UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-Q
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QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2006
Commission File Number 1-11681
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FOOTSTAR, INC.
(Exact name of registrant as specified in its charter)
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DELAWARE 22-3439443
(State or other jurisdiction (IRS Employer
of incorporation for organization) Identification No.)
933 MACARTHUR BLVD., MAHWAH, NEW JERSEY 07430
(Address of principal executive offices)
(201) 934-2000
(Registrant's telephone number, including area code)
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Indicate by check mark whether registrant (1) has filed all reports required to
be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
--- ---
Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer" in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer Accelerated filer X Non-accelerated filer
--- --- ---
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). Yes No X
--- ---
Indicate by check mark whether the registrant has filed all documents and
reports required to be filed by Sections 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court. (The registrant did not distribute new securities under
the plan confirmed by the court; there was no change to the holders of
securities as a result of the registrant's reorganization.) Yes X No
--- ---
Number of shares outstanding of common stock, par value $.01 per share, as of
October 28, 2006: 20,922,673.
1
FOOTSTAR, INC.
QUARTERLY REPORT ON FORM 10-Q
TABLE OF CONTENTS
Part I FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Statements of Operations - For the Three and Nine
Months Ended September 30, 2006 (unaudited) and October 1, 2005
(unaudited) ............................................................ 3
Condensed Consolidated Balance Sheets - As of September 30, 2006
(unaudited) and December 31, 2005 ...................................... 4
Condensed Consolidated Statements of Cash Flows - For the Nine Months
Ended September 30, 2006 (unaudited) and October 1, 2005 (unaudited) ... 5
Notes to Condensed Consolidated Financial Statements ................... 6
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations ............................................ 17
Item 3. Quantitative and Qualitative Disclosures about Market Risk ....... 24
Item 4. Controls and Procedures .......................................... 25
Part II. OTHER INFORMATION
Item 1. Legal Proceedings ................................................ 26
Item 1A. Risk Factors ..................................................... 26
Item 6. Exhibits ......................................................... 30
SIGNATURES ................................................................ 30
31.1 Certification of President and Chief Executive Officer of the
Company, pursuant to Section 302 of the Sarbanes-Oxley Act of
2002 ............................................................. 31
31.2 Certification of Senior Vice President, Chief Financial Officer of
the Company, Pursuant to Section 302 of the Sarbanes-Oxley Act of
2002 ............................................................. 32
32.1 Certification of President and Chief Executive Officer, and Senior
Vice President, Chief Financial Officer of the Company pursuant to
18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002 ....................................... 33
2
PART 1. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
FOOTSTAR, INC. AND SUBSIDIARY COMPANIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2006 AND OCTOBER 1, 2005
(Unaudited)
(in millions, except per share amounts)
Three Months Ended Nine Months Ended
------------------------------------ ------------------------------------
September 30, 2006 October 1, 2005 September 30, 2006 October 1, 2005
------------------ --------------- ------------------ ---------------
Net sales $153.6 $161.7 $478.1 $509.1
Cost of sales 107.8 113.9 328.0 354.4
------ ------ ------ ------
GROSS PROFIT 45.8 47.8 150.1 154.7
Store operating, selling, general and
administrative expenses 38.1 42.0 119.3 136.6
Depreciation and amortization 2.0 1.6 6.5 5.3
Interest expense 0.5 0.8 1.4 2.8
Interest income (1.2) -- (2.7) --
------ ------ ------ ------
INCOME BEFORE REORGANIZATION ITEMS 6.4 3.4 25.6 10.0
Reorganization items 0.2 4.5 0.3 14.1
------ ------ ------ ------
INCOME (LOSS) BEFORE INCOME TAXES AND
DISCONTINUED OPERATIONS 6.2 (1.1) 25.3 (4.1)
Income tax provision (0.1) (5.7) (0.4) (3.2)
------ ------ ------ ------
INCOME (LOSS) FROM CONTINUING OPERATIONS 6.1 (6.8) 24.9 (7.3)
Gain (loss) from discontinued operations,
net of taxes 0.2 (0.5) (0.7) (0.5)
Gain from disposal of discontinued
operations, net of taxes -- -- 0.1 --
------ ------ ------ ------
NET INCOME (LOSS) $ 6.3 $ (7.3) $ 24.3 $ (7.8)
====== ====== ====== ======
NET INCOME (LOSS) PER SHARE:
Basic and Diluted:
Income (loss) from continuing
operations $ 0.29 $(0.33) $ 1.19 $(0.35)
Income (loss) from discontinued
operations 0.01 (0.02) (0.03) (0.03)
------ ------ ------ ------
Net income (loss) $ 0.30 $(0.35) $ 1.16 $(0.38)
====== ====== ====== ======
Average common shares outstanding:
Basic and Diluted 21.0 20.5 20.9 20.5
====== ====== ====== ======
See accompanying notes to condensed consolidated financial statement.
3
FOOTSTAR, INC. AND SUBSIDIARY COMPANIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(in millions, except share amounts)
September December
30, 2006 31, 2005
----------- --------
(unaudited)
ASSETS
Current Assets:
Cash and cash equivalents $ 68.2 $196.1
Accounts receivable, net 10.6 8.8
Inventories 109.8 89.2
Prepaid expenses and other current assets 11.3 21.5
Assets of discontinued operations -- 0.1
------ ------
Total current assets 199.9 315.7
------ ------
Property and equipment, net 26.4 28.9
Intangible assets, net 7.5 10.0
Deferred charges and other assets 1.8 2.1
------ ------
Total assets $235.6 $356.7
====== ======
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities not subject to compromise:
Accounts payable $ 61.7 $ 60.0
Accrued expenses 22.5 45.9
Income taxes payable 0.7 1.9
Liabilities of discontinued operations 2.7 7.4
Liabilities subject to compromise 4.5 125.5
------ ------
Total current liabilities 92.1 240.7
Other long-term liabilities 37.6 35.0
Amount due under Kmart Settlement 5.2 5.5
------ ------
Total liabilities 134.9 281.2
Shareholders' Equity:
Common stock $.0l par value: 100,000,000 shares authorized,
31,634,242 and 31,084,647 shares issued 0.3 0.3
Additional paid-in capital 343.4 342.6
Treasury stock: 10,711,569 shares at cost (310.6) (310.6)
Unearned compensation -- (0.1)
Retained earnings 67.6 43.3
------ ------
Total shareholders' equity 100.7 75.5
------ ------
Total liabilities and shareholders' equity $235.6 $356.7
====== ======
See accompanying notes to condensed consolidated financial statements.
4
FOOTSTAR, INC. AND SUBSIDIARY COMPANIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2006 AND OCTOBER 1, 2005
(Unaudited)
(in millions)
Nine Months Ended
-------------------
September October
30, 2006 1, 2005
--------- -------
Net cash used in operating activities $(32.2) $(37.1)
------ ------
Cash flows (used in) provided by investing activities:
Additions to property and equipment (1.6) (1.0)
Proceeds from sale of furniture and equipment -- 0.6
------ ------
Net cash used in investing activities (1.6) (0.4)
------ ------
Cash flows used in financing activities:
Payments on mortgage note (0.8) --
------ ------
Net cash used in financing activities (0.8) --
------ ------
Cash flows from discontinued operations (REVISED):
Net cash (used in) provided by operating activities
of discontinued operations (93.3) 2.1
------ ------
Net decrease in cash and cash equivalents (127.9) (35.4)
Cash and cash equivalents, beginning of period 196.1 189.6
------ ------
Cash and cash equivalents, end of period $ 68.2 $154.2
====== ======
See accompanying notes to condensed consolidated financial statements.
5
FOOTSTAR, INC. and SUBSIDIARY COMPANIES
Notes to the Condensed Consolidated Financial Statements
(Unaudited)
THE COMPANY
Footstar, Inc., ("Footstar", the "Company", "we", "us", or "our") is a holding
company that operates its businesses through its subsidiaries. We are
principally a retailer selling family footwear through licensed footwear
departments and wholesale arrangements.
1. EMERGENCE FROM BANKRUPTCY
Commencing March 2, 2004 ("Petition Date"), Footstar and most of its
subsidiaries (collectively, the "Debtors") filed voluntary petitions for
reorganization 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 were jointly administered under the caption "In re: Footstar, Inc., et.
al. Case No. 04-22350 (ASH)" (the "Chapter 11 Cases"). The Debtors operated
their business and managed their properties as debtors-in-possession pursuant to
Sections 1107(a) and 1108 of the Bankruptcy Code. As debtors-in-possession, we
were authorized to continue to operate as an ongoing business but could not
engage in transactions outside the ordinary course of business without the
approval of the Court.
On July 2, 2005, the Company and Kmart Corporation ("Kmart") entered into an
agreement (the "Kmart Settlement") with respect to the assumption of the Master
Agreement with Kmart, effective July 1, 1995, as amended (the "Master
Agreement"), which was effective as of January 2, 2005, and allowed us to
continue operating the footwear departments in Kmart stores pursuant to an
Amended and Restated Master Agreement (the "Amended Master Agreement"). See Note
6 "Relationship with Kmart".
On November 12, 2004, we filed a proposed joint plan of reorganization with the
Court which was amended on October 28, 2005, and amended again on December 5,
2005, (the "Amended Plan"). On January 25, 2006, the Bankruptcy Court confirmed
our Amended Plan. On February 7, 2006, we successfully emerged from bankruptcy
and paid substantially all our creditors in full with interest. Pursuant to the
guidance provided by the American Institute of Certified Public Accountants in
Statement of Position 90-7, "Financial Reporting by Entities in Reorganization
Under the Bankruptcy Code ("SOP 90-7"), the Company has not adopted fresh-start
reporting because there was no change to the holders of existing voting shares
and the reorganization value of the Company's assets was greater than its post
petition liabilities and allowed claims.
2. BASIS OF PRESENTATION
Our condensed consolidated financial statements contained herein have been
prepared in accordance with the provisions of SOP 90-7. Pursuant to SOP 90-7,
our pre-petition liabilities that were subject to compromise are reported
separately in the accompanying balance sheet as an estimate of the amount that
will ultimately be allowed by the Court. SOP 90-7 also requires separate
reporting of certain expenses, realized gains and losses and provisions for
losses related to the bankruptcy filing as reorganization items.
The accompanying condensed consolidated financial statements are unaudited but,
in the opinion of management, contain all adjustments (which are of a normal
recurring nature) necessary to present
6
FOOTSTAR, INC. and SUBSIDIARY COMPANIES
Notes to the Condensed Consolidated Financial Statements
(Unaudited)
fairly the financial position, results of operations and cash flows for the
periods presented. All significant intercompany accounts and transactions have
been eliminated.
Detailed footnote information is not included in this report. The financial
information set forth herein should be read in conjunction with the Notes to
Condensed Consolidated Financial Statements contained in our fiscal 2005 Annual
Report on Form 10-K/A for the period ended December 31, 2005 filed with the SEC.
The results of operations for the three and nine months ended September 30, 2006
are not necessarily indicative of results to be expected for the entire fiscal
year ending December 30, 2006.
3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
As of September 30, 2006, there have been no material changes to any of our
significant accounting policies, except for the accounting for stock
compensation, described in our Annual Report on Form 10-K/A for the fiscal year
ended December 31, 2005. Effective January 1, 2006, the Company adopted
Financial Accounting Standards Board (FASB) Statement No. 123 (R), "Share Based
Payment," revising FAS 123 and requiring that all share-based payments to
employees be recognized in the financial statements. See Note 10 "Stock-Based
Compensation Plans."
4. IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS
In June, 2006 the FASB issued FASB Interpretation No. 48, Accounting for
Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109,
Accounting for Income Taxes ("FIN 48"). FIN 48 clarifies the accounting for
uncertainty in income taxes recognized in a company's financial statements in
accordance with FASB Statement No. 109. FIN 48 stipulates a recognition
threshold and measurement attribute for the financial statement recognition and
measurement of a tax position taken or expected to be taken in a tax return. FIN
48 also provides guidance on derecognition, classification, and interest and
penalties. The provisions of FIN 48 are to be effective for our fiscal year
beginning December 31, 2006. We have not yet determined the impact that
uncertain tax positions will have on our financial position or results of
operations.
In September 2006, the Financial Accounting Standards Board (FASB) issued FASB
Statement No. 158, Employers' Accounting for Defined Benefit Pension and Other
Postretirement Plans, which requires a company that sponsors one or more
single-employer defined benefit pension and other postretirement benefit plans
(benefit plans) to recognize in its balance sheet the funded status of a benefit
plan, which is the difference between the fair value of plan assets and the
benefit obligation, as a net asset or liability, with an offsetting adjustment
to accumulated other comprehensive income in shareholders' equity. FASB
Statement No. 158 requires additional financial statement disclosure regarding
certain effects on net periodic benefit cost. FASB Statement No. 158 requires
prospective application and the recognition and disclosure requirements are
effective for fiscal years ending after December 15, 2006. We will adopt FASB
Statement No. 158 as of December 30, 2006. We are currently evaluating the
potential impact of the adoption of FASB Statement No. 158 on our consolidated
financial position, results of operations and cash flows.
7
FOOTSTAR, INC. and SUBSIDIARY COMPANIES
Notes to the Condensed Consolidated Financial Statements
(Unaudited)
In addition, FASB Statement No. 158 requires that a company measure defined
benefit plan assets and obligations at its year-end balance sheet date. We
currently use our year-end balance sheet date as our measurement date and, as a
result, that new requirement will not affect us.
In September 2006, the FASB issued Statement No. 157, Fair Value Measurements,
which defines fair value, establishes a framework for measuring fair value under
GAAP, and expands disclosures about fair value measurements. FASB Statement No.
157 applies to other accounting pronouncements that require or permit fair value
measurements. The new guidance is effective for financial statements issued for
fiscal years beginning after November 15, 2007, and for interim periods within
those fiscal years. We are currently evaluating the potential impact, if any, of
the adoption of FASB Statement No. 157 on our consolidated financial position,
results of operations and cash flows.
5. DISCONTINUED OPERATIONS
The disposition of our Athletic Segment and certain operations within our
Meldisco Segment in fiscal year 2004, have been accounted for as discontinued
operations in accordance with FASB Statement No. 144, "Accounting for the
Impairment or Disposal of Long Lived Assets". Accordingly, we have reported our
results of the discontinued operations as a separate component of operations. In
addition, we applied the provisions of FASB Statement No. 144 to the stores
closed by Kmart during the third quarter of 2006 and 2005 and determined that
these stores either did not meet the criteria to be accounted for as
discontinued operations or were not considered material to our consolidated
results of operations.
Net sales, operating income (loss), interest expense, benefit from income taxes
and loss from discontinued operations for the three and nine months ended
September 30, 2006 and October 1, 2005 were as follows (in millions):
Three Months Ended Nine Months Ended
-------------------------- --------------------------
September 30, October 1, September 30, October 1,
2006 2005 2006 2005
------------- ---------- ------------- ----------
Net sales $ -- $ -- $ -- $ --
Operating income (loss) from
discontinued operations 0.2 0.3 (0.1) 0.6
Interest expense -- 0.4 0.6 1.1
Provision for income taxes -- 0.4 -- --
---- ----- ----- -----
Loss from discontinued operations $0.2 $(0.5) (0.7) $(0.5)
==== ===== ====== =====
6. RELATIONSHIP WITH KMART
The business relationship with Kmart is extremely important to us. The Kmart
licensed footwear departments account for substantially all of our sales and
operating profit from continuing operations. The loss of this operation, a
significant reduction in customer traffic in Kmart stores or the closing or
conversion of a significant number of additional Kmart stores would have a
material adverse effect on us.
8
FOOTSTAR, INC. and SUBSIDIARY COMPANIES
Notes to the Condensed Consolidated Financial Statements
(Unaudited)
We operated the footwear departments in 1,393 Kmart stores as of September 30,
2006.
On July 2, 2005, the Company and Kmart entered into the Kmart Settlement and
thereafter the Amended Master Agreement which dictates the structure of our
relationship with Kmart. Under the Master Agreement before amendment, the
Company and Kmart had formed in excess of 1,500 corporations to operate the
footwear departments in Kmart stores ("Shoemart Corporations") in which we had a
51% ownership interest and Kmart had a 49% ownership interest, other than 23 of
the Shoemart Corporations which were wholly-owned by us.
The Kmart Settlement provides that Kmart's equity interests in the Shoemart
Corporations were extinguished effective January 2, 2005, and accordingly, Kmart
does not share in the profits or losses of those entities for fiscal 2005 or
subsequent years. The Kmart Settlement fixed the cure amount with respect to our
assumption of the Amended Master Agreement at $45.0 million, which was paid on
August 26, 2005. The Amended Master Agreement provides that effective January 2,
2005, we pay Kmart 14.625% of the gross sales of the footwear departments, in
lieu of almost all of the fees and dividends required under the Master
Agreement. The Amended Master Agreement further provides that effective August
25, 2005, we pay Kmart a miscellaneous expense fee of $23,500 each year per open
store. The Amended Master Agreement expires at the end of 2008 at which time
Kmart is obligated to purchase our Shoemart inventory (but not our brands) at
book value, as defined.
We and Kmart each have the right to terminate the Amended Master Agreement early
if the gross sales of the footwear departments in any four consecutive fiscal
quarters are less than $550.0 million, provided that this gross sales minimum
will be reduced by $0.4 million for each store that is closed or converted after
August 25, 2005. Forty-six stores have been closed or converted from August 25,
2005 through September 30, 2006, of which 33 were subject to the $11,000 claim
per store as discussed below. The Company also has the unilateral right to
terminate the Amended Master Agreement if either (i) the number of Kmart stores
is less than 900 or (ii) the gross sales of the footwear departments in any four
consecutive fiscal quarters are less than $450.0 million. In the event of any
such termination, Kmart is obligated to purchase all of the inventory (including
inventory that is on order but excluding inventory that is damaged, unsaleable,
and seasonal inventory, as defined) for an amount equal to the book value of the
inventory, as defined.
Pursuant to the Amended Master Agreement, Kmart must pay us the stipulated loss
value (as set forth below), if it terminates our licenses to operate a certain
number of shoe departments in Kmart stores by disposing of, closing or
converting those stores. The number of stores it can dispose of, close or
convert per year before having to pay us the stipulated loss value, is capped at
85 in 2005, 150 in 2006 and 160 in each of 2007 and 2008, with any unused cap
carried over to the following year. In 2005, 61 stores were disposed of, closed
or converted. In 2006, through September 30, 2006, 28 stores were disposed of,
closed or converted. For each store that is disposed of, closed or converted,
Kmart must purchase all of our in-store inventory (excluding inventory that is
damaged, unsaleable and seasonal inventory, as defined) at book value, as
defined. In addition, to the extent Kmart exceeds the annual cap or the 550
aggregate limit, Kmart must pay us a non-refundable stipulated loss value for
each store above the cap equal to $60,000 for terminations occurring in 2006,
$40,000 for terminations occurring in 2007 and $20,000 for terminations
occurring in 2008.
9
FOOTSTAR, INC. and SUBSIDIARY COMPANIES
Notes to the Condensed Consolidated Financial Statements
(Unaudited)
If the entire Amended Master Agreement is terminated in accordance with its
terms, Kmart is not obligated to make any stipulated loss value payments for
such stores.
The Amended Master Agreement sets forth the parties' obligations with respect to
staffing and advertising. Specifically, we must spend at least 10% of gross
sales in the footwear departments on staffing costs, as defined, and we must
schedule the staffing in each store at a minimum of 40 hours per week. In
addition, Kmart is required to allocate at least 52 weekend newspaper
advertising insert pages per year to our products.
Kmart has a claim against us in the amount of $11,000 for each store that is an
existing store, as defined, on August 25, 2005, which is payable by us to Kmart
at the time a store is disposed of, closed or converted to another retail
format. However, upon the expiration of the Amended Master Agreement or upon
early termination of that agreement other than as a result of our breach, all
such claims not yet due and payable will be waived for any remaining stores. If
the Amended Master Agreement is terminated as a result of our breach, these
claims for remaining stores will not be waived and will become immediately due
and payable.
As set forth in the Amended Master Agreement, Kmart collects proceeds from the
sale of our inventory and remits those sales proceeds to us on a weekly basis
less any applicable fees outlined in the Kmart Settlement. Such fees were $29.4
million and $30.1 million for the three months ended September 30, 2006 and
October 1, 2005, respectively and $91.3 million and $94.5 million for the nine
months ended September 30, 2006 and October 1, 2005, respectively. As of
September 30, 2006 and December 31, 2005, we had outstanding accounts receivable
due from Kmart of $8.7 million and $5.2 million, respectively, which were
subsequently collected in October 2006 and January 2006, respectively.
7. ASSETS AND LIABILITIES RELATED TO DISCONTINUED OPERATIONS
Assets and liabilities related to discontinued operations not subject to
compromise consisted of the following (in millions):
SEPTEMBER 30, DECEMBER 31,
2006 2005
------------- -------------
ASSETS
Prepaid expenses and other current assets $ -- $0.1
---- ----
$ -- $0.1
==== ====
LIABILITIES
Accrued expenses $2.4 $7.4
Other long-term liabilities 0.3 --
---- ----
$2.7 $7.4
==== ====
8. LIABILITIES SUBJECT TO COMPROMISE
Liabilities subject to compromise represent our current estimate of the amount
of the pre-petition claims that are subject to restructuring in the Chapter 11
Cases. Pursuant to Court orders, we were 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 pre-petition creditors
must file a proof of claim, which bar date
10
FOOTSTAR, INC. and SUBSIDIARY COMPANIES
Notes to the Condensed Consolidated Financial Statements
(Unaudited)
has now passed for all such creditors. Differences between liability amounts
recorded by us and claims filed by pre-petition creditors have been
substantially reconciled and paid upon our emergence on February 7, 2006 (see
Note 1 "Emergence from Bankruptcy"). The Court will make a final determination
of allowable claims on remaining disputed amounts.
Liabilities subject to compromise consisted of the following (in millions):
SEPTEMBER 30, DECEMBER 31,
2006 2005
------------- ------------
Accounts payable $ -- $ 56.0
Accrued expenses 4.5 64.4
Long-term liabilities -- 5.1
---- ------
Total $4.5(a) $125.5(a)
==== ======
(a) Includes approximately $3.8 and $92.3 of liabilities subject to compromise
from discontinued operations as of September 30, 2006 and December 31,
2005, respectively.
9. REORGANIZATION ITEMS
Reorganization items, which consist of income and expenses that are related to
our bankruptcy proceedings, were comprised of the following for the three and
nine months ended September 30, 2006 and October 1, 2005 (in millions):
Three Months Ended Nine Months Ended
-------------------------- --------------------------
September 30, October 1, September 30, October 1,
2006 2005 2006 2005
------------- ---------- ------------- ----------
Store and distribution center closing and
related asset impairment costs $ -- $ -- $ -- $ 0.1
Professional fees 0.2 4.9 1.4 14.9
Trustee fees -- 1.1 0.1 3.1
Gain on disposition of
bankruptcy claims -- -- (0.5) --
Interest income -- (1.5) (0.7) (4.0)
---- ----- ----- -----
Total $0.2 $ 4.5 $ 0.3 $14.1
==== ===== ===== =====
10. STOCK-BASED COMPENSATION PLANS
In December 2004, the Financial Accounting Standards Board issued Statement No.
123(R) ("FAS 123R"), "Share-Based Payment," revising FAS 123 and requiring that
all share-based payments to employees be recognized in the financial statements.
We adopted the new statement effective January 1, 2006, using the
modified-prospective transition method described in the statement, which
requires measurement of compensation cost of all stock-based awards at fair
value on the date of grant and recognition of compensation over the service
periods for awards expected to vest. Under this method, we are required to
recognize compensation expense for (i) all awards granted after the adoption
date, and (ii) the unvested portion of previously granted options that remain
outstanding as of the adoption date. We recorded compensation expense during the
three and nine months ended September 30, 2006 of $0.3 million and $1.0 million,
respectively. Prior amounts have not been restated.
11
FOOTSTAR, INC. and SUBSIDIARY COMPANIES
Notes to the Condensed Consolidated Financial Statements
(Unaudited)
Prior to adopting FAS 123R, we applied the intrinsic value-based method of
accounting prescribed in APB Opinion No. 25 and, accordingly, did not recognize
compensation expense for stock option grants made at an exercise price equal to
or in excess of the fair market value of the stock at the date of grant.
The following table details the effect on the Company's net income and basic and
diluted net income per share had compensation expense for stock-based awards
been recorded in the three and nine months ended October 1, 2005 based on the
fair-value method under SFAS 123 (in millions, except per share amounts).
Three Months Nine Months
Ended Ended
October 1, 2005 October 1, 2005
--------------- ---------------
Net loss: $ (7.3) $ (7.8)
Reported
Add: Non-cash employee compensation, as reported -- 0.1
Deduct: Stock-based employee compensation
expense determined under fair value based
method for all awards, net of taxes (0.3) (1.1)
------ ------
Pro forma, net loss $ (7.6) $ (8.8)
====== ======
Basic and diluted net loss per share, as reported $(0.35) $(0.38)
====== ======
Basic and diluted net loss per share, pro forma $(0.37) $(0.43)
====== ======
There were no options granted in the nine months ended September 30, 2006 and
October 1, 2005.
As of September 30, 2006 there was $0.1 million of total unrecognized
compensation costs related to stock options. These costs are expected to be
recognized over a weighted average period of four months.
As of September 30, 2006 there was $1.2 million of unrecognized compensation
costs related to restricted stock, restricted stock units and performance-based
stock awards. These costs are expected to be recognized over a weighted average
period of 26 months.
2006 NON-EMPLOYEE DIRECTOR STOCK PLAN
Upon our emergence from bankruptcy on February 7, 2006, the 2006 Non-Employee
Director Stock Plan (the "2006 Director Stock Plan") became effective and the
1996 Director Stock Plan was frozen. The 2006 Director Stock Plan allows for the
grant of up to 458,044 shares of common stock of the Company (the "Common
Stock").
The 2006 Director Stock Plan provides for an automatic initial grant of 10,000
shares of restricted Common Stock to each eligible director. Beginning with the
2007 annual meeting of the Company, the Company shall make additional grants to
each eligible director of 10,000 shares of restricted Common Stock, or such
other amount determined by the Board of Directors of the Company (the "Board"),
subject to the provisions of the 2006 Director Stock Plan.
Unless the Board shall determine otherwise at the time of grant, each award of
restricted Common Stock shall vest with respect to 50% of the shares on the
first anniversary of the date of grant, an
12
FOOTSTAR, INC. and SUBSIDIARY COMPANIES
Notes to the Condensed Consolidated Financial Statements
(Unaudited)
additional 25% of the shares on the second anniversary of the date of grant, and
the remaining 25% of the shares on the third anniversary of the date of grant.
In the event of a participant's retirement, all unvested shares of restricted
Common Stock shall become vested as of the effective date of such retirement. In
the event of a change in control (as specified in the 2006 Director Stock Plan),
all unvested shares of restricted Common Stock shall become vested as of the
effective date of such change in control.
As of September 30, 2006 there was $0.2 million of unrecognized compensation
costs related to Director Stock units. These costs are expected to be recognized
over a weighted average period of 14 months.
11. EARNINGS PER SHARE
Basic EPS is computed by dividing net income available for common stockholders
by the weighted average number of common shares outstanding for the period.
Diluted EPS is computed by dividing net income available to common stockholders
by the weighted average shares outstanding, after giving effect to the potential
dilution that could occur if outstanding options or other contracts or
obligations to issue common stock were exercised or converted.
The following table reflects average shares outstanding used to compute basic
and diluted earnings (loss) per share (in millions):
Three Months Ended Nine Months Ended
-------------------------- --------------------------
September 30, October 1, September 30, October 1,
2006 2005 2006 2005
------------- ---------- ------------- ----------
Average shares outstanding 20.9 20.3 20.8 20.3
Average contingently issuable shares (1) 0.1 0.2 0.1 0.2
---- ---- ---- ----
Average shares outstanding - basic 21.0 20.5 20.9 20.5
==== ==== ==== ====
Average shares outstanding - diluted (2) 21.0 20.5 20.9 20.5
==== ==== ==== ====
(1) Represents shares earned under our stock incentive plans
(2) The computation of diluted EPS does not assume conversion, exercise or
issuance of shares that would have an anti-dilutive effect on EPS. During
both the three and nine months ended October 1, 2005 we had a net loss; as
a result, any assumed conversions would result in reducing the loss per
share and, therefore, are not included in the calculation. There were no
assumed shares having an anti-dilutive effect on EPS in any period. Shares
having exercise prices greater than the Company's market price per share
and therefore excluded from the calculation of diluted earnings per share,
totaled 585,010 shares for the three and nine months ended September 30,
2006 and 742,751 shares for the three and nine months ended October 1,
2005.
12. INCOME TAXES
Upon our emergence from bankruptcy on February 7, 2006, the Company realized
approximately $51 million of tax deductible expenses thereby creating a loss for
tax purposes in excess of the book income for the nine months ended September
30, 2006. In addition, we have recorded a non-cash valuation allowance on the
net deferred tax asset. The 2006 income tax provision relates to the estimated
income tax obligation of our stores located in Puerto Rico, Guam and the Virgin
Islands.
13
FOOTSTAR, INC. and SUBSIDIARY COMPANIES
Notes to the Condensed Consolidated Financial Statements
(Unaudited)
Although the Kmart Settlement was effective as of January 2, 2005, the effective
date for tax purposes was August 25, 2005, the date the Kmart Settlement was
approved by the Court. As a result, two tax periods were required for fiscal
2005. Due to the minority interest in each Shoemart store for the period January
2, 2005 through August 25, 2005, we could not file a consolidated federal tax
return. As losses from stores could not therefore be offset against profits from
other stores, this resulted in an unusually high estimated effective tax rate in
2005. As the minority interests are eliminated as of August 25, 2005, federal
tax returns will be filed on a consolidated basis for periods subsequent to this
date.
13. COMMITMENTS AND CONTINGENCIES
Kmart Relationship
In connection with the Kmart Settlement, all outstanding litigation between
Kmart and us has been settled. See Note 6 "Relationship with Kmart." The Amended
Master Agreement expires at the end of 2008.
If we fail to develop viable business alternatives to offset the termination of
our Amended Master Agreement, we will almost certainly be forced to liquidate
our business at the end of December, 2008. In addition, should we fail to meet
the minimum sales tests, staffing requirements or other provisions provided in
the Amended Master Agreement, termination of our business could occur prior to
December 31, 2008.
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 staff of the SEC began an enforcement
proceeding captioned, In the Matter of Footstar, Inc., MNY-7122, including an
investigation into the facts and circumstances giving rise to the discrepancies.
On November 25, 2003 the SEC issued a formal order in that investigation
empowering certain members of the SEC staff to take certain actions in the
course of the investigation, including requiring testimony and the production of
documents.
The enforcement investigation 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 condensed consolidated financial statements or the preparation and filing of
documents or reports we are required to file with the SEC.
As we announced on February 10, 2006, the Company received a Wells notice from
the SEC staff in connection with the enforcement investigation. Under SEC
procedures, a Wells notice indicates that the staff has made a preliminary
decision to recommend that the SEC authorize the staff to bring a civil or
administrative action against the recipient of the notice. The Wells notice that
14
FOOTSTAR, INC. and SUBSIDIARY COMPANIES
Notes to the Condensed Consolidated Financial Statements
(Unaudited)
Footstar received states that the SEC staff, as a result of its investigation,
is considering recommending that the SEC bring a civil injunctive action against
the Company for alleged violations of provisions of the Securities Exchange Act
of 1934 relating to the maintenance of books, records and internal accounting
controls, the establishment of disclosure controls and procedures and the
periodic filing requirements of Sections 10(b), 13(a) and 13(b)(2) of the
Exchange Act and in SEC Rules 10b-5, 12b-20, 13a-1 and 13a-13. A recipient of a
Wells notice can respond to the SEC staff before the staff makes a formal
recommendation regarding whether the SEC should bring any action. Footstar has
been, and intends to continue, cooperating fully with the SEC staff in
connection with this matter and is in discussions with the staff regarding the
possible resolution of this matter.
Other Litigation Matters
On or about March 3, 2005, a first amended complaint was filed against us in the
U.S. District Court for the District of Oregon, captioned Adidas America, Inc.
and Adidas -Salomon AG v. Kmart Corporation and Footstar, Inc. The first amended
complaint seeks injunctive relief and unspecified monetary damages for trademark
infringement, trademark dilution, unfair competition, deceptive trade practices
and breach of contract arising out of our use of four stripes as a design
element on footwear which Adidas alleges infringes on its registered three
stripe trademark. While it is too early in litigation to predict the outcome of
the claims against us, we believe that we have meritorious defenses to the
claims asserted by Adidas and have filed an answer denying the allegations. The
Company has recorded a reserve to cover the potential exposure relating to this
litigation, which reserve was not material to the financial condition, results
of operation or liquidity of the Company. In addition, the Company does not
believe an amount of loss in excess of recorded amounts is reasonably possible.
NAFTA Traders, Inc. ("NAFTA"), a salvage company which previously did business
with our former Footaction division, filed a proof of claim in our bankruptcy
proceeding alleging that NAFTA is owed the amount of $3.8 million. In July,
2006, NAFTA amended its claim to $9.1 million plus legal fees and expenses. We
objected to their initial and amended claim and reserved all rights to continue
to object to and challenge any claim by NAFTA on the basis that we do not owe
any amounts to NAFTA. This claim, which is an adversary proceeding in the
bankruptcy court, is currently in the discovery phase. While it is too early to
predict the outcome of this adversary proceeding, we intend to continue to
object and vigorously defend the proof of claim submitted by NAFTA. As a result
we are unable to estimate the amount of liability, if any, in the case of an
unfavorable outcome. In addition, the Company does not believe an amount of loss
in excess of recorded amounts is reasonably possible.
Mr. J. M. Robinson, our former Chairman, President and Chief Executive Officer,
was terminated on September 12, 2003. Mr. Robinson had an employment agreement
with us and initiated arbitration proceedings against us for benefits under such
agreement. In July 2004, the parties agreed to settle such matter for $5.1
million. This amount was accrued in fiscal 2003, and was offset by the reversal
of his $7.2 million Supplemental Executive Retirement Plan liability. In January
2006, the final installment which was due to Mr. Robinson under the settlement
was paid.
A former employee of the Company filed a proof of claim in our bankruptcy
proceeding alleging he
15
FOOTSTAR, INC. and SUBSIDIARY COMPANIES
Notes to the Condensed Consolidated Financial Statements
(Unaudited)
is owed $2,000,000 based on services rendered and agreements entered into during
his employment. We have objected to and intend to vigorously defend this claim.
We are involved in various other claims and legal actions arising in the
ordinary course of business. We do not believe that any of them will have a
material adverse effect on our financial position.
FMI Agreement
During our bankruptcy, we sold certain assets, including, among other things,
our distribution center in Mira Loma, California ("Mira Loma"). We sold Mira
Loma to Thrifty Oil Co. ("Thrifty") for approximately $28.0 million. Thrifty has
leased Mira Loma to FMI International LLC ("FMI"), a logistics provider, which
is obligated to provide us with warehousing and distribution services through
June 30, 2012 under a receiving, warehousing and distribution services agreement
(the "FMI Agreement"). Pursuant to the FMI Agreement, FMI is the Company's
exclusive provider of receiving, warehousing and physical distribution services
for (a) imported product where the Company or its subsidiaries are the importer
of record or (b) landed or domestic shipments controlled within the Company's
supply chain. In 2006, we are obligated to pay FMI a minimum of $15.1 million.
Commencing with calendar year 2007, there are no specified minimum payments due
under the FMI Agreement. The Company's obligation with respect to each calendar
year commencing with 2007 through the end of the term of the FMI Agreement is to
provide FMI with an estimated total unit volume, if any, prior to the start of
such year. Such estimated unit volume, if any, will be the Company's basis for
any minimum quantity commitment for such year.
16
FOOTSTAR, INC. and SUBSIDIARY COMPANIES
ITEM 2. 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:
- the Company's ability to operate within the provisions of the Amended
Master Agreement with Kmart through December 2008;
- the Company's ability to obtain and maintain normal terms with vendors
and service providers;
- the Company's ability to successfully implement and maintain internal
controls and procedures that ensure timely, effective and accurate
financial reporting;
- the Company's ability to reduce overhead costs commensurate with any
decline in sales;
- adverse impact on the Company's business as a result of the ongoing
SEC investigation or relating to increased review and scrutiny by
regulatory authorities, media and others of financial reporting issues
and practices or otherwise;
- the ability to maintain contracts that are critical to the Company's
operations;
- any adverse developments in existing commercial disputes or legal
proceedings;
- the Company's ability to manage and plan for the disposal of, closing
or conversion of Kmart stores; and
- intense competition in the markets in which the Company competes.
The Company's business in Kmart stores is the Company's only continuing business
and substantially all of the Company's continuing net sales and profits result
from this business. The Kmart Settlement will result in the liquidation of the
Company's Kmart business no later than the end of December 2008. If the Company
fails to develop viable business alternatives to offset this business, the
Company will almost certainly be forced to liquidate its business when the Kmart
relationship ends.
Because the information in this Quarterly Report on Form 10-Q 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 do not plan 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 Quarterly Report on Form 10-Q, other than as included in our
future required SEC filings.
17
FOOTSTAR, INC. and SUBSIDIARY COMPANIES
OVERVIEW
The following points highlight the first nine months of operations of 2006 for
the Company and our financial condition as of September 30, 2006:
- On February 7, 2006, the Company successfully emerged from bankruptcy;
- As of September 30, 2006, we operated in 1,393 Kmart stores compared with
1,425 stores on October 1, 2005, and as of September 30, 2006, we operated
in 849 Rite Aid stores in the western region of the United States, compared
with 857 stores on October 1, 2005;
- Operating profit increased to $24.3 million for the nine month period ended
September 30, 2006 as compared to an operating profit of $12.8 million for
the nine month period ended October 1, 2005 primarily due to a reduction in
corporate overhead and other selling, general and administrative expenses
in connection with our emergence from bankruptcy, as well as an increase in
gross profit percentage which offset a decrease in revenue;
- The Company used $125.5 million in cash (from operating activities of its
continuing and discontinued operations) during the first nine months of
2006, of which $123.8 million related to the payment of pre-petition claims
and related interest upon our emergence from bankruptcy;
- As of September 30, 2006, the Company had $68.2 million in cash and cash
equivalents with no loans outstanding under the Credit Facility and standby
letters of credit thereunder totaling $10.7 million. The Company had $62.5
million available for additional borrowing under the Credit Facility as of
September 30, 2006.
KMART SETTLEMENT
Our business relationship with Kmart is extremely important to us. The licensed
footwear departments in Kmart now provide substantially all of our sales and
profits. See Note 6 "Relationship with Kmart" in the Notes to the Condensed
Consolidated Financial Statements.
BUSINESS RELATIONSHIP WITH WAL-MART STORES
Until December 31, 2005, we were supplying Thom McAn family footwear to 1,500
Wal-Mart stores in the United States and 13 stores in Puerto Rico. Beginning in
January 2006, Wal-Mart stopped purchasing Thom McAn product for any of its
stores in the United States. However, Wal-Mart has continued to buy Thom McAn
footwear for Wal-Mart stores in Puerto Rico and has continued to source footwear
from us for Wal-Mart stores under Wal-Mart's proprietary brands. The wholesale
arrangement with Wal-Mart is on an order-by-order basis; therefore, there can be
no certainty regarding future business with Wal-Mart. For the three months ended
September 30, 2006, we had sales of approximately $2.8 million to Wal-Mart
stores in the United States and Puerto Rico, down from approximately $8.3
million for the three months ended October 1, 2005. For the nine months ended
September 30, 2006, we had sales of approximately $6.5 million to Wal-Mart
stores in the United States and Puerto Rico, down from approximately $23.0
million for the nine months ended October 1, 2005.
PRODUCT SOURCING
Product sourcing in the family footwear business is driven by relationships with
foreign manufacturers. Approximately 99% of our products are manufactured in
China where the cost of labor has increased. A portion of our footwear product
is comprised of petrochemical products which have risen in price dramatically
over the past year. Furthermore, higher product prices could
18
FOOTSTAR, INC. and SUBSIDIARY COMPANIES
result from China's July 2005 currency revaluation which allows the value of the
Yuan to link to a trade-weighted basket of currencies rather than being pegged
to the U.S. dollar at a fixed rate. Although we pay for finished goods in U.S.
dollars, it is possible that these costs could be passed on to us through higher
product costs. As a result of these issues, the Company has begun to shift
manufacturing production to lower cost regions of China. It is possible that the
Company could experience lower product quality and/or late shipments in these
new factories which could unfavorably impact the Company's financial results.
RESULTS OF OPERATIONS - THREE MONTHS ENDED SEPTEMBER 30, 2006 VERSUS
THREE MONTHS ENDED OCTOBER 1, 2005
The following is a discussion of the results of operations for the three months
ended September 30, 2006 compared with the three months ended October 1, 2005
(in millions):
2006 VERSUS 2005
% OF SALES - % OF SALES -
2006 2005 2006 2005
------ ------ ------------ ------------
Net Sales $153.6 $161.7 100.0 100.0
------ ------ ----- -----
Gross Profit 45.8 47.8 29.8 29.6
SG&A Expenses 38.1 42.0 24.8 26.0
Depreciation/Amortization 2.0 1.6 1.3 1.0
------ ------ ----- -----
Operating Profit $ 5.7 $ 4.2 3.7 2.6
------ ------ ----- -----
NET SALES
Net sales decreased $8.1 million, or 5.0%, to $153.6 million in 2006 compared
with $161.7 million in 2005. Shoemart sales decreased by $3.6 million or 2.4%
from $148.9 million in 2005 to $145.3 million in 2006 which was due to a
comparable store sales decrease of .5% and average store counts that were down
2.9% versus the prior year period. Rite Aid sales were essentially flat during
the third quarter. The balance of the sales decrease was the result of no longer
selling Thom McAn product within Wal-Mart domestic stores effective at the
beginning of 2006.
GROSS PROFIT
Gross profit decreased $2.0 million or 4.2% to $45.8 million in 2006 compared
with $47.8 million in 2005. The gross profit decrease is largely the result of
the sales decrease described above. The overall gross margin rate increased 0.2%
due to higher average selling prices realized in the Shoemart business.
SG&A EXPENSES
SG&A expenses decreased $3.9 million, or 9.3%, to $38.1 million in 2006 compared
with $42.0 million in 2005. The overall SG&A rate as a percentage of sales
decreased to 24.8% in 2006 versus 26.0% in 2005. SG&A expenses were reduced due
to a reduction in the number of open Shoemart stores along with reduced
corporate overhead resulting from our emergence from bankruptcy.
19
FOOTSTAR, INC. and SUBSIDIARY COMPANIES
DEPRECIATION AND AMORTIZATION
Depreciation and amortization increased $0.4 million to $2.0 million in 2006
compared with $1.6 million in 2005 due to higher trademark amortization expense
recorded in 2006.
OPERATING PROFIT
Operating profit increased $1.5 million to $5.7 million in 2006 compared with
$4.2 million in 2005 primarily due to the increase in the gross margin rate and
decrease in expenses noted above.
REORGANIZATION ITEMS
Reorganization items, which consist of income and expenses that are related to
our bankruptcy were comprised of the following for 2006 and 2005 (in millions):
2006 2005
---- -----
Professional fees $0.2 $ 4.9
Trustee fees -- 1.1
Interest income -- (1.5)
---- -----
Total $0.2 $ 4.5
==== =====
Reorganization items decreased $4.3 million to $0.2 million in 2006 compared
with $4.5 million in 2005 primarily because we emerged from bankruptcy on
February 7, 2006.
SOP 90-7 requires that interest income earned on cash accumulated during
bankruptcy proceedings be included as a reorganization item. During the third
quarter 2006 and 2005, interest income of $0 million and $1.5 million,
respectively, was earned on cash that would otherwise have been used to pay such
pre-petition liabilities.
RESULTS OF OPERATIONS - NINE MONTHS ENDED SEPTEMBER 30, 2006 VERSUS
NINE MONTHS ENDED OCTOBER 1, 2005
The following is a discussion of the results of operations for the nine months
ended September 30, 2006 compared with the nine months ended October 1, 2005 (in
millions):
2006 VERSUS 2005
% OF SALES - % OF SALES -
2006 2005 2006 2005
------ ------ ------------ ------------
Net Sales $478.1 $509.1 100.0 100.0
------ ------ ----- -----
Gross Profit 150.1 154.7 31.4 30.4
SG&A Expenses 119.3 136.6 25.0 26.8
Depreciation/Amortization 6.5 5.3 1.4 1.0
------ ------ ----- -----
Operating Profit $ 24.3 $ 12.8 5.1 2.5
====== ====== ===== =====
20
FOOTSTAR, INC. and SUBSIDIARY COMPANIES
NET SALES
Net sales decreased $31.0 million, or 6.1%, to $478.1 million in 2006 compared
with $509.1 million in 2005. Shoemart sales were approximately $456.0 million in
2006 and $473.0 million in 2005 for a 3.6% decrease during the first nine months
of 2006. The Shoemart sales decrease was the result of comparable store sales
that were down 0.2% and average store counts that were 4.3% lower than last
year. Rite Aid sales through the first nine months of 2006 were up 4.7% or $0.6
million. The balance of the sales decrease during the first nine months of 2006
was the result of no longer selling Thom McAn product within Wal-Mart domestic
stores effective at the beginning of 2006.
GROSS PROFIT
Gross profit decreased $4.6 million or 3.0% to $150.1 million in 2006 compared
with $154.7 million in 2005. The gross margin decline is due to the lower sales
volumes in 2006; however, the gross margin rate improved from 30.4% to 31.4%
during 2006. The improvement in gross margin rate is predominantly due to higher
average selling prices across both regular and promotional product lines.
SG&A EXPENSES
SG&A expenses decreased $17.3 million, or 12.7%, to $119.3 million in 2006
compared with $136.6 million in 2005. The overall SG&A rate as a percentage of
sales decreased to 25.0% in 2006 versus 26.8% in 2005. SG&A expenses were
reduced due to a reduction in the number of open Shoemart stores along with
reduced corporate overhead resulting from our emergence from bankruptcy.
DEPRECIATION AND AMORTIZATION
Depreciation and amortization increased $1.2 million to $6.5 million in 2006
compared with $5.3 million in 2005 due to higher trademark amortization expense
recorded in 2006.
OPERATING PROFIT
Operating profit increased $11.5 million to $24.3 million in 2006 compared with
$12.8 million in 2005 primarily due to the increase in the gross margin rate and
decrease in expenses noted above.
REORGANIZATION ITEMS
Reorganization items, which consist of income and expenses that are related to
our bankruptcy were comprised of the following for 2006 and 2005 (in millions):
2006 2005
----- -----
Store and distribution center closing and
related asset impairment costs $ -- $ 0.1
Professional fees 1.4 14.9
Trustee fees 0.1 3.1
Gain on disposition of bankruptcy claims (0.5) --
Interest income (0.7) (4.0)
----- -----
Total $ 0.3 $14.1
===== =====
21
FOOTSTAR, INC. and SUBSIDIARY COMPANIES
Reorganization items decreased $13.8 million to $0.3 million in 2006 compared
with $14.1 million in 2005 primarily because we emerged from bankruptcy on
February 7, 2006.
The disposition of bankruptcy claims resulted in an increase of $0.5 million in
income from continuing operations in 2006.
SOP 90-7 requires that interest income earned on cash accumulated during
bankruptcy proceedings be included as a reorganization item. During fiscal 2006
and 2005, interest income of $0.7 million and $4.0 million, respectively, was
earned on cash that would otherwise have been used to pay such pre-petition
liabilities.
LIQUIDITY AND CAPITAL RESOURCES
Our principal sources of liquidity used in funding short-term operations are our
current balances in cash and cash equivalents, operating cash flows and
borrowings available under our revolving credit facility (the "Credit
Facility"). The Credit Facility is structured to support general corporate
borrowing requirements. We also continue to benefit from improved payment terms
obtained from our vendors and factories overseas, which began in December 2004.
Subsequent to our emergence from Chapter 11 through September 30, 2006, we made
payments to creditors totaling $123.8 million, including interest where
applicable. These payments exclude claims for approximately $7.3 million which
we expect will be paid, with interest where applicable, upon final resolution.
Such distributions were and are expected to be paid from existing cash balances.
Net cash used in operating activities of continuing operations for the first
nine months of 2006 was $32.2 compared to cash used in operating activities of
continuing operations of $37.1 million for the first nine months of 2005. Cash
used in operating activities of continuing operations for the first nine months
of 2006 offset net income of $24.3 million and consisted primarily of payments
of pre-petition claims and interest of $31.0 million, an increase in inventory
of $20.7 million and a reduction of accounts payable and accrued expenses of
$49.8 million, primarily related to the payment of emergence related expenses.
In addition, the Company decreased prepaid expenses, deferred charges and other
assets by approximately $10.5 million, which primarily related to the collection
of income tax refunds. In the first nine months of 2005, the Company used $37.1
million in cash from operating activities of continuing operations primarily
from a decrease in accounts payable, accrued expenses and amount due Kmart under
the Kmart Settlement.
Cash used in investing activities was $1.6 million and $0.8 million in financing
activities in the first nine months of 2006 compared to using $0.4 million in
cash in investing activities and $0 million in cash in financing activities in
the first nine months of 2005.
Cash used in operating activities of discontinued operations was $93.3 million
in the first nine months of 2006 compared with cash provided by operating
activities of discontinued operations of $2.1 million in the first nine months
of 2005. Cash used in operating activities of discontinued operations for the
first nine months of 2006 consisted primarily of payments of pre-petition claims
and interest.
22
FOOTSTAR, INC. and SUBSIDIARY COMPANIES
Factors that could affect our short and long term liquidity include, among other
things, maintaining the support of our key vendors and lenders, retaining key
personnel, the impact of subsequent financial results and the timing of the
wind-down and ultimate liquidation of our Kmart business, many of which are
beyond our control. If the Company does not develop viable business alternatives
to offset the termination of its Kmart business, it is expected that the Company
will be required to liquidate its business by no later than the end of 2008.
Although we cannot reasonably assess the impact of these or other uncertainties,
we believe that our current cash, together with cash generated from operations
and borrowings available under our Credit Facility, will be sufficient to fund
our expected operating expenses, capital expenditures and working capital needs
during the next 12 to 18 months.
On February 7, 2006, upon our emergence from Chapter 11 we entered into a new
$100 million senior-secured revolving Credit Facility (containing a sub-limit
for issuance of letters of credit). We may borrow up to $100 million under the
Credit Facility subject to a sufficient borrowing base (based upon eligible
inventory and accounts receivable), and other terms of the facility. Revolving
loans under the Credit Facility bear interest, at our option, either at the
prime rate plus a variable margin of 0.0% to 0.5% or the London Interbank
Offered Rate ("LIBOR") plus a variable margin of 1.75% to 2.50%. The variable
margin is based upon quarterly excess availability levels specified in the
Credit Facility. A quarterly fee of 0.3% per annum is payable to the lenders on
the unused balance. The Credit Facility has a maturity date of the earlier of
November 30, 2008 and thirty days prior to the termination of the Amended Master
Agreement.
The Credit Facility is secured by substantially all of the assets of the Company
and contains various affirmative and negative covenants, representations,
warranties and events of default to which we are subject, including certain
financial covenants and restrictions such as limitations on additional
indebtedness, other liens, dividends, stock repurchases and capital
expenditures. The Company is required to maintain minimum excess availability
equal to at least (a) 5% of the borrowing base for the first twelve months
following the Company's emergence from bankruptcy (i.e., February 7, 2007) and
(b) 10% thereafter. In addition, if minimum excess availability falls below 20%
of the borrowing base, we will be subject to a fixed charge coverage covenant.
The Company is currently in compliance with the Credit Facility.
The Credit Facility also includes representations and warranties, that, on an
ongoing basis, there are no material adverse events affecting our business,
operations, property, assets, or condition and that the Amended Master Agreement
is in full force and effect and not in default. A failure by us to satisfy any
of the covenants, representations or warranties would result in default or other
adverse impact under the Credit Facility.
As of September 30, 2006, the Company had no loans outstanding under the Credit
Facility, standby letters of credit outstanding totaling $10.7 million and $62.5
million available for additional borrowings under the Credit Facility.
CRITICAL ACCOUNTING ESTIMATES
Our discussion of results of operations and financial condition relies on our
condensed consolidated financial statements that are prepared based on certain
critical accounting estimates that require management to make judgments and
estimates that are subject to varying degrees of uncertainty. We believe that
investors need to be aware of these policies and how they impact our financial
23
FOOTSTAR, INC. and SUBSIDIARY COMPANIES
statements as a whole, as well as our related discussion and analysis presented
herein. While we believe that these accounting estimates are based on sound
measurement criteria, actual future events can and often do result in outcomes
that can be materially different from these estimates or forecasts.
The accounting estimates and related risks described in our Annual Report on
Form 10-K/A for the fiscal year ended December 31, 2005 are those that depend
most heavily on these judgments and estimates. As of September 30, 2006, there
have been no material changes to any of the critical accounting estimates
contained therein.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
DERIVATIVES
As of September 30, 2006, we were not materially exposed to changes in the
underlying values of our assets or liabilities nor were we materially exposed to
changes in the value of expected foreign currency cash flows. We historically
have not entered into derivative instruments for any purpose other than to
manage our interest rate exposure. We do not hold derivative financial
investments for trading or speculative purposes.
INTEREST RATES
Revolving loans under our Credit Facility bear interest at rates that are tied
to the LIBOR and the Prime Rate and therefore, our condensed consolidated
financial statements could be exposed to changes in interest rates. We did not
incur loans under our Credit Facility at any point during the nine months ended
September 30, 2006, or as of the date of this filing. We assess interest rate
cash flow risk by identifying and monitoring changes in interest rate exposures
that may adversely impact expected future cash flows and by evaluating hedging
opportunities. The Company has engaged in interest rate hedging agreements in
the past for purposes of limiting portions of interest rate expense in
connection with outstanding variable rate debt.
FOREIGN EXCHANGE
A significant percentage of the Company's products are sourced or manufactured
offshore, with China accounting for approximately 99% of all sources. Our
offshore product sourcing and purchasing activities are currently, and have been
historically, denominated in U.S. dollars, and, therefore, we do not currently
have material exposure to cash flows denominated in foreign currencies nor have
net foreign exchange gains or losses been material to operating results in the
reporting periods presented in this report.
Historically, China's national currency, the Yuan, was pegged to the U.S. Dollar
at a fixed rate. However, in July 2005, the Chinese government revalued the Yuan
allowing its value to now link to a trade-weighted basket of currencies. If the
exchange rate of the Chinese Yuan were to continue increasing versus the U.S.
Dollar, the Company may experience higher product costs with regards to
inventory purchased from China.
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FOOTSTAR, INC. and SUBSIDIARY COMPANIES
ITEM 4. CONTROLS AND PROCEDURES
Under the supervision of our Chief Executive Officer and Senior Vice President,
Chief Financial Officer, management conducted an evaluation of the effectiveness
of the design and operation of our disclosure controls and procedures (as such
term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange
Act of 1934, as amended (the "Exchange Act")) as of the end of the period
covered by this report (the "Evaluation Date"). There are inherent limitations
to the effectiveness of any system of disclosure controls and procedures,
including the possibility of human error and the circumvention or overriding of
the controls and procedures. Accordingly, even effective disclosure controls and
procedures can only provide reasonable assurance of achieving their control
objectives. Based on such evaluation, the Chief Executive Officer and Senior
Vice President, Chief Financial Officer concluded that, as of the Evaluation
Date, our disclosure controls and procedures were effective at a reasonable
assurance level.
There were no changes in our internal control over financial reporting during
the quarterly period covered by this report that have materially affected, or
are reasonably likely to materially affect, our internal controls over financial
reporting.
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FOOTSTAR, INC. and SUBSIDIARY COMPANIES
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The information set forth on page 15 with respect to the NAFTA litigation under
the caption "Other Litigation Matters" in Note 13 to the Condensed Consolidated
Financial Statements is incorporated herein by reference.
ITEM 1A. RISK FACTORS
The Risk Factors included in the Company's Annual Report on Form 10-K/A for the
fiscal year ended December 31, 2005, have not materially changed, but given the
termination of the Company's principal business relationship with Kmart no later
than December 31, 2008 and the difficulty of the Company's ability to manage and
plan for the disposal of, conversion, or closing of additional Kmart stores, we
are repeating these factors below.
OUR KMART FOOTWEAR DEPARTMENTS ARE OUR ONLY CONTINUING BUSINESS AND
SUBSTANTIALLY ALL OF OUR CONTINUING NET SALES AND PROFITS RESULT FROM OUR
BUSINESS IN KMART STORES. THE AMENDED MASTER AGREEMENT PROVIDES FOR THE
LIQUIDATION OF OUR KMART BUSINESS NO LATER THAN THE END OF DECEMBER 2008 AND
ALLOWS FOR EARLIER TERMINATION IF WE FAIL TO MEET THE MINIMUM SALES TESTS,
STAFFING OBLIGATIONS OR OTHER PROVISIONS OF SUCH AGREEMENT. IF WE FAIL TO
DEVELOP VIABLE BUSINESS ALTERNATIVES TO OFFSET THIS BUSINESS WE WILL ALMOST
CERTAINLY BE FORCED TO LIQUIDATE WHEN THE KMART RELATIONSHIP ENDS.
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 and will seek to implement additional
programs to retain key executives and employees as necessary. 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, or put in place additional retention programs, it could adversely
affect our businesses. This risk is acute given the anticipated liquidation of
our Kmart business no later than the end of 2008 as a result of the Kmart
Settlement.
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 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. Also, if these foreign
manufacturers are unable to secure sufficient supplies of raw materials or
maintain adequate manufacturing capacity, they may be unable to provide us 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. A portion of our footwear product is comprised of petrochemical
products which have risen in price dramatically over the past year. It is very
possible that these raw material price increases will be passed on to us.
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FOOTSTAR, INC. and SUBSIDIARY COMPANIES
Furthermore, higher product prices could result from the recent decision by the
Chinese government to revalue their currency. Although we pay for finished goods
in U.S. dollars, it is possible that higher labor costs due primarily to the
currency revaluation could be passed on to us through higher product costs. If
we cannot recover these cost increases with increased pricing to our customers,
it could have a material adverse effect on our operations and financial
condition.
The Company is managing against possible product cost increases by shifting
manufacturing production to lower cost regions of China. While the Company is
exercising considerable diligence in selecting new factories, it is possible
that the Company could experience lower product quality and/or late shipments
from these new factories which could unfavorably impact the Company's financial
results.
We also depend on third parties to receive, transport and deliver our products.
If these third parties are unable to perform for any reason, or if they increase
the price of their services as a result of increases in the cost of fuel, there
could be a material adverse effect on our operations and financial performance.
WE ARE THE SUBJECT OF AN SEC ENFORCEMENT INVESTIGATION AND CANNOT YET DETERMINE
WHETHER ANY FINES WILL BE IMPOSED ON US BY THE SEC AND IF SO, WHAT THE IMPACT OF
ANY FINE OR SANCTION WILL BE ON OUR BUSINESS.
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 an enforcement proceeding, including
an investigation into the facts and circumstances giving rise to the
restatement. As we announced on February 10, 2006, the Company received a Wells
notice from the SEC staff in connection with the enforcement investigation.
Under SEC procedures, a Wells notice indicates that the staff has made a
preliminary decision to recommend that the SEC authorize the staff to bring a
civil or administrative action against the recipient of the notice. The Wells
notice that Footstar received states that the SEC staff, as a result of its
investigation, is considering recommending that the SEC bring a civil injunctive
action against the Company for alleged violations of provisions of the
Securities Exchange Act of 1934 relating to the maintenance of books, records
and internal accounting controls, the establishment of disclosure controls and
procedures and the periodic filing requirements of Sections 10(b), 13(a) and
13(b)(2) of the Exchange Act and in SEC Rules 10b-5, 12b-20, 13a-1 and 13a-13. A
recipient of a Wells notice can respond to the SEC staff before the staff makes
a formal recommendation regarding whether the SEC should bring any action.
Footstar has been, and intends to continue, cooperating fully with the SEC staff
in connection with this matter and is in discussions with the staff regarding
the possible resolution of this matter. We cannot predict the outcome of this
proceeding.
For a further description of our restatement related litigation, see
"Restatement Related Proceedings" under Item 3 - Legal Proceedings.
WE HAVE HAD MATERIAL WEAKNESSES IN INTERNAL CONTROL OVER FINANCIAL REPORTING AND
CANNOT ASSURE YOU THAT MATERIAL WEAKNESSES WILL NOT BE IDENTIFIED IN THE FUTURE.
OUR FAILURE TO EFFECTIVELY MAINTAIN INTERNAL CONTROL OVER FINANCIAL REPORTING
CAN RESULT IN MATERIAL MISSTATEMENTS IN OUR
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FOOTSTAR, INC. and SUBSIDIARY COMPANIES
FINANCIAL STATEMENTS WHICH COULD REQUIRE US TO RESTATE FINANCIAL STATEMENTS,
CAUSE INVESTORS TO LOSE CONFIDENCE IN OUR REPORTED FINANCIAL INFORMATION AND
HAVE A NEGATIVE EFFECT ON OUR STOCK PRICE.
We and our independent registered public accounting firm determined that we had
deficiencies in our internal control over financial reporting during fiscal 2004
that constitute "material weaknesses" as defined by the Public Company
Accounting Oversight Board's Audit Standard No. 2.
Although these material weaknesses have been remediated, we cannot assure you
that additional other weaknesses in our internal control over financial
reporting will not be identified in the future. Any failure to maintain or
implement required new or improved controls, or any difficulties we encounter in
their implementation, could result in other material weaknesses, cause us to
fail to meet our periodic reporting obligations or result in material
misstatements in our financial statements. Any such failure could also adversely
affect the results of periodic management evaluations and annual auditor
attestation reports regarding the effectiveness of our internal control over
financial reporting required under Section 404 of Sarbanes-Oxley and the rules
promulgated under Section 404. The existence of a material weakness could also
cause investors to lose confidence in our reported financial information,
leading to a decline in our stock price.
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, among other
things, the costs associated with operating as a public company and a
substantial portion of our labor expenses. As our sales continue to decline with
the disposition, closing or conversion of Kmart stores, we will be unable to
reduce our operating expenses proportionately. In accordance with the Kmart
Settlement, if Kmart store sales fall below a certain threshold, as defined, the
Amended Master Agreement may be terminated early.
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. The events that caused us to seek bankruptcy protection in 2004 and
the terms of the Kmart Settlement put us at a disadvantage with respect to our
competitors, many of which are growing rapidly and have substantial financial
and marketing resources which are unavailable to us. If we are unable to
overcome this disadvantage and respond effectively to our competitors, we may be
forced to liquidate our operations.
THERE ARE RISKS ASSOCIATED WITH OUR IMPORTATION OF PRODUCTS.
Approximately 99% of the Company'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
28
FOOTSTAR, INC. and SUBSIDIARY COMPANIES
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.
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.
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, including sustained increases in gasoline prices, 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 or an unusually warm
winter, 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.
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FOOTSTAR, INC. and SUBSIDIARY COMPANIES
ITEM 6. EXHIBITS
Exhibit 31.1 Certification of Chief Executive Officer pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002.
Exhibit 31.2 Certification of Senior Financial Officer and Chief Financial
Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
Exhibit 32.1 Certifications pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Footstar, Inc.
Date: November 8, 2006 By: /s/ Jeffrey A. Shepard
------------------------------------
Jeffrey A. Shepard
Chief Executive Officer and
President
Date: November 8, 2006 By: /s/ Michael J. Lynch
------------------------------------
Michael J. Lynch
Senior Vice President, Chief
Financial Officer
Date: November 8, 2006 By: /s/ Craig M. Haines
------------------------------------
Craig M. Haines
Vice President, Controller,
Principal Accounting Officer
30