10-Q 1 c00582e10vq.txt QUARTERLY REPORT SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) [XX] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD (13 WEEKS) ENDED OCTOBER 29, 2005 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _______________________ to _____________________ Commission file number 1-10876 SHOPKO STORES, INC. (Exact name of registrant as specified in its Charter) Wisconsin 41-0985054 --------------------------------- ------------------------------------ (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) 700 Pilgrim Way, Green Bay, Wisconsin 54304 ----------------------------------------- -------------- (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code (920) 429-2211 Former name, former address and former fiscal year, if changed since last report: N/A -------------------------------------------------------------------------------- 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 report(s), 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 an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ] Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X] The number of shares outstanding of each of the issuer's classes of Common Stock as of December 2, 2005 is as follows:
Title of Each Class Shares Outstanding ------------------- ------------------ Common Shares 30,266,726
Exhibit Index Page 1 of Page 36 on Page 29 1 SHOPKO STORES, INC. FORM 10-Q FOR THE 13 WEEKS ENDED OCTOBER 29, 2005 INDEX
Page ----- Part I Item 1 - Financial Statements Condensed Consolidated Statements of Operations for the 13 weeks ended October 29, 2005 and October 30, 2004 3 Condensed Consolidated Statements of Operations for the 39 weeks ended October 29, 2005 and October 30, 2004 4 Condensed Consolidated Balance Sheets as of October 29, 2005, October 30, 2004 and January 29, 2005 5 Condensed Consolidated Statements of Cash Flows for the 39 weeks ended October 29, 2005 and October 30, 2004 6 Condensed Consolidated Statement of Shareholders' Equity for the 39 weeks ended October 29, 2005 7 Notes to Condensed Consolidated Financial Statements 8-12 Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations 13-25 Item 3 - Quantitative and Qualitative Disclosures About Market Risk 25 Item 4 - Controls and Procedures 25 Part II Item 1 - Legal Proceedings 26 Item 6 - Exhibits 26-27 Signatures 28
2 PART I - FINANCIAL INFORMATION ITEM 1: FINANCIAL STATEMENTS CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS SHOPKO STORES, INC. AND SUBSIDIARIES (In thousands, except per share data)
THIRD QUARTER (13 WEEKS) ENDED ------------------------------ OCTOBER 29, OCTOBER 30, 2005 2004 ----------- ----------- (UNAUDITED) (UNAUDITED) Revenues: Net sales $ 704,845 $ 746,391 Licensed department rentals and other income 3,425 3,497 ----------- ----------- 708,270 749,888 Costs and expenses: Cost of sales 511,843 554,175 Selling, general and administrative expenses 168,136 162,684 Depreciation and amortization expenses 19,739 20,916 Merger-related expenses 16,256 - ----------- ----------- 715,974 737,775 (Loss) income from operations (7,704) 12,113 Interest expense 6,785 8,840 ----------- ----------- (Loss) income before income taxes (14,489) 3,273 Income tax (benefit) provision (383) 1,278 ----------- ----------- Net (loss) income $ (14,106) $ 1,995 =========== =========== Net (loss) income per share of common stock: Basic $ (0.47) $ 0.07 =========== =========== Diluted $ (0.47) $ 0.07 =========== =========== Weighted average number of common shares outstanding: Basic 30,211 29,362 Diluted 30,211 29,683
See notes to condensed consolidated financial statements. 3 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS SHOPKO STORES, INC. AND SUBSIDIARIES (In thousands, except per share data)
YEAR TO DATE (39 WEEKS) ENDED ----------------------------- OCTOBER 29, OCTOBER 30, 2005 2004 ----------- ----------- (UNAUDITED) (UNAUDITED) Revenues: Net sales $ 2,145,099 $ 2,257,000 Licensed department rentals and other income 10,384 9,847 ----------- ----------- 2,155,483 2,266,847 Costs and expenses: Cost of sales 1,558,989 1,677,679 Selling, general and administrative expenses 489,695 486,630 Depreciation and amortization expenses 61,265 63,574 Merger-related expenses 19,095 - ----------- ----------- 2,129,044 2,227,883 Income from operations 26,439 38,964 Interest expense 21,148 25,985 ----------- ----------- Income before income taxes 5,291 12,979 Income tax provision 7,235 5,064 ----------- ----------- Net (loss) income $ (1,944) $ 7,915 =========== =========== Net (loss) income per share of common stock: Basic $ (0.06) $ 0.27 =========== =========== Diluted $ (0.06) $ 0.27 =========== =========== Weighted average number of common shares outstanding: Basic 30,004 29,288 Diluted 30,004 29,553
See notes to condensed consolidated financial statements. 4 CONDENSED CONSOLIDATED BALANCE SHEETS SHOPKO STORES, INC. AND SUBSIDIARIES (In thousands)
THIRD QUARTER AS OF FISCAL YEAR END -------------------------- --------------- OCTOBER 29, OCTOBER 30, JANUARY 29, 2005 2004 2005 * ----------- ----------- ----------- (UNAUDITED) (UNAUDITED) ASSETS Current assets: Cash and cash equivalents $ 33,215 $ 29,280 $ 25,110 Receivables, less allowance for losses of $2,149 $2,438 and $1,833, respectively 50,574 55,398 62,019 Merchandise inventories 646,832 701,953 564,099 Other current assets 6,646 8,241 9,046 ----------- ----------- ----------- Total current assets 737,267 794,872 660,274 Other assets and deferred charges 8,904 7,943 9,037 Intangible assets, net of accumulated amortization of $15,873, $12,825 22,877 28,984 21,865 and $13,330, respectively Property and equipment, net of accumulated depreciation of $868,403, $828,447 and $828,768; impairment reserve of $686, $4,004 and $1,660, respectively 687,541 757,254 742,027 ----------- ----------- ----------- Total assets $ 1,456,589 $ 1,589,053 $ 1,433,203 =========== =========== =========== LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Short-term debt $ 65,000 $ 156,101 $ 85,679 Accounts payable - trade 280,323 297,489 225,777 Accrued compensation and related taxes 34,427 37,287 37,088 Deferred taxes and other accrued liabilities 112,534 113,873 104,903 Accrued income and other taxes 33,209 29,087 49,760 Current portion of long-term obligations and leases 6,288 62,304 8,018 ----------- ----------- ----------- Total current liabilities 531,781 696,141 511,225 Long-term obligations and leases, less current portion 230,297 240,637 238,612 Other long-term obligations 23,975 21,838 21,976 Deferred income taxes 22,039 29,791 22,963 Shareholders' equity: Common stock 322 314 316 Additional paid-in capital 408,296 394,016 396,514 Retained earnings 280,587 246,882 282,261 Less treasury stock (40,708) (40,566) (40,664) ----------- ----------- ----------- Total shareholders' equity 648,497 600,646 638,427 ----------- ----------- ----------- Total liabilities and shareholders' equity $ 1,456,589 $ 1,589,053 $ 1,433,203 =========== =========== ===========
* Condensed from audited financial statements. See notes to condensed consolidated financial statements. 5 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS SHOPKO STORES, INC. AND SUBSIDIARIES (In thousands)
YEAR TO DATE (39 WEEKS) ENDED ----------------------------- OCTOBER 29, OCTOBER 30, 2005 2004 ----------- ----------- (UNAUDITED) (UNAUDITED) Cash flows from operating activities: Net (loss) income $ (1,944) $ 7,915 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 61,265 63,574 Impairment charges 570 672 Gain on sale of property and equipment (4,106) (2,821) Deferred income taxes 3,380 6,987 Change in assets and liabilities: Receivables 11,445 7,410 Merchandise inventories (82,733) (132,637) Other current assets 2,400 2,634 Other assets 2,118 831 Accounts payable 54,546 44,176 Accrued liabilities (19,142) (12,702) Other long-term obligations 1,999 (3,367) ---------- ----------- Net cash provided by (used in) operating activities 34,996 (17,328) ---------- ----------- Cash flows from investing activities: Purchases of property and equipment (20,490) (50,799) Proceeds from the sale of property and equipment 18,768 14,948 Net payments for pharmacy customer lists (3,281) (7,410) ---------- ----------- Net cash (used in) investing activities (5,003) (43,261) ---------- ----------- Cash flows from financing activities: Proceeds from short-term borrowings 0 73,832 Payments of debt and capital lease obligations (31,596) (8,119) Sale of common stock due to exercise of stock options 9,752 1,622 Purchase of treasury stock (44) (252) ---------- ----------- Net cash (used in) provided by financing activities (21,888) 67,083 ---------- ----------- Net increase in cash and cash equivalents 8,105 6,494 Cash and cash equivalents at beginning of period 25,110 22,786 ---------- ----------- Cash and cash equivalents at end of period $ 33,215 $ 29,280 ---------- -----------
See notes to condensed consolidated financial statements. 6 CONDENSED CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY SHOPKO STORES, INC. AND SUBSIDIARIES (In thousands) (UNAUDITED)
Common Stock Additional Treasury Stock Total --------------- Paid-in Retained ------------------ ----------------- Shares Amount Capital Earnings Shares Amount Shares Amount ------ ------ ---------- --------- ------ -------- ------ -------- BALANCES AT JANUARY 29, 2005 31,580 $ 316 $ 396,514 $ 282,261 (1,930) $(40,664) 29,650 $638,427 Net (loss) (1,944) (1,944) Issuance of restricted stock 10 219 (219) 10 -0- Forfeiture of restricted stock (25) (325) 325 (25) -0- Sales of common stock under option plans 630 6 9,746 630 9,752 Income tax benefit related to stock options 2,142 2,142 Restricted stock expense 164 164 Purchase of treasury stock (2) (44) (2) (44) ------ ------ ---------- --------- ------ -------- ------ -------- BALANCES AT OCTOBER 29, 2005 32,195 $ 322 $ 408,296 $ 280,587 (1,932) $(40,708) 30,263 $648,497 ====== ====== ========== ========= ====== ======== ====== ========
See notes to condensed consolidated financial statements. 7 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) A. Interim Financial Statements The Company operates on a 52/53-week fiscal year basis. The 2005 fiscal year will end on January 28, 2006 and the 2004 fiscal year ended January 29, 2005. The accompanying condensed consolidated financial statements have been prepared by the Company without audit. However, the foregoing financial statements reflect all adjustments (which include only normal recurring adjustments) which are, in the opinion of Company management, necessary to present fairly the consolidated financial position of the Company as of October 29, 2005 and October 30, 2004, and the results of operations and cash flows for the then ended periods. These interim results are not necessarily indicative of the results of the fiscal years as a whole because the operations of the Company are highly seasonal. The fourth fiscal quarter has historically contributed a significant part of the Company's earnings due to the Christmas selling season. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted, pursuant to the rules and regulations of the Securities and Exchange Commission. The Company's fiscal 2004 Annual Report on Form 10-K, as amended, contains a summary of significant accounting policies and includes the consolidated financial statements and the notes to the consolidated financial statements. The same accounting policies are followed in the preparation of interim reports. The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the Company's consolidated financial statements and notes thereto for the fiscal year ended January 29, 2005. B. Restructuring Reserve In connection with the reorganization plan announced in the fourth quarter of fiscal 2000 to close 23 ShopKo retail stores, a distribution center, and to downsize its corporate workforce, the Company incurred a pre-tax charge of $125.0 million related to inventory and property write-downs, lease termination and property carrying costs, and employee separation and other costs. The inventory and fixed asset write-down reserves were recorded in the fourth quarter of fiscal 2000, and the Company closed all 23 stores and a distribution center in fiscal 2001. The Company utilized all of the employee severance reserve prior to fiscal 2002. Of the 24 properties initially covered by the restructuring reserve, twenty were disposed of in subsequent years, leaving four remaining leased properties covered by the restructuring reserve as of the beginning of fiscal 2005. During the third quarter of fiscal 2005, no additional leases were terminated. As of October 29, 2005, the remaining reserve for lease termination and related property carrying costs, as well as other costs, was $12.4 million. For balance sheet reporting purposes, the portion of the reserve for the lease termination, property carrying and other costs to be paid in the next 12 months is reported in accrued expenses ($1.8 million) as a current liability and the remainder ($10.6 million) is recorded in other long-term obligations at October 29, 2005. The Company believes the reserves are adequate, and continues to negotiate lease terminations with landlords. However, due to the Company's inability to terminate the leases or to sublease the four locations, the level of reserves could prove to be inadequate and additional charges may be required. The Company will continue to evaluate the adequacy of the amounts reserved as it proceeds with the termination of the leases. 8 Activity in the restructuring reserve (in thousands) during the first three quarters of fiscal 2005:
Lease termination and property carrying costs ----------------------- Balance as of January 29, 2005 $ 13,329 Cash Payments 884 ------------ Balance as of October 29, 2005 $ 12,445 ============
C. Stock-Based Employee Compensation Plans The Company has various stock-based employee compensation plans, which are described more fully in Note F of the Notes to Consolidated Financial Statements in the Company's fiscal 2004 Annual Report on Form 10-K, as amended. The Company accounts for those plans under the recognition and measurement principles of APB Opinion No. 25, "Accounting for Stock Issued to Employees," and related Interpretations. No stock-based employee compensation cost is reflected in results of operations for stock option awards, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. During the first three quarters of fiscal 2005, pre-tax expense related to the intrinsic value of restricted stock was $0.2 million compared with $0.5 million last year. The following pro forma information illustrates the effect on net earnings and earnings per share as if the Company had applied the fair value recognition provisions of FASB Statement No. 123, "Accounting for Stock-Based Compensation," in accounting for its employee stock options (in thousands):
THIRD QUARTER YEAR TO DATE (13 WEEKS) ENDED (39 WEEKS) ENDED ----------------------------- ---------------------------- Oct 29, 2005 Oct 30, 2004 Oct 29, 2005 Oct 30, 2004 ------------ -------------- ------------ ------------ Net (loss)income as reported $ (14,106) $ 1,995 $ (1,944) $ 7,915 Add: Stock-based employee compensation expense included in reported net income, net of related tax effects 44 114 101 309 Deduct: Total stock-based employee compensation expense determined under fair value method for all share and option awards, net of related tax effects (394) (625) (1,008) (1,773) ------------ -------------- ------------ ------------ Pro forma net (loss) income $ (14,456) $ 1,484 $ (2,851) $ 6,451 ============ ============== ============ ============ Net (loss) income per share: Basic - as reported $ (0.47) $ 0.07 $ (0.06) $ 0.27 Basic - pro forma $ (0.48) $ 0.05 $ (0.10) $ 0.22 Diluted - as reported $ (0.47) $ 0.07 $ (0.06) $ 0.27 Diluted - pro forma $ (0.48) $ 0.05 $ (0.10) $ 0.22
9 D. Business Segment Information The Company's reportable segments are based on the Company's strategic business operating units and include a ShopKo Retail segment and a Pamida Retail segment, each of which includes the following product categories: hardlines/home, softlines, and retail health services. The accounting policies of the segments are the same as those described in the summary of significant accounting policies in the Company's fiscal 2004 Annual Report on Form 10-K, as amended. The Company evaluates performance based on earnings from operations of the respective business segments. Summary financial information concerning the Company's reportable segments is shown in the following table (in thousands):
THIRD QUARTER (13 WEEKS) ENDED YEAR TO DATE (39 WEEKS) ENDED ------------------------------ ----------------------------- OCTOBER 29, OCTOBER 30, OCTOBER 29, OCTOBER 30, 2005 2004 2005 2004 ----------- ----------- ----------- ----------- Net sales ShopKo Retail $ 522,152 $ 553,134 $ 1,573,260 $ 1,674,734 Pamida Retail 182,693 193,257 571,839 582,266 ----------- ----------- ----------- ----------- Total net sales $ 704,845 $ 746,391 $ 2,145,099 $ 2,257,000 ----------- ----------- ----------- ----------- Earnings (loss) from operations ShopKo Retail $ 13,781 $ 18,466 $ 55,036 $ 55,625 Pamida Retail 2,024 (351) 11,538 3,378 Corporate (23,509) (6,002) (40,135) (20,039) ----------- ----------- ----------- ----------- Earnings (loss) from operations $ (7,704) $ 12,113 $ 26,439 $ 38,964 ----------- ----------- ----------- -----------
The Company's areas of operations are principally in the United States. No major customer accounted for a significant amount of consolidated revenue during the third quarter and first three quarters of fiscal 2005 and fiscal 2004. E. Commitments & Contingencies The Company is contingently liable on the lease payments for two former retail stores, which were assumed by an unrelated party. Total remaining lease obligations for the stores are $9.0 million as of October 29, 2005. F. Merger ShopKo entered into a merger agreement (the "Badger Merger Agreement"), dated April 7, 2005, with Badger Retail Holding, Inc. ("Badger Retail Holding") pursuant to which Badger Retail Holding would acquire all of the outstanding common stock of ShopKo for $24.00 per share. The merger agreement was amended on September 9, 2005 to $25.00 per share, and was subsequently amended to $25.50 per share on September 29, 2005. On October 18, 2005, a special committee of the Company's board of directors determined that a binding offer from SKO Group Holding Corp. ("SKO Group Holding"), a newly-formed Delaware corporation which is affiliated with Sun Capital Partners IV, L.P. ("Sun Capital Partners IV"), pursuant to which SKO Group Holding would acquire ShopKo, constituted a "superior proposal" as defined in the Badger Merger Agreement. The acquisition by SKO Group Holding would be effected by the merger of SKO Acquisition Corp. ("SKO Acquisition"), a wholly owned subsidiary of SKO Group Holding, with and into ShopKo, with ShopKo continuing as the surviving corporation in the merger (the 10 "SKO merger"). Thereafter, on October 18, 2005, ShopKo terminated the Badger Merger Agreement in accordance with its terms and paid Badger Retail Holding, Inc. a termination fee of $13.5 million (the "Badger Termination Fee"). On October 18, 2005, based on the unanimous recommendation of a special committee of independent directors, the Company's Board of Directors approved and the Company entered into a merger agreement with SKO Group Holding and SKO Acquisition which was amended by Amendment No. 1 dated as of October 18, 2005 and Amendment No. 2 dated as of October 28, 2005 (the "SKO Merger Agreement"). If the SKO merger is completed, the Company's stockholders will be entitled to receive $29.00 in cash for each outstanding share of the Company's common stock, plus an increase in the per share price at the rate of 6% per annum each day beginning on December 15, 2005 through and including the closing date of the SKO merger. At a special meeting of the stockholders of the Company scheduled for December 23, 2005, the Company's stockholders will be asked to vote on approval of the SKO Merger Agreement. In order to complete the SKO merger, stockholders holding a majority of shares of the Company's common stock outstanding on November 4, 2005, the record date for the Special Meeting, must vote for the approval of the SKO Merger Agreement. In addition to stockholder approval, the SKO merger is subject to customary conditions to closing, but is not subject to any financing condition. Merger-related expenses for the third quarter and first three quarters of fiscal 2005 were $2.8 million and $5.6 million, respectively. Additionally, due to the termination of the Badger Merger Agreement, the Company paid a termination fee of $13.5 million in the third quarter of 2005. Due to the non-deductibility of this fee for tax purposes the impact of the non-recurring merger-related expenses on net income was $15.2 million ($0.50 per share) and $16.9 million ($0.56 per share) for the third quarter and first three quarters of fiscal 2005, respectively. G. Long-Term Debt On June 30, 2005, the Company commenced an offer to purchase for cash any and all of its outstanding Senior Unsecured Notes (the "Offer") in connection with the Badger Merger Agreement. The SKO Merger Agreement requires the Company to continue the Offer subject to certain terms and conditions. Holders who tender their Senior Unsecured Notes are deemed to consent to certain proposed amendments to the indenture governing the Senior Unsecured Notes, which will eliminate substantially all of the restricted covenants and certain events of default in the indenture. As of August 16, 2005, holders of a majority in principal amount of the Senior Unsecured Notes had tendered their Senior Unsecured Notes into the Offer and provided the requisite consents to amend the indenture governing the Senior Unsecured Notes. The Company executed a supplemental indenture, which eliminated substantially all of the restrictive covenants and certain events of default in the indenture governing the Senior Unsecured Notes. While the consummation of the Offer is subject to specified conditions, including the consummation of the Badger Merger, the Company announced November 10, 2005 that it intends to waive such condition upon the consummation of the SKO Merger. Subsequently, the Company supplemented the Offer to reflect the terms of the SKO Merger Agreement and to disclose the filing of the lawsuit described below. The Offer is scheduled to expire on December 23, 2005 at 9:30 a.m., New York City time, unless further extended or earlier terminated by the Company. The SKO Merger is currently scheduled to close in the Company's fourth fiscal quarter. On November 25, 2005, ShopKo was served with a summons and complaint in a civil action relating to a lawsuit by certain holders who claim to hold a majority in principal amount of the Senior Unsecured Notes. (The case is entitled Federated Bond Fund, a portfolio of Federated Investment Series Funds, Inc., et. al. v. ShopKo Stores, Inc., et. al., Case No. 05CV9923, and was filed in United States District Court for the Southern District of New York). The Company believes the litigation is without merit and plans to defend it vigorously and is exploring all alternatives available 11 to it, including the termination of the Offer. In connection with the execution of the SKO Merger Agreement, ShopKo received from Sun Capital Partners IV a copy of a commitment letter from a group of lenders (which letter was amended on November 1, 2005) which would allow the Senior Unsecured Notes to remain outstanding after the effectiveness of the SKO merger. In such event, the Senior Unsecured Notes would rank pari passu with the new borrowings (that is, as provided for in the Indenture, the Senior Unsecured Notes will be equally and ratably secured with the new debt). H. Litigation Following the Company's April 8, 2005 announcement that it had signed the Badger merger agreement, six putative class action lawsuits challenging the proposed merger were filed in Circuit Court for Brown County, Wisconsin. These six lawsuits were consolidated under the caption In re ShopKo Shareholder Litigation, Case No. 05-CV-677, and the Company, each member of the Company's board of directors and Goldner Hawn were named as defendants. The consolidated compliant alleges, among other things, that the Company and its directors breached their fiduciary duties to the Company's shareholders by negotiating the Badger merger at a price that the plaintiffs allege to be inadequate, by supporting the Badger merger rather than effecting a recapitalization and by failing to disclose all material information concerning the Badger merger agreement, the transactions contemplated thereby and the background of and reasons for the Badger merger. In addition, the consolidated complaint alleges that Goldner Hawn aided and abetted the directors' breach of their fiduciary duties. The consolidated complaint sought, among other relief, rescission of the Badger merger, an injunction requiring disclosure of all material information and preventing completion of the Badger merger, and compensatory damages. On August 16, 2005 the plaintiffs filed a motion seeking a preliminary injunction. The hearing on the motion was held on September 1 and September 2, 2005. Following oral argument, the court denied the plaintiffs' motion, which would have allowed the Company's shareholders to vote on the Badger merger had the Badger merger not been later terminated in favor of the SKO merger. On November 30, 2005, the plaintiffs filed a motion claiming that their attorneys are entitled to $2 million in fees and expenses because they have benefited ShopKo and its shareholders through this litigation. At the same time, the plaintiffs filed a motion to temporarily enjoin the SKO merger if their motion for fees and expenses cannot be finally decided by December 23, 2005, the date of the special meeting of ShopKo shareholders called to consider approval of the SKO merger, so that any fees and expenses awarded to them could be satisfied from the SKO merger consideration. ShopKo believes that this litigation and these motions are without merit, and intends to continue to defend against the litigation vigorously and to oppose these motions. 12 ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RECENT DEVELOPMENTS: The Company entered into a merger agreement (the "Badger Merger Agreement"), dated April 7, 2005, with Badger Retail Holding, Inc. ("Badger Retail Holding") pursuant to which Badger Retail Holding would acquire all of the outstanding common stock of the Company for $24.00 per share. The merger agreement was amended on September 9, 2005 to $25.00 per share, and was subsequently amended to $25.50 per share on September 29, 2005. On October 18, 2005, a special committee of the Company's board of directors determined that a binding offer from SKO Group Holding Corp. ("SKO Group Holding"), a newly-formed Delaware corporation which is affiliated with Sun Capital Partners IV, L.P. ("Sun Capital Partners IV"), pursuant to which SKO Group Holding would acquire the Company, constituted a "superior proposal" as defined in the Badger Merger Agreement. The acquisition by SKO Group Holding would be effected by the merger of SKO Acquisition Corp. ("SKO Acquisition"), a wholly owned subsidiary of SKO Group Holding, with and into the Company, with the Company continuing as the surviving corporation in the merger (the "SKO merger"). Thereafter, on October 18, 2005, the Company terminated the Badger Merger Agreement in accordance with its terms and paid Badger Retail Holding a termination fee of $13.5 million (the "Badger Termination Fee"). On October 18, 2005, based on the unanimous recommendation of a special committee of independent directors, the Company's Board of Directors approved and the Company entered into a merger agreement with SKO Group Holding and SKO Acquisition which was amended by Amendment No. 1 dated as of October 18, 2005 and Amendment No. 2 dated as of October 28, 2005 (the "SKO Merger Agreement"). If the SKO merger is completed, the Company's stockholders will be entitled to receive $29.00 in cash for each outstanding share of the Company's common stock, plus an increase in the per share price at the rate of 6% per annum each day beginning on December 15, 2005 through and including the closing date of the SKO merger. At a special meeting of the stockholders of the Company scheduled for December 23, 2005, the Company's stockholders will be asked to vote on approval of the SKO Merger Agreement. In order to complete the SKO merger, stockholders holding a majority of shares of the Company's common stock outstanding on November 4, 2005, the record date for the Special Meeting, must vote for the approval of the SKO Merger Agreement. In addition to stockholder approval, the SKO merger is subject to customary conditions to closing but is not subject to any financing condition. The SKO merger is expected to close in the Company's fourth fiscal quarter. The total value of the transaction is approximately $1.2 billion, including assumed debt of approximately $275 million. 13 EXECUTIVE SUMMARY: ShopKo Stores, Inc. is a retailer headquartered in Green Bay, Wis., with 356 stores and approximately 23,000 teammates throughout the Midwest, Mountain and Pacific Northwest regions. The Company's reportable Retail segments include a ShopKo Retail segment and a Pamida Retail segment. The ShopKo Retail segment includes 137 ShopKo stores providing quality name-brand merchandise, great values, pharmacy and optical services in mid-sized to larger cities and three ShopKo Express Rx stores, a new and convenient neighborhood drugstore concept. The Pamida Retail segment includes 216 Pamida stores bringing value close to home in small, rural communities. During the third quarter, the Company closed three ShopKo stores in Colorado and closed four Pamida locations. Subsequent to the end of the third quarter, the Company announced the closing of two stores in Reno, Nevada to be completed in the first quarter of fiscal 2006. In the third quarter of fiscal 2005, net loss was $14.1 million, or $0.47 per diluted share compared with earnings of $2.0 million, or $0.07 per diluted share for the same period of fiscal 2004. The results reflect expenses of $16.3 million ($0.50 per diluted share) related to the Company's pending merger transaction, including a $13.5 million termination fee (for which no tax benefit was recognized) paid to Badger Retail Holding, Inc., an affiliate of Goldner Hawn Johnson & Morrison Incorporated. The Company's close monitoring of sales and inventory receipts resulted in a 7.9 percent decrease in consolidated inventory in the third quarter of fiscal 2005 compared to the same period last year. Consolidated sales during the third quarter of fiscal 2005 were $704.8 million compared with $746.4 million in fiscal 2004. Consolidated comparable store sales decreased 5.8 percent from the prior year. ShopKo comparable store sales decreased 5.6 percent. The Company believes the decline in sales is largely attributable to a change in the Company's promotional pricing strategy. Pamida comparable store sales decreased 6.1 percent, primarily due to a decline in general merchandise sales, partially offset by an increase in the retail health category. During the first three quarters of fiscal 2005, net loss was $1.9 million, or $0.06 per diluted share compared with net earnings of $7.9 million, or $0.27 per diluted share for the same period of fiscal 2004. Merger-related expenses of $19.1 million, ($0.56 per diluted share), negatively impacted the first three quarters of 2005 results. Consolidated sales decreased 5.0 percent to $2,145.1 million compared with $2,257.0 million for the same period last year. Consolidated comparable store sales decreased 5.4 percent from the prior year. ShopKo comparable store sales decreased 6.3 percent. The Company believes the decline in sales is largely attributable to a change in the Company's promotional pricing strategy. Pamida comparable store sales decreased 2.9 percent, primarily due to a decline in general merchandise sales, partially offset by an increase in the retail health category. Consistent with the past several years, the retail health category continued to increase as a percentage of the Company's sales in the third quarter of fiscal 2005. In the third quarter of fiscal 2005, retail health sales made up 33.2 percent and 28.4 percent of the ShopKo and Pamida retail segments' sales, respectively. In the first three quarters of fiscal 2005, retail health sales made up 33.4 percent and 26.7 percent of the ShopKo and Pamida segments' sales, respectively. The Company's third quarter of fiscal 2005 results highlight the Company's objectives of improving the mix between profitable sales and promotional activity, resulting in higher gross margin. The consolidated gross margin as a percent of sales was 27.4 percent compared to 25.8 percent for the same period last year. The increase is primarily attributable to improved general merchandise and pharmacy margins as well as less aggressive promotional pricing and better managed clearance inventory markdowns. During the first three quarters of fiscal 2005, gross margin as a percent of net sales was 27.3 percent compared with 25.7 percent for the same period last year. Debt declined 34.3 percent, or $157.5 million, compared to the end of the third 14 quarter of fiscal 2004, resulting in a $4.8 million interest expense reduction in the first three quarters of fiscal 2005 as compared with a year ago. During the third quarter of fiscal 2005, consolidated selling, general and administrative expenses (SG&A) as a percent of net sales increased to 23.9 percent compared with 21.8 percent last year. Consolidated SG&A expenses as a percent of net sales, for the first three quarters of fiscal 2005, increased to 22.8 percent from 21.6 percent for the same period last year. The increase in consolidated SG&A as a percent of net sales was primarily driven by the decline in sales. Capital expenditures for the third quarter of fiscal 2005 were $12.2 million compared with $19.4 million for the same period last year. In the first three quarters of fiscal 2005, capital expenditures were $20.5 million compared with $50.7 million for the same period last year. The decrease in capital expenditures is primarily due to $15.5 million related to the expansion of the Omaha distribution center and $15.2 million more in store remodeling activity during the first three quarters of fiscal 2004. In the first three quarters of fiscal 2005, the Company opened three new Pamida stores, had store remodeling activity in both divisions and invested in its technology infrastructure by replacing the optical center system in ShopKo. The Company expects capital expenditures of up to $35 million for the fiscal year. The retail industry is highly competitive and ShopKo competes in most of its markets with a variety of national and regional retailers. Pamida's competition varies by market, which includes other general merchandise retailers, supermarkets, dollar stores, drug and specialty stores, and mail order merchants. The Company expects to continue to be challenged by competitor store openings for the foreseeable future. While there can be no assurance that the Company's efforts will succeed, the Company remains committed to improving profitability. The following table sets forth items from the Company's unaudited condensed consolidated financial statements for the third quarter and year to date of fiscal 2005 and fiscal 2004 as a percentage of net sales:
THIRD QUARTER YEAR TO DATE (13 WEEKS) (39 WEEKS) ----------------- ---------------- FISCAL FISCAL FISCAL FISCAL 2005 2004 2005 2004 ------ ------ ------ ------ Revenues: Net sales 100.0% 100.0% 100.0% 100.0% Licensed department rentals and other income 0.5 0.5 0.5 0.4 ----- ----- ----- ----- 100.5 100.5 100.5 100.4 Cost of sales 72.6 74.2 72.7 74.3 Gross margin 27.4 25.8 27.3 25.7 Selling, general and administrative expenses 23.9 21.8 22.8 21.6 Depreciation and amortization expenses 2.8 2.8 2.9 2.8 Merger-related expenses 2.3 0.0 0.9 0.0 ----- ----- ----- ----- 29.0 24.6 26.6 24.4 (Loss) earnings from operations (1.1) 1.6 1.2 1.7 Interest expense 1.0 1.2 1.0 1.1 ----- ----- ----- ----- (2.1) 0.4 0.2 0.5 (Loss) earnings before income taxes Income tax (benefit) provision (0.1) 0.2 0.3 0.2 ----- ----- ----- ----- Net (loss) income (2.0)% 0.3% (0.1)% 0.3% ===== ===== ===== =====
15 The Company has two business segments: a ShopKo Retail segment and a Pamida Retail segment. The following tables set forth items from the Company's business segments as percentages of net sales:
THIRD QUARTER YEAR TO DATE (13 WEEKS) (39 WEEKS) -------------------- ----------------- FISCAL FISCAL FISCAL FISCAL 2005 2004 2005 2004 ------ ------ ------ ------ SHOPKO RETAIL SEGMENT Net sales 100.0% 100.0% 100.0% 100.0% Licensed department rentals and other income 0.6 0.5 0.6 0.5 ----- ----- ----- ----- 100.6 100.5 100.6 100.5 Cost of sales 72.7 73.8 72.7 74.3 Gross margin 27.3 26.2 27.3 25.7 Selling, general and administrative expenses 22.4 20.6 21.5 20.2 Depreciation and amortization expenses 2.8 2.8 2.9 2.7 ----- ----- ----- ----- 25.2 23.4 24.4 22.9 Earnings from operations 2.7% 3.3% 3.5% 3.3% ===== ===== ===== =====
THIRD QUARTER YEAR TO DATE (13 WEEKS) (39 WEEKS) --------------------- ----------------- FISCAL FISCAL FISCAL FISCAL 2005 2004 2005 2004 ------ ------ ------ ------ PAMIDA RETAIL SEGMENT Net sales 100.0% 100.0% 100.0% 100.0% Licensed department rentals and other income 0.2 0.2 0.2 0.2 ----- ----- ----- ----- 100.2 100.2 100.2 100.2 Cost of sales 72.3 75.7 72.5 74.5 Gross margin 27.7 24.3 27.5 25.5 Selling, general and administrative expenses 24.1 22.1 23.0 22.2 Depreciation and amortization expenses 2.7 2.7 2.7 2.9 ----- ----- ----- ----- 26.8 24.8 25.7 25.1 Earnings (loss) from operations 1.1% (0.3)% 2.0% 0.6% ===== ===== ===== =====
16 NET SALES: The following table presents the Company's consolidated net sales for the third quarter and year to date of fiscal 2005 and fiscal 2004:
THIRD QUARTER (13 WEEKS) % INCREASE ----------------------- --------------------- FISCAL FISCAL 2005 2004 TOTAL ** COMP* ------- ------- -------- ----- ShopKo Retail $ 522.2 $ 553.1 (5.6)% (5.6)% Pamida Retail 182.7 193.3 (5.5)% (6.1)% ------- ------- ---- ---- Consolidated $ 704.9 $ 746.4 (5.6)% (5.8)% ======= ======= ==== ====
YEAR TO DATE (39 WEEKS) % INCREASE ----------------------- --------------------- FISCAL FISCAL 2005 2004 TOTAL ** COMP* --------- --------- -------- ------ ShopKo Retail $ 1,573.3 $ 1,674.7 (6.1)% (6.3)% Pamida Retail 571.8 582.3 (1.8)% (2.9)% --------- --------- ---- ---- Consolidated $ 2,145.1 $ 2,257.0 (5.0)% (5.4)% ========= ========= ==== ====
* Comparable store sales represent sales of those stores open during both fiscal years and do not include sales from the ShopKo wholesale optical lab. ** ShopKo division total sales variance reflects sales from three closed ShopKo locations in fiscal 2005, one ShopKo closed location in fiscal 2004 and three new ShopKo Express Rx locations in 2004. Pamida division total sales variance reflects sales from five closed Pamida locations and seven new locations in fiscal 2004 and three new locations and seven closed locations in fiscal 2005. ShopKo comparable store sales decreased 5.6 percent during the third quarter of fiscal 2005, primarily due to the decline in the hardlines/home category as well as a change in promotional pricing strategy. Changes in ShopKo comparable store sales in the third quarter of fiscal 2005 by category were as follows: Retail Health, (2.1)%; Softlines, (3.7)%; and Hardlines/Home, (8.9)%. The 6.1 percent decrease in Pamida comparable store sales was primarily due to a decrease in apparel sales, partially offset by an increase in pharmacy sales. Changes in Pamida comparable store sales in the third quarter of fiscal 2005 by category were as follows: Pharmacy, 8.4%; Hardlines, (9.5)%; and Softlines, (16.2)%. The 6.3 percent decline in ShopKo comparable store sales during the first three quarters of fiscal 2005 is primarily due to decreased sales in the hardlines/home category as well as a change in promotional pricing strategy. Changes in ShopKo comparable store sales in the first three quarters of fiscal 2005 by category were as follows: Retail Health, (0.7)%; Softlines, (3.5)%; and Hardlines/Home, (11.0)%. The 2.9 percent decrease in Pamida comparable store sales is primarily attributable to decreased apparel sales, partially offset by increased pharmacy sales. Changes in Pamida comparable store sales in the first three quarters of fiscal 2005 by category were as follows: Pharmacy, 10.4%; Hardlines, (5.4)%; and Softlines, (13.4)%. The Company also believes comparable store sales continue to be negatively affected by ongoing competition from both national and regional retailers. 17 The Company's store activity is summarized below:
39 Weeks Ended Year Ended -------------------- ----------- Oct 29, Oct 30, January 29, 2005 2004 2005 ------- ------- ----------- SHOPKO STORES Beginning number of stores 143 141 141 Openings * 0 1 3 Closings 3 1 1 --- --- --- Ending number of stores 140 141 143 === === === PAMIDA STORES Beginning number of stores 220 218 218 Openings 3 7 7 Closings 7 5 5 --- --- --- Ending number of stores 216 220 220 === === ===
* ShopKo retail segment includes three new ShopKo Express locations. GROSS MARGIN: Consolidated gross margin dollars increased 0.4 percent to $193.0 million in the third quarter of fiscal 2005 from $192.2 million for the same period last year. Consolidated gross margin, as a percent of net sales for the third quarter of fiscal 2005, was 27.4 percent compared with 25.8 percent for the same period last year. The increase is primarily attributable to improved general merchandise and pharmacy margins. General merchandise margin improvement is attributable to improved initial markup, less aggressive promotional pricing and better managed clearance inventory markdowns in fiscal 2005. ShopKo's gross margin dollars decreased 1.8 percent to $142.5 million in the third quarter of fiscal 2005 from $145.2 million for the same period last year. ShopKo's gross margin, as a percent of net sales, was 27.3 percent compared with 26.2 percent for the same period last year. The rate increase was primarily due to higher general merchandise and pharmacy margins (collectively 104 basis points) and improved inventory shrinkage results (35 basis points), partially offset by increased distribution expenses (26 basis points). General merchandise margin improvement is attributable to improved initial markup, less aggressive promotional pricing and better managed clearance inventory markdowns in fiscal 2005. Pamida's gross margin dollars increased 7.3 percent to $50.5 million in the third quarter of fiscal 2005 from $47.1 million for the same period last year. As a percent of net sales, Pamida's gross margin was 27.7 percent in the third quarter of fiscal 2005 compared with 24.3 percent for the same period last year. The increase was primarily due to improved merchandise margins (205 basis points), improved inventory shrinkage results (62 basis points), a decline in distribution expenses (28 basis points) and other various individual immaterial variations that, in the aggregate, comprise the remainder of the difference. Consolidated gross margin dollars increased 1.2 percent to $586.1 million in the first three quarters of fiscal 2005 from $579.3 million for the same period last year. Consolidated gross margin, as a percent of net sales for the first three quarters of fiscal 2005, was 27.3 percent compared with 25.7 percent for the same period last year. The increase is primarily attributable to improved general merchandise and pharmacy margins. General merchandise margin improvement is attributable to improved initial markup, less aggressive promotional pricing and better managed clearance inventory markdowns in fiscal 2005. ShopKo's gross margin dollars decreased 0.4 percent to $429.1 million in the first three quarters of fiscal 2005 from $430.8 million for the same period last year. ShopKo's gross margin, as a percent of net sales, was 27.3 percent compared with 25.7 percent for the same period last year. The rate increase was primarily due to general merchandise and pharmacy margin improvement (collectively 18 169 basis points). Pamida's gross margin dollars increased 5.7 percent to $157.0 million in the first three quarters of fiscal 2005 from $148.5 million for the same period last year. As a percent of net sales, Pamida's gross margin was 27.5 percent in the first three quarters of fiscal 2005 compared with 25.5 percent for the same period last year. The increase was primarily due to improved merchandise margins (145 basis points), a decline in distribution expenses (33 basis points) and other various individual immaterial variations that, in the aggregate, comprise the remainder of the difference. The Company uses the last-in, first-out (LIFO) method for substantially all inventories. There was no LIFO charge or credit for the quarters ended October 29, 2005 and October 30, 2004. There was no difference between the LIFO and first-in, first-out (FIFO) cost methods at October 29, 2005, October 30, 2004 and January 29, 2005. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES: Consolidated SG&A expense dollars for the third quarter of fiscal 2005 increased 3.4 percent to $168.1 million from $162.7 million for the same period last year. SG&A expenses as a percent of net sales for the third quarter of fiscal 2005 increased to 23.9 percent compared with 21.8 percent for the same period last year, primarily due to the decline in sales. ShopKo's SG&A expenses as a percent of net sales for the third quarter of fiscal 2005 were 22.4 percent compared with 20.6 percent for the same period last year, primarily due to the decline in sales (135 basis points), increases in maintenance and repair expenses (30 basis points) and losses on the disposal of assets (23 basis points), partially offset by lower net advertising costs (13 basis points). Pamida's SG&A expenses as a percent of net sales for the third quarter of fiscal 2005 were 24.1 percent compared with 22.1 percent for the third quarter last year. The increase was primarily driven by the decline in sales (128 basis points), an increase in closed store expenses (58 basis points) and increases in workman's compensation and property and general liability insurance expenses (53 basis points), partially offset by lower net advertising costs (24 basis points), and other various individual immaterial variations that, in the aggregate, comprise the remainder of the difference. Consolidated SG&A expense dollars for the first three quarters of fiscal 2005 increased 0.6 percent to $489.7 million from $486.6 million for the same period last year. SG&A expenses as a percent of net sales for the first three quarters of fiscal 2005 increased to 22.8 percent compared with 21.6 percent for the same period last year, primarily due to the decline in sales. ShopKo's SG&A expenses as a percent of net sales for the first three quarters of fiscal 2005 were 21.5 percent compared with 20.2 percent last year, primarily attributable to the decline in sales (143 basis points), partially offset by a decrease in store payroll due to lower sales (17 basis points). Pamida's SG&A expenses as a percent of net sales for the first three quarters of fiscal 2005 were 23.0 percent compared with 22.2 percent last year. The increase was primarily driven by the decline in sales (40 basis points), higher payroll due to pharmacy growth (24 basis points), increases in workman's compensation and property and general liability insurance expenses (23 basis points), an increase in closed store reserves (18 basis points) and higher closed store location expenses (15 basis points), partially offset by lower net advertising expenses (12 basis points), and other various individual immaterial variations that, in the aggregate, comprise the remainder of the difference. 19 DEPRECIATION AND AMORTIZATION EXPENSE: Consolidated depreciation and amortization expenses were $19.7 million for the third quarter of fiscal 2005 compared with $20.9 million for the same period last year. For the first three quarters of fiscal 2005, consolidated depreciation and amortization expenses were $61.3 million compared with $63.6 million for the same period last year. As a percent of net sales, consolidated depreciation and amortization expenses were 2.8 percent for the third quarter of fiscal 2005 compared with 2.8 percent for the same period last year. Consolidated depreciation and amortization expenses as a percent of net sales for the first three quarters of fiscal 2005 were 2.9 percent compared with 2.8 percent last year. INTEREST EXPENSE: Interest expense for the third quarter of fiscal 2005 was $6.8 million compared with $8.8 million for the same period last year. For the first three quarters of fiscal 2005, interest expense decreased $4.8 million or 18.6 percent to $21.1 million compared with the same period last year. The decrease in interest expense for the third quarter and first three quarters of fiscal 2005 was primarily due to reduced debt levels versus last year. INCOME TAXES: The Company recorded an income tax benefit for the third quarter of fiscal 2005 of $0.4 million on a pre-tax loss of $14.5 million, compared with an income tax provision of $1.3 million on $3.3 million of pre-tax income for the same period last year. For the first three quarters of fiscal 2005, the income tax provision was $7.2 million on $5.3 million of pre-tax income, compared with an income tax provision of $5.1 million on $13.0 million of pre-tax income for the same period last year. The tax benefit/provision for the 2005 periods and the resulting effective income tax rate, reflect the non-deductibility of the $13.5 million termination fee paid to Badger Retail Holding, Inc. in the third quarter of 2005. The Company's combined federal and state statutory rate is 38.5 percent during the 2005 periods, as compared to 39.0 percent in the comparable 2004 periods. The decrease in the Company's statutory tax rate is due to a lower state income tax rate, net of federal benefits. CRITICAL ACCOUNTING POLICIES AND ESTIMATES: The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires the appropriate application of certain accounting policies, many of which require management to make estimates and assumptions about future events and their impact on amounts reported in our financial statements and related notes. Since future events and their impact cannot be determined with certainty, the actual results will inevitably differ from our estimates. Such differences could be material to the financial statements. Management believes that its application of applicable accounting policies, and the estimates inherently required therein, are reasonable. Management periodically reevaluates these accounting policies and estimates in the preparation of the financial statements and makes adjustments when facts and circumstances dictate a change. The Company has identified certain critical accounting policies, which are described below. Merchandise inventory. The Company's merchandise inventory is carried at the lower of cost or market on a LIFO basis utilizing the average cost method of accounting. The valuation of inventories at cost requires certain management judgments and estimates, including among 20 others, the assessment of shrinkage rates, obsolescence and the impact on inventory values of using the lower of cost or market valuation method. In valuing the inventory, the Company undertakes physical inventories at least annually at its stores and distribution centers and adjusts inventory values regularly to reflect market conditions and business trends. The Company estimates losses of inventory due to shrinkage based upon historical experience by store and by merchandise department, which are then verified by physical inventory counts. The Company's experience has been that there is little fluctuation or risk in the estimate of obsolescence or lower of cost or market reserve because (i) of the Company's inventory turnover rate, (ii) a large percentage of our inventory is returnable to our vendors for cost and (iii) the Company is able to receive vendor support monies if product is sold below expected prices. The non-returnable inventory goes through a markdown process that liquidates the inventory, generally at prices in excess of cost. Restructuring Reserve. In connection with the reorganization plan announced in the fourth quarter of fiscal 2000 to close 23 ShopKo retail stores, a distribution center, and to downsize its corporate workforce, the Company incurred a pre-tax charge of $125.0 million related to inventory and property write-downs, lease termination and property carrying costs, and employee separation and other costs. The inventory and fixed asset write-down reserves were recorded in the fourth quarter of fiscal 2000, and the Company closed all 23 stores and the distribution center in fiscal 2001. The Company utilized all of the employee severance reserve prior to fiscal 2002. Of the 24 properties initially covered by the restructuring reserve, twenty were disposed of in subsequent years, leaving four remaining leased properties covered by the restructuring reserve as of the beginning of fiscal 2005. During the third quarter of fiscal 2005, no additional leases were terminated. As of October 29, 2005, the remaining reserve for lease termination and related property carrying costs, as well as other costs, was $12.4 million. For balance sheet reporting purposes, the portion of the reserve for the lease termination, property carrying and other costs to be paid in the next 12 months is reported in accrued expenses ($1.8 million) as a current liability and the remainder ($10.6 million) is recorded in other long-term obligations at October 29, 2005. The Company believes the reserves are adequate, and continues to negotiate lease terminations with landlords. However, due to the Company's inability to terminate the leases or to sublease the four locations, the level of reserves could prove to be inadequate and additional charges may be required. The Company will continue to evaluate the adequacy of the amounts reserved as it proceeds with the termination of the leases. Vendor Allowances. The Company records vendor allowances and discounts in the income statement when the purpose for which those monies were designated is fulfilled. Allowances provided by vendors generally relate to inventory recently sold and, accordingly, are reflected as reductions of cost of sales as merchandise is sold. Vendor allowances received for advertising or fixturing programs reduce the Company's expense or cost for the related advertising or fixturing program. The Company recognizes vendor allowances based on the provisions of EITF No. 02-16. Impairment of Long-Lived Assets. In accordance with SFAS 144 "Accounting for the Impairment or Disposal of Long-Lived Assets", the Company evaluates long-lived assets whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable based on projected future undiscounted cash flows attributable to that asset. The measurement of possible impairment is based on the ability to recover the balance of assets from expected future operating cash flows on an undiscounted basis. Impairment losses, if any, would be measured by comparing the carrying amount of the asset to its fair value, determined based on appraised values or the present value of the cash flows using discount rates that reflect the inherent risks of the underlying business. Our impairment loss calculations require management to apply judgment in estimating future cash flows and asset fair values, including forecasting useful lives of the assets and selecting the discount rate that reflects the risk inherent in future cash flows. 21 Stock Based Compensation. As discussed in the Company's fiscal 2004 Annual Report on Form 10-K, as amended, the Company follows Accounting Principles Board Opinion (APB) No. 25, "Accounting for Stock Issued to Employees", which does not require recognition of expense for stock options when the exercise price of an option equals, or exceeds, the fair market value of the common stock on the date of grant. In December 2004, the FASB issued SFAS No. 123R "Share-Based Payment" ("SFAS 123R"), which requires the Company to expense all share-based payments to employees, including grants of employee stock options, in the financial statements. The grant-date fair value of employee stock options and similar instruments will be estimated using an option-pricing model adjusted for any unique characteristics of a particular instrument. In April 2005, the SEC amended the compliance dates for SFAS 123R from fiscal periods beginning after June 15, 2005 to fiscal years beginning after June 15, 2005. The Company will continue to account for share-based compensation using the intrinsic value method set forth in APB No. 25, until adoption of SFAS 123R on January 29, 2006. The pro forma impact on the 13 week and 39 week periods ended October 29, 2005 of expensing unvested stock options is disclosed, as required under FASB Statement No. 123, "Accounting for Stock-Based Compensation" in Note C to the unaudited Condensed Consolidated Financial Statements ("SFAS 123"). The impact of SFAS 123R is not expected to be materially different than the impact of SFAS 123. Income Taxes. The Company provides deferred income tax assets and liabilities based on the estimated future tax effects of differences between the financial and tax bases of assets and liabilities based on currently enacted laws. The tax balances and income tax expense recognized by the Company are based on management's interpretation of the tax laws of multiple jurisdictions. Income tax expense also reflects the Company's best estimates and assumptions regarding, among other things, the level of future taxable income, interpretation of the tax laws, and tax planning. The Company pays income taxes based on tax statutes, regulations and case law of the various jurisdictions in which it operates. At any one time, multiple tax years are subject to audit by the various taxing authorities. LIQUIDITY AND CAPITAL RESOURCES: The Company's liquidity requirements are met primarily by cash generated from operations, with remaining funding requirements provided by short-term and long-term borrowings. Cash provided by operating activities was $35.0 million for the first three quarters of fiscal 2005 compared with cash used by operating activities of $17.3 million for the same period last year. The Company finances a significant portion of its operations through vendor financing. As of October 29, 2005, accounts payable totaled $280.3 million, a decrease of $17.2 million, compared with $297.5 million at the end of the third quarter of fiscal 2004. The Company currently maintains favorable terms with its vendors, however these terms could change based on the Company's future operating performance. As of October 29, 2005, the Company had $147.0 million of long-term debt outstanding, consisting of $99.7 million of Senior Unsecured Notes and approximately $47.3 million of long-term notes payable. The Senior Unsecured Notes have maturity dates in March 2022. A more detailed description of these Senior Unsecured Notes is contained in Note D of the Notes to Consolidated Financial Statements in the Company's fiscal 2004 Annual Report on Form 10-K, as amended. Subject to certain limitations set forth in our Amended Secured Credit Facility, proceeds of the Facility or funds from other sources may be used to retire or repurchase Senior Unsecured Notes. Payments due under the Senior Unsecured Notes could be accelerated in the event the Company defaults on any debt obligation in excess of $25.0 million. On June 30, 2005, the Company commenced an offer to purchase for cash any and all of its outstanding Senior Unsecured Notes (the "Offer") in connection with the Badger Merger 22 Agreement. The SKO Merger Agreement requires the Company to continue the Offer subject to certain terms and conditions. Holders who tender their Senior Unsecured Notes are deemed to consent to certain proposed amendments to the indenture governing the Senior Unsecured Notes, which will eliminate substantially all of the restricted covenants and certain events of default in the indenture. As of August 16, 2005, holders of a majority in principal amount of the Senior Unsecured Notes had tendered their Senior Unsecured Notes into the Offer and provided the requisite consents to amend the indenture governing the Senior Unsecured Notes. The Company executed a supplemental indenture, which eliminated substantially all of the restrictive covenants and certain events of default in the indenture governing the Senior Unsecured Notes. While the consummation of the Offer is subject to specified conditions, including the consummation of the Badger Merger, the Company announced November 10, 2005 that it intends to waive such condition upon the consummation of the SKO Merger. Subsequently, the Company supplemented the Offer to reflect the terms of the SKO Merger Agreement and to disclose the filing of the lawsuit described below. The Offer is scheduled to expire on December 23, 2005 at 9:30 a.m., New York City time, unless further extended or earlier terminated by the Company. The SKO Merger is currently scheduled to close in the Company's fourth fiscal quarter. On November 25, 2005, ShopKo was served with a summons and complaint in a civil action relating to a lawsuit by certain holders who claim to hold a majority in principal amount of the Senior Unsecured Notes. (The case is entitled Federated Bond Fund, a portfolio of Federated Investment Series Funds, Inc., et. al. v. ShopKo Stores, Inc., et. al., Case No. 05CV9923, and was filed in United States District Court for the Southern District of New York). The Company believes the litigation is without merit and plans to defend it vigorously and is exploring all alternatives available to it, including the termination of the Offer. In connection with the execution of the SKO Merger Agreement, ShopKo received from Sun Capital Partners IV a copy of a commitment letter from a group of lenders (which letter was amended on November 1, 2005) which would allow the Senior Unsecured Notes to remain outstanding after the effectiveness of the SKO merger. In such event, the Senior Unsecured Notes would rank pari passu with the new borrowings (that is, as provided for in the Indenture, the Senior Unsecured Notes will be equally and ratably secured with the new debt). During the third quarter of fiscal 2003, the Company entered into the Amended Secured Credit Facility, which is secured by the Company's inventory and accounts receivable. The Amended Secured Credit Facility provides for revolving credit borrowings of up to $450.0 million, bearing interest at the bank's base rate plus a margin of 0.0% to 0.25% or the Eurodollar rate plus a margin of 1.5% to 2.0%, depending on borrowing availability under the facility. The Company had $65.0 million outstanding under its Amended Secured Credit Facility at the end of the third quarter of fiscal 2005 compared with $156.1 million outstanding at the end of the third quarter of fiscal 2004. Borrowings declined due to higher cash flows from operations (exclusive of merger-related costs) in 2005, reduced inventory levels, use of proceeds from the sale of the three Colorado stores, and reduced capital expenditures. The Company had $354.5 million in availability at the end of the third quarter of fiscal 2005. As a result of reduced borrowing levels and needs, on October 27, 2005, the Company elected to reduce its revolving credit facility by $100 million to $350 million. The Amended Secured Credit Facility terminates August 19, 2007, and limits the payment of dividends, new indebtedness, repurchases of common stock, and capital expenditures, and requires the Company to meet financial performance covenants relating to borrowing availability and minimum operating cash flows as defined therein. The consequences of failing to comply with the various covenants and requirements range from increasing the interest rate, to restrictions on cash management, to default and acceleration of the debt. The indebtedness under the Amended Secured Credit Facility can be declared immediately due and payable in the event other Company debt in excess of $10.0 million is accelerated. As of October 29, 2005, and for the third quarter of fiscal 2005, the Company was in compliance with all covenants in the Amended Secured Credit Facility. 23 The following schedule sets forth the Company's contractual obligations and commercial commitments as of October 29, 2005 (in thousands):
Less than 1 After CONTRACTUAL OBLIGATIONS (1) Total year 2-3 years 4-5 years 5 years ------------------------------- --------- ----------- --------- --------- --------- Long-Term Debt (2) $ 146,971 $ 800 $ 2,904 $ 3,061 $ 140,206 Capital Lease Obligations (3) 89,615 6,130 12,277 11,766 59,442 Operating Leases (4) 170,670 18,862 34,551 28,606 88,651 Total Contractual Cash Obligations 407,256 25,792 49,732 43,433 288,299
(1) The schedule excludes obligations of $65.0 million outstanding under the Amended Secured Credit Facility, which are classified on the balance sheet as short-term debt, as well as $9.4 million of outstanding documentary letters of credit and $20.9 million of standby letters of credit as of October 29, 2005 (which reduce availability under the Amended Secured Credit Facility). (2) Interest payments (in millions) due on long-term debt for less than 1 year are $14.2, 2-3 years are $28.0, 4-5 years are $27.3 and after 5 years are $111.1. (3) Capital lease obligations represent the total minimum future obligations, net of $60.9 million of interest. Interest payments (in millions) due on capital lease obligations for less than 1 year are $7.8, 2-3 years are $13.9, 4-5 years are $11.4 and after 5 years are $27.8. (4) Operating leases are the aggregate future payments for operating leases as of October 29, 2005, including closed stores. The Company believes that its availability under the Amended Secured Credit Facility, and expected cash from operations together with continued favorable vendor credit terms, will provide sufficient liquidity to finance continuing operations, including planned capital expenditures, for fiscal 2005. However, if the Company's operating results were to deteriorate significantly for any reason, or if the Company were to require significant additional capital for unexpected events, the Company could suffer liquidity problems, which would materially adversely affect its results of operations and financial condition. The Company incurred $12.2 million of capital expenditures in the third quarter of 2005 and $20.5 million in the first three quarters of fiscal 2005, compared with $19.4 million and $50.7 million in the third quarter and first three quarters of fiscal 2004, respectively. The decrease in capital expenditures is primarily due to reduced store remodeling activity in 2005, as well as the impact of the capital expenditures related to the expansion of the Omaha distribution center in 2004. In the first three quarters of fiscal 2005, the Company opened three new Pamida stores, had store remodeling activity in both divisions and invested in its technology infrastructure by replacing the optical center system in ShopKo. The Company expects capital expenditures of up to $35 million for the fiscal year. INFLATION: The Company does not believe that inflation has had a material effect on the results of operations during the periods presented. However, there can be no assurance that the Company's business will not be affected by inflation in the future. FORWARD-LOOKING STATEMENTS AND RISK FACTORS: Certain statements contained in Item 2, "Management's Discussion and Analysis" and elsewhere in this Form 10-Q are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements discuss, among other things, expected growth, future revenues, product development, debt reduction, capital expenditures and deployment plans and future operating and financial performance. The forward-looking statements are subject to risks and uncertainties, which could cause actual results to differ materially from those discussed in such forward-looking statements. These risks and uncertainties include, but are not 24 limited to: 1.) the impact of accounting pronouncements as described herein; and 2.) the following which are more fully discussed in the Company's fiscal 2004 Annual Report on Form 10-K, as amended, for the fiscal year ended January 29, 2005: a.) significant debt levels; b.) continued availability of vendor financing; c.) failure to achieve the expected benefits of reorganizations; d.) inability to execute future expansion plans; e.) failure to remodel existing stores on schedule or within budget; f.) quarterly performance fluctuations - most notably the highly seasonal nature of the business; g.) competition; h.) U.S. and international political unrest and extended economic slowdown; i.) general economic conditions and weather; j.) smooth functioning distribution network; k.) labor conditions; l.) anti-takeover provisions in the Company's organizational documents; m.) pending or future changes in laws or regulations and n.) pending or future litigation. These and other risks and uncertainties as may be indicated in subsequent filings with the Securities and Exchange Commission, are incorporated herein by reference. These forward-looking statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions, which may, or may not come to fruition. In addition, the Company does not undertake any obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise. ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK For information as to the Company's Quantitative and Qualitative Disclosures about Market Risk, please see the Company's fiscal 2004 Annual Report on Form 10-K, as amended, for the fiscal year ended January 29, 2005. There have been no material changes in the Company's quantitative or qualitative exposure to market risk since the end of fiscal 2004. ITEM 4: CONTROLS AND PROCEDURES (a) Evaluation of Disclosure Controls and Procedures The Company maintains a set of disclosure controls and procedures designed to ensure that information required to be disclosed by us in the reports filed under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), is recorded, processed, summarized and reported within the time periods specified by the SEC. The Company carried out an evaluation, under the supervision and with the participation of the Company's Disclosure Committee and the Company's management, including the acting members of the office of the Chief Executive Officer, which includes the Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures pursuant to Rule 13a-15 promulgated under the Exchange Act. Based upon that evaluation, the Co-Chief Executive Officers, including the Chief Financial Officer, concluded that the Company's disclosure controls and procedures are effective as of the end of the period covered by this report. (b) Changes in Internal Control There have been no significant changes in the Company's internal control over financial reporting identified in connection with the evaluation discussed above that occurred during the quarter ended October 29, 2005 that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. 25 PART II - OTHER INFORMATION ITEM 1: LEGAL PROCEEDINGS Following the Company's April 8, 2005 announcement that it had signed the Badger merger agreement, six putative class action lawsuits challenging the proposed merger were filed in Circuit Court for Brown County, Wisconsin. These six lawsuits were consolidated under the caption In re ShopKo Shareholder Litigation, Case No. 05-CV-677, and the Company, each member of the Company board of directors and Goldner Hawn were named as defendants. The consolidated compliant alleges, among other things, that the Company and its directors breached their fiduciary duties to the Company's shareholders by negotiating the Badger merger at a price that the plaintiffs allege to be inadequate, by supporting the Badger merger rather than effecting a recapitalization and by failing to disclose all material information concerning the Badger merger agreement, the transactions contemplated thereby and the background of and reasons for the Badger merger. In addition, the consolidated complaint alleges that Goldner Hawn aided and abetted the directors' breach of their fiduciary duties. The consolidated complaint sought, among other relief, rescission of the Badger merger, an injunction requiring disclosure of all material information and preventing completion of the Badger merger, and compensatory damages. On August 16, 2005 the plaintiffs filed a motion seeking a preliminary injunction. The hearing on the motion was held on September 1 and September 2, 2005. Following oral argument, the court denied the plaintiffs' motion, which would have allowed the Company's shareholders to vote on the Badger merger had the Badger merger not been later terminated in favor of the SKO merger. On November 30, 2005, the plaintiffs filed a motion claiming that their attorneys are entitled to $2 million in fees and expenses because they have benefited ShopKo and its shareholders through this litigation. At the same time, the plaintiffs filed a motion to temporarily enjoin the SKO merger if their motion for fees and expenses cannot be finally decided by December 23, 2005, the date of the special meeting of ShopKo shareholders called to consider approval of the SKO merger, so that any fees and expenses awarded to them could be satisfied from the SKO merger consideration. ShopKo believes that this litigation and these motions are without merit, and intends to continue to defend against the litigation vigorously and to oppose these motions. ITEM 6: EXHIBITS (a) Exhibits. 3.1 Amendment to the By-Laws of ShopKo Stores, Inc., incorporated by reference to the Registrant's Current Report on Form 8-K filed on September 9, 2005. 4.1 Third Amendment to the Rights Agreement, dated as of October 18, 2005, to the Rights Agreement, dated as of July 3, 1992, as amended and restated as of September 24, 1997 and further amended as of May 22, 1998 and April 7, 2005, between ShopKo Stores, Inc. and Wells Fargo Bank, N.A., as successor to Northwest Bank Minnesota, National Association, incorporated by reference to the Registrant's Current Report on Form 8-K filed on October 20, 2005. 10.1 First Amendment to Agreement and Plan of Merger, dated as of September 9, 2005, by and among Badger Retail Holding, Inc., Badger Acquisition Corp. and ShopKo Stores, Inc., incorporated by reference to the Registrant's Current Report on Form 8-K filed on September 9, 2005. 26 10.2 Second Amendment to Agreement and Plan of Merger, dated as of September 29, 2005, by and among Badger Retail Holding, Inc., Badger Acquisition Corp. and ShopKo Stores, Inc., incorporated by reference to the Registrant's Current Report on Form 8-K filed on September 29, 2005. 10.3 Agreement and Plan of Merger, by and among SKO Group Holding Corp., SKO Acquisition Corp. and ShopKo Stores, Inc., dated as of October 18, 2005 and amended by Amendment No. 1 dated as of October 18, 2005 and Amendment No. 2 dated as of October 28, 2005, incorporated by reference to Registrant's definitive proxy statement on Form 14A filed on November 23, 2005. 31.1 Certification of Brian W. Bender, Senior Vice President, Chief Financial Officer, Co-Chief Executive Officer*, pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as amended. 31.2 Certification of Michael J. Hopkins, President, Pamida Division, Co-Chief Executive Officer*, pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as amended. 31.3 Certification of Paul G. White, Senior Vice President, Chief Merchandising Officer, Co-Chief Executive Officer*, pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as amended. 32.1 Statement of Brian W. Bender, Senior Vice President, Chief Financial Officer, Co-Chief Executive Officer*, pursuant to 18 U.S.C. Section 1350. 32.2 Statement of Michael J. Hopkins, President, Pamida Division, Co-Chief Executive Officer*, pursuant to 18 U.S.C. Section 1350. 32.3 Statement of Paul G. White, Senior Vice President, Chief Merchandising Officer, Co-Chief Executive Officer*, pursuant to 18 U.S.C. Section 1350. * The office of Chief Executive Officer is comprised of three executive officers, each serving as Co-Chief Executive Officer. 27 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. SHOPKO STORES, INC. (Registrant) Date: December 8, 2005 By: /s/ Brian W. Bender ------------------------------ Brian W. Bender Senior Vice President, Chief Financial Officer Co-Chief Executive Officer* (Duly Authorized Officer of Registrant and Principal Financial Officer) * The office of Chief Executive Officer is comprised of three executive officers, each serving as Co-Chief Executive Officer. 28 EXHIBIT INDEX SHOPKO STORES, INC. 10-Q REPORT Exhibit Number Exhibit ------- ------- 3.1 Amendment to the By-Laws of ShopKo Stores, Inc., incorporated by reference to the Registrant's Current Report on Form 8-K filed on September 9, 2005. 4.1 Third Amendment to the Rights Agreement, dated as of October 18, 2005, to the Rights Agreement, dated as of July 3, 1992, as amended and restated as of September 24, 1997 and further amended as of May 22, 1998 and April 7, 2005, between ShopKo Stores, Inc. and Wells Fargo Bank, N.A., as successor to Northwest Bank Minnesota, National Association, incorporated by reference to the Registrant's Current Report on Form 8-K filed on October 20, 2005. 10.1 First Amendment to Agreement and Plan of Merger, dated as of September 9, 2005, by and among Badger Retail Holding, Inc., Badger Acquisition Corp. and ShopKo Stores, Inc., incorporated by reference to the Registrant's Current Report on Form 8-K filed on September 9, 2005. 10.2 Second Amendment to Agreement and Plan of Merger, dated as of September 29, 2005, by and among Badger Retail Holding Inc., Badger Acquisition Corp. and ShopKo Stores, Inc., incorporated by reference to the Registrant's Current Report on Form 8-K filed on September 29, 2005. 10.3 Agreement and Plan of Merger, by and among SKO Group Holding Corp., SKO Acquisition Corp. and ShopKo Stores, Inc., dated as of October 18, 2005 and amended by Amendment No. 1 dated as of October 18, 2005 and Amendment No. 2 dated as of October 28, 2005, incorporated by reference to Registrant's definitive proxy statement on Form 14A filed on November 23, 2005. 31.1 Certification of Brian W. Bender, Senior Vice President, Chief Financial Officer, Co-Chief Executive Officer*, pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as amended. 31.2 Certification of Michael J. Hopkins, President, Pamida Division, Co-Chief Executive Officer*, pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as amended. 31.3 Certification of Paul G. White, Senior Vice President, Chief Merchandising Officer, Co-Chief Executive Officer*, pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as amended. 29 32.1 Statement of Brian W. Bender, Senior Vice President, Chief Financial Officer, Co-Chief Executive Officer*, pursuant to 18 U.S.C. Section 1350. 32.2 Statement of Michael J. Hopkins, President, Pamida Division, Co-Chief Executive Officer*, pursuant to 18 U.S.C. Section 1350. 32.3 Statement of Paul G. White, Senior Vice President, Chief Merchandising Officer, Co-Chief Executive Officer*, pursuant to 18 U.S.C. Section 1350. * The office of Chief Executive Officer is comprised of three executive officers, each serving as Co-Chief Executive Officer. 30