SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


FORM 10-K


Annual Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934

For the fiscal year ended January 31, 2004

Commission file number 1-10299

FOOT LOCKER, INC.

(Exact name of Registrant as specified in its charter)

New York
(State or other jurisdiction of
incorporation or organization)
              
13-3513936
(I.R.S. Employer Identification No.)
 
112 West 34th Street, New York, New York
(Address of principal executive offices)
              
10120

(Zip Code)
 

Registrant’s telephone number, including area code:
(212) 720-3700

Securities registered pursuant to Section 12(b) of the Act:

Title of each class
         Name of each exchange on which registered
Common Stock, par value $0.01
              
New York Stock Exchange
Preferred Stock Purchase Rights
              
New York Stock Exchange
 

Securities registered pursuant to Section 12(g) of the Act:
None

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X]  No [  ]

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  [X]

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes [X]  No [  ]

See pages 60 through 63 for Index of Exhibits.

Number of shares of Common Stock outstanding at March 26, 2004:
                    144,761,434    
 
The aggregate market value of voting stock held by non-affiliates of the Registrant computed by reference to the closing price as of the last business day of the Registrant’s most recently completed second fiscal quarter, August 1, 2003, was approximately:
                 $ 1,788,814,575 *  
 
*   For purposes of this calculation only (a) all directors plus one executive officer and owners of five percent or more of the Registrant are deemed to be affiliates of the Registrant and (b) shares deemed to be “held” by such persons at August 1, 2003, include only outstanding shares of the Registrant’s voting stock with respect to which such persons had, on such date, voting or investment power.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant’s definitive Proxy Statement (the “Proxy Statement”) to be filed in connection with the 2004 Annual Meeting of Shareholders: Parts III and IV.





TABLE OF CONTENTS

PART I
              
 
               
 
Item 1
              
Business
          1   
Item 2
              
Properties
          2    
Item 3
              
Legal Proceedings
          2    
Item 4
              
Submission of Matters to a Vote of Security Holders
          2    
 
PART II
              
 
               
 
Item 5
              
Market for the Company’s Common Equity and Related Stockholder Matters
          3   
Item 6
              
Selected Financial Data
          3    
Item 7
              
Management’s Discussion and Analysis of Financial Condition and Results of Operations
          3    
Item 7A
              
Quantitative and Qualitative Disclosures about Market Risk
          19    
Item 8
              
Consolidated Financial Statements and Supplementary Data
          20    
Item 9
              
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
          57    
Item 9A
              
Controls and Procedures
          57    
 
PART III
              
 
               
 
Item 10
              
Directors and Executive Officers of the Company
          57   
Item 11
              
Executive Compensation
          57    
Item 12
              
Security Ownership of Certain Beneficial Owners and Management
          57    
Item 13
              
Certain Relationships and Related Transactions
          58    
Item 14
              
Principal Accountant Fees and Services
          58    
 
PART IV
              
 
               
 
Item 15
              
Exhibits, Financial Statement Schedules and Reports on Form 8-K
          58   
 


PART I

Item 1.  Business

General

Foot Locker, Inc., incorporated under the laws of the State of New York in 1989, is a leading global retailer of athletic footwear and apparel, operating as of January 31, 2004, 3,610 primarily mall-based stores in North America, Europe and Australia. Foot Locker, Inc. and its subsidiaries hereafter are referred to as the “Registrant” or “Company.” Information regarding the business is contained under the “Business Overview” section in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

The Company maintains a website on the Internet at www.footlocker-inc.com. The Company’s filings with the Securities and Exchange Commission, including its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports are available free of charge through this website as soon as reasonably practicable after they are filed with or furnished to the SEC by clicking on the “SEC Filings” link. The Corporate Governance section of the Company’s corporate website at www.footlocker-inc.com contains the Company’s Corporate Governance Guidelines, Committee Charters and the Company’s Code of Business Conduct for directors, officers and employees, including the Chief Executive Officer, Chief Financial Officer and Chief Accounting Officer. Copies of these documents may also be obtained free of charge upon written request to the Company’s Corporate Secretary at 112 West 34th Street, New York, NY 10120.

Information Regarding Business Segments and Geographic Areas

The financial information concerning business segments, divisions and geographic areas is contained under the “Business Overview” and “Segment Information” sections in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Information regarding sales, operating results and identifiable assets of the Company by business segment and by geographic area is contained under the “Segment Information” footnote in “Item 8. Consolidated Financial Statements and Supplementary Data.”

The service marks and trademarks appearing on this page and elsewhere in this report (except for NFL, NBA, Nike, Amazon.com, Burger King, Popeye’s, The San Francisco Music Box Company and USOC) are owned by Foot Locker, Inc. or its subsidiaries.

Employees

The Company and its consolidated subsidiaries had 15,782 full-time and 24,516 part-time employees at January 31, 2004. The Company considers employee relations to be satisfactory.

Competition

The financial information concerning competition is contained under the “Business Risk” section in the “Financial Instruments and Risk Management” footnote in “Item 8. Consolidated Financial Statements and Supplementary Data.”

Merchandise Purchases

The financial information concerning merchandise purchases is contained under the “Business Concentration” section in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and under the “Business Risk” section in the “Financial Instruments and Risk Management” footnote in “Item 8. Consolidated Financial Statements and Supplementary Data.”

1



Item 2.  Properties

The properties of the Company and its consolidated subsidiaries consist of land, leased and owned stores and administrative and distribution facilities. Total selling area for the Athletic Stores segment at the end of 2003 was approximately 7.92 million square feet. These properties are primarily located in the United States, Canada and Europe.

The Company currently operates three distribution centers, of which one is owned and two are leased, occupying an aggregate of 1.88 million square feet. Two of the three distribution centers are located in the United States and one is in Europe. The Company also has one additional distribution center that is leased and sublet, occupying approximately 0.1 million square feet.

Item 3.  Legal Proceedings

Legal proceedings pending against the Company or its consolidated subsidiaries consist of ordinary, routine litigation, including administrative proceedings, incident to the businesses of the Company, as well as litigation incident to the sale and disposition of businesses that have occurred in the past several years. Management does not believe that the outcome of such proceedings will have a material effect on the Company’s consolidated financial position, liquidity, or results of operations.

Item 4.  Submission of Matters to a Vote of Security Holders

There were no matters submitted to a vote of security holders during the fourth quarter of the year ended January 31, 2004.

Executive Officers of the Company

Information with respect to Executive Officers of the Company, as of April 5, 2004, is set forth below:

Chairman of the Board, President and Chief Executive Officer
              
Matthew D. Serra
Executive Vice President and Chief Financial Officer
              
Bruce L. Hartman
President and Chief Executive Officer, Foot Locker, Inc. — U.S.A.
              
Richard T. Mina
Senior Vice President, General Counsel and Secretary
              
Gary M. Bahler
Senior Vice President — Real Estate
              
Jeffrey L. Berk
Senior Vice President — Chief Information Officer
              
Marc D. Katz
Senior Vice President — Strategic Planning
              
Lauren B. Peters
Senior Vice President — Human Resources
              
Laurie J. Petrucci
Vice President — Investor Relations and Treasurer
              
Peter D. Brown
Vice President and Chief Accounting Officer
              
Robert W. McHugh
 

Matthew D. Serra, age 59, has served as Chairman of the Board since February 1, 2004. He served as President since April 12, 2000 and Chief Executive Officer since March 4, 2001. Mr. Serra served as Chief Operating Officer from February 2000 to March 3, 2001 and as President and Chief Executive Officer of Foot Locker Worldwide from September 1998 to February 2000.

Bruce L. Hartman, age 50, has served as Executive Vice President since April 18, 2002 and Chief Financial Officer since February 27, 1999. He served as Senior Vice President from February 1999 to April 2002. Mr. Hartman served as Vice President-Corporate Shared Services from August 1998 to February 1999.

Richard T. Mina, age 47, has served as President and Chief Executive Officer of Foot Locker, Inc. — U.S.A. since February 2, 2003. He served as President and Chief Executive Officer of Champs Sports from April 1999 to February 1, 2003. He served as President of Foot Locker Europe from January 1996 to April 1999.

Gary M. Bahler, age 52, has served as Senior Vice President since August 1998, General Counsel since February 1993 and Secretary since February 1990.

2



Jeffrey L. Berk, age 48, has served as Senior Vice President — Real Estate since February 2000 and President of Foot Locker Realty, North America from January 1997 to February 2000.

Marc D. Katz, age 39, has served as Senior Vice President — Chief Information Officer since May 12, 2003. Mr. Katz served as Vice President and Chief Information Officer from July 2002 to May 11, 2003 and as Vice President and Controller from April 2002 to July 2002. During the period of 1997 to 2002, he served in the following capacities at the Financial Services Center of Foot Locker Corporate Services: Vice President and Controller from July 2001 to April 2002; Controller from December 1999 to July 2001; and Retail Controller from October 1997 to December 1999.

Lauren B. Peters, age 42, has served as Senior Vice President — Strategic Planning since April 18, 2002. Ms. Peters served as Vice President — Planning from January 2000 to April 17, 2002. She served as Vice President and Controller from August 1998 to January 2000.

Laurie J. Petrucci, age 45, has served as Senior Vice President — Human Resources since May 2001. Ms. Petrucci served as Senior Vice President — Human Resources of Foot Locker Worldwide from March 2000 to April 2001. She served as Vice President of Organizational Development and Training of Foot Locker Worldwide from February 1999 to March 2000 and as Vice President — Human Resources of Foot Locker Canada from February 1997 to February 1999.

Peter D. Brown, age 49, has served as Vice President — Investor Relations and Treasurer since October 2001. Mr. Brown served as Vice President — Investor Relations and Corporate Development from April 2001 to October 2001 and as Assistant Treasurer — Investor Relations and Corporate Development from August 2000 to April 2001. He served as Vice President and Chief Financial Officer of Lady Foot Locker from October 1999 to August 2000, and as Director of the Company’s Profit Improvement Task Force from November 1998 to October 1999.

Robert W. McHugh, age 45, has served as Vice President and Chief Accounting Officer since January 2000. He served as Vice President — Taxation from November 1997 to January 2000.

There are no family relationships among the executive officers or directors of the Company.

PART II

Item 5.  Market for the Company’s Common Equity and Related Stockholder Matters

Information regarding the Company’s market for common equity, quarterly high and low prices, dividend policy and stock exchange listings are contained in the “Shareholder Information and Market Prices” footnote under “Item 8. Consolidated Financial Statements and Supplementary Data.”

Item 6.  Selected Financial Data

Selected financial data is included as the “Five Year Summary of Selected Financial Data” footnote in “Item 8. Consolidated Financial Statements and Supplementary Data.”

Item 7.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

Business Overview

Foot Locker, Inc., through its subsidiaries, operates in two reportable segments — Athletic Stores and Direct-to-Customers. The Athletic Stores segment is one of the largest athletic footwear and apparel retailers in the world, whose formats include Foot Locker, Lady Foot Locker, Kids Foot Locker and Champs Sports. The Direct-to-Customers segment reflects Footlocker.com, Inc., which sells, through its affiliates, including Eastbay, Inc., to customers through catalogs and Internet websites.

3



The Foot Locker brand is one of the most widely recognized names in the market segments in which the Company operates, epitomizing high quality for the active lifestyle customer. This brand equity has aided the Company’s ability to successfully develop and increase its portfolio of complementary retail store formats, specifically, Lady Foot Locker and Kids Foot Locker, as well as Footlocker.com, Inc., its direct-to-customers business. Through various marketing channels, including television campaigns and sponsorships of various sporting events, Foot Locker, Inc. reinforces its image with a consistent message; namely, that it is the destination store for athletic apparel and footwear with a wide selection of merchandise in a full-service environment.

Athletic Stores

The Company operates 3,610 stores in the Athletic Stores segment. The following is a brief description of the Athletic Stores segment’s operating businesses:

Foot Locker — Foot Locker is a leading athletic footwear and apparel retailer. Its stores offer the latest in athletic-inspired performance products, manufactured primarily by the leading athletic brands. Foot Locker offers products for a wide variety of activities including running, basketball, hiking, tennis, aerobics, fitness, baseball, football and soccer. Its 2,088 stores are located in 16 countries including 1,448 in the United States, Puerto Rico, the United States Virgin Islands and Guam, 129 in Canada, 427 in Europe and a combined 84 in Australia and New Zealand. The domestic stores have an average of 2,400 selling square feet and the international stores have an average of 1,600 selling square feet.

Lady Foot Locker — Lady Foot Locker is a leading U.S. retailer of athletic footwear, apparel and accessories for women. Its stores carry all major athletic footwear and apparel brands, as well as casual wear and an assortment of proprietary merchandise designed for a variety of activities, including running, basketball, walking and fitness. Its 584 stores are located in the United States and Puerto Rico and have an average of 1,200 selling square feet.

Kids Foot Locker — Kids Foot Locker is a national children’s athletic retailer that offers the largest selection of brand-name athletic footwear, apparel and accessories for infants, boys and girls, primarily on an exclusive basis. Its stores feature an entertaining environment geared to both parents and children. Its 357 stores are located in the United States and Puerto Rico and have an average of 1,400 selling square feet.

Champs Sports — Champs Sports is one of the largest mall-based specialty athletic footwear and apparel retailers in the United States. Its product categories include athletic footwear, apparel and accessories, and a focused assortment of equipment. This combination allows Champs Sports to differentiate itself from other mall-based stores by presenting complete product assortments in a select number of sporting activities. Its 581 stores are located throughout the United States and Canada. The Champs Sports stores have an average of 3,900 selling square feet.

Store Profile


 
         At
February 1, 2003
     Opened
     Closed
     At
January 31, 2004
Foot Locker
                    2,060              94               66               2,088   
Lady Foot Locker
                    606               2               24               584    
Kids Foot Locker
                    377                             20               357    
Champs Sports
                    582               17               18               581    
Total Athletic Stores
                    3,625              113               128               3,610   
 

4



Direct-to-Customers

Footlocker.com — Footlocker.com, Inc., sells, through its affiliates, directly to customers through catalogs and its Internet websites. Eastbay, Inc., one of its affiliates, is one of the largest direct marketers of athletic footwear, apparel, equipment and licensed private-label merchandise in the United States and provides the Company’s seven full-service e-commerce sites access to an integrated fulfillment and distribution system. The Company has an agreement with the National Football League as its official catalog and e-commerce retailer, which includes managing the NFL catalog and e-commerce businesses. Footlocker.com designs, merchandises and fulfills the NFL’s official catalog (NFL Shop) and the e-commerce site linked to www.NFLshop.com. The Company has a strategic alliance to offer footwear and apparel on the Amazon.com website and the Foot Locker brands are featured in the Amazon.com specialty stores for apparel and accessories and sporting goods. During 2003, the Company entered into an arrangement with the NBA and Amazon.com whereby Foot Locker began to provide the fulfillment services for NBA licensed products sold over the Internet at NBAstore.com and the NBA store on Amazon.com. In addition, the Company also entered into a marketing agreement with the U.S. Olympic Committee (USOC) providing the Company with the exclusive rights to sell USOC licensed products through catalogs and via a new e-commerce site.

Sales by Segment

The following table summarizes sales by segment, after reclassification for businesses disposed. The disposition of all businesses previously held for disposal was completed by the end of 2001:


 
         2003
     2002
     2001
    

 
         (in millions)
 
    
Athletic Stores
                 $ 4,413           $ 4,160           $ 3,999                       
Direct-to-Customers
                    366               349               326                        
 
                    4,779              4,509              4,325                       
Disposed(1)
                                                54                        
 
                 $ 4,779           $ 4,509           $ 4,379                       
 

Division Profit

The Company evaluates performance based on several factors, of which, the primary financial measure is division results. Division profit reflects income from continuing operations before income taxes, corporate expense, non-operating income and net interest expense. The following table reconciles division profit by segment to income from continuing operations before income taxes.


 
         2003
     2002
     2001
    

 
         (in millions)
 
    
Athletic Stores
                 $ 363            $ 279            $ 283                        
Direct-to-Customers
                    53               40               24                        
Division profit from ongoing operations
                    416               319               307                        
Disposed(1)
                                                (12 )                      
Restructuring income (charges)(2)
                    (1 )             2               (33 )                      
Total division profit
                    415               321               262                        
Corporate expense(3)
                    (73 )             (52 )             (65 )                      
Total operating profit
                    342               269               197                        
Non-operating income
                                  3               2                        
Interest expense, net
                    (18 )             (26 )             (24 )                      
Income from continuing operations before
                                                                                         
income taxes
                 $ 324            $ 246            $ 175                        
 


(1)
  Includes The San Francisco Music Box Company and Burger King and Popeye’s franchises.

(2)
  Restructuring charges of $1 million and $33 million in 2003 and 2001, respectively, and restructuring income of $2 million in 2002 reflect the disposition of non-core businesses and an accelerated store-closing program.

(3)
  2001 includes a $1 million restructuring charge related to the 1999 closure of a distribution center.

5



Sales

All references to comparable-store sales for a given period relate to sales of stores that are open at the period-end and that have been open for more than one year. Accordingly, stores opened and closed during the period are not included. All comparable-store sales increases and decreases exclude the impact of foreign currency fluctuations.

Sales of $4,779 million in 2003 increased by 6.0 percent from sales of $4,509 million in 2002. Excluding the effect of foreign currency fluctuations, sales increased by 2.2 percent as compared with 2002, primarily as a result of the Company’s continuation of the new store opening program. Comparable-store sales decreased by 0.5 percent.

Sales of $4,509 million in 2002 increased 3.0 percent from sales of $4,379 million in 2001. Excluding sales from businesses disposed and the effect of foreign currency fluctuations, 2002 sales increased by 3.1 percent as compared with 2001 primarily as a result of the new store opening program. Comparable-store sales increased by 0.1 percent.

Gross Margin

Gross margin, as a percentage of sales, of 30.9 percent increased by 110 basis points in 2003 from 29.8 percent in 2002, primarily reflecting a decrease in the cost of merchandise, as a percentage of sales. Increased vendor allowances improved gross margin, as a percentage of sales, by 28 basis points, year over year.

Gross margin, as a percentage of sales, of 29.8 percent declined by 10 basis points in 2002 as compared with 29.9 percent in 2001, primarily resulting from the increase in the cost of merchandise, as a percentage of sales, due to increased markdown activity. The impact of the vendor allowances was an improvement in gross margin in 2002, as a percentage of sales, of 30 basis points as compared with 2001.

Segment Information

Athletic Stores


 
         2003
     2002
     2001
    

 
         (in millions)
 
    
Sales
                 $ 4,413           $ 4,160           $ 3,999                       
Division profit
                                                                                         
Stores
                 $ 363            $ 279            $ 283                        
Restructuring income
                                  1                                      
Total division profit
                 $ 363            $ 280            $ 283                        
Sales as a percentage of consolidated total
                    92 %             92 %             92 %                      
Number of stores at year end
                    3,610              3,625              3,590                       
Selling square footage (in millions)
                    7.92              8.04              7.94                       
Gross square footage (in millions)
                    13.14              13.22              13.14                       
 

Athletic Stores sales of $4,413 million increased 6.1 percent in 2003, as compared with $4,160 million in 2002. Excluding the effect of foreign currency fluctuations, primarily related to the euro, sales from athletic store formats increased 1.9 percent in 2003, driven by the Company’s new store opening program, particularly in Foot Locker Europe and Foot Locker Australia. Foot Locker Europe and Foot Locker Australia also continued to generate solid comparable-store sales increases. Total Athletic Stores comparable-store sales decreased by 0.9 percent in 2003.

6



Footwear sales in the U.S. were led by the classic category. Consumer demand for “retro” fashioned athletic footwear was also a primary driver of sales throughout 2003. The Company also benefited from exclusive offerings from its primary suppliers, such as the Nike 20 pack line in the latter part of 2003. Sales of private label and licensed product also contributed to the increase in sales, as consumer interest began to show improvement with the strengthening of the economy.

Comparable-store sales at Kids Foot Locker continually improved since the realignment under the Foot Locker U.S. management team in 2002. Kids Foot Locker’s sales, significantly improved during the fourth quarter of 2003, nearly reaching double-digit comparable-store sales.

Lady Foot Locker sales remained essentially unchanged in 2003 versus the prior year as this business continued to modify its merchandising mix to better suit its target customers. The Company closed a number of underperforming stores, focused on remodeling and relocating numerous stores and changed its merchandise assortment.

Athletic Stores sales of $4,160 million increased 4.0 percent in 2002, as compared with $3,999 million in 2001. The increase was in part due to the euro strengthening against the U.S. dollar in 2002, particularly in the third and fourth quarters. Excluding the effect of foreign currency fluctuations, sales from athletic store formats increased 2.8 percent in 2002, which was driven by the Company’s new store opening program, particularly in Foot Locker Europe and Champs Sports. Foot Locker Europe and Foot Locker Australia generated impressive comparable-store sales increases. Champs Sports also contributed a comparable-store sales increase. Total Athletic Stores comparable-store sales decreased by 0.4 percent in 2002.

The Foot Locker business in the United States, as a whole, showed disappointing sales during 2002. In the United States, both the basketball category as well as the trend in classic shoes led footwear sales across most formats, although certain higher-priced marquee footwear did not sell as well as anticipated in the first quarter of 2002. During the second quarter of 2002, the Company successfully moved its marquee footwear back in line with historical levels and re-focused its marquee footwear selection on products having a retail price of $90 to $120 per pair and made changes to the product assortment, which accommodated customer demands in the third quarter of 2002. Lower mall traffic resulted in disappointing sales during the fourth quarter of 2002. Sales, however, benefited from the apparel strategy led by merchandise in private label and licensed offerings.

Sales from the Lady Foot Locker and Kids Foot Locker formats were particularly disappointing in 2002. The Kids Foot Locker format, which had previously been managed in conjunction with Lady Foot Locker, was realigned and is currently being managed by the Foot Locker U.S. management team. Pursuant to SFAS No. 144, the Company performed an analysis of the recoverability of store long-lived assets for the Lady Foot Locker format during the third quarter of 2002 and for the Kids Foot Locker format during the fourth quarter of 2002 and recorded asset impairment charges of $1 million and $6 million, respectively.

Division profit from Athletic Stores increased by 30.1 percent to $363 million in 2003 from $279 million in 2002. Division profit, as a percentage of sales, increased to 8.2 percent in 2003 from 6.7 percent in 2002. The increase in 2003 was primarily driven by the overall improvement in the gross margin rate, as a result of better merchandise purchasing, as well as, increased vendor allowances which contributed 30 basis points to the overall improvement. Additionally, during 2002 the Company recorded $7 million of impairment charges for the Kids Foot Locker and Lady Foot Locker formats. Operating performance improved in the U.S. Foot Locker, Kids Foot Locker and international formats as compared with the prior year. Champs Sports and Lady Foot Locker remained relatively flat as compared with 2002. However, for the second half of 2003 the operating results of the Lady Foot Locker format improved considerably, as compared with the corresponding prior year period. Management expects this trend to continue.

7



Division profit from athletic store formats decreased 1.4 percent to $279 million in 2002 from $283 million in 2001. Division profit, as a percentage of sales, decreased to 6.7 percent in 2002 from 7.1 percent in 2001 primarily due to the increased operating expenses associated with the new store-opening program. The impact of no longer amortizing goodwill as a result of the Company’s adoption of SFAS No. 142 was a reduction of amortization expense of $2 million in 2002. Operating performance improved internationally but was more than offset by the decline in performance in the United States from the Foot Locker, Lady Foot Locker and Kids Foot Locker formats. Division profit included asset impairment charges of $1 million and $2 million in 2002 and 2001, respectively, for the Lady Foot Locker format. An asset impairment charge of $6 million was also recorded in 2002 related to the Kids Foot Locker format.

Direct-to-Customers


 
         2003
     2002
     2001
    

 
         (in millions)
 
    
Sales
                 $ 366            $ 349            $ 326                        
Division profit
                 $ 53            $ 40            $ 24                        
Sales as a percentage of consolidated total
                    8 %             8 %             7 %                      
 

Direct-to-Customers sales increased 4.9 percent in 2003 to $366 million as compared with $349 million in 2002. Division profit, as a percentage of sales, in this quickly expanding division, is more profitable than the store business. The growth of the Internet business continued to drive sales in 2003. Internet sales increased by 32.6 percent to $191 million from $144 million in 2002. Catalog sales decreased by 14.6 percent to $175 million in 2003 from $205 million in 2002. Management believes that the decrease in catalog sales is substantially offset by the increase in Internet sales as the trend has continued for customers to browse and select products through its catalogs and then to make their purchases via the Internet. The Company continues to implement new initiatives to grow this business, including new marketing arrangements and strategic alliances with well-known third parties. During 2003, the Company extended its agreement with the NFL, entered into new alliance agreements with the NBA and the USOC and expanded its services through on-line specialty stores with Amazon.com. These agreements generally provide for the Company to merchandise, fulfill and manage the websites of these strategic partners.

Direct-to-Customers sales increased by 7.1 percent to $349 million in 2002 from $326 million in 2001. The Internet business continued to drive the sales growth in 2002. Internet sales increased by $44 million, or 44.0 percent, to $144 million in 2002 compared with $100 million in 2001. Catalog sales decreased 9.3 percent to $205 million in 2002 from $226 million in 2001. During 2002, the Company implemented many new initiatives designed to increase market share within the Internet arena. A new catalog website was launched that offers value-based products. The Company began to offer product customization to further differentiate its products from those of competitors, expanded on the existing relationship with the National Football League and, prior to the end of 2002, entered into a strategic alliance to offer footwear and apparel on the Amazon.com website. Foot Locker is a featured brand in the Amazon.com specialty store for apparel and accessories.

The Direct-to-Customers business generated division profit of $53 million in 2003, as compared with $40 million in 2002. The increase in division profit was primarily due to increased sales. Division profit, as a percentage of sales, increased to 14.5 percent in 2003 from 11.5 percent in 2002. Management anticipates that the sales and earnings of the integrated Internet and catalog business will continue to grow.

The Direct-to-Customers business generated division profit of $40 million in 2002 as compared with $24 million in 2001. Division profit, as a percentage of sales, increased to 11.5 percent in 2002 from 7.4 percent in 2001. The increase was primarily due to the increase in gross margin, reduced marketing costs and $5 million related to the impact of no longer amortizing goodwill as a result of the Company’s adoption of SFAS No. 142 in 2002.

8



All Other Businesses

The “All Other” category included Afterthoughts, The San Francisco Music Box Company (“SFMB”), the Burger King and Popeye’s franchises, Randy River Canada, Weekend Edition and the Garden Centers. The disposition of these businesses was completed by the end of 2001.


 
         2003
     2002
     2001
    

 
         (in millions)
 
    
Sales
                 $            $            $ 54                        
Division profit (loss)
                                                                                         
Disposed
                 $            $            $ (12 )                      
Restructuring income (charges)
                    (1 )             1               (33 )                      
Total division profit (loss)
                 $ (1 )          $ 1            $ (45 )                      
Sales as a percentage of consolidated total
                    %           %           1 %                      
 

In connection with the 1999 restructuring program, restructuring charges of $1 million and $33 million, were recorded in 2003 and 2001, respectively, related to the dispositions of the non-core businesses. The charge in 2003 was primarily related to the Company’s guarantee of the lease liabilities of the distribution center and certain stores of SFMB as a result of their filing for bankruptcy, while the restructuring charges of $33 million recorded in 2001 related to the disposition of SFMB and the Burger King and Popeye’s franchises. In 2002, a $1 million reduction was recorded due to actual amounts being better than anticipated.

The sale of SFMB was completed on November 13, 2001, for cash proceeds of approximately $14 million. In addition, on October 10, 2001, the Company completed the sale of assets related to its Burger King and Popeye’s franchises for cash proceeds of approximately $5 million.

Corporate Expense

Corporate expense consists of unallocated general and administrative expenses related to the Company’s corporate headquarters, centrally managed departments, unallocated insurance and benefit programs, certain foreign exchange transaction gains and losses and other items. Corporate expense included depreciation and amortization of $25 million in 2003, $26 million in 2002 and $28 million in 2001. The increase in corporate expense in 2003 was primarily related to increased compensation costs for incentive bonuses and increased restricted stock expense related to additional grants.

Corporate expense in 2002 declined compared with 2001 primarily reflecting decreased payroll expenses related to reductions in headcount. Corporate expense in 2002 was also reduced by a net foreign exchange gain of $4 million related to intercompany foreign currency denominated firm commitments.

9



Results of Operations

Selling, General and Administrative Expenses

Selling, general and administrative expenses (“SG&A”) increased by $59 million to $987 million in 2003, or by 6.4 percent, as compared with 2002. Excluding the effect of foreign currency fluctuations, primarily related to the euro, SG&A increased by 2.7 percent. The increases were related to additional payroll costs of $16 million in Europe, primarily as a result of new store openings and $12 million related to compensation costs for incentive bonuses due to the Company’s performance. Additionally, pension expense increased by $8 million due to the decline in plan asset values experienced in prior years, partially offset by a $4 million increase in the recognition of postretirement income and foreign exchange gain recorded in 2002. During 2002, the Company recorded asset impairment charges of $6 million and $1 million related to the Kids Foot Locker and Lady Foot Locker formats, respectively. SG&A as a percentage of sales remained relatively flat as compared with the corresponding prior year period.

SG&A increased by $5 million in 2002 to $928 million. The increase included $13 million related to new store openings, $11 million related to the impact of foreign currency fluctuations, primarily related to the euro, and $10 million related to increased pension costs. The increase in pension costs resulted from the decline in the retirement plans’ asset values experienced in prior years and the expected long-term rate of return used to determine the expense. These increases were partially offset by $29 million in the reduction in SG&A expenses related to the dispositions of SFMB and the Burger King and Popeye’s franchises during the third quarter of 2001, and a $3 million increase in income related to the postretirement plan. The increase in postretirement income of $3 million resulted from the amortization of the associated gains. SG&A, as a percentage of sales, decreased to 20.6 percent in 2002 from 21.1 percent in 2001. During 2002, the Company recorded asset impairment charges of $6 million and $1 million related to the Kids Foot Locker and Lady Foot Locker formats, respectively, compared with $2 million in 2001 for the Lady Foot Locker format. SG&A in 2002 was reduced by a net foreign exchange gain of $4 million related to intercompany foreign currency denominated firm commitments.

Depreciation and Amortization

Depreciation and amortization of $147 million decreased by 1.3 percent in 2003 from $149 million in 2002. Excluding the impact of foreign currency fluctuations, depreciation and amortization declined by $5 million. The decrease relates primarily to assets becoming fully depreciated for the U.S. Athletic stores, offset in part by an increase related to the European new stores.

Depreciation and amortization of $149 million decreased by 3.2 percent in 2002 from $154 million in 2001. The impact of no longer amortizing goodwill, as required by SFAS No. 142, which was adopted by the Company effective February 3, 2002, was $7 million and was partially offset by increased depreciation of $2 million associated with the new store opening program, primarily in Europe.

Interest Expense, Net


 
         2003
     2002
     2001
    

 
         (in millions)
 
    
Interest expense
                 $ 26            $ 33            $ 35                        
Interest income
                    (8 )             (7 )             (11 )                      
Interest expense, net
                 $ 18            $ 26            $ 24                        
Weighted-average interest rate (excluding facility fees):
                                                                                         
Short-term debt
                    %           %           6.0 %                      
Long-term debt
                    6.1 %             7.2 %             7.4 %                      
Total debt
                    6.1 %             7.2 %             7.4 %                      
Short-term debt outstanding during the year:
                                                                                         
High
                 $            $            $ 11                        
Weighted-average
                 $            $            $                        
 

10



Interest expense of $26 million declined by 21.2 percent in 2003 from $33 million in 2002. Interest expense primarily related to the facility fees and amortization of the issuance costs for the credit facility, remained flat at $3 million. Interest expense related to long-term debt declined by $6 million primarily as a result of the $100 million of interest rate swaps that were outstanding during 2003. These interest rate swaps were entered into in order to convert the 8.50 percent fixed-rate debentures, which are due in 2022 to a lower variable rate. The Company entered into an interest rate swap agreement in December 2002 to convert $50 million of the 8.50 percent debentures to variable rate debt and subsequently entered into two additional swaps during 2003, totaling $50 million, which allowed the Company to lower the net amount of interest expense being paid at each interest payment date. The swaps reduced interest expense by approximately $4 million. The remaining decrease is a result of the lower debt balance as the Company repurchased $19 million of the 8.50 percent debentures in 2003 and $9 million in the latter part of 2002. Interest expense was further reduced as a result of the repayment of the remaining $32 million of the $40 million 7.00 percent medium-term notes that matured in October 2002.

Interest expense of $33 million declined by 5.7 percent in 2002 from $35 million in 2001. Interest expense related to the revolving credit facility decreased by $1 million primarily as a result of the amortization of deferred financing costs over the amended agreement term. Interest expense related to long-term debt also declined by $1 million. There was an increase of $3 million in interest expense in 2002 resulting from the issuance of the $150 million 5.50 percent convertible notes in June 2001. This increase was more than offset by the reduction in interest expense that resulted from the repayment of the remaining $32 million of the $40 million 7.00 percent medium-term notes in October 2002 and the interest expense in 2001 associated with the $50 million 6.98 percent medium-term notes that were repaid in October 2001.

Interest income related to cash and cash equivalents and other short-term investments amounted to $5 million in both 2003 and 2002. Additional interest income in 2003 of $2 million was generated through accretion of the Northern Group note to its present value and accrued interest income on the note, which was recorded during the fourth quarter of 2002. Interest income of $1 million and $2 million was related to tax refunds and settlements in 2003 and 2002, respectively.

Interest income related to cash and cash equivalents and other short-term investments amounted to $5 million in 2002 and $4 million in 2001. Interest income in both 2002 and 2001 included $2 million of interest income related to tax refunds and settlements. Also included was intercompany interest of $5 million in 2001 related to the Northern Group segment. The offsetting interest expense for the Northern Group was charged to the reserve for discontinued operations.

Income Taxes

The effective rate for 2003 was 35.5 percent, as compared with 34.2 percent in the prior year. The increased tax rate was primarily due to the Company recording tax benefits of $5 million in 2003 as compared to $9 million in 2002. In addition the rate increased due to a shift in taxable income by jurisdiction. During 2003, the Company recorded a $1 million tax benefit related to state tax law changes, a $2 million tax benefit related to a reduction in the valuation allowance for deferred tax assets related to a multi-state tax planning strategy, a $1 million tax benefit related to a reduction in the valuation allowance for foreign tax loss carryforwards and a tax benefit of $1 million related to the settlement of tax examinations.

The effective rate for 2002 was 34.2 percent. The Company recorded a tax benefit during 2002 of $5 million related to a multi-state tax planning strategy, a $1 million tax benefit related to settlement of tax examinations, a $2 million benefit related to the reduction in the valuation allowance for deferred tax assets related to foreign tax credits and a $1 million benefit related to international tax planning strategies. The combined effect of these items, in addition to higher earnings in lower tax jurisdictions and the utilization of tax loss carryforwards reduced the effective tax rate.

In 2001, the effective tax rate was 36.6 percent. The Company recorded a tax benefit during 2001 of $7 million related to state and local income tax settlements, partially offset by a $2 million charge from the impact of Canadian tax rate reductions on existing deferred tax assets. The combined effect of these items, in addition to higher earnings in lower tax jurisdictions and the utilization of tax loss carryforwards were offset, in part, by the impact of non-deductible goodwill which reduced the effective tax rate.

11



Liquidity and Capital Resources

Cash Flow and Liquidity

Generally, the Company’s primary source of cash has been from operations. The Company has a revolving credit facility, which was amended on July 30, 2003. As a result of the amendment, the credit facility was increased by $10 million to $200 million and the maturity date was extended to July 2006 from June 2004. The amendment also provided for a lower pricing structure and increased covenant flexibility. Other than $24 million utilized for stand-by letter of credit requirements, this revolving credit facility was not used during 2003. In 2001, the Company raised $150 million in cash through the issuance of subordinated convertible notes. The Company may redeem all or a portion of the notes at any time on or after June 4, 2004. If the Company were to exercise its option, the Company anticipates that the holders of the notes would convert to common stock, provided that the Company’s common stock price at that time exceeds the conversion price of $15.806; however, the holders of the notes may elect to receive cash at the then applicable conversion premium. The Company generally finances real estate with operating leases. The principal uses of cash have been to finance inventory requirements, capital expenditures related to store openings, store remodelings and management information systems, and to fund other general working capital requirements.

Management believes operating cash flows and current credit facilities will be adequate to finance its working capital requirements, to make scheduled pension contributions for the Company’s retirement plans, to fund quarterly dividend payments, and support the development of its short-term and long-term operating strategies. The Company contributed an additional $44 million and $6 million to its U.S. and Canadian qualified pension plans, respectively, in February 2004. The U.S. contribution was made in advance of ERISA requirements. Planned capital expenditures for 2004 are $141 million, of which $97 million relates to new store openings and modernizations of existing stores and $44 million reflects the development of information systems and other support facilities. In addition, planned lease acquisition costs are $24 million and primarily relate to the Company’s operations in Europe. The Company has the ability to revise and reschedule the anticipated capital expenditure program, should the Company’s financial position require it.

Any materially adverse reaction to customer demand, fashion trends, competitive market forces, uncertainties related to the effect of competitive products and pricing, customer acceptance of the Company’s merchandise mix and retail locations, the Company’s reliance on a few key vendors for a significant portion of its merchandise purchases (and on one key vendor for approximately 40 percent of its merchandise purchases), risks associated with foreign global sourcing or economic conditions worldwide could affect the ability of the Company to continue to fund its needs from business operations.

Operating activities of continuing operations provided cash of $264 million in 2003 as compared with $347 million in 2002. These amounts reflect income from continuing operations adjusted for non-cash items and working capital changes. The decrease was primarily the result of a $50 million pension contribution and working capital usage, partially offset by increased income from continuing operations. Income from continuing operations increased by $54 million in 2003. Working capital usage included higher net cash outflow for merchandise inventories in 2003 as compared with 2002 and the Company increased its inventory position to accommodate anticipated sales in 2004. The decrease in income taxes payable was attributable to increased payments made during 2003. The Company received a refund of tax and interest of $13 million during the fourth quarter of 2003.

Operating activities of continuing operations provided cash of $347 million in 2002 compared with $204 million in 2001. The increase in cashflow from operations of $143 million in 2002 was primarily due to improved operating performance and was also related to working capital changes primarily related to merchandise inventories, offset by the related payables and income taxes payable. During the third quarter of 2002, the Company recorded a current receivable of approximately $45 million related to a Federal income tax refund and subsequently received the cash during the fourth quarter. Payments charged to the repositioning and restructuring reserves were $3 million in 2002 compared with $62 million in 2001.

12



Net cash used in investing activities of the Company’s continuing operations was $159 million in 2003 compared with $162 million in 2002. Capital expenditures of $144 million in 2003 and $150 million in 2002 primarily related to store remodelings and new stores. Lease acquisition costs, primarily related to the process of securing and extending prime lease locations for real estate in Europe, were $15 million and $18 million in 2003 and 2002, respectively. Proceeds from the disposal of real estate of $6 million in 2002 primarily related to the condemnation of a part-owned and part-leased property. This real estate transaction resulted in a gain of $3 million, which was recorded in other income.

Net cash used in investing activities of continuing operations was $162 million in 2002 compared with $116 million in 2001. The change was due to a $34 million increase in capital expenditures in 2002 related to store remodelings and new stores. Lease acquisition costs were $18 million and $20 million in 2002 and 2001, respectively. Proceeds from sales of real estate and other assets and investments were $6 million in 2002 compared with $20 million in 2001. Proceeds from the condemnation of the Company’s part-owned and part-leased property contributed $6 million of cash received in 2002. Proceeds from the sales of The San Francisco Music Box Company and the Burger King and Popeye’s franchises contributed $14 million and $5 million in cash, respectively, in 2001.

Net cash used in financing activities of continuing operations was $13 million in 2003 compared with $36 million in 2002. The Company repurchased $19 million of its 8.50 percent debentures that are due in 2022 during 2003. During 2002, the Company repaid the remaining $32 million of the $40 million 7.00 percent medium-term notes due in October 2002 and retired approximately $9 million of its 8.50 percent debentures. The Company declared and paid a $0.03 per share dividend in each of the first three quarters and a $0.06 per share dividend in the fourth quarter of 2003, totaling $21 million for the year. During 2002, the Company declared and paid a dividend during the fourth quarter of $0.03 per share totaling $4 million. During 2003 and 2002, the Company received proceeds from the issuance of common stock in connection with employee stock programs of $27 million and $10 million, respectively.

Net cash used in financing activities of the Company’s continuing operations was $36 million in 2002 as compared with $89 million of cash provided by financing activities of continuing operations in 2001. The change in 2002 compared with 2001 was primarily due to the issuance of $150 million of convertible notes on June 8, 2001, which was partially offset by the repayment of the $50 million 6.98 percent medium-term notes that matured in October 2001 and the repurchase and retirement of $8 million of the $40 million 7.00 percent medium-term notes. During 2002, the Company repaid the balance of the $40 million 7.00 percent medium-term notes that were due in October 2002 and $9 million of the $200 million of debentures due in 2022. There were no outstanding borrowings under the Company’s revolving credit agreement as of February 1, 2003 and February 2, 2002. During 2002, the Company declared and paid a $0.03 per share dividend during the fourth quarter of $4 million.

Net cash provided by and used in discontinued operations includes the loss from discontinued operations, the change in assets and liabilities of the discontinued segments and disposition activity related to the reserves. In 2003, net cash provided by discontinued operations was $7 million and primarily related to an income tax benefit of $21 million offset by payments against the reserves of $13 million. In 2002 and 2001, discontinued operations utilized cash of $10 million and $75 million, respectively, which consisted of payments for the Northern Group’s operations and disposition activity related to the other discontinued segments.

Capital Structure

As of January 31, 2004, the Company increased cash, net of debt and capital lease obligations, to $112 million. In 2003, the Company repurchased $19 million of the 8.50 percent debentures due in 2022. The Company declared and paid dividends totaling $21 million during 2003. The Company’s revolving credit facility was amended in 2003 to increase the available line of credit by $10 million to $200 million and lengthened the term to July 2006. The amended agreement includes various restrictive financial covenants with which the Company was in compliance on January 31, 2004. The Company made a $50 million contribution to its U.S. qualified retirement plan in February 2003, in advance of ERISA requirements.

13



The Company reduced debt and capital lease obligations, net of cash and cash equivalents, to zero at February 1, 2003, from $184 million at February 2, 2002. In 2002, the Company repaid the remaining $32 million of the $40 million 7.00 percent medium-term notes that were payable in October 2002 and repurchased and retired $9 million of the $200 million 8.50 percent notes due in 2022, contributing to the reduction of debt and capital lease obligations. During the fourth quarter of 2002, the Board of Directors initiated the Company’s dividend program and declared and paid a dividend of $0.03 per share.

During 2001, the Company issued $150 million of subordinated convertible notes due in 2008 and simultaneously amended its $300 million revolving credit agreement to a reduced $190 million three-year facility. The subordinated convertible notes bear interest at 5.50 percent and are convertible into the Company’s common stock at the option of the holder, at a conversion price of $15.806 per share. The net proceeds of the offering are being used for working capital and general corporate purposes and to reduce reliance on bank financing.

Credit Rating

The Company’s credit rating from Standard & Poor’s is BB+. On February 26, 2004, Moody’s Investors Service’s increased the Company’s credit rating to Ba1 citing that “the upgrade was based on the Company’s considerable progress in improving profit margins, free cash flow and credit metrics despite shifts in consumer preferences and a challenging retail environment.” The Company is working toward attaining an investment grade rating from both agencies.

Debt Capitalization

For purposes of calculating debt to total capitalization, the Company includes the present value of operating lease commitments. These commitments are the primary financing vehicle used to fund store expansion. The following table sets forth the components of the Company’s capitalization, both with and without the present value of operating leases, and excludes the effect of an interest rate swap of $1 million that reduced long-term debt at January 31, 2004:


 
         2003
     2002

 
         (in millions)
 
    
Cash and cash equivalents, net of debt and capital lease obligations
                 $ 112            $    
Present value of operating leases
                    1,683              1,571   
Total net debt
                    1,571              1,571   
Shareholders’ equity
                    1,375              1,110   
Total capitalization
                 $ 2,946           $ 2,681   
Net debt capitalization percent
                    53.3 %             58.6 %  
Net debt capitalization percent without operating leases
                    %           %
 

Excluding the present value of operating leases, the Company increased cash and cash equivalents, net of debt and capital lease obligations to $112 million at January 31, 2004 from zero at February 1, 2003. The Company reduced debt and capital lease obligations by $21 million while increasing cash and cash equivalents by $91 million. These improvements were offset by an increase of $112 million in the present value of operating leases for additional leases entered into or renewals during 2003, resulting in no change to total net debt.

Including the present value of operating leases, the Company’s net debt capitalization percent improved 5.3 percentage points in 2003. Total capitalization improved by $265 million in 2003, which was attributable to an increase in shareholders’ equity. The increase in shareholders’ equity relates primarily to net income of $207 million in 2003, an increase of $31 million in the foreign exchange currency translation adjustment, primarily related to the increase in the euro, and a reduction of $16 million to the minimum liability for the Company’s pension plans. The reduction in the minimum liability was a result of an improvement in the plans’ asset performance coupled with a $50 million contribution made in February 2003, offset by a 60 basis point decrease in the discount rate used to value the benefit obligations. The Company contributed an additional $44 million and $6 million to its U.S. and Canadian qualified pension plans, respectively, in February 2004. The U.S. contribution was made in advance of ERISA requirements.

14



Contractual Obligations and Commitments

The following tables represent the scheduled maturities of the Company’s contractual cash obligations and other commercial commitments as of January 31, 2004:


 
        
 
     Payments Due by Period
    
Contractual Cash Obligations
         Total
     Less than
1 Year
     2 – 3
Years
     4 – 5
Years
     After 5
Years

 
         (in millions)
 
    
Long-term debt(1)
                 $ 321            $            $            $ 150            $ 171    
Operating leases
                    2,366              387               693               533               753    
Capital lease obligations
                    14                                           14                  
Other long-term liabilities(2)
                                                                               
Total contractual cash obligations
                 $ 2,701           $ 387            $ 693            $ 697            $ 924    
 


 
        
 
     Amount of Commitment Expiration by Period
    
Other Commercial Commitments
         Total
Amounts
Committed
     Less than
1 Year
     2 – 3
Years
     4 – 5
Years
     After 5
Years

 
         (in millions)
 
    
Line of credit
                 $ 176            $            $ 176            $            $    
Stand-by letters of credit
                    24                             24                                
Purchase commitments(3)
                    1,377              1,377                                             
Other(4)
                    56               6               19               27               4    
Total commercial commitments
                 $ 1,633           $ 1,383           $ 219            $ 27            $ 4    
 


(1)
  The Company raised $150 million in cash through the issuance of subordinated convertible notes in 2001. The Company may redeem all or a portion of the notes at any time on or after June 4, 2004. If the Company exercises its option, the Company anticipates that the holders of the notes will convert to common stock, provided that the Company’s common stock price at that time exceeds the conversion price of $15.806; however, holders may elect to receive cash at the then applicable conversion premium.

(2)
  The Company’s other liabilities in the Consolidated Balance Sheet as of January 31, 2004 primarily include pension and postretirement benefits, deferred taxes, workers’ compensation and general liability reserves and various other sundry accruals. These liabilities have been excluded from the above table as the timing and/or amount of any cash payment is uncertain. The timing of the remaining amounts that are known have not been included as they are minimal and not useful to the presentation. Additional information on the balance sheet caption is included in the “Other Liabilities” footnote under “Item 8. Consolidated Financial Statements and Supplementary Data.”

(3)
  Represents open purchase orders at January 31, 2004. The Company is obligated under the terms of purchase orders; however, the Company is generally able to renegotiate the timing and quantity of these orders with certain vendors, in response to shifts in consumer preferences. Commitments associated with non-inventory services are not significant and have also been excluded.

(4)
  Represents minimum payments required by merchandising and sales agreements.

The Company does not have any off-balance sheet financing, (other than operating leases entered into in the normal course of business and disclosed above) or unconsolidated special purpose entities. The Company’s policy prohibits the use of leveraged derivatives or derivatives for trading purposes.

In connection with the sale of various businesses and assets, the Company may be obligated for certain lease commitments transferred to third parties and pursuant to certain normal representations, warranties, or indemnifications entered into with the purchasers of such businesses or assets. Although the maximum potential amounts for such obligations cannot be readily determined, management believes that the resolution of such contingencies will not significantly affect the Company’s consolidated financial position, liquidity, or results of operations. The Company is also operating certain stores for which lease agreements are in the process of being negotiated with landlords. Although there is no contractual commitment to make these payments, it is likely that leases will be executed.

15



Critical Accounting Policies

Management’s responsibility for integrity and objectivity in the preparation and presentation of the Company’s financial statements requires diligent application of appropriate accounting policies. Generally, the Company’s accounting policies and methods are those specifically required by accounting principles generally accepted in the United States of America (“GAAP”). Included in the “Summary of Significant Accounting Policies” footnote in Item 8. “Consolidated Financial Statements and Supplementary Data” is a summary of the Company’s most significant accounting policies. In some cases, management is required to calculate amounts based on estimates for matters that are inherently uncertain. The Company believes the following to be the most critical of those accounting policies that necessitate subjective judgments.

Merchandise Inventories

Merchandise inventories for the Company’s Athletic Stores are valued at the lower of cost or market using the retail inventory method. The retail inventory method (“RIM”) is commonly used by retail companies to value inventories at cost and calculate gross margins by applying a cost-to-retail percentage to the retail value of inventories. The RIM is a system of averages that requires management’s estimates and assumptions regarding markups, markdowns and shrink, among others, and as such, could result in distortions of inventory amounts. Judgment is required to differentiate between promotional and other markdowns that may be required to correctly reflect merchandise inventories at the lower of cost or market. Management believes this method and its related assumptions, which have been consistently applied, to be reasonable.

Vendor Allowances

In the normal course of business, the Company receives allowances from its vendors for markdowns previously taken. Vendor allowances are recognized as a reduction in cost of sales in the period in which the markdowns are taken. The Company has volume-related agreements with certain vendors, under which it receives rebates based on fixed percentages of cost purchases. These volume-related rebates are recorded in cost of sales when the product is sold and they contributed 10 basis points to the 2003 gross margin rate.

The Company receives support from some of its vendors in the form of reimbursements for cooperative advertising and catalog costs for the launch and promotion of certain products. The reimbursements are agreed upon with vendors for specific advertising campaigns and catalogs. Such cooperative income, to the extent that it reimburses specific, incremental and identifiable costs incurred to date, is recorded in SG&A in the same period as the associated expense is incurred. Income received that is in excess of specific, incremental and identifiable costs incurred to date is recognized as a reduction to the cost of merchandise as the merchandise is sold. Cooperative income amounted to approximately 24 percent of total advertising costs and approximately 8 percent of catalog costs in 2003.

Impairment of Long-Lived Assets

In accordance with SFAS No. 144, which the Company adopted in 2002, the Company recognizes an impairment loss when circumstances indicate that the carrying value of long-lived tangible and intangible assets with finite lives may not be recoverable. Management’s policy in determining whether an impairment indicator exists, a triggering event, comprises measurable operating performance criteria as well as qualitative measures. If an analysis is necessitated by the occurrence of a triggering event, the Company uses assumptions, which are predominately identified from the Company’s three-year strategic plans, in determining the impairment amount. The calculation of fair value of long-lived assets is based on estimated expected discounted future cash flows by store, which is generally measured by discounting the expected future cash flows at the Company’s weighted-average cost of capital. Management believes its policy is reasonable and is consistently applied. Future expected cash flows are based upon estimates that, if not achieved, may result in significantly different results. Long-lived tangible assets and intangible assets with finite lives primarily include property and equipment and intangible lease acquisition costs.

16



The Company is required to perform an impairment review of its goodwill, at least annually. The Company has chosen to perform this review at the beginning of each fiscal year, and it is done in a two-step approach. The initial step requires that the carrying value of each reporting unit be compared with its estimated fair value. The second step — to evaluate goodwill of a reporting unit for impairment — is only required if the carrying value of that reporting unit exceeds its estimated fair value. The fair value of each of the Company’s reporting units exceeded its carrying value as of February 2, 2003. The Company used a combination of a discounted cash flow approach and market-based approach to determine the fair value of a reporting unit, which requires judgment and uses one or more methods to compare the reporting unit with similar businesses, business ownership interests or securities that have been sold.

Pension and Postretirement Liabilities

The Company determines its obligations for pension and postretirement liabilities based upon assumptions related to discount rates, expected long-term rates of return on invested plan assets, salary increases, age, mortality and health care cost trends, among others. Management reviews all assumptions annually with its independent actuaries, taking into consideration existing and future economic conditions and the Company’s intentions with regard to the plans. Management believes that its estimates for 2003, as disclosed in “Item 8. Consolidated Financial Statements and Supplementary Data,” to be reasonable. The expected long-term rate of return on invested plan assets is a component of pension expense and the rate is based on the plans’ weighted-average target asset allocation of 64 percent equity securities and 36 percent fixed income investments, as well as historical and future expected performance of those assets. The Company’s common stock represented approximately two percent of the total pension plans’ assets at January 31, 2004. A decrease of 50 basis points in the weighted-average expected long-term rate of return would have increased 2003 pension expense by approximately $2.5 million. The actual return on plan assets in a given year may differ from the expected long-term rate of return and the resulting gain or loss is deferred and amortized into the plans’ performance over time. An assumed discount rate is used to measure the present value of future cash flow obligations of the plans and the interest cost component of pension expense and postretirement income. The discount rate is selected with reference to the long-term corporate bond yield. A decrease of 50 basis points in the weighted-average discount rate would have increased the accumulated benefit obligation as of January 31, 2004 of the pension and postretirement plans by approximately $30 million and approximately $0.6 million, respectively. Such a decrease would not have significantly changed 2003 pension expense or postretirement income. There is limited risk to the Company for increases in healthcare costs related to the postretirement plan as new retirees have assumed the full expected costs and existing retirees have assumed all increases in such costs since the beginning of fiscal year 2001. The additional minimum liability included in shareholders’ equity at January 31, 2004 for the pension plans represented the amount by which the accumulated benefit obligation exceeded the fair market value of the plan assets. The Company was able to reduce the additional minimum liability by $16 million during 2003 to reflect the better performance of the plans’ assets as well as a $50 million contribution made in February 2003.

The Company expects to record postretirement income of approximately $13 million and pension expense of approximately $18 million in 2004. Pension expense would be $22 million in 2004 had the Company not made the $44 million contribution to its U.S. qualified retirement plan and the $6 million required contribution to its Canadian qualified retirement plan.

Discontinued, Repositioning and Restructuring Reserves

The Company exited four business segments as part of its discontinuation and restructuring programs. The final discontinued segment and disposition of the restructured businesses were completed in 2001. In order to identify and calculate the associated costs to exit these businesses, management made assumptions regarding estimates of future liabilities for operating leases and other contractual agreements, the net realizable value of assets held for sale or disposal and the fair value of non-cash consideration received. The Company has settled the majority of these liabilities and the remaining activity relates to the disposition of the residual lease liabilities.

17



As a result of achieving divestiture accounting in the fourth quarter of 2002, the Northern Group note was recorded at its fair value. The Company is required to review the collectibility of the note based upon various criteria such as the credit-worthiness of the issuer or a delay in payment of the principal or interest. Future adjustments, if any, to the carrying value of the note will be recorded pursuant to SEC Staff Accounting Bulletin Topic 5:Z:5, “Accounting and Disclosure Regarding Discontinued Operations,” which requires changes in the carrying value of assets received as consideration from the disposal of a discontinued operation to be classified within continuing operations.

The remaining discontinued reserve balances at January 31, 2004 totaled $19 million of which $8 million is expected to be utilized within the next twelve months. The remaining repositioning and restructuring reserves totaled $3 million at January 31, 2004, whereby $1 million is expected to be utilized within the next twelve months.

Income Taxes

In accordance with GAAP, deferred tax assets are recognized for tax credit and net operating loss carryforwards, reduced by a valuation allowance, which is established when it is more likely than not that some portion or all of the deferred tax assets will not be realized. Management is required to estimate taxable income for future years by taxing jurisdiction and to use its judgment to determine whether or not to record a valuation allowance for part or all of a deferred tax asset. A one percent change in the Company’s overall statutory tax rate for 2003 would have resulted in a $6 million change in the carrying value of the net deferred tax asset and a corresponding charge or credit to income tax expense depending on whether such tax rate change was a decrease or increase.

The Company has operations in multiple taxing jurisdictions and is subject to audit in these jurisdictions. Tax audits by their nature are often complex and can require several years to resolve. Accruals of tax contingencies require management to make estimates and judgments with respect to the ultimate outcome of tax audits. Actual results could vary from these estimates.

Business Concentration

In 2003, the Company purchased approximately 73 percent of its merchandise from five vendors and expects to continue to obtain a significant percentage of its athletic product from these vendors in future periods. Of that amount, approximately 40 percent was purchased from one vendor — Nike, Inc. (“Nike”) — and 14 percent from another. During 2003, Nike purchases were lower than historical levels, however, in the latter part of 2003, the Company increased its purchases and anticipates that by the end of 2004, the percentage of Nike purchases will have returned to historical levels. While the Company generally considers its relationships with its vendors to be satisfactory, given the significant concentration of its purchases from a few key vendors, its access to merchandise that it considers appropriate for its stores, catalogs, and on-line retail sites may be subject to the policies and practices of key vendors.

18



Disclosure Regarding Forward-Looking Statements

This report, including the Shareholders’ Letter, contains forward-looking statements within the meaning of the federal securities laws. All statements, other than statements of historical facts, which address activities, events or developments that the Company expects or anticipates will or may occur in the future, including, but not limited to, such things as future capital expenditures, expansion, strategic plans, dividend payments, stock repurchases, growth of the Company’s business and operations, including future cash flows, revenues and earnings, and other such matters are forward-looking statements. These forward-looking statements are based on many assumptions and factors, including, but not limited to, the effects of currency fluctuations, customer demand, fashion trends, competitive market forces, uncertainties related to the effect of competitive products and pricing, customer acceptance of the Company’s merchandise mix and retail locations, the Company’s reliance on a few key vendors for a majority of its merchandise purchases (including a significant portion from one key vendor for approximately 40 percent of its merchandise purchases), unseasonable weather, risks associated with foreign global sourcing, including political instability, changes in import regulations, disruptions to transportation services and distribution, the presence of severe acute respiratory syndrome, economic conditions worldwide, any changes in business, political and economic conditions due to the threat of future terrorist activities in the United States or in other parts of the world and related U.S. military action overseas, and the ability of the Company to execute its business plans effectively with regard to each of its business units, including its plans for marquee and launch footwear component of its business. Any changes in such assumptions or factors could produce significantly different results. The Company undertakes no obligation to publicly update forward-looking statements, whether as a result of new information, future events or otherwise.

Item 7A.  Quantitative and Qualitative Disclosures About Market Risk

Information regarding interest rate risk management and foreign exchange risk management is included in the “Financial Instruments and Risk Management” footnote under “Item 8. Consolidated Financial Statements and Supplementary Data.”

19



Item 8.  Consolidated Financial Statements and Supplementary Data

MANAGEMENT’S REPORT

The integrity and objectivity of the financial statements and other financial information presented in this annual report are the responsibility of the management of the Company. The financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America and include, when necessary, amounts based on the best estimates and judgments of management.

The Company maintains a system of internal controls designed to provide reasonable assurance, at appropriate cost, that assets are safeguarded, transactions are executed in accordance with management’s authorization and the accounting records provide a reliable basis for the preparation of the financial statements. The system of internal accounting controls is continually reviewed by management and improved and modified as necessary in response to changing business conditions. The Company also maintains an internal audit function to assist management in evaluating and formally reporting on the adequacy and effectiveness of internal accounting controls, policies and procedures.

The Company’s financial statements have been audited by KPMG LLP, the Company’s independent auditors, whose report expresses their opinion with respect to the fairness of the presentation of these statements.

The Audit Committee of the Board of Directors, which is comprised solely of independent non-management directors who are not officers or employees of the Company, meets regularly with the Company’s management, internal auditors, legal counsel and KPMG LLP to review the activities of each group and to satisfy itself that each is properly discharging its responsibility. In addition, the Audit Committee meets on a periodic basis with KPMG LLP, without management’s presence, to discuss the audit of the financial statements as well as other auditing and financial reporting matters. The Company’s internal auditors and independent auditors have direct access to the Audit Committee.

 
 

MATTHEW D. SERRA,
 Chairman of the Board,
        President and
Chief Executive Officer

 

     BRUCE L. HARTMAN,
Executive Vice President and
      Chief Financial Officer

April 1, 2004

20



INDEPENDENT AUDITORS’ REPORT

 
To the Board of Directors and Shareholders of
Foot Locker, Inc.

We have audited the accompanying consolidated balance sheets of Foot Locker, Inc. and subsidiaries as of January 31, 2004 and February 1, 2003, and the related consolidated statements of operations, comprehensive income (loss), shareholders’ equity, and cash flows for each of the years in the three-year period ended January 31, 2004. These consolidated financial statements are the responsibility of Foot Locker, Inc.’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Foot Locker, Inc. and subsidiaries as of January 31, 2004 and February 1, 2003, and the results of their operations and their cash flows for each of the years in the three-year period ended January 31, 2004 in conformity with accounting principles generally accepted in the United States of America.

As discussed in note 1 to the consolidated financial statements, in 2002 the Company changed its method of accounting for goodwill and certain other intangible assets.

 
 
 

New York, New York
March 2, 2004

21



CONSOLIDATED STATEMENTS OF OPERATIONS


 
         2003
     2002
     2001

 
         (in millions, except per
share amounts)
 
    
Sales
                 $ 4,779           $ 4,509           $ 4,379   
Costs and expenses
                                                                     
Cost of sales
                    3,302              3,165              3,071   
Selling, general and administrative expenses
                    987               928               923    
Depreciation and amortization
                    147               149               154    
Restructuring charges (income)
                    1               (2 )             34    
Interest expense, net
                    18               26               24    
 
                    4,455              4,266              4,206   
Other income
                                  (3 )             (2 )  
 
                    4,455              4,263              4,204   
Income from continuing operations before income taxes
                    324               246               175    
Income tax expense
                    115               84               64    
Income from continuing operations
                    209               162               111    
 
Loss on disposal of discontinued operations, net of income
tax benefit of $4, $2, and $—, respectively
                    (1 )             (9 )             (19 )  
 
Cumulative effect of accounting change, net of income
tax benefit of $—
                    (1 )                              
 
Net income
                 $ 207            $ 153            $ 92    
 
Basic earnings per share:
                                                                     
Income from continuing operations
                 $ 1.47           $ 1.15           $ 0.79   
Loss from discontinued operations
                    (0.01 )             (0.06 )             (0.13 )  
Cumulative effect of accounting change
                                                   
Net income
                 $ 1.46           $ 1.09           $ 0.66   
 
Diluted earnings per share:
                                                                     
Income from continuing operations
                 $ 1.40           $ 1.10           $ 0.77   
Loss from discontinued operations
                    (0.01 )             (0.05 )             (0.13 )  
Cumulative effect of accounting change
                                                   
Net income
                 $ 1.39           $ 1.05           $ 0.64   
 

See Accompanying Notes to Consolidated Financial Statements.

22



CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)


 
         2003
     2002
     2001

 
         (in millions)
 
    
Net income
                 $ 207            $ 153            $ 92    
Other comprehensive income (loss), net of tax
                                                                     
 
Foreign currency translation adjustment:
                                                                     
Translation adjustment arising during the period
                    31               38               (12 )  
 
Cash flow hedges:
                                                                     
Cumulative effect of accounting change, net of income
tax expense of $1
                                                1    
Change in fair value of derivatives, net of income tax
                                                   
Reclassification adjustments, net of income tax benefit of $1
                    (1 )                           (1 )  
Net change in cash flow hedges
                    (1 )                              
 
Minimum pension liability adjustment:
                                                                     
Minimum pension liability adjustment, net of deferred tax expense (benefit) of $10, $(56) and $(71), respectively
                    16               (83 )             (115 )  
Comprehensive income (loss)
                 $ 253            $ 108            $ (35 )  
 

See Accompanying Notes to Consolidated Financial Statements.

23



CONSOLIDATED BALANCE SHEETS


 
         2003
     2002

 
         (in millions)
 
    
ASSETS
                                                 
 
Current assets
                                                 
Cash and cash equivalents
                 $ 448            $ 357    
Merchandise inventories
                    920               835    
Assets of discontinued operations
                    2               2    
Other current assets
                    149               90    
 
                    1,519              1,284   
 
Property and equipment, net
                    644               636    
Deferred taxes
                    194               240    
Goodwill
                    136               136    
Intangible assets, net
                    96               80    
Other assets
                    100               110    
 
                 $ 2,689           $ 2,486   
LIABILITIES AND SHAREHOLDERS’ EQUITY
                                                 
 
Current liabilities
                                                 
Accounts payable
                 $ 234            $ 251    
Accrued liabilities
                    300               296    
Liabilities of discontinued operations
                    2               3    
Current portion of repositioning and restructuring reserves
                    1               3    
Current portion of reserve for discontinued operations
                    8               18    
Current portion of long-term debt and obligations under capital leases
                                  1    
 
                    545               572    
 
Long-term debt and obligations under capital leases
                    335               356    
Other liabilities
                    434               448    
Total liabilities
                    1,314              1,376   
 
Shareholders’ equity
                    1,375              1,110   
 
                 $ 2,689           $ 2,486   
 

See Accompanying Notes to Consolidated Financial Statements.

24



CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY


 
         2003
     2002
     2001
    

 
         Shares
     Amount
     Shares
     Amount
     Shares
     Amount

 
         (shares in thousands, amounts in millions)
 
    
Common Stock and Paid-In Capital
                                                                                                                                 
Par value $0.01 per share,
500 million shares authorized
                                                                                                                                 
Issued at beginning of year
                    141,180           $ 378               139,981           $ 363               138,691           $ 351    
Restricted stock issued under stock option and award plans
                    845                             60                             210               (2 )  
Forfeitures of restricted stock
                                  1                             1                             1    
Amortization of stock issued under
restricted stock option plans
                                  4                             2                             2    
Issued under director and employee stock plans, net of tax
                    1,984              28               1,139              12               1,080              11    
Issued at end of year
                    144,009              411               141,180              378               139,981              363    
Common stock in treasury at beginning
of year
                    (105 )             (1 )             (70 )                           (200 )             (2 )  
Reissued under employee stock plans
                    152               1                                           192               1    
Restricted stock issued under stock option and award plans
                                                30                             210               2    
Forfeitures of restricted stock
                    (80 )             (1 )             (60 )             (1 )             (270 )             (1 )  
Exchange of options
                    (24 )                           (5 )                           (2 )                
Common stock in treasury at end of year
                    (57 )             (1 )             (105 )             (1 )             (70 )                
 
                    143,952              410               141,075              377               139,911              363    
Retained Earnings
                                                                                                                                 
Balance at beginning of year
                                    946                               797                               705    
Net income
                                    207                               153                               92    
Cash dividends declared on common stock $0.15, $0.03 and $— per share, respectively
                                    (21 )                             (4 )                                
Balance at end of year
                                    1,132                              946                               797    
Accumulated Other Comprehensive Loss
                                                                                                                                 
Foreign Currency Translation Adjustment
                                                                                                                                 
Balance at beginning of year
                                    (15 )                             (53 )                             (41 )  
Translation adjustment arising during
the period
                                    31                               38                               (12 )  
Balance at end of year
                                    16                               (15 )                             (53 )  
Cash Flow Hedges
                                                                                                                                 
Balance at beginning of year
                                                                                                   
Change during year, net of tax
                                    (1 )                                                              
Balance at end of year
                                    (1 )                                                              
Minimum Pension Liability Adjustment
                                                                                                                                 
Balance at beginning of year
                                    (198 )                             (115 )                                
Change during year, net of tax
                                    16                               (83 )                             (115 )  
Balance at end of year
                                    (182 )                             (198 )                             (115 )  
Total Accumulated Other
Comprehensive Loss
                                    (167 )                             (213 )                             (168 )  
Total Shareholders’ Equity
                                 $ 1,375                           $ 1,110                           $ 992    
 

See Accompanying Notes to Consolidated Financial Statements.

25



CONSOLIDATED STATEMENTS OF CASH FLOWS


 
         2003
     2002
     2001

 
         (in millions)
 
    
From Operating Activities
                                                                     
Net income
                 $ 207            $ 153            $ 92    
Adjustments to reconcile net income to net cash provided
by operating activities of continuing operations:
                                                                     
Loss on disposal of discontinued operations, net of tax
                    1               9               19    
Restructuring charges (income)
                    1               (2 )             34    
Cumulative effect of accounting change, net of tax
                    1                                
Depreciation and amortization
                    147               149               154    
Impairment of long-lived assets
                                  7               2    
Restricted stock compensation expense
                    4               2               2    
Tax benefit on stock compensation
                    2               2               2    
Gains on sales of real estate and assets
                                  (3 )             (2 )  
Deferred income taxes
                    (5 )             38               38    
Change in assets and liabilities, net of dispositions:
                                                                     
Merchandise inventories
                    (63 )             (22 )             (69 )  
Accounts payable and other accruals
                    (17 )             (22 )             9    
Repositioning and restructuring reserves
                    (1 )             (3 )             (62 )  
Pension contribution
                    (50 )                              
Income taxes
                    9               42               (45 )  
Other, net
                    28               (3 )             30    
Net cash provided by operating activities of continuing operations
                    264               347               204    
From Investing Activities
                                                                     
Proceeds from sales of real estate and assets
                                  6               20    
Lease acquisition costs
                    (15 )             (18 )             (20 )  
Capital expenditures
                    (144 )             (150 )             (116 )  
Net cash used in investing activities of continuing operations
                    (159 )             (162 )             (116 )  
From Financing Activities
                                                                     
Issuance of convertible long-term debt
                                                150    
Debt issuance costs
                                                (8 )  
Reduction in long-term debt
                    (19 )             (41 )             (58 )  
Reduction in capital lease obligations
                                  (1 )             (4 )  
Dividends paid on common stock
                    (21 )             (4 )                
Issuance of common stock
                    27               10               9    
Net cash (used in) provided by financing activities of continuing operations
                    (13 )             (36 )             89    
Net Cash Provided by (Used in) Discontinued Operations
                    7               (10 )             (75 )  
Effect of Exchange Rate Fluctuations on Cash
and Cash Equivalents
                    (8 )             3               4    
Net Change in Cash and Cash Equivalents
                    91               142               106    
Cash and Cash Equivalents at Beginning of Year
                    357               215               109    
Cash and Cash Equivalents at End of Year
                 $ 448            $ 357            $ 215    
Cash Paid During the Year:
                                                                     
Interest
                 $ 25            $ 27            $ 36    
Income taxes
                 $ 77            $ 39            $ 35    
 

See Accompanying Notes to Consolidated Financial Statements.

26



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1    Summary of Significant Accounting Policies

Basis of Presentation

The consolidated financial statements include the accounts of Foot Locker, Inc. and its domestic and international subsidiaries (the “Company”), all of which are wholly-owned. All significant intercompany amounts have been eliminated. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results may differ from those estimates.

Reporting Year

The reporting period for the Company is the Saturday closest to the last day in January. Fiscal years 2003, 2002 and 2001 represented the 52 weeks ended January 31, 2004, February 1, 2003 and February 2, 2002, respectively. References to years in this annual report relate to fiscal years rather than calendar years.

Revenue Recognition

Revenue from retail store sales is recognized when the product is delivered to customers. Retail sales include merchandise, net of returns and exclude all taxes. The Company recognizes revenue, including layaway sales, in accordance with SEC Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements.” Revenue from layaway sales is recognized when the customer receives the product, rather than when the initial deposit is paid. Revenue from Internet and catalog sales is recognized when the product is shipped to customers. Sales include shipping and handling fees for all periods presented.

Store Pre-Opening and Closing Costs

Store pre-opening costs are charged to expense as incurred. In the event a store is closed before its lease has expired, the estimated post-closing lease exit costs, less the fair market value of sublease rental income, is provided for once the store ceases to be used, in accordance with SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” which the Company adopted in 2002.

Advertising Costs

Advertising and sales promotion costs are expensed at the time the advertising or promotion takes place, net of reimbursements for cooperative advertising. Cooperative advertising income earned for the launch and promotion of certain products is agreed upon with vendors and is recorded in the same period as the associated expense is incurred. Advertising costs as a component of selling, general and administrative expenses of $74.1 million in 2003, $73.8 million in 2002 and $79.7 million in 2001, net of reimbursements for cooperative advertising of $23.4 million in 2003, $15.4 million in 2002 and $8.8 million in 2001. Income recognized in excess of expenses incurred related to specific, incremental advertising during 2003 was recorded in accordance with EITF 02-16, which was applied as a reduction to the cost of merchandise as the merchandise was sold.

Catalog Costs

Catalog costs, which primarily comprise paper, printing, and postage, are capitalized and amortized over the expected customer response period to each catalog, generally 60 days. Cooperative income earned for the promotion of certain products is agreed upon with vendors and is recorded in the same period as the associated catalog expenses are amortized. Catalog costs as a component of selling, general and administrative expenses of $38.9 million in 2003, $39.0 million in 2002 and $37.7 million in 2001 were net of cooperative reimbursements of $3.5 million in 2003, $2.9 million in 2002 and $2.3 million in 2001. Prepaid catalog costs totaled $2.9 million and $3.5 million at January 31, 2004 and February 1, 2003, respectively.

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Earnings Per Share

Basic earnings per share is computed as net income divided by the weighted-average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur from common shares issuable through stock-based compensation including stock options and the conversion of convertible long-term debt. The following table reconciles the numerator and denominator used to compute basic and diluted earnings per share for continuing operations.


 
         2003
     2002
     2001

 
         (in millions)
 
    
Income from continuing operations
                 $ 209            $ 162            $ 111    
Effect of Dilution:
                                                                     
Convertible debt
                    5               5               3    
Income from continuing operations assuming dilution
                 $ 214            $ 167            $ 114    
Weighted-average common shares outstanding
                    141.6              140.7              139.4   
Effect of Dilution:
                                                                     
Stock options and awards
                    1.8              0.6              1.3   
Convertible debt
                    9.5              9.5              6.2   
Weighted-average common shares outstanding
assuming dilution
                    152.9              150.8              146.9   
 

Options to purchase 3.6 million, 6.8 million and 3.1 million shares of common stock for the years ended January 31, 2004, February 1, 2003, and February 2, 2002, respectively, were not included in the computations because the exercise price of the options was greater than the average market price of the common shares and, therefore, the effect of their inclusion would be antidilutive.

Stock-Based Compensation

The Company accounts for stock-based compensation by applying APB No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”), as permitted by SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”). In accordance with APB No. 25, compensation expense is not recorded for options granted if the option price is not less than the quoted market price at the date of grant. Compensation expense is also not recorded for employee purchases of stock under the 1994 Stock Purchase Plan. The plan, which is compensatory as defined in SFAS No. 123, is non-compensatory as defined in APB No. 25. SFAS No. 123 requires disclosure of the impact on earnings per share if the fair value method of accounting for stock-based compensation is applied for companies electing to continue to account for stock-based plans under APB No. 25. Accounting for the Company’s stock-based compensation during the three-year period ended January 31, 2004, in accordance with the fair value method provisions of SFAS No. 123 would have resulted in the following:


 
         2003
     2002
     2001

 
         (in millions, except
per share amounts)
 
    
Net income:
                                                                     
As reported
                 $ 207            $ 153            $ 92    
Compensation expense included in reported net income,
net of income tax benefit
                    2               1               1    
Total compensation expense under fair value method for all awards, net of income tax benefit
                    (7 )             (6 )             (7 )  
Pro forma
                 $ 202            $ 148            $ 86    
Basic earnings per share:
                                                                     
As reported
                 $ 1.46           $ 1.09           $ 0.66   
Pro forma
                 $ 1.43           $ 1.05           $ 0.62   
Diluted earnings per share:
                                                                     
As reported
                 $ 1.39           $ 1.05           $ 0.64   
Pro forma
                 $ 1.36           $ 1.02           $ 0.61   
 

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SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure an amendment of FASB Statement No. 123,” which was issued in December 2002, provides alternative methods of transition for an entity that changes to the fair value based method of accounting for stock-based compensation and requires more prominent disclosure of the pro forma impact on earnings per share. The disclosure portion of the statement was adopted in 2002. On April 22, 2003, the FASB determined that fair value of stock-based compensation should be recognized as a cost in the financial statements. On March 31, 2004, the FASB issued an exposure draft that provides for a comment period, which ends June 30, 2004. The proposed statement would be effective for awards that are granted, modified, or settled in fiscal years beginning after December 15, 2004. The Company has not yet determined the impact of this statement on its consolidated financial position, results of operations or cash flows.

Cash and Cash Equivalents

The Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents. Cash equivalents at January 31, 2004 and February 1, 2003 were $388 million and $297 million, respectively.

Merchandise Inventories and Cost of Sales

Merchandise inventories for the Company’s Athletic Stores are valued at the lower of cost or market using the retail inventory method. Cost for retail stores is determined on the last-in, first-out (LIFO) basis for domestic inventories and on the first-in, first-out (FIFO) basis for international inventories. Merchandise inventories of the Direct-to-Customers business are valued at FIFO cost. Transportation, distribution center and sourcing costs are capitalized in merchandise inventories.

Cost of sales is comprised of the cost of merchandise, occupancy, buyers’ compensation and shipping and handling costs. The cost of merchandise is recorded net of amounts received from vendors for damaged product returns, markdown allowances and volume rebates as well as cooperative advertising income received in excess of specific, incremental advertising expenses.

Property and Equipment

Property and equipment are recorded at cost, less accumulated depreciation and amortization. Significant additions and improvements to property and equipment are capitalized. Maintenance and repairs are charged to current operations as incurred. Major renewals or replacements that substantially extend the useful life of an asset are capitalized and depreciated. Owned property and equipment is depreciated on a straight-line basis over the estimated useful lives of the assets: 25 to 45 years for buildings and 3 to 10 years for furniture, fixtures and equipment. Property and equipment under capital leases and improvements to leased premises are generally amortized on a straight-line basis over the shorter of the estimated useful life of the asset or the remaining lease term. Capitalized software reflects certain costs related to software developed for internal use that are capitalized and amortized. After substantial completion of the project, the costs are amortized on a straight-line basis over a 2 to 8 year period. Capitalized software, net of accumulated amortization, is included in property and equipment and was $55.4 million at January 31, 2004 and $63.0 million at February 1, 2003.

The Company adopted SFAS No. 143, “Accounting for Asset Retirement Obligations” (“SFAS No. 143”) as of February 2, 2003. The statement requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate can be made. The carrying amount of the related long-lived asset shall be increased by the same amount as the liability and that amount will be amortized over the useful life of the underlying long-lived asset. The difference between the fair value and the value of the ultimate liability will be accreted over time using the credit-adjusted risk-free interest rate in effect when the liability is initially recognized. Asset retirement obligations of the Company may at any time include structural alterations to store locations and equipment removal costs from distribution centers required by certain leases. On February 2, 2003, the Company recorded a liability of $2 million for the expected present value of future retirement obligations, increased property and equipment by $1 million and recognized a $1 million after tax charge for the cumulative effect of the accounting change. Additional asset retirement obligations recorded during 2003 were approximately $1 million. Accretion and amortization expense recorded during 2003 were not material. The pro forma effects of the asset retirement liability assuming adoption of SFAS No. 143 as of February 3, 2002 were not material to the liability, the net earnings or the per share amounts, and therefore, have not been presented.

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Recoverability of Long-Lived Assets

Effective as of the beginning of 2002, the Company adopted SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS No. 144”), which superseded SFAS No. 121. In accordance with SFAS No. 144, an impairment loss is recognized whenever events or changes in circumstances indicate that the carrying amounts of long-lived tangible and intangible assets with finite lives may not be recoverable. Assets are grouped and evaluated at the lowest level for which there are identifiable cash flows that are largely independent of the cash flows of other groups of assets. The Company has identified this lowest level to be principally individual stores. The Company considers historical performance and future estimated results in its evaluation of potential impairment and then compares the carrying amount of the asset with the estimated future cash flows expected to result from the use of the asset. If the carrying amount of the asset exceeds estimated expected undiscounted future cash flows, the Company measures the amount of the impairment by comparing the carrying amount of the asset with its estimated fair value. The estimation of fair value is generally measured by discounting expected future cash flows at the Company’s weighted-average cost of capital. The Company estimates fair value based on the best information available using estimates, judgments and projections as considered necessary.

Goodwill and Intangible Assets

In 2002, the Company adopted SFAS No. 142, “Goodwill and Intangible Assets,” which requires that goodwill and intangible assets with indefinite lives no longer be amortized but reviewed for impairment if impairment indicators arise and, at a minimum, annually. The Company performs its annual impairment review as of the beginning of each fiscal year. The fair value of each reporting unit, which was determined using a combination of market and discounted cash flow approach, exceeded the carrying value of each respective reporting unit.

Previously, goodwill was amortized on a straight-line basis over 20 years for acquisitions after 1995 and over 40 years prior to 1995. The following would have resulted had the provisions of the new standards been applied for 2001:


 
         2001

 
         (in millions, except
per share amounts)
 
Income from continuing operations:
                             
As reported
                 $ 111    
Pro forma
                 $ 118    
Basic earnings per share:
                             
As reported
                 $ 0.79   
Pro forma
                 $ 0.84   
Diluted earnings per share:
                             
As reported
                 $ 0.77   
Pro forma
                 $ 0.82   
 

Separable intangible assets that are deemed to have finite lives will continue to be amortized over their estimated useful lives (but with no maximum life). Intangible assets with finite lives primarily reflect lease acquisition costs and are amortized over the lease term.

Derivative Financial Instruments

All derivative financial instruments are recorded in the Consolidated Balance Sheets at their fair values. Changes in fair values of derivatives are recorded each period in earnings or other comprehensive income (loss), depending on whether a derivative is designated and effective as part of a hedge transaction and, if it is, the type of hedge transaction. The effective portion of the gain or loss on the hedging derivative instrument is reported as a component of other comprehensive income (loss) and reclassified to earnings in the period in which the hedged item affects earnings. To the extent derivatives do not qualify as hedges, or are ineffective, their changes in fair value are recorded in earnings immediately, which may subject the Company to increased earnings volatility. The adoption of SFAS No. 133 in 2001 did not have a material impact on the Company’s consolidated earnings and reduced accumulated other comprehensive loss by approximately $1 million.

Fair Value of Financial Instruments

The fair value of financial instruments is determined by reference to various market data and other valuation techniques as appropriate. The carrying value of cash and cash equivalents, and other current receivables and payables approximate fair value due to the short-term maturities of these assets and liabilities. Quoted market prices of the same or similar instruments are used to determine fair value of long-term debt and forward foreign exchange contracts. Discounted cash flows are used to determine the fair value of long-term investments and notes receivable if quoted market prices on these instruments are unavailable.

30



Income Taxes

The Company determines its deferred tax provision under the liability method, whereby deferred tax assets and liabilities are recognized for the expected tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts using presently enacted tax rates. Deferred tax assets are recognized for tax credit and net operating loss carryforwards, reduced by a valuation allowance, which is established when it is more likely than not that some portion or all of the deferred tax assets will not be realized. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

A taxing authority may challenge positions that the Company has adopted in its income tax filings. Accordingly, the Company may apply different tax treatments for transactions in filing its income tax returns than for income tax financial reporting. The Company regularly assesses its tax position for such transactions and records reserves for those differences.

Provision for U.S. income taxes on undistributed earnings of foreign subsidiaries is made only on those amounts in excess of the funds considered to be permanently reinvested.

Insurance Liabilities

The Company is primarily self-insured for health care, workers’ compensation and general liability costs. Accordingly, provisions are made for the Company’s actuarially determined estimates of discounted future claim costs for such risks for the aggregate of claims reported and claims incurred but not yet reported. Self-insured liabilities totaled $14.0 million and $16.1 million at January 31, 2004 and February 1, 2003, respectively. The Company discounts its workers’ compensation and general liability using a risk-free interest rate. Imputed interest expense related to these liabilities was $1 million in 2003 and $2 million in both 2002 and 2001.

Foreign Currency Translation

The functional currency of the Company’s international operations is the applicable local currency. The translation of the applicable foreign currency into U.S. dollars is performed for balance sheet accounts using current exchange rates in effect at the balance sheet date and for revenue and expense accounts using the weighted-average rates of exchange prevailing during the year. The unearned gains and losses resulting from such translation are included as a separate component of accumulated other comprehensive loss within shareholders’ equity.

Reclassifications

Certain balances in prior fiscal years have been reclassified to conform to the presentation adopted in the current year. In addition, the adoption of SFAS No. 144 in 2002, which also supersedes the accounting and reporting requirements of APB No. 30, “Reporting the Results of Operations — Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events,” required balance sheet reclassifications for the presentation of discontinued operations and other long-lived assets held for disposal.

Recent Accounting Pronouncements

Several recent accounting pronouncements not previously discussed herein became effective during 2003. The adoption of these pronouncements did not have a material impact on the Company’s consolidated financial position, results of operations or cash flows. The adopted pronouncements were as follows:

•  
  SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities”

•  
  SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity”

•  
  FASB Interpretation No. 46, “Consolidation of Variable Interest Entities”

31



2    Discontinued Operations

On January 23, 2001, the Company announced that it was exiting its 694 store Northern Group segment. The Company recorded a charge to earnings of $252 million before-tax, or $294 million after-tax, in 2000 for the loss on disposal of the segment. Major components of the charge included expected cash outlays for lease buyouts and real estate disposition costs of $68 million, severance and personnel related costs of $23 million and operating losses and other exit costs from the measurement date through the expected date of disposal of $24 million. Non-cash charges included the realization of a $118 million currency translation loss, resulting from the movement in the Canadian dollar during the period the Company held its investment in the segment and asset write-offs of $19 million. The Company also recorded a tax benefit for the liquidation of the Northern U.S. stores of $42 million, which was offset by a valuation allowance of $84 million to reduce the deferred tax assets related to the Canadian operations to an amount that is more likely than not to be realized.

In the first quarter of 2001, the Company recorded a tax benefit of $5 million as a result of the implementation of tax planning strategies related to the discontinuance of the Northern Group. During the second quarter of 2001, the Company completed the liquidation of the 324 stores in the United States and recorded a charge to earnings of $12 million before-tax, or $19 million after-tax. The charge comprised the write-down of the net assets of the Canadian business to their net realizable value pursuant to the then pending transaction, which was partially offset by reduced severance costs as a result of the transaction and favorable results from the liquidation of the U.S. stores and real estate disposition activity. On September 28, 2001, the Company completed the stock transfer of the 370 Northern Group stores in Canada, through one of its wholly-owned subsidiaries for approximately CAD$59 million (approximately US$38 million), which was paid in the form of a note (the “Note”). The purchaser agreed to obtain a revolving line of credit with a lending institution, satisfactory to the Company, in an amount not less than CAD$25 million (approximately US$17 million). Another wholly-owned subsidiary of the Company was the assignor of the store leases involved in the transaction and therefore retains potential liability for such leases. The Company also entered into a credit agreement with the purchaser to provide a revolving credit facility to be used to fund its working capital needs, up to a maximum of CAD$5 million (approximately US$3 million). The net amount of the assets and liabilities of the former operations was written down to the estimated fair value of the Note (approximately US$18 million). The transaction was accounted for pursuant to SEC Staff Accounting Bulletin Topic 5:E “Accounting for Divestiture of a Subsidiary or Other Business Operation,” (“SAB Topic 5:E”) as a “transfer of assets and liabilities under contractual arrangement” as no cash proceeds were received and the consideration comprised the Note, the repayment of which is dependent on the future successful operations of the business. The assets and liabilities related to the former operations were presented under the balance sheet captions as “Assets of business transferred under contractual arrangement (note receivable)” and “Liabilities of business transferred under contractual arrangement.”

In the fourth quarter of 2001, the Company further reduced its estimate for real estate costs by $5 million based on then current negotiations, which was completely offset by increased severance, personnel and other disposition costs.

The Company recorded a charge of $18 million in the first quarter of 2002 reflecting the poor performance of the Northern Group stores in Canada since the date of the transaction. There was no tax benefit recorded related to the $18 million charge, which comprised a valuation allowance in the amount of the operating losses incurred by the purchaser and a further reduction in the carrying value of the net amount of the assets and liabilities of the former operations to zero, due to greater uncertainty with respect to the collectibility of the Note. This charge was recorded pursuant to SAB Topic 5:E, which requires accounting for the Note in a manner somewhat analogous to equity accounting for an investment in common stock. In the third quarter of 2002, the Company recorded a charge of approximately $1 million before-tax for lease exit costs in excess of previous estimates. In addition, the Company recorded a tax benefit of $2 million, which also reflected the impact of the tax planning strategies implemented related to the discontinuance of the Northern Group.

On December 31, 2002, the Company-provided revolving credit facility expired, without having been used. Furthermore, the operating results of the Northern Group had significantly improved during the year such that the Company had reached an agreement in principle to receive CAD$5 million (approximately US$3 million) cash consideration in partial prepayment of the Note and accrued interest and agreed to reduce the face value of the Note to CAD$17.5 million (approximately US$12 million). Based upon the improved results of the Northern Canada business, the Company believes there is no substantial uncertainty as to the amount of the future costs and expenses that could be payable by the Company. As indicated above, as the assignor of the Northern Canada leases, the Company remains secondarily liable under those leases. As of January 31, 2004, the Company estimates that its gross contingent lease liability is between CAD$71 to $65 million (approximately US$53 to $49 million). Based upon its assessment of the risk of having to satisfy that liability and the resultant possible outcomes of lease settlement, the Company currently estimates the expected value of the lease liability to be approximately US$2 million. The Company believes that it is unlikely that it would be required to make such contingent payments, and further, such contingent obligations would not be expected to have a material effect on the Company’s consolidated financial position, liquidity or results of operations. As a result of the aforementioned developments, during the fourth quarter of 2002 circumstances had changed sufficiently such that it became appropriate to recognize the transaction as an accounting divestiture.

32



During the fourth quarter of 2002, as a result of the accounting divestiture, the Note was recorded in the financial statements at its estimated fair value of CAD$16 million (approximately US$10 million). The Company, with the assistance of an independent third party, determined the estimated fair value by discounting expected cash flows at an interest rate of 18 percent. This rate was selected considering such factors as the credit rating of the purchaser, rates for similar instruments and the lack of marketability of the Note. As the net assets of the former operations were previously written down to zero, the fair value of the Note was recorded as a gain on disposal within discontinued operations. The Company will no longer present the assets and liabilities of Northern Canada as “Assets of business transferred under contractual arrangement (note receivable)” and “Liabilities of business transferred under contractual arrangement,” but rather will record the Note, initially at its estimated fair value.

On May 6, 2003, the amendments to the Note were executed and a cash payment of CAD$5.2 million (approximately US$3.5 million) was received representing principal and interest through the date of the amendment. After taking into account this payment, the remaining principal due under the Note was reduced to CAD$17.5 million (approximately US$12 million). Under the terms of the renegotiated Note, a principal payment of CAD$1 million was due and received on January 15, 2004, further reducing the principal balance on the note. Under the terms of the amended Note, an accelerated principal payment of CAD$1 million may be due if certain events occur. The remaining amount of the Note is required to be repaid upon the occurrence of “payment events,” as defined in the purchase agreement, but no later than September 28, 2008. Interest is payable semiannually and began to accrue on May 1, 2003 at a rate of 7.0 percent per annum. At January 31, 2004 and February 1, 2003, US$2 million and US$4 million, respectively, are classified as a current receivable, with the remainder classified as long term within other assets in the accompanying Condensed Consolidated Balance Sheet.

Future adjustments, if any, to the carrying value of the Note will be recorded pursuant to SEC Staff Accounting Bulletin Topic 5:Z:5, “Accounting and Disclosure Regarding Discontinued Operations,” which requires changes in the carrying value of assets received as consideration from the disposal of a discontinued operation to be classified within continuing operations. Interest income will also be recorded within continuing operations. The Company will recognize an impairment loss when, and if, circumstances indicate that the carrying value of the Note may not be recoverable. Such circumstances would include a deterioration in the business, as evidenced by significant operating losses incurred by the purchaser or nonpayment of an amount due under the terms of the Note.

As the stock transfer on September 28, 2001 was accounted for in accordance with SAB Topic 5:E, a disposal was not achieved pursuant to APB No. 30. If the Company had applied the provisions of Emerging Issues Task Force 90-16, “Accounting for Discontinued Operations Subsequently Retained” (“EITF 90-16”), prior-reporting periods would not be restated, accordingly reported net income would not have changed. However, the results of operations of the Northern business segment in all prior periods would have been reclassified from discontinued operations to continuing operations. The incurred loss on disposal at September 28, 2001 would continue to be classified as discontinued operations, however, the remaining accrued loss on disposal at this date, of U.S. $24 million, primarily relating to the lease liability of the Northern U.S. business, would have been reversed as part of discontinued operations. Since the liquidation of this business was complete, this lease liability would have been recorded in continuing operations in the same period pursuant to EITF 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” With respect to Northern Canada, the business was legally sold as of September 28, 2001 and thus operations would no longer be recorded, but instead the business would be accounted for pursuant to SAB Topic 5:E. In the first quarter of 2002, the $18 million charge recorded within discontinued operations would be classified as continuing operations. Similarly, the $1 million benefit recorded in the third quarter of 2002 would also have been classified as continuing operations. Having achieved divestiture accounting in the fourth quarter of 2002 and applying the provisions of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the Company would have then reclassified all prior periods’ of the Northern Group to discontinued operations. Reported net income in each of the periods would not have changed and therefore the Company did not amend any of its prior filings.

During the third quarter of 2003, a charge in the amount of $1 million before-tax was recorded to cover additional liabilities related to the exiting of the former leased corporate office in excess of the previous estimate. In the fourth quarter of 2003, the Company made a CAD$10 million payment (approximately US$7 million) to the landlord, which released the Company from all future liability related to the lease.

Net disposition activity of $6 million in 2003 primarily related to the $7 million payment for the buyout of the former leased corporate office. Net disposition activity of $13 million in 2002 included the $18 million reduction in the carrying value of the net assets and liabilities, recognition of the note receivable of $10 million, real estate disposition activity of $1 million and severance and other costs of $4 million. The remaining reserve balance of $2 million at January 31, 2004 is expected to be utilized within twelve months.

33



In 1998, the Company exited both its International General Merchandise and Specialty Footwear segments. In the second quarter of 2002, the Company recorded a $1 million charge for a lease liability related to a Woolco store in the former International General Merchandise segment, which was more than offset by a net reduction of $2 million before-tax, or $1 million after-tax, for each of the second and third quarters of 2002 in the Specialty Footwear reserve primarily reflecting real estate costs more favorable than original estimates.

In 1997, the Company announced that it was exiting its Domestic General Merchandise segment. In the second quarter of 2002, the Company recorded a charge of $4 million before-tax, or $2 million after-tax, for legal actions related to this segment, which have since been settled. In addition, the successor-assignee of the leases of a former business included in the Domestic General Merchandise segment has filed a petition in bankruptcy, and rejected in the bankruptcy proceeding 15 leases it originally acquired from a subsidiary of the Company. There are currently several actions pending against this subsidiary by former landlords for the lease obligations. In the fourth quarter of 2002, the Company recorded a charge of $1 million after-tax related to certain actions. In each of the second and fourth quarters of 2003, the Company recorded an additional after-tax charge of $1 million, related to certain actions. The Company estimates the gross contingent lease liability related to the remaining actions as approximately $6 million. The Company believes that it may have valid defenses; however, the outcome of these actions cannot be predicted with any degree of certainty.

The remaining reserve balances for these three discontinued segments totaled $17 million as of January 31, 2004, $6 million of which is expected to be utilized within twelve months and the remaining $11 million thereafter.

The major components of the pre-tax losses (gains) on disposal and disposition activity related to the reserves are presented below:

Northern Group


 
         2000
     2001
     2002
     2003
    

 
         Balance
     Charge/
(Income)
     Net
Usage*
     Balance
     Charge/
(Income)
     Net
Usage*
     Balance
     Charge/
(Income)
     Net
Usage*
     Balance

 
         (in millions)
 
    
Realized loss — currency movement
                 $            $            $            $            $            $            $            $            $            $    
Asset write-offs & impairments
                                  23               (23 )                           18               (18 )                                                          
Recognition of note receivable
                                                                            (10 )             10                                                            
Real estate & lease liabilities
                    68               (16 )             (46 )             6               1               (1 )             6               1               (7 )                
Severance & personnel
                    23               (13 )             (8 )             2                             (2 )                                                          
Operating losses & other costs
                    24               18               (39 )             3                             (2 )             1                             1               2    
Total
                 $ 115            $ 12            $ (116 )          $ 11            $ 9            $ (13 )          $ 7            $ 1            $ (6 )          $ 2    
 

International General Merchandise


 
         2000
     2001
     2002
     2003
    

 
         Balance
     Charge/
(Income)
     Net
Usage*
     Balance
     Charge/
(Income)
     Net
Usage*
     Balance
     Charge/
(Income)
     Net
Usage*
     Balance

 
         (in millions)
 
    
Woolco
                 $            $ 4            $ (4 )          $            $ 1            $            $ 1            $            $ (1 )          $    
The Bargain! Shop
                    7                             (1 )             6                                           6                             (1 )             5    
Total
                 $ 7            $ 4            $ (5 )          $ 6            $ 1            $            $ 7            $            $ (2 )          $ 5    
 

Specialty Footwear


 
         2000
     2001
     2002
     2003
    

 
         Balance
     Charge/
(Income)
     Net
Usage
     Balance
     Charge/
(Income)
     Net
Usage
     Balance
     Charge/
(Income)
     Net
Usage
     Balance

 
         (in millions)
 
    
Lease liabilities
                 $ 9            $            $ (2 )          $ 7            $ (4 )          $ (1 )          $ 2            $            $            $ 2    
Operating losses & other costs
                    3                             (1 )             2                             (1 )             1                             (1 )                
Total
                 $ 12            $            $ (3 )          $ 9            $ (4 )          $ (2 )          $ 3            $            $ (1 )          $ 2    
 

Domestic General Merchandise


 
         2000
     2001
     2002
     2003
    

 
         Balance
     Charge/
(Income)
     Net
Usage
     Balance
     Charge/
(Income)
     Net
Usage
     Balance
     Charge/
(Income)
     Net
Usage
     Balance

 
         (in millions)
 
    
Lease liabilities
                 $ 16            $            $ (6 )          $ 10            $            $ (3 )          $ 7            $            $ (1 )          $ 6    
Legal and other costs
                    2               3               (3 )             2               5               (4 )             3               4               (3 )             4    
Total
                 $ 18            $ 3            $ (9 )          $ 12            $ 5            $ (7 )          $ 10            $ 4            $ (4 )          $ 10    
 


*     Net usage includes effect of foreign exchange translation adjustments

34



The results of operations and assets and liabilities for the Northern Group segment, the International General Merchandise segment, the Specialty Footwear segment and the Domestic General Merchandise segment have been classified as discontinued operations for all periods presented in the Consolidated Statements of Operations and Consolidated Balance Sheets.

Presented below is a summary of the assets and liabilities of discontinued operations at January 31, 2004 and February 1, 2003. The Northern Group assets and liabilities of discontinued operations primarily comprised the Northern Group stores in the U.S. Liabilities included accounts payable, restructuring reserves and other accrued liabilities. The net assets of the Specialty Footwear and Domestic General Merchandise segments consist primarily of fixed assets and accrued liabilities.


 
         Northern
Group
     Specialty
Footwear
     Domestic
General
Merchandise
     Total

 
         (in millions)
 
    
2003
                                                                                     
Assets
                 $            $            $ 2            $ 2    
Liabilities
                    1                             1               2    
 
                 $ (1 )          $            $ 1            $    
2002
                                                                                     
Assets
                 $            $            $ 2            $ 2    
Liabilities
                    1                             2               3    
 
                 $ (1 )          $            $            $ (1 )  
 

35



3    Repositioning and Restructuring Reserves

1999 Restructuring

Total restructuring charges of $96 million before-tax were recorded in 1999 for the Company’s restructuring program to sell or liquidate eight non-core businesses. The restructuring plan also included an accelerated store-closing program in North America and Asia, corporate headcount reduction and a distribution center shutdown. The dispositions of Randy River Canada, Foot Locker Outlets, Colorado, Going to the Game!, Weekend Edition and the store-closing program were essentially completed in 2000 and an additional charge of $8 million was recorded. Also in 2000, management decided to continue to operate 32 stores included in the store-closing program as a result of favorable lease renewal terms offered during negotiations with landlords. The impact on the reserve was not significant and was, in any event, offset by lease buy-out costs for other stores in excess of original estimates. Of the original 1,400 planned terminations associated with the store-closing program, approximately 200 positions were retained as a result of the continued operation of the 32 stores.

In 2001, the Company completed the sales of The San Francisco Music Box Company (“SFMB”) and the assets related to its Burger King and Popeye’s franchises for cash proceeds of approximately $14 million and $5 million, respectively. In the fourth quarter of 2001, the Company recorded a $1 million restructuring charge in connection with the termination of its Maumelle distribution center lease, which was completed in 2002. Restructuring charges of $33 million in 2001 and reductions to the reserves of $2 million in 2002 were primarily due to the SFMB sale. Included in the consolidated results of operations are sales of $54 million and operating losses of $12 million in 2001, for the above non-core businesses.

In connection with the sale of SFMB, the Company remained as an assignor or guarantor of leases of SFMB related to a distribution center and five store locations. In May 2003, SFMB filed a voluntary petition under Chapter 11 of the Bankruptcy Code in the U.S. Bankruptcy Court for the District of Delaware. During July and August 2003, SFMB rejected five of the leases and assumed one of the store leases in the bankruptcy proceedings. The lease for the distribution center expires January 31, 2010, while the remaining store leases expired on January 31, 2004. As of January 31, 2004, the Company estimates its gross contingent lease liability for the distribution center lease to be approximately $4 million. During the second quarter of 2003, the Company recorded a charge of $1 million, primarily related to this lease, representing the expected cost to exit this lease.

The remaining reserve balance related to the above businesses of $1 million at January 31, 2004 is expected to be utilized within twelve months.

1993 Repositioning and 1991 Restructuring

The Company recorded charges of $558 million in 1993 and $390 million in 1991 to reflect the anticipated costs to sell or close under-performing specialty and general merchandise stores in the United States and Canada. Under the 1993 repositioning program, approximately 970 stores were identified for closing. Approximately 900 stores were closed under the 1991 restructuring program. The remaining reserve balance totaled $2 million at January 31, 2004, of which, $1 million is expected to be utilized within the next twelve months and the remaining $1 million thereafter.

36



The components of the pre-tax losses (gains) on restructuring charges and disposition activity related to the reserves are presented below:

Non-Core Businesses


 
         2000
     2001
     2002
     2003
    

 
         Balance
     Charge/
(Income)

     Net
Usage

     Balance
     Charge/
(Income)

     Net
Usage

     Balance
     Charge/
(Income)

     Net
Usage

     Balance

 
         (in millions)
 
    
Real estate
                 $ 4            $            $ (3 )          $ 1            $            $            $ 1            $ 1            $ (1 )          $ 1    
Asset impairment
                                  30               (30 )                                                                                                    
Severance & personnel
                    2                             (2 )                                                                                                    
Other disposition costs
                    3               3               (3 )             3               (2 )             (1 )                                                          
Total
                 $ 9            $ 33            $ (38 )          $ 4            $ (2 )          $ (1 )          $ 1            $ 1            $ (1 )          $ 1    
 

Corporate Overhead and Logistics


 
         2000
     2001
     2002
     2003
    

 
         Balance
     Charge/
(Income)
     Net
Usage
     Balance
     Charge/
(Income)
     Net
Usage
     Balance
     Charge/
(Income)
     Net
Usage
     Balance

 
         (in millions)
 
    
Real estate
                 $            $ 1            $            $ 1            $            $ (1 )          $            $            $            $    
Severance & personnel
                    2                             (2 )                                                                                                    
Other disposition costs
                                                                                                                                                     
Total
                 $ 2            $ 1            $ (2 )          $ 1            $            $ (1 )          $            $            $            $    
 

     Total 1999 Restructuring


 
         2000
     2001
     2002
     2003
    

 
         Balance
     Charge/
(Income)
     Net
Usage
     Balance
     Charge/
(Income)
     Net
Usage
     Balance
     Charge/
(Income)
     Net
Usage
     Balance

 
         (in millions)
 
    
Real estate
                 $ 4            $ 1            $ (3 )          $ 2            $            $ (1 )          $ 1            $ 1            $ (1 )          $ 1    
Asset impairment
                                  30               (30 )                                                                                                    
Severance & personnel
                    4                             (4 )                                                                                                    
Other disposition costs
                    3               3               (3 )             3               (2 )             (1 )                                                          
Total
                 $ 11            $ 34            $ (40 )          $ 5            $ (2 )          $ (2 )          $ 1            $ 1            $ (1 )          $ 1    
 

1993 Repositioning and 1991 Restructuring


 
         2000
     2001
     2002
     2003
    

 
         Balance
     Charge/
(Income)
     Net
Usage
     Balance
     Charge/
(Income)
     Net
Usage
     Balance
     Charge/
(Income)
     Net
Usage
     Balance

 
         (in millions)
 
    
Real estate
                 $ 3            $            $ (2 )          $ 1            $            $            $ 1            $            $            $ 1    
Other disposition costs
                    3                             (1 )             2                             (1 )             1                                           1    
Total
                 $ 6            $            $ (3 )          $ 3            $            $ (1 )          $ 2            $            $            $ 2    
 

     Total Restructuring Reserves


 
         2000
     2001
     2002
     2003
    

 
         Balance
     Charge/
(Income)
     Net
Usage
     Balance
     Charge/
(Income)
     Net
Usage
     Balance
     Charge/
(Income)
     Net
Usage
     Balance

 
         (in millions)
 
    
Real estate
                 $ 7            $ 1            $ (5 )          $ 3            $            $ (1 )          $ 2            $ 1            $ (1 )          $ 2    
Asset impairment
                                  30               (30 )                                                                                                    
Severance & personnel
                    4                             (4 )                                                                                                    
Other disposition costs
                    6               3               (4 )             5               (2 )             (2 )             1                                           1    
Total
                 $ 17            $ 34            $ (43 )          $ 8            $ (2 )          $ (3 )          $ 3            $ 1            $ (1 )          $ 3    
 

37



4    Other Income

In 2002, other income of $2 million related to the condemnation of a part-owned and part-leased property for which the Company received proceeds of $6 million. Other income also included real estate gains from the sale of corporate properties of $1 million in both 2002 and 2001.

In 2001, the Company recorded an additional $1 million gain related to the 1999 sale of the assets of its Afterthoughts retail chain.

5    Impairment of Long-Lived Assets

The Company recorded non-cash pre-tax charges in selling, general and administrative expenses of approximately $7 million and $2 million in 2002 and 2001, respectively, which represented impairment of long-lived assets such as store fixtures and leasehold improvements related to Athletic Stores.

In addition, the Company recorded non-cash pre-tax asset impairment charges of $30 million related to assets held for sale in 2001. These charges primarily related to the disposition of The San Francisco Music Box Company, which was sold in 2001, and were included in the net restructuring charges of $34 million recorded in 2001.

6    Segment Information

The Company has determined that its reportable segments are those that are based on its method of internal reporting. As of January 31, 2004, the Company has two reportable segments, Athletic Stores, which sells athletic footwear and apparel through its various retail stores, and Direct-to-Customers, which includes the Company’s catalogs and Internet business. The disposition of all formats presented as “All Other” was completed during 2001.

The accounting policies of both segments are the same as those described in the “Summary of Significant Accounting Policies.” The Company evaluates performance based on several factors, of which the primary financial measure is division results. Division profit reflects income from continuing operations before income taxes, corporate expense, non-operating income and net interest expense.

Sales


 
         2003
     2002
     2001

 
         (in millions)
 
    
Athletic Stores
                 $ 4,413           $ 4,160           $ 3,999   
Direct-to-Customers
                    366               349               326    
 
                    4,779              4,509              4,325   
All Other
                                                54    
Total sales
                 $ 4,779           $ 4,509           $ 4,379   
 

38



Operating Results


 
         2003
     2002
     2001

 
         (in millions)
 
    
Athletic Stores(1)
                 $ 363            $ 280            $ 283    
Direct-to-Customers
                    53               40               24    
 
                    416               320               307    
All Other(2)
                    (1 )             1               (45 )  
Division profit
                    415               321               262    
Corporate expense(3)
                    (73 )             (52 )             (65 )  
Operating profit
                    342               269               197    
Non-operating income
                                  3               2    
Interest expense, net
                    (18 )             (26 )             (24 )  
Income from continuing operations before income taxes
                 $ 324            $ 246            $ 175    
 


(1)   2002 includes reductions in restructuring charges of $1 million.

(2)   2003 includes restructuring charges of $1 million. 2002 includes a $1 million reduction in restructuring charges. 2001 includes restructuring charges of $33 million.

(3)   2001 includes restructuring charges of $1 million.


 
         Depreciation and
Amortization
     Capital Expenditures
     Total Assets
    

 
         2003
     2002
     2001
     2003
     2002
     2001
     2003
     2002
     2001

 
         (in millions)
 
    
Athletic Stores
                 $ 118            $ 119            $ 115            $ 126            $ 124            $ 106            $ 1,715           $ 1,564           $ 1,474   
Direct-to-Customers(1)
                    4               4               11               6               8               4               183               177               179    
 
                    122               123               126               132               132               110               1,898              1,741              1,653   
Corporate
                    25               26               28               12               18               6               789               743               612    
Assets of business transferred under contractual arrangement
                                                                                                                                                30    
Discontinued operations, net
                                                                                                                    2               2               5    
Total Company
                 $ 147            $ 149            $ 154            $ 144            $ 150            $ 116            $ 2,689           $ 2,486           $ 2,300   
 


(1)   Decrease in 2002 depreciation and amortization primarily reflects the impact of no longer amortizing goodwill.

Sales and long-lived asset information by geographic area as of and for the fiscal years ended January 31, 2004, February 1, 2003 and February 2, 2002 are presented below. Sales are attributed to the country in which the sales originate, which is where the legal subsidiary is domiciled. Long-lived assets reflect property and equipment. No individual country included in the International category is significant.

Sales


 
         2003
     2002
     2001

 
         (in millions)
 
    
United States
                 $ 3,597           $ 3,639           $ 3,686   
International
                    1,182              870               693    
Total sales
                 $ 4,779           $ 4,509           $ 4,379   
 

Long-Lived Assets


 
         2003
     2002
     2001

 
         (in millions)
 
    
United States
                 $ 504            $ 518            $ 549    
International
                    140               118               88    
Total long-lived assets
                 $   644            $   636            $   637    
 

39



7    Merchandise Inventories


 
         2003
     2002

 
         (in millions)
 
    
LIFO inventories
                 $ 651            $ 622    
FIFO inventories
                    269               213    
Total merchandise inventories
                 $ 920            $ 835    
 

The value of the Company’s LIFO inventories, as calculated on a LIFO basis, approximates their value as calculated on a FIFO basis.

8    Other Current Assets


 
         2003
     2002

 
         (in millions)
 
    
Net receivables
                 $ 41            $ 33    
Prepaid expenses and other current assets
                    45               37    
Deferred taxes
                    60               15    
Current portion of Northern Group note receivable
                    2               4    
Fair value of derivative contracts
                    1               1    
 
                 $ 149            $ 90    
 

9    Property and Equipment, net


 
         2003
     2002

 
         (in millions)
 
    
Land
                 $ 3            $ 3    
Buildings:
                                                 
Owned
                    32               32    
Leased
                                  1    
Furniture, fixtures and equipment:
                                                 
Owned
                    1,015              994    
Leased
                    14               18    
 
                    1,064              1,048   
Less: accumulated depreciation
                    (706 )             (675 )  
 
                    358               373    
Alterations to leased and owned buildings,
net of accumulated amortization
                    286               263    
 
                 $ 644            $ 636    
 

10    Goodwill

The carrying value of goodwill related to the Athletic Stores segment was $56 million at January 31, 2004 and February 2, 2003. The carrying value of goodwill related to the Direct-to-Customers segment was $80 million at January 31, 2004 and February 1, 2003.

11    Intangible Assets, net


 
         2003
     2002

 
         (in millions)
 
    
Intangible assets not subject to amortization
                 $ 2            $ 2    
Intangible assets subject to amortization
                    94               78    
 
                 $ 96            $ 80    
 

40



Intangible assets not subject to amortization relate to the Company’s U.S. defined benefit retirement plan. The minimum liability required at January 31, 2004 and February 1, 2003, which represented the amount by which the accumulated benefit obligation exceeded the fair market value of plan assets, was offset by an intangible asset to the extent of previously unrecognized prior service costs of $2 million at each of the periods.

The net intangible asset balance increased by $16 million from February 1, 2003. The increase is primarily a result of additional lease acquisition costs of $15 million and the effect of foreign exchange rates of $12 million, resulting from the rise in the euro as compared to the U.S. dollar, offset by amortization expense of $11 million.

Intangible assets subject to amortization comprise lease acquisition costs, which are required to secure prime lease locations and other lease rights, primarily in Europe. The weighted-average amortization period as of January 31, 2004 was 12.4 years. Amortization expense for lease acquisition costs was $11 million in 2003, $8 million in 2002 and $7 million in 2001. Annual estimated amortization expense is expected to be $13 million for 2004, $12 million in 2005, 2006 and 2007 and approximately $11 million for 2008. Finite life intangible assets subject to amortization, were as follows:

Lease Acquisition Costs (in millions)
         Gross
Carrying
Amount
     Accumulated
Amortization
     Net
2003
                 $ 145            $ (51 )          $ 94    
2002
                 $ 114            $ (36 )          $ 78    
 

12    Other Assets


 
         2003
     2002

 
         (in millions)
 
    
Deferred tax costs
                 $ 35            $ 39    
Investments and notes receivable
                    23               23    
Northern Group note receivable, net of current portion
                    6               6    
Income taxes receivable
                    1               8    
Fair value of derivative contracts
                                  1    
Other
                    35               33    
 
                 $ 100            $ 110    
 

13    Accrued Liabilities


 
         2003
     2002

 
         (in millions)
 
    
Pension and postretirement benefits
                 $ 57            $ 59    
Incentive bonuses
                    38               29    
Other payroll and payroll related costs, excluding taxes
                    44               38    
Taxes other than income taxes
                    44               36    
Property and equipment
                    32               25    
Gift cards and certificates
                    16               21    
Income taxes payable
                    9               23    
Fair value of derivative contracts
                    3               8    
Other operating costs
                    57               57    
 
                 $ 300            $ 296    
 

41



14    Revolving Credit Facility

At January 31, 2004, the Company had unused domestic lines of credit of $176 million, pursuant to a $200 million unsecured revolving credit agreement. $24 million of the line of credit was committed to support standby letters of credit.

On July 30, 2003, the Company amended its revolving credit agreement. As a result of the amendment, the credit facility was increased by $10 million to $200 million and the maturity date was extended to July 2006 from June 2004. The amendment also provided for a lower pricing structure and increased covenant flexibility. The agreement includes various restrictive financial covenants with which the Company was in compliance on January 31, 2004. Interest is determined at the time of borrowing based on variable rates and the Company’s fixed charge coverage ratio, as defined in the agreement. The rates range from LIBOR plus 1.50 percent to LIBOR plus 2.00 percent. Up-front fees paid and direct costs incurred to amend the agreement are amortized over the life of the facility on a pro-rata basis. In addition, the quarterly facility fees paid on the unused portion ranged from 0.50 percent in the earlier part of 2003 to 0.25 percent during the fourth quarter, based on the Company’s third quarter fixed charge coverage ratio. Fees paid in 2002 had been reduced to 0.5 percent based on the Company’s then fixed charge coverage ratio. There were no short-term borrowings during 2003.

Interest expense, including facility fees, related to the revolving credit facility was $3 million in 2003, $3 million in 2002 and $4 million in 2001.

15    Long-Term Debt and Obligations under Capital Leases

In 2001, the Company issued $150 million of subordinated convertible notes due 2008, which bear interest at 5.50 percent and are convertible into the Company’s common stock at the option of the holder, at a conversion price of $15.806 per share. The Company may redeem all or a portion of the notes at any time on or after June 4, 2004. During 2002, the Company repaid the remaining $32 million of the $40 million 7.00 percent medium-term notes that matured in October 2002, in addition to purchasing and retiring $9 million of the $200 million 8.50 percent debentures payable in 2022. The Company entered into an interest rate swap agreement in December 2002 to convert $50 million of the 8.50 percent debentures to variable rate debt. The interest rate swap did not have a significant impact on interest expense in 2002.

In 2003, the Company purchased and retired an additional $19 million of the $200 million 8.50 percent debentures payable in 2022, bringing the total amount retired to date to $28 million. Also in 2003, the Company entered into two additional swaps, to convert an additional $50 million of the 8.50 percent debentures to variable rate debt. The outstanding interest rate swaps during 2003 converted a total of $100 million of the 8.50 percent fixed rate on the debentures to lower variable rates resulting in a reduction of interest expense of approximately $4 million. As of Janu