart to be in contempt for violation of the Automatic Stay and
assess compensatory damages. Kmart replied to the Enforcement Motion by arguing
that the Automatic Stay did not prevent Kmart from converting the stores to a
different format because our rights under the Master Agreement to sell footwear
in the converting stores expires upon their conversion.
On February 24, 2005, the Court held a preliminary hearing with respect to the
Enforcement Motion and ruled that the Automatic Stay barred Kmart from taking
any actions to remove us from the stores absent a motion for relief from the
Automatic Stay. Accordingly, on March 4, 2005, Kmart filed the Kmart Stay
Motion. On April 6, 2005, the Court heard legal arguments concerning our claim
that we have the right to continue to operate in the converted stores and
reserved decision. Footstar and Kmart are currently discussing a schedule for
discovery on any factual issues relating to the Kmart Stay Motion that might
remain outstanding after the Court renders an opinion on the issues raised at
the April 6, 2005 hearing.
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
2003 as no annual meeting was held.
26
PART II
ITEM 5. MARKET PRICES FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
Our common stock was listed on the NYSE under the trading symbol "FTS". On
December 29, 2003, the NYSE suspended trading in our common stock and, at a
later date, our common stock was delisted. See "Introductory Note". Since
December 30, 2003, our common stock has been traded on the over-the-counter
bulletin board ("OTCBB") under the symbol "FTSTQ:PK". Prices shown for quarters
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 stock 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 February
26, 2005, the closing price of our common stock was $5.50 and there were 2,444
shareholders of record. Information concerning the market prices of our common
stock is set forth below:
High LOW
-------- --------
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
Third Quarter $ 5.60 $ 2.60
Fourth Quarter $ 4.85 $ 2.40
We have not paid dividends at any time since we became a public company and we
do not expect to pay any dividends for the foreseeable future. The DIP and Exit
Facility prohibits cash dividends without lender consent.
27
ITEM 6. SELECTED FINANCIAL DATA
FIVE-YEAR HISTORICAL FINANCIAL SUMMARY
(dollars in millions)
2003 2002 2001 2000 1999
-------- --------- -------- -------- --------
STATEMENT OF OPERATIONS DATA
Net sales $1,015.6 $ 1,346.0 $1,444.2 $1,310.1 $1,236.7
Cost of sales 691.8 917.4 986.9 883.1 845.2
-------- --------- -------- -------- --------
Gross profit 323.8 428.6 457.3 427.0 391.5
Store operating, selling, general
and administrative expenses 269.5 316.8 323.2 272.3 257.5
Bad debt expense - Ames Department Stores - 9.2 - - -
Depreciation and amortization 21.1 20.3 18.9 15.1 14.2
Loss on investment - - - 3.0 -
Other income (5.4) - - - -
Restructuring, asset impairment
and other charges (reversals), net 2.5 14.0 3.3 - (1.4)
-------- --------- -------- -------- --------
Operating profit 36.1 68.3 111.9 136.6 121.2
Interest expense 31.0 17.9 21.5 32.8 29.5
Interest income (7.7) (9.2) (19.3) (32.8) (31.3)
Provision for income taxes(1) 10.0 35.2 27.8 39.4 38.7
Minority interests in net income 17.3 37.1 44.8 51.4 44.6
(Loss) earnings from operations of
discontinued Athletic Segment(2)(3) (39.9) (66.5) (67.7) (1.4) 20.3
Cumulative effect of a change in
accounting principle(4) - 24.3 - - -
-------- --------- -------- -------- --------
Net (loss) income $ (54.4) $ (103.5) $ (30.6) $ 44.4 $ 60.0
======== ========= ======== ======== ========
BALANCE SHEET DATA
Current assets:
Cash and cash equivalents $ 1.1 $ 13.4 $ 12.5 $ 14.3 $ 31.8
Inventories 179.7 360.9 389.5 392.1 281.9
Other 39.7 87.5 123.7 90.5 77.1
Assets held for sale 284.5 - - - -
-------- --------- -------- -------- --------
Total current assets 505.0 461.8 525.7 496.9 390.8
Property and equipment, net 147.2 266.7 256.2 258.5 198.7
Other assets 12.5 46.8 116.9 58.4 32.3
-------- --------- -------- -------- --------
Total assets 664.7 775.3 898.8 813.8 621.8
-------- --------- -------- -------- --------
Notes payable 198.0 146.8 146.9 74.0 -
Other current liabilities 133.2 319.0 322.4 287.7 243.4
Liabilities held for sale 110.5 - - - -
-------- --------- -------- -------- --------
Total current liabilities 441.7 465.8 469.3 361.7 243.4
Other liabilities 58.9 72.8 81.5 71.5 44.1
Minority interests in subsidiaries 42.2 61.9 70.1 78.9 73.1
-------- --------- -------- -------- --------
Total liabilities 542.8 600.5 620.9 512.1 360.6
-------- --------- -------- -------- --------
Shareholders' equity 121.9 174.8 277.9 301.7 261.2
-------- --------- -------- -------- --------
Total liabilities and equity $ 664.7 $ 775.3 $ 898.8 $ 813.8 $ 621.8
======== ========= ======== ======== ========
(1) In connection with the preparation of our fiscal 2003 and 2002 consolidated
financial statements, we reviewed the valuation of our deferred tax assets based
on projections of our future taxable earnings. Primarily due to our historical
losses and projected results, for accounting purposes we cannot rely on
anticipated long-term future profits to utilize certain of these deferred tax
assets. As a result, we could not conclude that it is more likely than not that
the deferred tax assets will be realized and have recorded in fiscal year 2003
an additional non-cash valuation allowance of $24.7 million, of which
approximately $17.6 million is applicable to discontinued operations and in
fiscal 2002 recorded $70.2 million, of which $48.9 million is applicable to
discontinued operations.
28
(2) In 2004 we sold/liquidated our Athletic Segment. We have restated our
financial statements to reflect the Athletic Segment as a discontinued operation
for all periods presented as the process for sale commenced prior to fiscal
2004. (See Note 3 of Notes to Consolidated Financial Statements).
(3) During fiscal 1999, we reversed $3.8 million ($2.4 million after taxes) of a
discontinued business charge of $85.0 million originally recorded in fiscal year
1996 which related to our Meldisco Segment.
(4) Represents write-off of goodwill recorded in connection with the acquisition
of J. Baker assets upon the adoption of Statement of Financial Accounting
Standards No. 142, "Goodwill and Other Intangible Assets". Amortization of
goodwill in fiscal years 2001, 2000 and 1999 was $2.3 million, $0.7 million and
$0.8 million, respectively.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
FORWARD-LOOKING STATEMENTS
This report contains forward-looking statements made in reliance upon the safe
harbor provisions of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended. These statements
may be identified by the use of words such as "anticipate," "estimates,"
"should," "expect," "guidance," "project," "intend," "plan," "believe" and other
words and terms of similar meaning, in connection with any discussion of our
financial statements, business, results of operations, liquidity and future
operating or financial performance. Factors that could affect our
forward-looking statements include, among other things:
- our ability to successfully assume, with Court approval, the Master
Agreement with Kmart, and to cure defaults thereunder at a cost
substantially higher than our estimate thereof;
- changes to our relationship with Kmart relating to the Sears Acquisition;
- the degree to which Kmart transfers additional store locations to Sears or
to independent third parties, and the success in litigation of our
position that stores converted to the Sears format remain subject to the
Master Agreement;
- our ability to emerge from bankruptcy protection and operate successfully
as a going concern;
- our ability to operate pursuant to the terms of the DIP and Exit Facility
and to otherwise obtain financing necessary to operate our business on
satisfactory terms both during and after our emergence from bankruptcy
protection;
- our ability to obtain Court approval and any other required approvals with
respect to motions in the Chapter 11 proceeding prosecuted by us from time
to time;
- our ability to develop, prosecute, confirm and consummate one or more
plans of reorganization with respect to the Chapter 11 cases;
- risks associated with third parties seeking and obtaining court approval
to terminate or shorten the exclusivity period that we have to propose and
confirm one or more plans of reorganization, to appoint a Chapter 11
trustee or to convert the cases to Chapter 7 cases;
- our ability to obtain and maintain normal terms with vendors and service
providers and to maintain contracts that are critical to our operations;
- the audit of the 2004 fiscal year and the review of subsequent quarters by
our independent external auditors;
- our compliance with the requirements of Sarbanes-Oxley;
- negative reactions from our stockholders, creditors or vendors to the
delay in providing financial information caused by the investigation and
restatement and the delisting of our common stock by the NYSE;
29
- the impact and result of any litigation (including private litigation),
any action by the SEC or any investigation by any other governmental
agency related to us or the financial statement restatement process;
- additional delays in the filing of other reports with the SEC;
- our ability to successfully implement internal controls and procedures
that ensure timely, effective and accurate financial reporting;
- higher than anticipated employee levels, capital expenditures and
operating expenses, including our ability to reduce overhead and
rationalize assets, both generally and with respect to changes being
implemented to address the results of the investigation and the
restatement;
- adverse results on our business relating to increased review and scrutiny
by regulatory authorities, media and others of financial reporting issues
and practices or otherwise;
- any adverse developments in existing commercial disputes or legal
proceedings; and
- intense competition in the markets in which we compete.
Additionally, due to material uncertainties, it is not possible to predict the
length of time we will operate under Chapter 11 protection, the outcome of the
proceeding in general, whether we will continue to operate under our current
organizational structure, or the effect of the proceeding on our businesses and
the interests of various creditors and security holders.
Because the information in this Annual Report on Form 10-K is based solely on
data currently available, it is subject to change and should not be viewed as
providing any assurance regarding our future performance. Actual results and
performance may differ from our current projections, estimates and expectations
and the differences may be material, individually or in the aggregate, to our
business, financial condition, results of operations, liquidity or prospects.
Additionally, we assume no obligation to update any of our forward looking
statements based on changes in assumptions, changes in results or other events
subsequent to the date of this Annual Report on Form 10-K.
OVERVIEW
Management confronts major challenges in reorganizing the Company through the
Chapter 11 process. We decided to seek bankruptcy protection after management
determined it was unable to obtain necessary liquidity from our lending
syndicate or additional debt or equity financing. We suffered a decline in our
liquidity primarily resulting from unprofitable results in the Athletic Segment,
a 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 capital market volatility. As a
debtor-in-possession, we are 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.
Since the Petition Date, actions to collect pre-petition indebtedness are stayed
and other contractual obligations against us may not be enforced. In addition,
under the Bankruptcy Code, we may assume or reject executory contracts,
including leases of non-residential real property. Parties affected by these
rejections may file claims with the Court in accordance with the Bankruptcy Code
and orders issued by the Court. In a Chapter 11 case, holders of pre-petition,
general, unsecured
30
claims are entitled to receive at least as much as they would receive if we were
liquidated under Chapter 7 of the Bankruptcy Code. In a Chapter 11 case,
creditors and equity holders are generally allowed to vote to approve a Chapter
11 plan. For the period from the Petition Date to February 26, 2005, we incurred
$28.0 million in costs associated with the Chapter 11 cases. We expect to
continue to incur significant additional costs through the remaining Chapter 11
process.
We have not filed our Quarterly Reports on Form 10-Q for the fiscal quarters
ended March 29, 2003, June 28, 2003 and September 27, 2003. In lieu of filing
such Quarterly Reports, this Form 10-K includes summarized quarterly financial
data and other material information that would have been disclosed in our 2003
Quarterly Reports on Form 10-Q. These reports were delayed as a result of our
internal investigation, the restatement of our consolidated financial statements
included in our previously filed fiscal 2002 Annual Report on Form 10-K and our
operation under protection of the bankruptcy laws. Similarly, we intend to
include in our fiscal 2004 Annual Report on Form 10-K, which we plan to file as
soon as practicable following the filing of this 2003 Form 10-K, summarized
financial data and other material information that would have been available in
our 2004 Quarterly Reports on Form 10-Q. We also intend to file our Form 10-Q's
for fiscal 2005 as soon as practicable following the filing of our fiscal 2004
Annual Report on Form 10-K. Although an Internal Process and Controls Plan has
been implemented, there is no guarantee that it will result in timely and
accurate financial reporting in the future.
As part of our initial reorganization plans after filing for Chapter 11, we
closed 166 underperforming stores within the Athletic Segment, all 88 Just For
Feet stores, 75 Footaction stores and three Uprise stores.
After filing for bankruptcy protection, we received indications of significant
interest from potential acquirers of the remaining 353 Footaction retail stores
comprising the Athletic Segment. We determined that a sale of these stores 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, we
decided to establish an orderly sale process for the remaining Footaction retail
stores.
On March 26, 2004, we filed a motion seeking Court approval to conduct an
auction accepting all types of bids with respect to our 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
approved the Procedures Order.
On April 21, 2004, we received Court approval to accept an offer from Foot
Locker to purchase 349 of the remaining Footaction stores (including all lease
rights and inventory at these stores), along with the remaining inventory from
the 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 that were on month-to-month leases on the following basis:
if Foot Locker enters into a new lease for any of these store locations, the
escrow amount relating to that location will be paid to us. The escrow amount
relating to any location for which Foot Locker has not entered into a new lease
within one year after the closing is to be paid to Foot Locker, thereby reducing
the purchase price by that amount. As of February 26, 2005, we have been paid
approximately $9.1 million from
31
the escrow account, Foot Locker has been paid approximately $2.2 million and
approximately $1.7 million remained in escrow.
The sale to Foot Locker together with the closure of the Just For Feet and
Footaction stores has been accounted for as discontinued operations in
accordance with FASB Statement No. 144, "Accounting for the Impairment or
Disposal of Long Lived Assets". Accordingly, our financial statements have been
restated to reflect the Athletic Segment as a discontinued operation for all
periods presented. The estimated gain on the sale of the Athletic Segment,
including the effect of the closing of the 166 underperforming stores, is
approximately $14.6 million, including the escrow payments through February 26,
2005. The $14.6 million will increase by any remaining escrowed cash that is
released to us.
Under the Procedures Order, we pursued the sale of certain other assets,
including our Mira Loma and Gaffney distribution centers. We 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 us with
warehousing and distribution services for the next eight years under a
receiving, warehousing and distribution services agreement. The sale of Mira
Loma closed on July 22, 2004 and resulted in a loss of approximately $24.8
million. On September 8, 2004, we sold Gaffney to Automated Distribution
Systems, L.P., a logistics provider, for approximately $20.2 million. The gain
on the sale of Gaffney was approximately $0.5 million.
We previously operated a Shared Services Center in Dallas, Texas. The Shared
Services Center administered accounts payable, loss prevention, payroll,
benefits, store accounting and inventory control for the entire Company and also
contained our information system's data center. In connection with our decision
to sell the Athletic Segment and streamline our Meldisco business, we determined
that from both an internal control and cost perspective, the Shared Services
Center was no longer a viable concept given our significantly reduced operating
structure. Accordingly, during 2004 we transitioned all Shared Services Center
functions to the Meldisco headquarters building in Mahwah, New Jersey.
Meldisco has historically maintained inventory levels sufficient to support
sales growth potential in the event that Kmart store traffic grew and/or
favorable weather increased seasonal footwear sales. Following its emergence
from bankruptcy in May 2003, Kmart pursued a strategy, which included reducing
advertising in weekly sale circulars that had the effect of lessening traffic in
Kmart stores and, therefore, negatively impacting sales in Meldisco footwear
departments in Kmart stores. We did not anticipate this decline in advertising
and thus were not able to adjust our inventories commensurate with the reduced
customer traffic and sales levels because product purchase lead times are
generally six months. As a result of this inventory situation, we made a
determined effort to both improve the aged content and reduce overall inventory
levels in 2004. In order to effect an improvement in inventory quality and
quantity, we increased markdowns in an effort to move product. This resulted in
gross margins in 2004 being approximately 330 basis points lower than historical
levels. By the end of fiscal 2004, inventory balances were 38% below year-end
2003 and the aged content of the inventory improved from 15% of total inventory
in fiscal 2003 to 6% by fiscal 2004 year end. Our expectation and focus will be
to continue to operate with significantly lower levels of inventory,
particularly in the aged category. We believe this strategy will result in
higher gross margins and more attractive product offerings to the Shoemart
consumer. This focus
32
on maintaining lower and fresher inventory levels is part of our broader
strategy to maximize free cash flow by reducing our working capital
requirements.
On November 12, 2004, we filed our Plan with the Court. The Plan provides for an
orderly reorganization of the Company and cash distributions to impaired parties
and is subject to a vote by eligible ballot holders. Alternatively, the Plan
allows for a sale of all or substantially all of our assets and/or equity
interests in the Meldisco business, following notice and a hearing.
The Plan provides for some flexibility in the timing of its confirmation and our
emergence from bankruptcy. Key events that could impact this timing include
determinations by the Court on our motion to assume the Master Agreement prior
to Plan confirmation. The Plan also provides that we will not emerge from
bankruptcy until we are current in filing periodic reports with the SEC.
If and when the Plan is confirmed, we expect to make an initial distribution of
cash to creditors. The amount of this initial distribution will be based upon
our cash balance remaining after payment of, or establishing reasonable reserves
for, administrative claims, cure claims to the extent applicable, priority tax
claims, secured tax claims and convenience claims as well as establishing a
working capital cash reserve of $28.0 million. As set forth in the Plan, if the
initial distribution does not exceed the lesser of $121.0 million or 85% of the
then estimated general unsecured claims, we will apply up to $21.0 million of
our working capital cash reserve to increase the initial distribution to an
amount equal to the lesser of $121.0 million or 85% of the then estimated
general unsecured claims. Balances due creditors after the initial distribution,
if any, will be paid subject to our generation of free cash flow, as defined.
Such amounts will be distributed following the first and third quarters of each
fiscal year until such obligations have been satisfied.
The DIP and Exit Facility expires upon Plan confirmation and the ensuing Exit
Facility is effective upon our emergence from bankruptcy (See "Introductory
Note"). Because there could be a number of months between confirmation and
emergence, we plan to work with our current lenders to ensure the DIP and Exit
Facility is amended to provide continuous financial support to us during this
interim period.
Meldisco's sales decreased $191.3 million, or 18.8%, from $1,015.6 million in
fiscal 2003 to $824.3 million in fiscal 2004. Fiscal 2004 was a 52 week period
compared with a 53 week period in fiscal 2003. The additional week in fiscal
2003 represented approximately $12.2 million in increased sales compared with
2004. Shoemart sales declined by $137.9 million with approximately $57.7 million
due to stores closed during 2003 and 2004 as a result of Kmart's bankruptcy and
their store rationalization strategy. In addition, Shoemart experienced a 9.8%
comparable store sales decline in 2004 primarily due to Kmart's strategy of
increasing gross margins at the expense of customer traffic and sales. This
comparable store sales decline in 2004 resulted in an $80.2 million sales
decrease. During the twelve months ended January 26, 2005, Kmart stores
registered an overall 11.0% comparable store sales decline and the apparel
division registered a 13.5% comparable store sales decline. The balance of the
Meldisco sales decline in 2004 of $41.2 million was primarily due to our
decision to streamline our Meldisco businesses by selling or liquidating all of
our Shoe Zone stores ($11.6 million) and exit the footwear departments in
Federated ($8.8 million) and Gordmans ($7.5 million).
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SIGNIFICANT KMART RELATIONSHIP
The business relationship between Meldisco and Kmart is extremely important to
us. The licensed footwear departments in Kmart have historically provided a
significant portion of our total sales and profits, and comprise an even greater
percentage of our sales and profits now that we have exited all of our Athletic
Segment businesses and most of our other Meldisco businesses. The loss of
Meldisco's Kmart business, a significant further reduction in customer traffic
in Kmart stores or the closing of a significant number of Kmart stores would
have a material adverse effect on us and would likely not allow us to continue
to operate.
We operate licensed footwear departments in every Kmart store in the United
States, the U.S. Virgin Islands, Puerto Rico and Guam, through 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 we have a
100% equity interest as of February 26, 2005. Meldisco has operated licensed
footwear departments in Kmart since 1961.
Our arrangement with Kmart is governed by the Master Agreement. The Master
Agreement provides us with the non-transferable, exclusive right and license to
operate a footwear department in every Kmart store. The initial term of the
Master Agreement expires on July 1, 2012, and is renewable for a 15 year term
upon mutual agreement, unless either party gives notice of termination at least
four years prior to the end of the applicable term. Certain sub-agreements for
particular Kmart stores allow the parties to terminate those agreements under
specified circumstances.
On August 12, 2004, we filed the Assumption Motion. Assuming that the Court
concludes that we have the right to assume the Master Agreement, we will be
required under Section 365 of the Bankruptcy Code to cure existing defaults
under the Master Agreement as a pre-condition to that assumption. Kmart asserts
that the cure amounts are no less than $57.8 million. Without taking into
account any claims we may have against Kmart in connection with Kmart's cure
claim, we estimate that, as of the Petition Date, we owed Kmart no more than
approximately $19.0 million.
Kmart objected to our motion to assume the Master Agreement and the
sub-agreements, arguing that assumption is barred as a matter of law under
Section 365(a) of the Bankruptcy Code and challenging the cure amount associated
with the assumption. Kmart has also sought to lift the Automatic Stay so that it
can terminate the Master Agreement. On February 16, 2005, the Court issued a
decision overruling Kmart's objection that assumption is barred as a matter of
law under Section 365(a). Kmart then filed a motion for reargument of the
decision on the motion to assume the Master Agreement, which was the subject of
a hearing held on March 31, 2005. At this hearing, the Court reaffirmed the
Assumption Decision. For a more complete discussion of this important litigation
and other hearings on the Assumption Motion, see "Adversary Proceedings
Involving Kmart" under Item 3 - Legal Proceedings.
Even if we are successful in assuming the Master Agreement and sub-agreements,
we have lost and will continue to lose revenues whenever Kmart closes stores or
transfers stores to entities that are not subject to the Master Agreement.
During the first six months of 2002, while operating under the protection of
Chapter 11 of the U.S. Bankruptcy Code, Kmart closed 283 stores. Kmart closed an
additional 319 stores during the first four months of 2003. Kmart emerged from
bankruptcy
34
protection on May 6, 2003 and Kmart has continued and we believe will continue,
to consider sales of both performing and underperforming stores. Store sales by
Kmart will adversely effect us since virtually all of the footwear departments
in those stores are operated at a profit by us.
In June 2004, Kmart announced the sale of 54 of its retail store locations to
Sears but agreed that Kmart would continue to operate such stores until Sears
could complete its conversion plans. Thereafter, in November 2004, Kmart
announced the Sears Acquisition which closed on March 24, 2005.
Following the announcement of the Sears Acquisition, Kmart advised us of its
intent to convert certain of the 54 stores to a Sears retail format, and that
Kmart expected us to discontinue operating the footwear departments in those
stores. We received a notice from Kmart instructing us to either vacate
approximately 24 stores or have the footwear departments relocated within the
stores while their reconfiguration to a new Sears format took place. We believe
that the Master Agreement continues to grant us the exclusive right to operate
footwear departments in all stores which are directly or indirectly owned by
Kmart and which were at one time operated as Kmart stores, whether or not Kmart
operates certain of the stores under a different retail name, such as Sears
Essentials. Accordingly, we filed the Enforcement Motion requesting that the
Court adjudge and determine Kmart to be in contempt for violation of the
Automatic Stay and assess compensatory damages. Kmart replied to the Enforcement
Motion by arguing that the Automatic Stay did not prevent Kmart from converting
the stores to a different format because our rights under the Master Agreement
to sell footwear in the converting stores expire upon their conversion.
On February 24, 2005, the Court held a preliminary hearing with respect to the
Enforcement Motion and ruled that the Automatic Stay barred Kmart from taking
any actions to remove us from the stores absent a motion for relief from the
Automatic Stay. Accordingly, on March 4, 2005, Kmart filed the Kmart Stay
Motion. On April 6, 2005, the Court heard legal arguments concerning our claim
that we have the right to continue to operate in the converted stores and
reserved decision. Footstar and Kmart are discussing a schedule for discovery on
any factual issues relating to the Kmart Stay Motion that might remain
outstanding after the Court renders an opinion on the issues raised at the April
6, 2005 hearing. For a more complete discussion of this important litigation,
see "Adversary Proceedings Involving Kmart" under Item 3 - Legal Proceedings.
If Kmart sells stores to independent third parties (i.e., not Sears) we may lose
our right to operate footwear departments in such stores. If the Court clearly
rules in Kmart's favor in connection with the Sears/Kmart conversion litigation
after any appeals have been exhausted, Kmart is likely to continue to take the
position pre and post-bankruptcy that we are not entitled to sell footwear in
stores that are converted to Sears Essentials or any other name that does not
include the Kmart name.
RESULTS OF OPERATIONS
The following discussion and analysis should be read in conjunction with and is
qualified in its entirety by our Consolidated Financial Statements and the Notes
thereto that appear elsewhere in this report.
35
FISCAL 2003 VERSUS 2002
Meldisco represents substantially al