##### Table of Contents



SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (D)
OF THE SECURITIES EXCHANGE ACT OF 1934 For The Quarterly Period Ended July 31, 2004 Commission File Number 1-14770 PAYLESS SHOESOURCE, INC.  DELAWARE
    
    43-1813160(State or other jurisdiction of
    
    (I.R.S. Employerincorporation or organization)
    
    Identification Number)3231 SOUTHEAST SIXTH AVENUE, TOPEKA, KANSAS
    
    66607-2207(Address of principal executive offices)
    
    (Zip Code)
 (785) 233-5171
(Registrants telephone number,
including area code) 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 and (2) has been subject to such filing
requirements for the past 90 days. YES x     NO o
 Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Securities Exchange Act of 1934). YES x     NO o
 Indicate the number of shares outstanding of each of the issuers classes of
common stock, as of the latest practicable date. Common Stock, $.01 par value
68,120,068 shares as September 2, 2004




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TABLE OF CONTENTS  PART I - FINANCIAL INFORMATIONITEM 1 - FINANCIAL STATEMENTSCONDENSED CONSOLIDATED BALANCE SHEETSCONDENSED CONSOLIDATED STATEMENTS OF EARNINGSCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWSNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTSITEM 2 - MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSITEM 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKITEM 4 - CONTROLS AND PROCEDURESPART II - OTHER INFORMATIONITEM 1 - LEGAL PROCEEDINGSITEM 2  CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIESITEM 6 - EXHIBITS AND REPORTS ON FORM 8-KSIGNATURESComputation of Net Earnings Per Share302 Certification of Chief Executive Officer302 Certification of Chief Financial Officer906 Certification of Chief Executive Officer906 Certification of Chief Financial Officer    Table of Contents  
 PART I - FINANCIAL INFORMATION 
 ITEM 1 - FINANCIAL STATEMENTS PAYLESS SHOESOURCE, INC. AND SUBSIDIARIES 
   (dollars in millions) July 31,
    
    August 2,
    
    January 31,2004
    
    2003
    
    2004ASSETSCurrent Assets:Cash and cash equivalents
    
    $
    185.7
    
    
    $
    114.4
    
    
    $
    148.9Restricted cash
    
    
    33.5
    
    
    
    33.0
    
    
    
    33.5Inventories
    
    
    414.3
    
    
    
    418.6
    
    
    
    392.4Current deferred income taxes
    
    
    23.3
    
    
    
    16.1
    
    
    
    17.3Other current assets
    
    
    65.1
    
    
    
    67.8
    
    
    
    61.0Total current assets
    
    
    721.9
    
    
    
    649.9
    
    
    
    653.1Property and Equipment:Land
    
    
    8.0
    
    
    
    8.4
    
    
    
    8.0Buildings and leasehold improvements
    
    
    644.7
    
    
    
    637.7
    
    
    
    666.5Furniture, fixtures and equipment
    
    
    537.7
    
    
    
    507.4
    
    
    
    517.6Property under capital leases
    
    
    4.6
    
    
    
    4.6
    
    
    
    4.6Total property and equipment
    
    
    1,195.0
    
    
    
    1,158.1
    
    
    
    1,196.7Accumulated depreciation and amortization
    
    
    (795.9
    )
    
    
    (737.7
    )
    
    
    (764.7
    )Property and equipment, net
    
    
    399.1
    
    
    
    420.4
    
    
    
    432.0Favorable leases, net
    
    
    24.3
    
    
    
    31.8
    
    
    
    29.2Deferred income taxes
    
    
    32.8
    
    
    
    29.1
    
    
    
    27.7Goodwill
    
    
    5.9
    
    
    
    5.9
    
    
    
    5.9Other assets
    
    
    26.2
    
    
    
    31.7
    
    
    
    24.9Total Assets
    
    $
    1,210.2
    
    
    $
    1,168.8
    
    
    $
    1,172.8LIABILITIES AND SHAREOWNERS EQUITYCurrent Liabilities:Current maturities of long-term debt
    
    $
    0.8
    
    
    $
    0.9
    
    
    $
    0.9Notes payable
    
    
    33.5
    
    
    
    33.0
    
    
    
    33.5Accounts payable
    
    
    129.9
    
    
    
    114.3
    
    
    
    133.0Accrued expenses
    
    
    146.6
    
    
    
    120.6
    
    
    
    117.8Total current liabilities
    
    
    310.8
    
    
    
    268.8
    
    
    
    285.2Long-term debt
    
    
    204.1
    
    
    
    203.1
    
    
    
    202.8Other liabilities
    
    
    62.6
    
    
    
    54.9
    
    
    
    61.3Minority interest
    
    
    8.2
    
    
    
    18.3
    
    
    
    16.0Total shareowners equity
    
    
    624.5
    
    
    
    623.7
    
    
    
    607.5Total Liabilities and Shareowners Equity
    
    $
    1,210.2
    
    
    $
    1,168.8
    
    
    $
    1,172.8
 See Notes to Condensed Consolidated Financial Statements. 2




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PAYLESS SHOESOURCE, INC. AND SUBSIDIARIES 
   (dollars and shares in millions, except per share) 13 Weeks Ended
    
    26 Weeks EndedJuly 31, 2004
    
    August 2, 2003
    
    July 31, 2004
    
    August 2, 2003Net sales
    
    $
    727.9
    
    
    $
    731.5
    
    
    $
    1,449.9
    
    
    $
    1,429.2Cost of sales
    
    
    502.7
    
    
    
    533.2
    
    
    
    1,003.5
    
    
    
    1,026.5Selling, general and administrative expenses
    
    
    190.7
    
    
    
    188.7
    
    
    
    390.0
    
    
    
    368.8Restructuring charges
    
    
    36.7
    
    
    
    
    
    
    
    36.7
    
    
    
    Operating (loss) profit
    
    
    (2.2
    )
    
    
    9.6
    
    
    
    19.7
    
    
    
    33.9Interest expense
    
    
    5.8
    
    
    
    4.3
    
    
    
    11.2
    
    
    
    9.4Interest income
    
    
    (1.3
    )
    
    
    (1.0
    )
    
    
    (2.3
    )
    
    
    (2.0
    )(Loss) Earnings before income taxes and
minority interest
    
    
    (6.7
    )
    
    
    6.3
    
    
    
    10.8
    
    
    
    26.5(Benefit) Provision for income taxes
    
    
    (3.9
    )
    
    
    2.3
    
    
    
    2.5
    
    
    
    9.7(Loss) Earnings before minority interest
    
    
    (2.8
    )
    
    
    4.0
    
    
    
    8.3
    
    
    
    16.8Minority interest, net of income tax
    
    
    6.5
    
    
    
    1.2
    
    
    
    9.2
    
    
    
    2.5Net Earnings
    
    $
    3.7
    
    
    $
    5.2
    
    
    $
    17.5
    
    
    $
    19.3Diluted Earnings per Share
    
    $
    0.05
    
    
    $
    0.08
    
    
    $
    0.26
    
    
    $
    0.28Basic Earnings per Share
    
    $
    0.05
    
    
    $
    0.08
    
    
    $
    0.26
    
    
    $
    0.28Diluted Weighted Average Shares Outstanding
    
    
    68.1
    

    
    
    68.1
    
    
    
    68.0
    
    
    
    68.1Basic Weighted Average Shares Outstanding
    
    
    68.0
    
    
    
    68.0
    
    
    
    68.0
    
    
    
    68.0
 See Notes to Condensed Consolidated Financial Statements. 3




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PAYLESS SHOESOURCE, INC. AND SUBSIDIARIES 
   (dollars in millions) 26 Weeks EndedJuly 31, 2004
    
    August 2, 2003Operating Activities:Net earnings
    
    $
    17.5
    
    
    $
    19.3Adjustments for non-cash items included
in net earnings:Restructuring charges
    
    
    36.7
    
    
    
    Loss on impairment of and disposal of assets
    
    
    4.8
    
    
    
    10.3Depreciation and amortization
    
    
    49.8
    
    
    
    50.2Amortization of unearned restricted stock
    
    
    0.4
    
    
    
    0.3Deferred income taxes
    
    
    (11.8
    )
    
    
    0.2Minority interest, net of tax
    
    
    (9.2
    )
    
    
    (2.5
    )Changes in working capital:Inventories
    
    
    (21.9
    )
    
    
    33.9Other current assets
    
    
    (4.1
    )
    
    
    (6.9
    )Accounts payable
    
    
    (3.1
    )
    
    
    7.9Accrued expenses
    
    
    28.8
    
    
    
    (5.1
    )Other assets and liabilities, net
    
    
    (2.4
    )
    
    
    10.8Cash flow provided by operating activities
    
    
    85.5
    
    
    
    118.4Investing Activities:Capital expenditures
    
    
    (51.0
    )
    
    
    (55.3
    )Cash flow used in investing activities
    
    
    (51.0
    )
    
    
    (55.3
    )Financing Activities:Issuance of notes payable
    
    
    
    
    
    
    4.5Restricted cash
    
    
    
    
    
    
    (4.5
    )Issuance of long-term debt
    
    
    1.6
    
    
    
    196.7Payment of deferred financing costs
    
    
    (0.2
    )
    
    
    (5.0
    )Repayment of long-term debt
    
    
    (0.5
    )
    
    
    (216.6
    )Net purchases of common stock
    
    
    
    
    
    
    (0.2
    )Contributions by minority owners
    
    
    1.5
    
    
    
    3.6Other financing activities
    
    
    (0.1
    )
    
    
    (0.7
    )Cash flow provided by (used in) financing
activities
    
    
    2.3
    
    
    
    (22.2
    )Increase in cash and cash equivalents
    
    
    36.8
    
    
    
    40.9Cash and cash equivalents, beginning of year
    
    
    148.9
    
    
    
    73.5Cash and cash equivalents, end of period
    
    $
    185.7
    
    
    $
    114.4Cash paid during the period for:Interest
    
    $
    11.1
    
    
    $
    9.0Income Taxes

    
    $
    0.3
    
    
    $
    13.7
 See Notes to Condensed Consolidated Financial Statements. 4




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PAYLESS SHOESOURCE, INC. AND SUBSIDIARIES 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  NOTE 1. INTERIM RESULTS. These unaudited Condensed Consolidated Financial
Statements of Payless ShoeSource, Inc. and subsidiaries (the Company) have
been prepared in accordance with the instructions to Form 10-Q of the United
States Securities and Exchange Commission and should be read in conjunction
with the Notes to the Consolidated Financial Statements (pages 30-52) in the
Companys 2003 Annual Report on Form 10-K. Certain information and footnote
disclosures normally included in financial statements prepared in accordance
with generally accepted accounting principles have been condensed or omitted
pursuant to such rules and regulations. In the opinion of management, the
unaudited Condensed Consolidated Financial Statements are fairly presented and
all adjustments (consisting only of normal recurring adjustments, except for
the restructuring charges) necessary for a fair statement of the results for
the interim periods have been included; however, certain items are included in
these statements based upon estimates for the entire year. During 2003, the
Company changed the reporting period for its operations in the Central American
and South American Regions to use a December 31 year-end. The Central American
Region is composed of operations in Costa Rica, the Dominican Republic, El
Salvador, Guatemala, Honduras, Nicaragua, Panama and Trinidad & Tobago. The
South American Region is composed of operations in Chile, Ecuador and Peru. The
effect of this one-month lag on the Companys financial position and results of
operations is not significant. The results for the three-month period and
six-month period ended July 31, 2004, are not necessarily indicative of the
results that may be expected for the entire fiscal year ending January 29,
2005. NOTE 2. STOCK-BASED COMPENSATION. The Company follows the disclosure provisions
of Statement of Financial Accounting Standards (SFAS) No. 148, Accounting
for Stock-Based Compensation - Transition and Disclosure, an amendment of FASB
Statement No. 123. The Statement requires prominent disclosures in both annual
and interim financial statements regarding the method of accounting for
stock-based employee compensation and the effect of the method used on reported
results. The Company accounts for stock compensation awards under the intrinsic
value method of Accounting Principles Board (APB) Opinion No. 25. APB Opinion
No. 25 requires compensation cost to be recognized based on the excess, if any,
between the quoted market price of the stock at the date of grant and the
amount an employee must pay to acquire the stock. All options awarded under all
of the Companys plans are granted with an exercise price equal to the fair
market value on the date of the grant. SFAS 123, Accounting for Stock-Based Compensation, provides an alternative
method of accounting for stock-based compensation, which establishes a fair
value based method of accounting for employee stock options or similar equity
instruments. The Company uses the Black-Scholes option pricing model to
estimate the grant date fair value of its 1996 and later option grants. The
fair value is recognized over the option vesting period. The following table
presents the effect on net earnings and earnings per share had the Company
adopted the fair value based method of accounting for stock-based compensation
under SFAS No. 123, Accounting for Stock-Based Compensation. (dollars in millions, except per share amounts) 13 Weeks Ended
    
    26 Weeks EndedJuly 31, 2004
    
    August 2, 2003
    
    July 31, 2004
    
    August 2, 2003Net earnings:As reported
    
    $
    3.7
    
    
    $
    5.2
    
    
    $
    17.5
    
    
    $
    19.3Add: Total stock-based employee compensation expense included in
net earnings as reported, net of related income taxes
    
    
    0.1
    
    
    
    0.1
    
    
    
    0.6
    
    
    
    0.3Less: Total stock-based employee compensation expense determined
under fair value based method for all awards, net of related
income taxes
    
    
    0.9
    
    
    
    1.2
    
    
    
    2.0
    
    
    
    2.8Pro forma
    
    $
    2.9
    
    
    $
    4.1
    
    
    $
    16.1
    
    
    $
    16.8Diluted earnings per share:As reported
    
    $
    0.05
    
    
    $
    0.08
    
    
    $
    0.26
    
    
    $
    0.28Pro forma
    
    $
    0.04
    
    
    $
    0.06
    
    
    $
    0.24
    
    
    $
    0.24Basic earnings per share:As reported
    
    $
    0.05
    
    
    $
    0.08
    
    
    $
    0.26
    
    
    $
    0.28Pro forma
    
    $
    0.04
    
    
    $
    0.06
    
    
    $
    0.24
    
    
    $
    0.24
 NOTE 3. INVENTORIES. Merchandise inventories in our stores are valued by the
retail method and are stated at the lower of cost, determined using the
first-in, first-out (FIFO) basis, or market. Prior to shipment to a specific
store, inventories are valued at the lower of cost using the FIFO basis, or
market. Raw materials of $16.8 million, $13.5 million and $19.5 million are
included in inventories in the condensed consolidated balance sheet at July 31,
2004, August 2, 2003, and January 31, 2004, respectively. 5




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NOTE 4. INTANGIBLES. The Company follows SFAS No. 142, Goodwill and Other
Intangible Assets. SFAS No. 142 requires that an intangible asset that is
acquired other than by business combination shall be initially recognized and
measured based on its fair value. This Statement also provides that goodwill
and indefinitely-lived intangible assets should not be amortized, but shall be
tested for impairment annually, or more frequently if circumstances indicate
potential impairment, through a comparison of fair value to its carrying
amount. Intangible assets with finite lives will continue to be amortized over
their useful lives. The Company assesses the fair value of its relevant
reporting units annually. No impairment loss was recorded during the first six
months of 2004 related to goodwill; however, as part of the $36.7 million
restructuring charges discussed in Footnote 10, the Company reduced the
carrying value of the favorable leases associated with the Payless stores to be
closed by $1.9 million during the quarter ended July 31, 2004. Favorable leases subject to amortization pursuant to SFAS 142 are as follows: (dollars in millions) July 31, 2004
    
    August 2, 2003
    
    January 31, 2004Gross carrying amount
    
    $
    83.4
    
    
    $
    88.6
    
    
    $
    87.9Less: accumulated amortization
    
    
    59.1
    
    
    
    56.8
    
    
    
    58.7Carrying amount, end of period
    
    $
    24.3
    
    
    $
    31.8
    
    
    $
    29.2
 Amortization expense on favorable leases was as follows: (dollars in millions) 13 Weeks Ended
    
    26 Weeks EndedJuly 31, 2004
    
    August 2, 2003
    
    July 31, 2004
    
    August 2, 2003Amortization
expense on
favorable leases
    
    $
    1.1
    
    
    $
    1.2
    
    
    $
    2.2
    
    
    $
    2.5
 The Company expects annual amortization expense for favorable leases for the
next five years to be as follows (dollars in millions): Year
    
    AmountRemainder of 2004
    
    $
    2.22005
    
    
    3.92006
    
    
    3.52007
    
    
    3.12008
    
    
    2.7
 NOTE 5. LONG-TERM DEBT AND LINE OF CREDIT. In January 2004, the Company
replaced its $150 million senior secured revolving credit facility (the Old
Facility) with a new $200 million senior secured revolving credit facility
(the New Facility). Funds borrowed under the New Facility are secured by
domestic merchandise inventory and receivables. The Company may borrow up to
$200 million through the New Facility, subject to a sufficient borrowing base.
The New Facility bears interest at the London Inter-bank Offered Rate
(LIBOR), plus a variable margin of 1.25 percent to 2.0 percent, or the base
rate defined in the agreement governing the New Facility. The margin on the New
Facility varies based upon certain borrowing levels specified in the agreement
governing the New Facility. The variable interest rate including the applicable
variable margin at July 31, 2004, was 2.95 percent. A quarterly commitment fee
of 0.30 percent per annum is payable on the unborrowed balance. The New
Facility is scheduled to expire in January 2008, with a one-year extension to
January 2009 at the Companys option. No amounts were drawn on the New Facility
as of July 31, 2004. Based on its borrowing base, the Company may borrow up to
$200.0 million under its New Facility, less $16.1 million in outstanding
letters of credit as of July 31, 2004. 6




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In July 2003, the Company sold $200.0 million of 8.25% Senior Subordinated
Notes (the Notes) for $196.7 million, due 2013. The discount of $3.3 million
is being amortized to interest expense over the life of the Notes. The Notes
are guaranteed by all of the Companys domestic subsidiaries. Interest on the
Notes is payable semi-annually, beginning February 1, 2004. The Notes contain
various covenants including those that may limit the Companys ability to pay
dividends, repurchase stock, accelerate the retirement of other subordinated
debt or make certain investments. As of July 31, 2004, the Company was in
compliance with all covenants. The proceeds of the Notes and additional general
funds were used to repay the entire $200.0 million term loan portion of the
Companys Old Facility. As of July 31, 2004, the fair value of the Notes was
$195.0 million based on recent trading activity of the Notes. On or after
August 1, 2008, the Company may, on any one or more occasions, redeem all or a
part of the Notes at the redemption prices set forth below, plus accrued and
unpaid interest, if any, on the Notes redeemed, to the applicable redemption
date: Year
    
    Percentage2008
    
    
    104.125
    %2009
    
    
    102.750
    %2010
    
    
    101.375
    %2011 and thereafter
    
    
    100.000
    %
 NOTE 6. PENSION PLAN. The Company has a nonqualified, supplementary defined
benefit plan for certain management employees. The plan is an unfunded,
noncontributory plan and provides for benefits based upon years of service and
cash compensation during employment. Pension expense is based on information provided to an outside actuarial firm
that uses assumptions to estimate the total benefits ultimately payable to
management employees and allocates this cost to service periods. The actuarial
assumptions used to calculate pension expense are reviewed annually for
reasonableness. The components of net periodic benefit costs for the plan were: (dollars in millions) 13 Weeks Ended
    
    26 Weeks EndedJuly 31, 2004
    
    August 2, 2003
    
    July 31, 2004
    
    August 2, 2003Components of pension expense:Service cost
    
    $
    0.2
    
    
    $
    0.2
    
    
    $
    0.4
    
    
    $
    0.4Interest cost
    
    
    0.3
    
    
    
    0.3
    
    
    
    0.6
    
    
    
    0.6Amortization of prior service cost
    
    
    0.1
    
    
    
    
    
    
    
    0.2
    
    
    
    Amortization of actuarial loss
    
    
    0.1
    
    
    
    0.1
    
    
    
    0.2
    
    
    
    0.2Total
    
    $
    0.7
    
    
    $
    0.6
    
    
    $
    1.4
    
    
    $
    1.2
 NOTE 7. INCOME TAXES. In the second quarter of 2004, the impact of impairment
charges and expected restructuring costs on estimated annual taxable income
resulted in a revised projection of the effective income tax rate for the full
fiscal year. In order to record the revised estimated effective tax rate for
the year, an adjustment was required in the second quarter, resulting in a 58.2
percent effective income tax benefit for the second quarter of 2004 and a 23.2
percent effective income tax rate for the first six months of 2004. The
Companys effective income tax rate was 36.5 percent in the second quarter and
first six months of 2003. 7




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NOTE 8. COMPREHENSIVE INCOME. The following table shows the computation of
comprehensive income: (dollars in millions) 13 Weeks Ended
    
    26 Weeks EndedJuly 31, 2004
    
    August 2, 2003
    
    July 31, 2004
    
    August 2, 2003Net Income
    
    $
    3.7
    
    
    $
    5.2
    
    
    $
    17.5
    
    
    $
    19.3Other Comprehensive Gain (Loss):Change in fair value of derivatives
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    0.1Derivative losses translated into interest expense
    
    
    
    
    
    
    0.7
    
    
    
    
    
    
    
    1.7Foreign currency translation adjustments
    
    
    2.4
    
    
    
    1.8
    
    
    
    (0.9
    )
    
    
    4.1Total other comprehensive gain (loss)
    
    
    2.4
    
    
    
    2.5
    
    
    
    (0.9
    )
    
    
    5.9Total Comprehensive Income
    
    $
    6.1
    
    
    $
    7.7
    
    
    $
    16.6
    
    
    $
    25.2
 The changes in the Companys cumulative foreign currency translation
adjustment were not adjusted for income taxes, as they relate to specific
indefinite investments in foreign subsidiaries. NOTE 9. EARNINGS PER SHARE. Basic earnings per share are computed by dividing
net earnings by the weighted average number of shares of common stock
outstanding during the period. Diluted earnings per share include the effect of
exercise of stock options. NOTE 10. RESTRUCTURING CHARGES. During the second quarter of 2004, the Company
initiated a restructuring plan to build long-term shareowner value. As part of
the restructuring, the Company committed to a plan to sell or otherwise dispose
of all 32 Payless ShoeSource stores in Chile and Peru and their related
operations, as well as its 181 Parade stores by the end of the fiscal year. As
part of the restructuring, the Company also committed to a plan to close
approximately 260 Payless stores by the end of the fiscal year. The store
closings differ from closings in the normal course of business in that they
have longer remaining lease terms. The operations in Chile and Peru, Parade
stores located in Puerto Rico and Payless stores located in Puerto Rico and
Canada are components of the Payless International segment. The Parade and
Payless stores located in the United States are components of the Payless
Domestic segment. In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of
Long-Lived Assets, during the second quarter of 2004 the Company recorded a
non-cash impairment charge of $36.7 million related to a reassessment of the
carrying value of the long-lived assets associated with the 32 stores in Chile
and Peru, the 181 Parade stores and the approximately 260 Payless stores to be
closed. In accordance with SFAS No. 144, the net assets associated with the
restructuring initiatives remain classified as held and used at the end of the
quarter. The fair value of the long-lived assets evaluated for recoverability
was determined using the present value of estimated future cash flows. For the
stores and operations to be disposed, the non-cash impairment charge for the
Payless Domestic and Payless International segments were $27.5 million and $9.2
million, respectively. The Payless Domestic charge includes a $1.9 million
reduction in the carrying value of favorable leases. The Company estimates that the costs for lease terminations, severance, and
other exit activities relating to the strategic initiatives could be in the
range of $40 million to $60 million. However, the final financial impact and
presentation of the strategic initiatives is dependent upon the ultimate exit
transactions. In accordance with SFAS No. 146, Accounting for Costs
Associated with Exit or Disposal Activities, no severance or contract
termination charges have been recorded as of the end of the second quarter
because liabilities for these charges have not yet been incurred. NOTE 11. SEGMENT REPORTING. The Company and its subsidiaries are principally
engaged in the operation of retail locations offering family footwear and
accessories. The Company operates its business in two reportable business
segments: Payless Domestic and Payless International. These segments have been
determined based on internal management reporting and management
responsibilities. The Payless Domestic segment includes retail operations in
the United States, Guam and Saipan and sourcing operations. The Payless
International segment includes retail operations in Canada, the South American
Region, the Central American Region, Puerto Rico and the U.S. Virgin Islands.
The Companys operations in its Central American and South American Regions are
operated as joint ventures in which the Company maintains a 60-percent
ownership interest. Minority interest represents the Companys joint venture
partners share of net earnings or losses on international operations. Certain
management costs for services performed by Payless Domestic and certain royalty
fees and sourcing fees charged by Payless Domestic are allocated to the Payless 8




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##### Table of Contents



International segment. These total costs and fees amounted to $5.9 million
during the second quarter of 2004 and $4.7 million during the same period in
2003. For the first six months of 2004, these total costs and fees amounted to
$9.6 million, compared with $9.0 million for the first six months of 2003. The
Companys reporting period for its operations in the South American and Central
American Regions is a December 31 year-end. The effect of this one-month lag on
the Companys financial position and results of operations is not significant.
Information on the segments is as follows: (dollars in millions) Payless Domestic
    
    Payless International
    
    Payless ConsolidatedQuarter ended July 31, 2004Revenues from external customers
    
    $
    637.9
    
    
    $
    90.0
    
    
    $
    727.9Operating profit (loss)
    
    
    2.6
    
    
    
    (4.8
    )
    
    
    (2.2
    )Six months ended July 31, 2004Revenues from external customers
    
    $
    1,287.2
    
    
    $
    162.7
    
    
    $
    1,449.9Operating profit (loss)
    
    
    23.0
    
    
    
    (3.3
    )
    
    
    19.7Total assets
    
    
    1,001.9
    
    
    
    208.3
    
    
    
    1,210.2Quarter ended August 2, 2003Revenues from external customers
    
    $
    648.2
    
    
    $
    83.3
    
    
    $
    731.5Operating profit
    
    
    9.5
    
    
    
    0.1
    
    
    
    9.6Six months ended August 2, 2003Revenues from external customers
    
    $
    1,277.9
    
    
    $
    151.3
    
    
    $
    1,429.2Operating profit (loss)
    
    
    37.6
    
    
    
    (3.7
    )
    
    
    33.9Total assets
    
    
    975.1
    
    
    
    193.7
    
    
    
    1,168.8
 Total assets for the Payless Domestic segment include $5.9 million in goodwill
as of July 31, 2004, and August 2, 2003. NOTE 12. RECLASSIFICATIONS. Certain reclassifications have been made to prior
years balances to conform to the current year presentation. NOTE 13. FOREIGN CURRENCY TRANSLATION. Local currencies are the functional
currencies for all subsidiaries. Accordingly, assets and liabilities of foreign
subsidiaries are translated at the rate of exchange at the balance sheet date.
Adjustments from the translation process are accumulated as part of other
comprehensive income and are included as a separate component of shareowners
equity. The changes in foreign currency translation adjustments were not
adjusted for income taxes since they relate to indefinite term investments in
non-United States subsidiaries. Income and expense items of these subsidiaries
are translated at average rates of exchange. NOTE 14. CONTINGENCIES. On or about December 20, 2001, a First Amended
Complaint was filed against the Company in the U.S. District Court for the
District of Oregon, captioned Adidas America, Inc. and Adidas-Salomon AG v.
Payless ShoeSource, Inc. The First Amended Complaint seeks injunctive relief
and unspecified monetary damages for trademark and trade dress infringement,
unfair competition, deceptive trade practices and breach of contract. The
Company believes it has meritorious defenses to claims asserted in the lawsuit
and has filed an answer and a motion for summary judgment which the court
granted in part. An estimate of the possible loss, if any, or the range of loss
cannot be made. On or about January 20, 2000, a complaint was filed against the Company in the
U.S. District Court for the District of New Hampshire, captioned Howard J.
Dananberg, D.P.M. v. Payless ShoeSource, Inc. The Complaint seeks injunctive
relief, unspecified treble monetary damages, attorneys fees, interest and
costs for patent infringement. The Company believes it has meritorious defenses
to claims asserted in the lawsuit. An estimate of the possible loss, if any, or
the range of loss cannot be made. NOTE 15. IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS. During May 2003, the
FASB issued SFAS 150, Accounting for Certain Financial Instruments with
Characteristics of both Liabilities and Equity. SFAS 150 clarifies the
accounting for certain financial instruments with characteristics of both
liabilities and equity and requires that those instruments be classified as
liabilities in statements of financial position. SFAS 150 is effective for
financial instruments entered into or modified after May 31, 2003, and
otherwise is effective at the beginning of the first interim period beginning
after June 15, 2003, except that certain provisions have been deferred pursuant
to FASB Staff Position No. FAS 150-3. The application of FAS 150-3 and the
adoption of SFAS 150 did not have a material impact on the Companys
consolidated financial statements. 9




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##### Table of Contents



In December 2003, the FASB issued FASB Interpretation No. 46R, Consolidation
of Variable Interest Entities and Interpretation of ARB No. 51. This
interpretation, which replaces FASB Interpretation No. 46, Consolidation of
Variable Interest Entities, clarifies the application of Accounting Research
Bulletin No. 51, Consolidated Financial Statements, to certain entities in
which equity investors do not have the characteristics of a controlling
financial interest or do not have sufficient equity at risk for the entity to
finance its activities without additional subordinated financial support. This
interpretation is required in financial statements for periods ending after
March 15, 2004, for those companies that have yet to adopt the provisions of
FIN 46. The application of FASB Interpretation No. 46R did not have a material
impact on the Companys condensed consolidated financial statements. In January 2003, the FASB issued SFAS 132 (revised 2003), Employers
Disclosures about Pensions and Other Postretirement Benefits, which retains
all of the disclosures that are required by SFAS 132 and includes several
additional disclosures. It also amends APB Opinion 28, Interim Financial
Reporting, to require certain disclosures about pension and other
postretirement benefit plans in interim financial statements. The provisions of
SFAS 132 (revised 2003) are effective for fiscal years ending after June 15,
2004. The interim disclosure provisions are effective for interim periods
beginning after December 15, 2003. The Company adopted the provisions of SFAS
132 (revised 2003) in the first quarter of fiscal year 2004. NOTE 16. SUBSIDIARY GUARANTORS OF SENIOR NOTES  CONDENSED CONSOLIDATING
FINANCIAL INFORMATION. The Company has issued Notes guaranteed by all of its
domestic subsidiaries (the Guarantor Subsidiaries). The Guarantor
Subsidiaries are direct or indirect wholly owned domestic subsidiaries of the
Company. The guarantees are full and unconditional, to the extent allowed by
law, and joint and several. The following supplemental financial information sets forth, on a consolidating
basis, the statements of earnings and cash flows for Payless ShoeSource, Inc.,
a Delaware corporation (the Parent Company), for the Guarantor Subsidiaries
and for the Companys non-guarantor subsidiaries (the Non-guarantor
Subsidiaries) and the Company for the thirteen-week and twenty-six-week
periods ended July 31, 2004, and August 2, 2003, and the related condensed
consolidating balanced sheets as of July 31, 2004, August 2, 2003, and January
31, 2004. The intercompany investment for each subsidiary is recorded by its
parent in Other Assets. The Non-guarantor Subsidiaries are made up of the Companys retail operations
in the Central American and South American Regions, Canada, Saipan, and Puerto
Rico, and the Companys sourcing organization in Hong Kong, Taiwan, China,
Indonesia and Brazil. During 2003, the Company changed the reporting period
for its operations in the Central American and South American Regions to use a
December 31 year-end. Stores in our Central American and South American Regions
are included in our results on a one-month lag relative to results from other
regions. The effect of this one-month lag on our financial position and results
of operations is not significant. 10




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##### Table of Contents



CONDENSED CONSOLIDATING BALANCE SHEET
(UNAUDITED)
As of July 31, 2004 (dollars in millions) Parent
    
    Guarantor
    
    Non-guarantorCompany
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedASSETSCurrent Assets:Cash and cash equivalents
    
    $
    
    
    
    $
    134.2
    
    
    $
    51.5
    
    
    $
    
    
    
    $
    185.7Restricted cash
    
    
    
    
    
    
    
    
    
    
    33.5
    
    
    
    
    
    
    
    33.5Inventories
    
    
    
    
    
    
    341.8
    
    
    
    75.8
    
    
    
    (3.3
    )
    
    
    414.3Current deferred income taxes
    
    
    
    
    
    
    22.6
    
    
    
    0.7
    
    
    
    
    
    
    
    23.3Other current assets
    
    
    11.6
    
    
    
    64.2
    
    
    
    38.0
    
    
    
    (48.7
    )
    
    
    65.1Total current assets
    
    
    11.6
    
    
    
    562.8
    
    
    
    199.5
    
    
    
    (52.0
    )
    
    
    721.9Property and Equipment:Land
    
    
    
    
    
    
    8.0
    
    
    
    
    
    
    
    
    
    
    
    8.0Buildings and leasehold improvements
    
    
    
    
    
    
    574.6
    
    
    
    70.1
    
    
    
    
    
    
    
    644.7Furniture, fixtures and equipment
    
    
    
    
    
    
    479.7
    
    
    
    58.0
    
    
    
    
    
    
    
    537.7Property under capital leases
    
    
    
    
    
    
    4.6
    
    
    
    
    
    
    
    
    
    
    
    4.6Total property and equipment
    
    
    
    
    
    
    1,066.9
    
    
    
    128.1
    
    
    
    
    
    
    
    1,195.0Accumulated depreciation and amortization
    
    
    
    
    
    
    (735.7
    )
    
    
    (60.2
    )
    
    
    
    
    
    
    (795.9
    )Property and equipment, net
    
    
    
    
    
    
    331.2
    
    
    
    67.9
    
    
    
    
    
    
    
    399.1Favorable leases, net
    
    
    
    
    
    
    24.3
    
    
    
    
    
    
    
    
    
    
    
    24.3Deferred income taxes
    
    
    
    
    
    
    25.0
    
    
    
    7.8
    
    
    
    
    
    
    
    32.8Goodwill
    
    
    
    
    
    
    5.9
    
    
    
    
    
    
    
    
    
    
    
    5.9Other assets
    
    
    1,100.3
    
    
    
    439.6
    
    
    
    0.6
    
    
    
    (1,514.3
    )
    
    
    26.2Total Assets
    
    $
    1,111.9
    
    
    $
    1,388.8
    
    
    $
    275.8
    
    
    $
    (1,566.3
    )
    
    $
    1,210.2LIABILITIES AND SHAREOWNERS EQUITYCurrent Liabilities:Current maturities of long-term debt
    
    $
    
    
    
    $
    0.8
    
    
    $
    
    
    
    $
    
    
    
    $
    0.8Notes payable
    
    
    
    
    
    
    
    
    
    
    33.5
    
    
    
    
    
    
    
    33.5Accounts payable
    
    
    
    
    
    
    99.1
    
    
    
    71.4
    
    
    
    (41.0
    )
    
    
    129.9Accrued expenses
    
    
    7.2
    
    
    
    133.3
    
    
    
    17.7
    
    
    
    (11.0
    )
    
    
    146.6Total current liabilities
    
    
    7.2
    
    
    
    233.2
    
    
    
    122.6
    
    
    
    (52.0
    )
    
    
    310.8Long-term debt
    
    
    479.9
    
    
    
    1.6
    
    
    
    5.6
    
    
    
    (283.0
    )
    
    
    204.1Other liabilities
    
    
    0.3
    
    
    
    104.3
    
    
    
    8.6
    
    
    
    (50.6
    )
    
    
    62.6Minority interest
    
    
    
    
    
    
    
    
    
    
    8.2
    
    
    
    
    
    
    
    8.2Total shareowners equity
    
    
    624.5
    
    
    
    1,049.7
    
    
    
    131.0
    
    
    
    (1,180.7
    )
    
    
    624.5Total Liabilities and Shareowners Equity
    
    $
    1,111.9
    
    
    $
    1,388.8
    
    
    $
    275.8
    
    
    $
    (1,566.3
    )
    
    $
    1,210.2
 11




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##### Table of Contents



CONDENSED CONSOLIDATING BALANCE SHEET
(UNAUDITED)
As of August 2, 2003 (dollars in millions) Parent
    
    Guarantor
    
    Non-guarantorCompany
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedASSETSCurrent Assets:Cash and cash equivalents
    
    $
    
    
    
    $
    76.2
    
    
    $
    38.2
    
    
    $
    
    
    
    $
    114.4Restricted cash
    
    
    
    
    
    
    
    
    
    
    33.0
    
    
    
    
    
    
    
    33.0Inventories
    
    
    
    
    
    
    346.8
    
    
    
    74.8

    
    
    
    (3.0
    )
    
    
    418.6Current deferred income taxes
    
    
    
    
    
    
    16.7
    
    
    
    
    
    
    
    (0.6
    )
    
    
    16.1Other current assets
    
    
    3.1
    
    
    
    78.3
    
    
    
    37.5
    
    
    
    (51.1
    )
    
    
    67.8Total current assets
    
    
    3.1
    
    
    
    518.0
    
    
    
    183.5
    
    
    
    (54.7
    )
    
    
    649.9Property and Equipment:Land
    
    
    
    
    
    
    8.4
    
    
    
    
    
    
    
    
    
    
    
    8.4Buildings and leasehold improvements
    
    
    
    
    
    
    571.7
    
    
    
    66.0
    
    
    
    
    
    
    
    637.7Furniture, fixtures and equipment
    
    
    
    
    
    
    449.9
    
    
    
    57.5
    
    
    
    
    
    
    
    507.4Property under capital leases
    
    
    
    
    
    
    4.6
    
    
    
    
    
    
    
    
    
    
    
    4.6Total property and equipment
    
    
    
    
    
    
    1,034.6
    
    
    
    123.5
    
    
    
    
    
    
    
    1,158.1Accumulated depreciation and amortization
    
    
    
    
    
    
    (688.6
    )
    
    
    (49.1
    )
    
    
    
    
    
    
    (737.7
    )Property and equipment, net
    
    
    
    
    
    
    346.0
    
    
    
    74.4
    
    
    
    
    
    
    
    420.4Favorable leases, net
    
    
    
    
    
    
    31.8
    
    
    
    
    
    
    
    
    
    
    
    31.8Deferred income taxes
    
    
    
    
    
    
    18.8
    
    
    
    10.3
    
    
    
    
    
    
    
    29.1Goodwill
    
    
    
    
    
    
    5.9
    
    
    
    
    
    
    
    
    
    
    
    5.9Other assets
    
    
    1,106.0
    
    
    
    411.2
    
    
    
    19.0
    
    
    
    (1,504.5
    )
    
    
    31.7Total Assets
    
    $
    1,109.1
    
    
    $
    1,331.7
    
    
    $
    287.2
    
    
    $
    (1,559.2
    )
    
    $
    1,168.8LIABILITIES AND SHAREOWNERS EQUITYCurrent Liabilities:Current maturities of long-term debt
    
    $
    
    
    
    $
    0.9
    
    
    $
    
    
    
    $
    
    
    
    $
    0.9Notes payable
    
    
    
    
    
    
    
    
    
    
    33.0
    
    
    
    
    
    
    
    33.0Accounts payable
    
    
    3.9
    
    
    
    73.5
    
    
    
    87.2
    
    
    
    (50.3
    )
    
    
    114.3Accrued expenses
    
    
    1.7
    
    
    
    108.3
    
    
    
    15.0
    
    
    
    (4.4
    )
    
    
    120.6Total current liabilities
    
    
    5.6
    
    
    
    182.7
    
    
    
    135.2
    
    
    
    (54.7
    )
    
    
    268.8Long-term debt
    
    
    479.8
    
    
    
    2.4
    
    
    
    4.0
    
    
    
    (283.1
    )
    
    
    203.1Other liabilities
    
    
    
    
    
    
    110.5
    
    
    
    6.3
    
    
    
    (61.9
    )
    
    
    54.9Minority interest
    
    
    
    
    
    
    
    
    
    
    18.3
    
    
    
    
    
    
    
    18.3Total shareowners equity
    
    
    623.7
    
    
    
    1,036.1
    
    
    
    123.4
    
    
    
    (1,159.5
    )
    
    
    623.7Total Liabilities and Shareowners Equity
    
    $
    1,109.1
    
    
    $
    1,331.7
    
    
    $
    287.2
    
    
    $
    (1,559.2
    )
    
    $
    1,168.8
 12




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##### Table of Contents



CONDENSED CONSOLIDATING BALANCE SHEET
(UNAUDITED)
As of January 31, 2004 (dollars in millions) Parent
    
    Guarantor
    
    Non-guarantorCompany
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedASSETSCurrent Assets:Cash and cash equivalents
    
    $
    
    
    
    $
    77.5
    
    
    $
    71.4
    
    
    $
    
    
    
    $
    148.9Restricted cash
    
    
    
    
    
    
    
    
    
    
    33.5
    
    
    
    
    
    
    
    33.5Inventories
    
    
    
    
    
    
    322.9
    
    
    
    73.7
    
    
    
    (4.2
    )
    
    
    392.4Current deferred income taxes
    
    
    
    
    
    
    17.2
    
    
    
    0.1
    
    
    
    
    
    
    
    17.3Other current assets
    
    
    6.6
    
    
    
    65.9
    
    
    
    43.8
    
    
    
    (55.3
    )
    
    
    61.0Total current assets
    
    
    6.6
    
    
    
    483.5
    
    
    
    222.5
    
    
    
    (59.5
    )
    
    
    653.1Property and Equipment:Land
    
    
    
    
    
    
    8.0
    
    
    
    
    
    
    
    
    
    
    
    8.0Buildings and leasehold improvements
    
    
    
    
    
    
    593.9
    
    
    
    72.6
    
    
    
    
    
    
    
    666.5Furniture, fixtures and equipment
    
    
    
    
    
    
    457.4
    
    
    
    60.2
    
    
    
    
    
    
    
    517.6Property under capital leases
    
    
    
    
    
    
    4.6
    
    
    
    
    
    
    
    
    
    
    
    4.6Total property and equipment
    
    
    
    
    
    
    1,063.9
    
    
    
    132.8
    
    
    
    
    
    
    
    1,196.7Accumulated depreciation and amortization
    
    
    
    
    
    
    (711.2
    )
    
    
    (53.5
    )
    
    
    
    
    
    
    (764.7
    )Property and equipment, net
    
    
    
    
    
    
    352.7
    
    
    
    79.3
    
    
    
    
    
    
    
    432.0Favorable leases, net
    
    
    
    
    
    
    29.2
    
    
    
    
    
    
    
    
    
    
    
    29.2Deferred income taxes
    
    
    
    
    
    
    21.2
    
    
    
    6.5
    
    
    
    
    
    
    
    27.7Goodwill
    
    
    
    
    
    
    5.9
    
    
    
    
    
    
    
    
    
    
    
    5.9Other assets
    
    
    1,088.2
    
    
    
    440.7
    
    
    
    3.5
    
    
    
    (1,507.5
    )
    
    
    24.9Total Assets
    
    $
    1,094.8
    
    
    $
    1,333.2
    
    
    $
    311.8
    
    
    $
    (1,567.0
    )
    
    $
    1,172.8LIABILITIES AND SHAREOWNERS EQUITYCurrent Liabilities:Current maturities of long-term debt
    
    $
    
    
    
    $
    0.9
    
    
    $
    
    
    
    $
    
    
    
    $
    0.9Notes payable
    
    
    
    
    
    
    
    
    
    
    33.5
    
    
    
    
    
    
    
    33.5Accounts payable
    
    
    
    
    
    
    86.9
    
    
    
    98.1
    
    
    
    (52.0
    )
    
    
    133.0Accrued expenses
    
    
    7.5
    
    
    
    101.9
    
    
    
    15.9
    
    
    
    (7.5
    )
    
    
    117.8Total current liabilities
    
    
    7.5
    
    
    
    189.7
    
    
    
    147.5
    
    
    
    (59.5
    )
    
    
    285.2Long-term debt
    
    
    479.8
    
    
    
    2.0
    
    
    
    4.0
    
    
    
    (283.0
    )
    
    
    202.8Other liabilities
    
    
    
    
    
    
    113.0
    
    
    
    8.8
    
    
    
    (60.5
    )
    
    
    61.3Minority interest
    
    
    
    
    
    
    
    
    
    
    16.0
    
    
    
    
    
    
    
    16.0Total shareowners equity
    
    
    607.5
    
    
    
    1,028.5
    
    
    
    135.5
    
    
    
    (1,164.0
    )
    
    
    607.5Total Liabilities and Shareowners Equity
    
    $

    1,094.8
    
    
    $
    1,333.2
    
    
    $
    311.8
    
    
    $
    (1,567.0
    )
    
    $
    1,172.8
 13




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##### Table of Contents



CONDENSED CONSOLIDATING STATEMENT OF EARNINGS
(UNAUDITED)
For the Thirteen Weeks Ended July 31, 2004 (dollars in millions) Parent
    
    Guarantor
    
    Non-guarantorCompany
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedNet sales
    
    $
    
    
    
    $
    669.9
    
    
    $
    169.0
    

    
    $
    (111.0
    )
    
    $
    727.9Cost of sales
    
    
    
    
    
    
    471.4
    
    
    
    140.2
    
    
    
    (108.9
    )
    
    
    502.7Selling, general and administrative expense
    
    
    0.5
    
    
    
    158.8
    
    
    
    33.5
    
    
    
    (2.1
    )
    
    
    190.7Restructuring charges
    
    
    
    
    
    
    27.5
    
    
    
    9.2
    
    
    
    
    
    
    
    36.7Operating (loss) profit
    
    
    (0.5
    )
    
    
    12.2
    
    
    
    (13.9
    )
    
    
    
    
    
    
    (2.2
    )Interest expense
    
    
    6.5
    
    
    
    
    
    
    
    1.6
    
    
    
    (2.3
    )
    
    
    5.8Interest income
    
    
    
    
    
    
    (2.7
    )
    
    
    (0.9
    )
    
    
    2.3
    
    
    
    (1.3
    )Equity in earnings of subsidiaries
    
    
    (8.1
    )
    
    
    3.5
    
    
    
    
    
    
    
    4.6
    
    
    
    Earnings (Loss) before income taxes and minority
interest
    
    
    1.1
    
    
    
    11.4
    
    
    
    (14.6
    )
    
    
    (4.6
    )
    
    
    (6.7
    )(Benefit) Provision for income taxes
    
    
    (2.6
    )
    
    
    3.3
    
    
    
    (4.6
    )
    
    
    
    
    
    
    (3.9
    )Earnings (Loss) before minority interest
    
    
    3.7
    
    
    
    8.1
    
    
    
    (10.0
    )
    
    
    (4.6
    )
    
    
    (2.8
    )Minority interest, net of income tax
    
    
    
    
    
    
    
    
    
    
    6.5
    
    
    
    
    
    
    
    6.5Net earnings
    
    $
    3.7
    
    
    $
    8.1
    
    
    $
    (3.5
    )
    
    $
    (4.6
    )
    
    $
    3.7
 CONDENSED CONSOLIDATING STATEMENT OF EARNINGS
(UNAUDITED)
For the Thirteen Weeks Ended August 2, 2003 (dollars in millions) Parent
    
    Guarantor
    
    Non-guarantorCompany
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedNet sales
    
    $
    
    
    
    $
    678.7
    
    
    $
    174.1
    
    
    $
    (121.3
    )
    
    $
    731.5Cost of sales
    
    
    
    
    
    
    514.3
    
    
    
    138.4
    
    
    
    (119.5
    )
    
    
    533.2Selling, general and administrative expense
    
    
    0.1
    
    
    
    166.7
    
    
    
    23.7
    
    
    
    (1.8
    )
    
    
    188.7Operating (loss) profit
    
    
    (0.1
    )
    
    
    (2.3
    )
    
    
    12.0
    
    
    
    
    
    
    
    9.6Interest expense
    
    
    3.4
    
    
    
    3.1
    
    
    
    0.9
    
    
    
    (3.1
    )
    
    
    4.3Interest income
    
    
    
    
    
    
    (3.3
    )
    
    
    (0.8
    )
    
    
    3.1
    
    
    
    (1.0
    )Equity in earnings of subsidiaries
    
    
    (7.4
    )
    
    
    (12.8
    )
    
    
    
    
    
    
    20.2
    
    
    
    Earnings before income taxes and minority
interest
    
    
    3.9
    
    
    
    10.7
    
    
    
    11.9
    
    
    
    (20.2
    )
    
    
    6.3(Benefit) Provision for income taxes
    
    
    (1.3
    )
    
    
    3.3
    
    
    
    0.3
    
    
    
    
    
    
    
    2.3Earnings before minority interest
    
    
    5.2
    
    
    
    7.4
    
    
    
    11.6
    
    
    
    (20.2
    )
    
    
    4.0Minority interest, net of tax
    
    
    
    
    
    
    
    
    
    
    1.2
    
    
    
    
    
    
    
    1.2Net earnings
    
    $
    5.2
    
    
    $
    7.4
    
    
    $
    12.8
    
    
    $
    (20.2
    )
    
    $
    5.2
 14




---



##### Table of Contents



CONDENSED CONSOLIDATING STATEMENT OF EARNINGS
(UNAUDITED)
For the Twenty-six Weeks Ended July 31, 2004 (dollars in millions) Parent
    
    Guarantor
    
    Non-guarantorCompany
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedNet sales
    
    $
    
    
    
    $
    1,351.0
    
    
    $
    333.0
    
    
    $
    (234.1
    )
    
    $
    1,449.9Cost of sales
    
    
    
    
    
    
    953.8
    
    
    
    279.5
    
    
    
    (229.8
    )
    
    
    1,003.5Selling, general and administrative expense
    
    
    1.0
    
    
    
    335.9
    
    
    
    57.4
    
    
    
    (4.3
    )
    
    
    390.0Restructuring charges
    
    
    
    
    
    
    27.5
    
    
    
    9.2
    
    
    
    
    
    
    
    36.7Operating (loss) profit
    
    
    (1.0
    )
    
    
    33.8
    
    
    
    (13.1
    )
    
    
    
    
    
    
    19.7Interest expense
    
    
    12.7
    
    
    
    0.3
    
    
    
    2.7
    
    
    
    (4.5
    )
    
    
    11.2Interest income
    
    
    
    
    
    
    (5.0
    )
    
    
    (1.8
    )
    
    
    4.5
    
    
    
    (2.3
    )Equity in earnings of subsidiaries
    
    
    (26.2
    )
    
    
    0.2
    
    
    
    
    
    
    
    26.0
    
    
    
    Earnings (Loss) before income taxes and minority
interest
    
    
    12.5
    
    
    
    38.3
    
    
    
    (14.0
    )
    
    
    (26.0
    )
    
    
    10.8(Benefit) Provision for income taxes
    
    
    (5.0
    )
    
    
    12.1
    
    
    
    (4.6
    )
    
    
    
    
    
    
    2.5Earnings (Loss) before minority interest
    
    
    17.5
    
    
    
    26.2
    
    
    
    (9.4
    )
    
    
    (26.0
    )
    
    
    8.3Minority interest, net of income tax
    
    
    
    
    
    
    
    
    
    
    9.2
    
    
    
    
    
    
    
    9.2Net earnings
    
    $
    17.5
    
    
    $
    26.2
    
    
    $
    (0.2
    )
    
    $
    (26.0
    )
    
    $
    17.5
 CONDENSED CONSOLIDATING STATEMENT OF EARNINGS
(UNAUDITED)
For the Twenty-six Weeks Ended August 2, 2003 (dollars in millions) Parent
    
    Guarantor
    
    Non-guarantorCompany
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedNet sales
    
    $
    
    
    
    $
    1,340.1
    
    
    $
    357.4
    
    
    $
    (268.3
    )
    
    $
    1,429.2Cost of sales
    
    
    
    
    
    
    994.0
    
    
    
    297.4
    
    
    
    (264.9
    )
    
    
    1,026.5Selling, general and administrative expense
    
    
    0.1
    
    
    
    326.1
    
    
    
    46.0
    
    
    
    (3.4
    )
    
    
    368.8Operating (loss) profit
    
    
    (0.1
    )
    
    
    20.0
    
    
    
    14.0
    
    
    
    
    
    
    
    33.9Interest expense
    
    
    6.5
    
    
    
    7.1
    
    
    
    2.1
    
    
    
    (6.3
    )
    
    
    9.4Interest income
    
    
    
    
    
    
    (6.6
    )
    
    
    (1.7
    )
    
    
    6.3
    
    
    
    (2.0
    )Equity in earnings of subsidiaries
    
    
    (23.5
    )
    
    
    (17.1
    )
    
    
    
    
    
    
    40.6
    
    
    
    Earnings before income taxes and minority
interest
    
    
    16.9
    
    
    
    36.6
    
    
    
    13.6
    
    
    
    (40.6
    )
    
    
    26.5(Benefit) Provision for income taxes
    
    
    (2.4
    )
    
    
    13.1
    
    
    
    (1.0
    )
    
    
    
    
    
    
    9.7Earnings before minority interest
    
    
    19.3
    
    
    
    23.5
    
    
    
    14.6
    
    
    
    (40.6
    )
    
    
    16.8Minority interest, net of income tax
    
    
    
    
    
    
    
    
    
    
    2.5
    
    
    
    
    
    
    
    2.5Net earnings
    
    $
    19.3
    
    
    $
    23.5
    
    
    $
    17.1
    
    
    $
    (40.6
    )
    
    $
    19.3
 15




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##### Table of Contents



CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
(UNAUDITED)
For the Twenty-six Weeks Ended July 31, 2004 (dollars in millions) Parent
    
    Guarantor
    
    Non-guarantorCompany
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedOperating Activities:Net Earnings
    
    $
    17.5
    
    
    $
    26.2
    
    
    $
    (0.2
    )
    
    $
    (26.0
    )
    
    $
    17.5Adjustments for non-cash items included in
earnings:Restructuring charges
    
    
    
    
    
    
    27.5
    
    
    
    9.2
    
    
    
    
    
    
    
    36.7Loss on impairment of and disposal of assets
    
    
    
    
    
    
    4.1
    
    
    
    0.7
    
    
    
    
    
    
    
    4.8Depreciation and amortization
    
    
    
    
    
    
    43.7
    
    
    
    6.1
    
    
    
    
    
    
    
    49.8Amortization of unearned restricted stock
    
    
    
    
    
    
    0.4
    
    
    
    
    
    
    
    
    
    
    
    0.4Deferred income taxes
    
    
    
    
    
    
    (9.3
    )
    
    
    (2.5
    )
    
    
    
    
    
    
    (11.8
    )Minority interest, net of tax
    
    
    
    
    
    
    
    
    
    
    (9.2
    )
    
    
    
    
    
    
    (9.2
    )Changes in working capital:Inventories
    
    
    
    
    
    
    (18.9
    )
    
    
    (2.1
    )
    
    
    (0.9
    )
    
    
    (21.9
    )Other current assets
    
    
    (5.0
    )
    
    
    1.7
    
    
    
    5.8
    
    
    
    (6.6
    )
    
    
    (4.1
    )Accounts payable
    
    
    
    
    
    
    12.2
    
    
    
    (26.3
    )
    
    
    11.0
    
    
    
    (3.1
    )Accrued expenses
    
    
    (0.3
    )
    
    
    31.4
    
    
    
    1.2
    
    
    
    (3.5
    )
    
    
    28.8Other assets and liabilities, net
    
    
    (12.2
    )
    
    
    (12.1
    )
    
    
    (4.1
    )
    
    
    26.0
    
    
    
    (2.4
    )Cash flow provided by (used in) operating
activities
    
    
    
    
    
    
    106.9
    
    
    
    (21.4
    )
    
    
    
    
    
    
    85.5Investing Activities:Capital expenditures
    
    
    
    
    
    
    (47.2
    )
    
    
    (3.8
    )
    
    
    
    
    
    
    (51.0
    )Investment in subsidiaries
    
    
    
    
    
    
    (2.3
    )
    
    
    
    
    
    
    2.3
    
    
    
    Cash flow used in investing activities
    
    
    
    
    
    
    (49.5
    )
    
    
    (3.8
    )
    
    
    2.3
    
    
    
    (51.0
    )Financing Activities:Issuance of long-term debt
    
    
    
    
    
    
    
    
    
    
    1.6
    
    
    
    
    
    
    
    1.6Payment of deferred financing costs
    
    
    
    
    
    
    (0.2
    )
    
    
    
    
    
    
    
    
    
    
    (0.2
    )Repayment of long-term debt
    
    
    
    
    
    
    (0.5
    )
    
    
    
    
    
    
    
    
    
    
    (0.5
    )Contributions by parents
    
    
    
    
    
    
    
    
    
    
    2.3
    
    
    
    (2.3
    )
    
    
    Contributions by minority owners
    
    
    
    
    
    
    
    
    
    
    1.5
    
    
    
    
    
    
    
    1.5Other financing activities
    
    
    
    
    
    
    
    
    
    
    (0.1
    )
    
    
    
    
    
    
    (0.1
    )Cash flow (used in) provided by financing
activities
    
    
    
    
    
    
    (0.7
    )
    
    
    5.3
    
    
    
    (2.3
    )
    
    
    2.3Increase (decrease) in cash
    
    
    
    
    
    
    56.7
    
    
    
    (19.9
    )
    
    
    
    
    
    
    36.8Cash and cash equivalents, beginning of period
    
    
    
    
    
    
    77.5
    
    
    
    71.4
    
    
    
    
    
    
    
    148.9Cash and cash equivalents, end of period
    
    $
    
    
    
    $
    134.2
    
    
    $
    51.5
    
    
    $
    
    
    
    $
    185.7
 16




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##### Table of Contents



CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
(UNAUDITED)
For the Twenty-six Weeks Ended August 2, 2003 (dollars in millions) Parent
    
    Guarantor
    
    Non-guarantorCompany
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedOperating Activities:Net Earnings
    
    $
    19.3
    
    
    $
    23.4
    
    
    $
    17.1
    
    
    $
    (40.5
    )
    
    $
    19.3Adjustments for non-cash items included in
earnings:Loss on impairment of and disposal of assets
    
    
    
    
    
    
    10.1
    
    
    
    0.2
    
    
    
    
    
    
    
    10.3Depreciation and amortization
    
    
    
    
    
    
    43.5
    
    
    
    6.7
    
    
    
    
    
    
    
    50.2Amortization of unearned restricted stock
    
    
    
    
    
    
    0.3
    
    
    
    
    
    
    
    
    
    
    
    0.3Deferred income taxes
    
    
    
    
    
    
    1.1
    
    
    
    (1.5
    )
    
    
    0.6
    
    
    
    0.2Minority interest, net of tax
    
    
    
    
    
    
    
    
    
    
    (2.5
    )
    
    
    
    
    
    
    (2.5
    )Changes in working capital:Inventories
    
    
    
    
    
    
    22.4
    
    
    
    14.2
    
    
    
    (2.7
    )
    
    
    33.9Other current assets
    
    
    2.5
    
    
    
    90.6
    
    
    
    (17.3
    )
    
    
    (82.7
    )
    
    
    (6.9
    )Accounts payable
    
    
    3.9
    
    
    
    4.5
    
    
    
    15.9
    
    
    
    (16.4
    )
    
    
    7.9Accrued expenses
    
    
    (68.3
    )
    
    
    (2.0
    )
    
    
    (6.0
    )
    
    
    71.2
    
    
    
    (5.1
    )Other assets and liabilities, net
    
    
    (37.0
    )
    
    
    (27.7
    )
    
    
    5.0
    
    
    
    70.5
    
    
    
    10.8Cash flow provided by (used in) operating
activities
    
    
    (79.6
    )
    
    
    166.2
    
    
    
    31.8
    
    
    
    
    
    
    
    118.4Investing Activities:Capital expenditures
    
    
    
    
    
    
    (40.8
    )
    
    
    (14.5
    )
    
    
    
    
    
    
    (55.3
    )Investment in subsidiaries
    
    
    
    
    
    
    (6.4
    )
    
    
    
    
    
    
    6.4
    
    
    
    Repayment of loan from parent/subsidiary
    
    
    
    
    
    
    146.9
    
    
    
    
    
    
    
    (146.9
    )
    
    
    Cash flow provided by (used in) investing
activities
    
    
    
    
    
    
    99.7
    
    
    
    (14.5
    )
    
    
    (140.5
    )
    
    
    (55.3
    )Financing Activities:Issuance of notes payable
    
    
    
    
    
    
    
    
    
    
    4.5
    
    
    
    
    
    
    
    4.5Restricted cash
    
    
    
    
    
    
    
    
    
    
    (4.5
    )
    
    
    
    
    
    
    (4.5
    )Issuance of long-term debt
    
    
    196.7
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    196.7Payment of deferred financing costs
    
    
    
    
    
    
    (5.0
    )
    
    
    
    
    
    
    
    
    
    
    (5.0
    )Repayment of long-term debt
    
    
    
    
    
    
    (216.6
    )
    
    
    
    
    
    
    
    
    
    
    (216.6
    )Loan from parent/subsidiary
    
    
    (116.9
    )
    
    
    
    
    
    
    (30.0
    )
    
    
    146.9
    
    
    
    Net purchases of common stock
    
    
    (0.2
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (0.2
    )Contributions by parents
    
    
    
    
    
    
    
    
    
    
    6.4
    
    
    
    (6.4
    )
    
    
    Contributions by minority owners
    
    
    
    
    
    
    
    
    
    
    3.6
    
    
    
    
    
    
    
    3.6Other financing activities
    
    
    
    
    
    
    
    
    
    
    (0.7
    )
    
    
    
    
    
    
    (0.7
    )Cash flow used in financing activities
    
    
    79.6
    
    
    
    (221.6
    )
    
    
    (20.7
    )
    
    
    140.5
    
    
    
    (22.2
    )Increase in cash
    
    
    
    
    
    
    44.3
    
    
    
    (3.4
    )
    
    
    
    
    
    
    40.9Cash and cash equivalents, beginning of period
    
    
    
    
    
    
    31.9
    
    
    
    41.6
    
    
    
    
    
    
    
    73.5Cash and cash equivalents, end of period
    
    $
    
    
    
    $
    76.2
    
    
    $
    38.2
    
    
    $
    
    
    
    $
    114.4
 17




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##### Table of Contents



ITEM 2 - MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS This discussion and analysis should be read in conjunction with the Condensed
Consolidated Financial Statements and Notes to the Condensed Consolidated
Financial Statements included in this Form 10-Q. FORWARD-LOOKING STATEMENTS This report contains, and from time to time we may publish, forward-looking
statements relating to such matters as anticipated financial performance,
business prospects, technological developments, new products, future store
openings and closings, international expansion, possible strategic
alternatives, new business concepts, capital expenditures, fashion trends and
similar matters. Statements including the words expects, anticipates,
intends, plans, believes, seeks, or variations of such words and
similar expressions are forward-looking statements. We note that a variety of
factors could cause our actual results and experience to differ materially from
the anticipated results or other expectations expressed in our forward-looking
statements. The risks and uncertainties that may affect the operations,
performance, development and results of our business include, but are not
limited to, the following: changes in consumer spending patterns; changes in
consumer preferences and overall economic conditions; the impact of competition
and pricing; changes in weather patterns; the financial condition of the
suppliers and manufacturers from whom we source our merchandise; changes in
existing or potential duties, tariffs or quotas; changes in relationships
between the United States and foreign countries; changes in relationships
between Canada and foreign countries; economic and political instability in
foreign countries or restrictive actions by the governments of foreign
countries in which suppliers and manufacturers from whom we source products are
located or in which we operate stores; changes in trade, customs and/or tax
laws; fluctuations in currency exchange rates; availability of suitable store
locations on appropriate terms; the ability to terminate leases on acceptable
terms; the ability to hire, train and retain associates; the performance of
other parties in strategic alliances; general economic, business and social
conditions in the countries from which we source products, supplies or have or
intend to open stores; the performance of partners in joint ventures; the
ability to comply with local laws in foreign countries; threats or acts of
terrorism or war; and strikes, work stoppages or slow downs by unions that play
a significant role in the manufacture, distribution or sale of product. All
subsequent written and oral forward-looking statements attributable to us or
persons acting on our behalf are expressly qualified in their entirety by these
cautionary statements. We do not undertake any obligation to release publicly
any revisions to such forward-looking statements to reflect events or
circumstances after the date hereof or thereof or to reflect the occurrence of
unanticipated events. OVERVIEW We are the largest specialty family footwear retailer in the Western Hemisphere
with retail stores in the United States, Canada, the Caribbean, and the Central
American and South American Regions. The Central American Region is composed of
operations in Costa Rica, the Dominican Republic, El Salvador, Guatemala,
Honduras, Nicaragua, Panama and Trinidad & Tobago. The South American Region is
composed of operations in Chile, Ecuador and Peru; however, we have entered
into a plan to sell or dispose of all store operations in Chile and Peru during
2004. Our 4,888 Payless ShoeSource stores offer fashionable, quality, private
and branded label footwear and accessories for women, men and children at
affordable prices in a self-selection shopping format, and our 184 Parade
stores offer fashionable, quality, private label womens shoes at moderate
prices in a self-selection shopping format; however, we intend to sell or
dispose of our Parade operations during 2004. For the second quarter of 2004, total sales decreased 0.5 percent, or $3.6
million, to $727.9 million as compared to the second quarter of the prior year.
Same-store sales, one of the key indicators we consider as a measure of
performance, decreased 0.9 percent. Gross margin was 30.9 percent of sales in
the current years second quarter, versus 27.1 percent in the prior years
second quarter. For the first six months of 2004, total sales increased 1.4
percent, or $20.7 million, to $1,449.9 as compared to the first six months of
2003. Same-store sales increased 0.9 percent. Gross margin was 30.8 percent of
sales in the first six months of 2004, versus 28.2 percent in the same period
in 2003. We began the second quarter with strong sales performance. However, in
June, sales softened across much of the country and many competitors in the
apparel and footwear market took clearance markdowns earlier in the season. In
July, we chose to remain less promotional than the prior year in order to
protect our gross margins. 18




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##### Table of Contents



During the second quarter of 2004, we initiated a restructuring plan and took
action related to five strategic initiatives that are directed toward
sharpening our focus on our core business strategy, increasing profitability,
improving our operating margin and building long-term shareowner value. The
strategic initiatives include:  
    
    The sale or disposal of 181 Parade stores (the restructuring
excludes 3 Parade stores already scheduled to be closed in the normal
course of business), and related operations;
    
    The sale or disposal of all 32 Payless ShoeSource stores in Peru
and Chile, and related operations;
    
    The closing of approximately 260 Payless ShoeSource stores, in
addition to the approximately 230 stores that had originally been
scheduled for closing or relocation as a part of the normal course of
business in fiscal 2004;
    
    The reduction of wholesale businesses that provide no significant growth opportunity, and;
    
    A comprehensive review of our expense structure and appropriate reductions to improve profitability. As part of the strategic initiatives, we recorded a non-cash restructuring
charge of $36.7 million related to the impairment of the assets associated with
Chile, Peru, Parade and the approximately 260 Payless stores to be closed. In addition to the impairment charge, we estimate that the restructuring costs
for lease terminations, severance, and other exit activities relating to the
strategic initiatives could be in the range of $40 million to $60 million.
However, the final financial impact of the strategic initiatives is dependent
upon the ultimate exit transactions. We intend to complete the strategic
initiatives by the end of fiscal 2004. Our cash and cash equivalents balance at the end of the 2004 second quarter was
$185.7 million, an increase of $36.8 million from the end of 2003 and $71.3
million over the 2003 second quarter. Total inventories at the end of the 2004
second quarter were $414.3 million, a reduction of $4.3 million from the 2003
second quarter. Inventory per store declined by 2 percent on a cost basis and 5
percent on a unit basis over the same period. Despite disappointing sales results in the second quarter, we remain committed
to our core business strategy: to be the Merchandise Authority in value-priced
footwear and accessories. Our strategy, the result of intensive study, testing
and review, is designed to distinctively position us in the value-priced
footwear and accessories marketplace. We believe that the effective execution
of our strategy is the best means for us to build shareowner value over the
long term. We will attempt to do so through:  
    
    More consistent, improved execution of our Merchandise Authority
strategy, delivering value to customers through merchandise that is
right, distinctive and targeted for our customers;
    
    Tight control of inventory, reacting quickly to changes in
consumer demand in order to minimize the need for markdowns.
    
    Focused marketing with complete alignment of messages;
    
    Continued emphasis on educating our store associates to use key
service behaviors that have been identified to impact conversion; and,
    
    Completion of our restructuring plan in a timely manner. REVIEW OF OPERATIONS The following discussion summarizes the significant factors affecting operating
results for the quarters ended July 31, 2004 (2004) and August 2, 2003 (2003). 19




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NET EARNINGS We posted net earnings of $3.7 million in the second quarter of 2004 compared
with net earnings of $5.2 million in the second quarter of 2003. For the first
six months of 2004 net earnings were $17.5 million compared with $19.3 million
in the 2003 period.
The following table presents the components of costs and expenses, as a percent
of revenues, for the second quarter and first six months of 2004 and 2003. Second Quarter
    
    First Six Months2004
    
    2003
    
    2004
    
    2003Cost of sales
    
    
    69.1
    %
    
    
    72.9
    %
    
    
    69.2
    %
    
    
    71.8
    %Selling, general and administrative expense
    
    
    26.2
    
    
    
    25.8
    
    
    
    26.9
    
    
    
    25.8Restructuring charges
    
    
    5.0
    
    
    
    
    
    
    
    2.6
    
    
    
    Operating (loss) profit
    
    
    (0.3
    )
    
    
    1.3
    
    
    
    1.3
    
    
    
    2.4Interest expense, net
    
    
    0.6
    
    
    
    0.4
    
    
    
    0.6
    
    
    
    0.5(Loss) Earnings before income taxes and
minority interest
    
    
    (0.9
    )
    
    
    0.9
    
    
    
    0.7
    
    
    
    1.9Effective income tax rate*
    
    
    58.2
    %
    
    
    36.5
    %
    
    
    23.2
    %
    
    
    36.5
    %(Loss) Earnings before minority interest
    
    
    (0.4
    )
    
    
    0.5
    
    
    
    0.6
    
    
    
    1.2Minority interest
    
    
    0.9
    
    
    
    0.2
    
    
    
    0.6
    
    
    
    0.2Net Earnings
    
    
    0.5
    %
    
    
    0.7
    %
    
    
    1.2
    %
    
    
    1.4
    %* Percent of pre-tax (loss) earnings
 NET SALES Net sales are recognized at the time the sale is made to the customer, are net
of estimated returns and current promotional discounts and exclude sales tax.
Same-store sales are calculated on a weekly basis. If a store is open the
entire week in each of the two years being compared, its GAAP sales are
included in the same-store sales calculation for that week. Relocated and
remodeled stores are also included in the same-store sales calculation if they
were open during the entire week in each of the two years being compared.
Same-store sales for the second quarter and first six months of 2004 and 2003
exclude 212 stores in the South American and Central American Regions. Sales percent increases (decreases) are as follows: Second Quarter
    
    First Six Months2004
    
    2003
    
    2004
    
    2003Net Sales
    
    
    (0.5
    )%
    
    
    (5.8
    )%
    
    
    1.4
    %
    
    
    (5.6
    )%Same-store Sales
    
    
    (0.9
    )
    
    
    (6.4
    )
    
    
    0.9
    
    
    
    (6.3
    )Average selling price per unit
    
    
    8.3
    
    
    
    0.1
    
    
    
    7.5
    
    
    
    2.8Unit volume
    
    
    (7.5
    )
    
    
    (5.8
    )
    
    
    (5.3
    )
    
    
    (8.2
    )Footwear average selling price per unit
    
    
    6.5
    
    
    
    0.2
    
    
    
    3.7
    
    
    
    3.1Footwear unit volume
    
    
    (6.2
    )%
    
    
    (7.6
    )%
    
    
    (2.4
    )%
    
    
    (9.8
    )%
 Net sales for the 2004 second quarter totaled $727.9 million compared with
$731.5 million in the 2003 second quarter. Net sales and same-store sales
decreased in the second quarter of 2004 from 2003 primarily due to a more
promotional footwear environment beginning in mid-June and our decision to
remain less promotional than last year in order to protect our gross margins.
Furthermore, in June, sales of seasonal merchandise were affected by the rainy
and cool weather across much of the country. It is also likely that consumer
buying patterns throughout the quarter were impacted by higher energy prices. Net sales for the first six months of 2004 totaled $1,449.9 million compared
with $1,429.2 million in the first six months of 2003. Net sales and same-store
sales increased in the first six months of 2004 from 2003 primarily due to
positive sales performance in womens sandals and dress shoes, and accessories. 20




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##### Table of Contents



COST OF SALES Cost of sales includes cost of merchandise sold and our buying and occupancy
costs. Cost of sales was $502.7 million in the 2004 second quarter, down 5.7
percent from $533.2 million in the 2003 second quarter. For the first six
months of 2004, cost of sales was $1,003.5 million, down 2.2 percent from
$1,026.5 million in 2003. As a percentage of net sales, cost of sales was 69.1 percent in the second
quarter of 2004, compared with 72.9 percent in the second quarter of 2003. As a
percentage of net sales, cost of sales was 69.2 percent in the first six months
of 2004, compared with 71.8 percent in the first six months of 2003. The
decrease in cost of sales as a percentage of net sales was due primarily to
more favorable initial markups and fewer markdowns relative to the same period
last year. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES Selling, general and administrative expenses were $190.7 million in the second
quarter of 2004, an increase of 1.1 percent from $188.7 million in the second
quarter of 2003. For the first six months of 2004, selling, general and
administrative expenses were $390.0 million, an increase of 5.7 percent from
$368.8 million in the 2003 period. As a percentage of net sales, selling, general and administrative expenses were
26.2 percent during the second quarter of 2004 compared with 25.8 percent in
the second quarter of 2003. For the first six months of 2004, selling, general
and administrative expenses as a percentage of net sales were 26.9 percent
compared with 25.8 percent in the 2003 period. The increase in the second quarter of 2004 was primarily the result of $5.3
million of additional payroll and payroll-related costs, $2.5 million in
increased professional services related to a proxy contest and Sarbanes-Oxley
compliance, $2.2 million in increased workers compensation insurance costs,
and negative leverage due to lower sales partially offset by a $2.6 million
decrease in advertising expense and $2.4 million in decreased medical insurance
costs. In addition, during the second quarter of 2003 we wrote off $2.1
million in debt issuance costs in conjunction with our debt restructuring. The
increase in the first six months of 2004 was primarily the result of $12.6
million of additional payroll and payroll-related costs, $5.2 million of
additional advertising expense, $4.2 million in increased workers compensation
insurance costs, $3.1 million in increased professional services related to the
proxy contest and Sarbanes-Oxley compliance, and $2.3 million in increased
travel, partially offset by $3.7 million in decreased medical insurance costs,
positive leverage due to higher same-store sales and the write off of $3.1
million in debt costs in conjunction with our debt restructuring during the
2003 period. RESTRUCTURING The $36.7 million non-cash restructuring charge relates to the impairment of
long-lived assets associated with Chile, Peru, Parade and the approximately 260
Payless stores to be closed. INTEREST EXPENSE, NET Net interest expense increased from $3.3 million in the second quarter of 2003
to $4.5 million in the second quarter of 2004. For the first six months of
2004, net interest expense increased from $7.4 million in the first six months
of 2003 to $8.9 million. The increase in net interest expense reflects the
higher interest rate associated with the Senior Subordinated Notes compared
with the $200 million term loan portion of the credit facility that was in
place during 2003. EFFECTIVE INCOME TAX RATE In the second quarter of 2004, the impact of impairment charges and expected
restructuring costs on estimated annual taxable income resulted in a revised
projection of the effective income tax rate for the full fiscal year. In order
to record the revised estimated effective tax rate for the year, an adjustment
was required in the second quarter, resulting in a 58.2 percent effective
income tax benefit for the second quarter of 2004 and a 23.2 percent effective
income tax rate for the first six months of 2004. The Companys effective
income tax rate was 36.5 percent in the second quarter and first six months of
2003. MINORITY INTEREST, NET OF TAX Minority interest represents our joint venture partners share of net earnings
or losses on international operations. The increase in minority interest in
the second quarter of 2004 is due primarily to the impairment charge recorded
on operations in Peru and Chile. 21




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##### Table of Contents



LIQUIDITY AND CAPITAL RESOURCES We ended the second quarter of 2004 with a cash balance of $185.7 million, an
increase of $71.3 million over the 2003 second quarter. Internally generated
cash flow from operations is expected to continue to be the most important
component of our capital resources. Cash Flow Provided by Operating Activities Cash flow provided by operations was $85.5 million in the first six months of
2004, compared with $118.4 million in the 2003 period. As a percentage of net
sales, cash flow from operations was 5.9 percent in the first six months of
2004, compared with 8.3 percent in the same period in 2003. The significant
changes in cash flow during the first six months of 2004 as compared with the
2003 period are as follows: higher net earnings (excluding the $36.7 million
non-cash restructuring charge in the second quarter of 2004); inventory
increased by $21.9 million in 2004 compared with a $33.9 million decrease in
2003 for a net cash outflow of $55.8 million due primarily to lower inventory
at the beginning of 2004 compared with 2003; accounts payable decreased $3.1
million in 2004 compared with a $7.9 million increase in 2003 for a net cash
outflow of $11 million; and accrued expenses increased $28.8 million in 2004
compared with a $5.1 million decrease in 2003 for a net cash inflow of $33.9
million primarily due to accrued interest, accrued payroll-related costs and
accrued insurance costs. Cash Flow Used in Investing Activities In the first six months of 2004, our capital expenditures totaled $51.0
million, compared with $55.3 million for the same period in 2003. We estimate
that capital expenditures for the remainder of the year will be $59.0 million,
including $0.9 million to be contributed by our joint venture partners in the
Central American and South American Regions. We anticipate that internal cash
flow and available financing from our $200 million revolving credit agreement
will be sufficient to finance all of these expenditures. Cash Flow Provided by Financing Activities In January 2004, we replaced our $150 million senior secured revolving credit
facility (the Old Facility) with a new $200 million senior secured revolving
credit facility (the New Facility). Funds borrowed under the New Facility are
secured by domestic merchandise inventory and receivables. We may borrow up to
$200 million through the New Facility, subject to a sufficient borrowing base.
The New Facility bears interest at the LIBOR rate, plus a variable margin of
1.25 percent to 2.0 percent, or the base rate defined in the agreement
governing the New Facility. The margin on the New Facility varies based upon
certain borrowing levels specified in the agreement governing the New Facility.
The variable interest rate at July 31, 2004, was 2.95 percent. A quarterly
commitment fee of 0.30 percent per annum is payable on the unborrowed balance.
The New Facility is scheduled to expire in January 2008, with a one-year
extension to January 2009 at our option. No amounts were drawn on the New
Facility as of July 31, 2004. Based on our borrowing base, we may borrow up to
$200.0 million under the New Facility, less $16.1 million in outstanding
letters of credit as of July 31, 2004. In July 2003, we sold $200.0 million of 8.25% Senior Subordinated Notes (the
Notes) for $196.7 million, due 2013. The discount of $3.3 million is being
amortized to interest expense over the life of the Notes. The Notes are
guaranteed by all of our domestic subsidiaries. Interest on the Notes is
payable semi-annually, beginning February 1, 2004. The Notes contain various
covenants including those that may limit our ability to pay dividends,
repurchase stock, accelerate the retirement of other subordinated debt or make
certain investments. As of July 31, 2004, we were in compliance with all
covenants. The proceeds of the Notes and additional general funds were used to
repay the entire $200.0 million term loan portion of our Old Facility. As of
July 31, 2004, the fair value of the Notes was $195.0 million based on recent
trading activity of the Notes. On or after August 1, 2008, we may, on any one
or more occasions, redeem all or a part of the Notes at the redemption prices
set forth below, plus accrued and unpaid interest, if any, on the Notes
redeemed, to the applicable redemption date: Year
    
    Percentage2008
    
    
    104.125
    %2009
    
    
    102.750
    %2010
    
    
    101.375
    %2011 and thereafter
    
    
    100.000
    %
 22




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##### Table of Contents



We have entered into $33.5 million of demand notes payable to efficiently
finance our Latin American subsidiaries in the Central American and South
American Regions. We maintain cash balances of $33.5 million in certificates of
deposit as compensating balances to collateralize these notes payable. The
notes payable accrue interest at a weighted average 8.44 percent. The
certificates of deposit earn interest at a weighted average of 8.05 percent and
are reflected as restricted cash in the accompanying condensed consolidated
balance sheet. Financial Commitments As a result of the restructuring, we estimate that cash commitments for lease
terminations, severance and other exit activities could be in the range $40
million to $60 million. However, the final financial impact of the
restructuring is dependent upon the ultimate exit transactions. As of July 31, 2004, no amounts were drawn against our $200 million revolving
credit facility. The availability under the New Facility has been reduced,
however, by $16.1 million in outstanding letters of credit. For a discussion of
our contractual obligations, see a discussion of future commitments under Item
7, Managements Discussion and Analysis of Financial Condition and Results of
Operations, in our Form 10-K for the fiscal year ended January 31, 2004. There
have been no significant developments with respect to our contractual
obligations since January 31, 2004. FINANCIAL CONDITION RATIOS A summary of key financial information for the periods indicated is as follows: July 31,
    
    August 2,
    
    January 31,2004
    
    2003
    
    2004Current Ratio
    
    
    2.3
    
    
    
    2.4
    
    
    
    2.3Debt-Capitalization Ratio*
    
    
    27.6
    %
    
    
    27.5
    %
    
    
    28.1
    %
  *
    
    Debt-to-capitalization has been computed by dividing total debt by
capitalization. Total debt is defined as long-term debt including current
maturities, notes payable and borrowings under the revolving line of
credit. Capitalization is defined as total debt and shareowners equity.
The debt-to-capitalization ratio, including the present value of future
minimum rental payments under operating leases as debt and as
capitalization, was 66.1%, 64.4% and 66.0% respectively, for the periods
referred to above. STORE ACTIVITY As of July 31, 2004, we operated 5,072 retail shoe stores offering quality
footwear and accessories in all 50 of the United States, the District of
Columbia, Puerto Rico, Guam, Saipan, the U.S. Virgin Islands, Canada, and the
Central and South American Regions. The following table presents the change in
store count for the entire company for the second quarter and first six months
of 2004 and 2003. We consider a store relocation to be both a store opening and
a store closing. Second Quarter
    
    First Six Months2004
    
    2003
    
    2004
    
    2003Beginning of period
    
    
    5,066
    
    
    
    5,003
    
    
    
    5,042
    
    
    
    4,992Stores opened
    
    
    68
    
    
    
    58
    
    
    
    148
    
    
    
    118Stores closed
    
    
    (62
    )
    
    
    (41
    )
    
    
    (118
    )
    
    
    (90
    )Ending store count
    
    
    5,072
    
    
    
    5,020
    
    
    
    5,072
    
    
    
    5,020
 As of July 31, 2004, we operated 150 stores in the Central America Region, 62
stores in the South America Region and 296 stores in Canada. We have entered
into a joint venture agreement to operate Payless ShoeSource stores in Japan.
We own 60 percent of the Japanese joint venture and, therefore, will
consolidate the results of such operations in our financial statements. We
intend to open the 23




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##### Table of Contents



first test store in Japan during 2004. We have curtailed any other expansion
into new international markets to focus on our core business. We intend to exit from all 32 stores in Chile and Peru, 181 Parade stores and
approximately 260 Payless stores pursuant to the restructuring plan strategic
initiatives. Furthermore, 230 stores were already scheduled for closing or
relocation as part of the normal course of business in 2004. In total, we now
intend to close approximately 700 to 705 stores in 2004. In addition to store
closings, we remain on schedule to open approximately 300 new stores in 2004,
resulting in a total expected net reduction of 400 to 405 stores for the year.
We began the year with 5,042 stores. Thus, our store count is expected to be
approximately 4,640 stores at the end of 2004. CRITICAL ACCOUNTING POLICIES In preparing the condensed consolidated financial statements included in this
Form 10-Q, management makes estimates and assumptions that affect the amounts
reported within the financial statements. Actual results could differ from
these estimates. For more information regarding our critical accounting
policies, estimates and judgments, see the discussion under Managements
Discussion and Analysis of Financial Condition and Results of Operations in our
Form 10-K for the year ended January 31, 2004. 
 ITEM 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK INTEREST RATE RISK Interest on our senior secured revolving credit facility, which is entirely
comprised of a revolving line of credit, is based on the London Inter-Bank
Offered Rate (LIBOR) plus a variable margin of 1.25 percent to 2.0 percent,
or the base rate, as defined in the credit agreement. There are no outstanding
borrowings on the revolving line of credit; however, if we were to borrow
against our revolving line of credit, borrowing costs may fluctuate depending
upon the volatility of LIBOR and amounts borrowed. FOREIGN CURRENCY RISK We have retail operations in foreign countries; therefore, our cash flows in
U.S. dollars are impacted by fluctuations in foreign currency exchange rates.
We adjust our retail prices, when possible, to reflect changes in exchange
rates to mitigate this risk. To further mitigate this risk, we may, from time
to time, enter into forward contracts to purchase or sell foreign currencies.
For the quarters and six-month periods ended July 31, 2004, and August 2, 2003,
fluctuations in foreign currency exchange rates did not have a material impact
on our operations or cash flows and we did not enter into any forward contracts
to purchase or sell foreign currencies. 
 ITEM 4 - CONTROLS AND PROCEDURES As of July 31, 2004, we carried out an evaluation, under the supervision and
with the participation of our principal executive officer and principal
financial officer, of the effectiveness of the design and operation of our
disclosure controls and procedures. Based on this evaluation, our principal
executive officer and principal financial officer concluded that our disclosure
controls and procedures are effective in alerting them in a timely manner to
material information required to be disclosed in our periodic reports filed
with the Securities Exchange Commission. In addition, there was no significant change in our internal control over
financial reporting that occurred during our most recently completed fiscal
quarter that has materially affected, or is reasonably likely to materially
affect, our internal control over financial reporting. 24




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##### Table of Contents



PART II - OTHER INFORMATION 
 ITEM 1 - LEGAL PROCEEDINGS Other than as described below, there are no material pending legal proceedings
other than ordinary, routine litigation incidental to the business to which the
Company is a party or of which any of its property is subject. On or about December 20, 2001, a First Amended Complaint was filed against the
Company in the U.S. District Court for the District of Oregon, captioned Adidas
America, Inc. and Adidas-Salomon AG v. Payless ShoeSource, Inc. The First
Amended Complaint seeks injunctive relief and unspecified monetary damages for
trademark and trade dress infringement, unfair competition, deceptive trade
practices and breach of contract. The Company believes it has meritorious
defenses to claims asserted in the lawsuit and has filed an answer and a motion
for summary judgment which the court granted in part. An estimate of the
possible loss, if any, or the range of loss cannot be made. On or about January 20, 2000, a complaint was filed against the Company in the
U.S. District Court for the District of New Hampshire, captioned Howard J.
Dananberg, D.P.M. v. Payless ShoeSource, Inc. The Complaint seeks injunctive
relief, unspecified treble monetary damages, attorneys fees, interest and
costs for patent infringement. The Company believes it has meritorious defenses
to claims asserted in the lawsuit. An estimate of the possible loss, if any, or
the range of loss cannot be made. 
 ITEM 2  CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY
SECURITIES The following table provides information about purchases by the Company (and
its affiliated purchasers) during the quarter ended July 31, 2004, of equity
securities that are registered by the Company pursuant to Section 12 of the
Exchange Act: ISSUER PURCHASES OF EQUITY SECURITIES Total Number of Shares
    
    Approximate Dollar Value ofTotal Number of
    
    
    
    
    
    Purchased as Part of
    
    Shares that May Yet BeShares Purchased (1)
    
    Average Price Paid
    
    Publicly Announced
    
    Purchased Under the Plans orPeriod
    
    (in Thousands)
    
    per Share
    
    Plans or Programs (2)
    
    Programs (in Millions) (3)05/02/04  05/29/04
    
    
    12
    
    
    $
    16.02
    
    
    
    0
    
    
    $
    248.205/30/04  07/03/04
    
    
    4
    
    
    $
    16.04
    
    
    
    0
    
    
    $
    248.207/04/04  07/31/04
    
    
    4
    
    
    $
    14.30
    
    
    
    0
    
    
    $
    248.2Total
    
    
    20
    
    
    $
    15.67
    
    
    
    0
    
    
    
    248.2
 (1) We repurchased an aggregate of 19,636 shares of our common stock in
connection with our employee stock purchase and stock incentive plans. (2) In 2001, our Board of Directors approved the repurchase of our common stock
having a value of up to $250 million in the aggregate pursuant to the Program. (3) The timing and amount of share repurchases, if any, are limited by the
terms of the Companys Credit Agreement and Senior Subordinated Notes. 25




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##### Table of Contents



ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits: Number
    
    Description11.1
    
    Computation of Net Earnings Per Share*31.1
    
    Certification Pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002 of the Chairman of the Board and Chief Executive
Officer*31.2
    
    Certification Pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002 of the Senior Vice President, Chief Financial
Officer and Treasurer*32.1
    
    Certification Pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002 of the Chairman of the Board and Chief Executive
Officer*32.2
    
    Certification Pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002 of the Senior Vice President, Chief Financial
Officer and Treasurer*
 * Filed herewith (b) Reports on Form 8-K On September 2, 2004, the Company filed a Current Report on Form 8-K furnishing
under Items 5.02, 7.01 and 8.01 the Companys press release announcing its sales
for the fiscal month of August, which ended August 28, 2004 and certain
management restructuring actions. On August 12, 2004, the Company filed a Current Report on Form 8-K furnishing
under Items 9 and 12 the Companys press release announcing its results for the
second fiscal quarter of 2004, which ended July 31, 2004. On August 5, 2004, the Company filed a Current Report on Form 8-K furnishing
under Items 5 and 9 the Companys press release announcing its sales for the
fiscal month of July, which ended July 31, 2004. On July 29, 2004, the Company filed a Current Report on Form 8-K furnishing
under Item 5 the Companys press release announcing that it is considering
certain strategic alternatives. On July 26, 2004, the Company filed a Current Report on Form 8-K furnishing
under Item 5 the Companys press release announcing the election of Judith K.
Hofer to the Companys Board of Directors and its Compensation, Nominating and
Governance Committee. On July 8, 2004, the Company filed a Current Report on Form 8-K furnishing
under Items 5 and 9 the Companys press release announcing its sales for the
fiscal month of June, which ended July 3, 2004. On June 3, 2004, the Company filed a Current Report on Form 8-K furnishing
under Items 5 and 9 the Companys press release announcing its sales for the
fiscal month of May, which ended May 29, 2004. 26




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##### Table of Contents



SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
Company has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. PAYLESS SHOESOURCE, INC.Date: September 7, 2004
    By:
    /s/ Steven J. DouglassSteven J. DouglassChairman of the Board and
Chief Executive Officer
(Principal Executive Officer) Date: September 7, 2004
    By:
    /s/ Ullrich E. PorzigUllrich E. PorzigSenior Vice President
Chief Financial Officer and Treasurer
(Principal Financial and Accounting Officer) 27