UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 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 August 1, 1998 -------------- Commission file number 1-6049 ------ Dayton Hudson Corporation - ------------------------------------------------------------------------------ (Exact name of registrant as specified in its charter) Minnesota 41-0215170 - ------------------------------------------------------------------------------ (State of incorporation or organization) (I.R.S. Employer Identification No.) 777 Nicollet Mall Minneapolis, Minnesota 55402-2055 - ------------------------------------------------------------------------------ (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code (612) 370-6948 - ------------------------------------------------------------------------------ None - ------------------------------------------------------------------------------ (Former name, former address and former fiscal year, if changed since last report.) 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. The number of shares outstanding of common stock as of August 1, 1998 was 439,944,303.
DAYTON HUDSON CORPORATION AND SUBSIDIARIES TABLE OF CONTENTS <TABLE> <CAPTION> PAGE NO. <S> <C> PART I FINANCIAL INFORMATION: ITEM 1 - FINANCIAL STATEMENTS Condensed Consolidated Results of Operations for the Three 1 Months, Six Months and Twelve Months ended August 1, 1998 and August 2, 1997 Condensed Consolidated Statements of Financial Position at 2 August 1, 1998, January 31, 1998 and August 2, 1997 Condensed Consolidated Statements of Cash Flows for the Six 3 Months ended August 1, 1998 and August 2, 1997 Notes to Condensed Consolidated Financial Statements 4-6 ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF OPERATIONS AND 7-12 FINANCIAL CONDITION PART II OTHER INFORMATION: ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K 13 Signatures 14 Exhibit Index 15 </TABLE>
PART I. FINANCIAL INFORMATION CONDENSED CONSOLIDATED Dayton Hudson Corporation RESULTS OF OPERATIONS and Subsidiaries <TABLE> <CAPTION> (MILLIONS OF DOLLARS, EXCEPT PER SHARE DATA) THREE MONTHS ENDED SIX MONTHS ENDED TWELVE MONTHS ENDED - ----------------------------------------------------------------------------------------------------------------------------- AUGUST 1, August 2, AUGUST 1, August 2, AUGUST 1, August 2, (Unaudited) 1998 1997 1998 1997 1998 1997 - ----------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> REVENUES $7,056 $6,293 $13,524 $12,182 $29,099 $26,422 COSTS AND EXPENSES: Cost of retail sales, buying and occupancy 5,143 4,586 9,870 8,839 21,351 19,321 Selling, publicity and administrative 1,214 1,080 2,288 2,114 4,705 4,411 Depreciation and amortization 193 174 377 344 727 678 Interest expense, net 101 107 197 214 399 436 Taxes other than income taxes 121 113 243 230 483 455 Real estate repositioning charge - - - - - 134 - ----------------------------------------------------------------------------------------------------------------------------- Total Costs and Expenses 6,772 6,060 12,975 11,741 27,665 25,435 - ----------------------------------------------------------------------------------------------------------------------------- EARNINGS BEFORE INCOME TAXES AND EXTRAORDINARY CHARGES 284 233 549 441 1,434 987 Provision for Income Taxes 112 92 217 174 567 389 - ----------------------------------------------------------------------------------------------------------------------------- NET EARNINGS BEFORE EXTRAORDINARY CHARGES 172 141 332 267 867 598 Extraordinary Charges from Purchase and Redemption of Debt, Net of Tax - 11 2 32 21 42 - ----------------------------------------------------------------------------------------------------------------------------- NET EARNINGS $ 172 $ 130 $ 330 $ 235 $ 846 $ 556 - ----------------------------------------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------------------------------------- BASIC EARNINGS PER SHARE: Earnings Before Extraordinary Charges $ .38 $ .32 $ .74 $ .59 $ 1.94 $ 1.33 Extraordinary Charges - (.03) (.01) (.07) (.05) (.10) - ----------------------------------------------------------------------------------------------------------------------------- BASIC EARNINGS PER SHARE $ .38 $ .29 $ .73 $ .52 $ 1.89 $ 1.23 - ----------------------------------------------------------------------------------------------------------------------------- DILUTED EARNINGS PER SHARE: Earnings Before Extraordinary Charges $ .36 $ .29 $ .70 $ .56 $ 1.84 $ 1.27 Extraordinary Charges - (.02) (.01) (.07) (.05) (.10) - ----------------------------------------------------------------------------------------------------------------------------- DILUTED EARNINGS PER SHARE $ .36 $ .27 $ .69 $ .49 $ 1.79 $ 1.17 - ----------------------------------------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------------------------------------- DIVIDENDS DECLARED PER COMMON SHARE $ .09 $ .08 $ .18 $ .16 $ .35 $ .32 AVERAGE COMMON SHARES OUTSTANDING (Millions): Basic 439.6 435.7 439.1 435.3 438.0 434.6 Diluted 467.6 463.8 467.1 463.1 465.6 461.3 - ----------------------------------------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------------------------------------- </TABLE> See accompanying Notes to Condensed Consolidated Financial Statements. 1
CONDENSED CONSOLIDATED STATEMENTS Dayton Hudson Corporation OF FINANCIAL POSITION and Subsidiaries <TABLE> <CAPTION> AUGUST 1, January 31, August 2, (MILLIONS OF DOLLARS) 1998 1998* 1997 - ----------------------------------------------------------------------------------------- <S> <C> <C> <C> ASSETS (Unaudited) (Unaudited) CURRENT ASSETS Cash and cash equivalents $ 237 $ 211 $ 216 Retained securitized receivables 1,295 1,555 1,551 Merchandise inventories 3,697 3,251 3,363 Other 926 544 409 - ----------------------------------------------------------------------------------------- Total Current Assets 6,155 5,561 5,539 PROPERTY AND EQUIPMENT 12,240 11,513 10,920 Accumulated depreciation (3,676) (3,388) (3,171) Property and Equipment, net 8,564 8,125 7,749 OTHER 589 505 487 - ----------------------------------------------------------------------------------------- TOTAL ASSETS $ 15,308 $ 14,191 $ 13,775 - ----------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------- LIABILITIES AND SHAREHOLDERS' INVESTMENT CURRENT LIABILITIES Accounts payable $ 2,852 $ 2,727 $ 2,399 Current portion of long-term debt and notes payable 351 273 384 Other 1,462 1,556 1,264 - ----------------------------------------------------------------------------------------- Total Current Liabilities 4,665 4,556 4,047 LONG-TERM DEBT 5,132 4,425 5,072 DEFERRED INCOME TAXES AND OTHER 750 720 636 CONVERTIBLE PREFERRED STOCK, NET 20 30 34 SHAREHOLDERS' INVESTMENT 4,741 4,460 3,986 - ----------------------------------------------------------------------------------------- TOTAL LIABILITIES AND SHAREHOLDERS' INVESTMENT $ 15,308 $ 14,191 $ 13,775 - ----------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------- COMMON SHARES OUTSTANDING (Millions) 439.9 437.8 436.1 - ----------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------- </TABLE> * The January 31, 1998 Consolidated Statement of Financial Position is condensed from the audited financial statement. See accompanying Notes to Condensed Consolidated Financial Statements. 2
CONDENSED CONSOLIDATED Dayton Hudson Corporation STATEMENTS OF CASH FLOWS and Subsidiaries <TABLE> <CAPTION> (MILLIONS OF DOLLARS) SIX MONTHS ENDED - ----------------------------------------------------------------------------------------------------- AUGUST 1, August 2, (UNAUDITED) 1998 1997 - ----------------------------------------------------------------------------------------------------- <S> <C> <C> OPERATING ACTIVITIES Net earnings before extraordinary charges $ 332 $267 Reconciliation to cash flow: Depreciation and amortization 377 344 Deferred tax provision 10 (60) Other non-cash items affecting earnings 14 7 Changes in operating accounts providing/(requiring) cash, net of acquisitions: Retained securitized receivables 305 169 Merchandise inventories (420) (332) Accounts payable 39 (136) Accrued liabilities (58) 83 Income taxes payable (53) (139) Securities in trust for principal payment on sold securitized receivables (270) - Other (93) 54 - ----------------------------------------------------------------------------------------------------- Cash Flow Provided by Operations 183 257 - ----------------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------------- INVESTING ACTIVITIES Expenditures for property and equipment (793) (637) Proceeds from disposals of property and equipment 29 110 Acquisition of subsidiaries, net of cash received (100) - Other (6) - - ----------------------------------------------------------------------------------------------------- Cash Flow (Required) for Investing Activities (870) (527) - ----------------------------------------------------------------------------------------------------- Net Financing Requirements (687) (270) - ----------------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------------- FINANCING ACTIVITIES Increase in notes payable, net 466 537 Additions to long-term debt 400 100 Reductions of long-term debt (87) (438) Principal payments received on loan to ESOP 8 9 Dividends paid (89) (80) Sale of subsidiary preferred stock - 160 Other 15 (3) - ----------------------------------------------------------------------------------------------------- Cash Flow Provided by Financing Activities 713 285 - ----------------------------------------------------------------------------------------------------- Net Increase in Cash and Cash Equivalents 26 15 Cash and Cash Equivalents at Beginning of Period 211 201 - ----------------------------------------------------------------------------------------------------- CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 237 $ 216 - ----------------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------------- </TABLE> Amounts in this statement are presented on a cash basis and therefore may differ from those shown elsewhere in this 10-Q report. Cash paid for income taxes was $265 million and $342 million during the first six months of 1998 and 1997, respectively. Cash paid for interest (including interest capitalized) in the first six months of 1998 and 1997 was $195 million and $284 million, respectively. See accompanying Notes to Condensed Consolidated Financial Statements. 3
NOTES TO CONDENSED CONSOLIDATED Dayton Hudson Corporation FINANCIAL STATEMENTS and Subsidiaries ACCOUNTING POLICIES The accompanying condensed consolidated financial statements should be read in conjunction with the financial statement disclosures contained in our 1997 Annual Shareholders' Report throughout pages 25-36. As explained on page 35 of the Annual Report, the same accounting policies are followed in preparing quarterly financial data as are followed in preparing annual data. In the opinion of management, all adjustments necessary for a fair presentation of quarterly operating results are reflected herein and are of a normal, recurring nature. Due to the seasonal nature of the retail industry, quarterly earnings are not necessarily indicative of the results that may be expected for the full fiscal year. INTERNAL USE SOFTWARE We adopted Statement of Position (SOP) 98-1 "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use" in first quarter 1998. The adoption resulted in expense savings which increased pre-tax earnings by approximately $23 and $38 million, net of depreciation, for the second quarter and first half of 1998, respectively ($.03 and $.05 per share) which partially offset our other systems expenses. PER SHARE DATA References to earnings per share relate to diluted earnings per share. <TABLE> <CAPTION> Basic EPS - ----------------------------------------------------------------------------------------------------- Three Months Six Months Twelve Months Ended Ended Ended - ----------------------------------------------------------------------------------------------------- AUG 1, Aug 2, AUG 1, Aug 2, AUG 1, Aug 2, 1998 1997 1998 1997 1998 1997 - ----------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> Net earnings* $ 172 $ 141 $ 332 $ 267 $ 867 $ 598 Less: ESOP net earnings adjustment (5) (5) (10) (10) (20) (20) - ----------------------------------------------------------------------------------------------------- Adjusted net earnings* $ 167 $ 136 $ 322 $ 257 $ 847 $ 578 - ----------------------------------------------------------------------------------------------------- Weighted average common shares outstanding 439.6 435.7 439.1 435.3 438.0 434.6 Performance shares - - - - - - Stock options - - - - - - Assumed conversion of ESOP preferred shares - - - - - - - ----------------------------------------------------------------------------------------------------- Total common equivalent shares outstanding 439.6 435.7 439.1 435.3 438.0 434.6 - ----------------------------------------------------------------------------------------------------- Earnings Per Share* $ .38 $ .32 $ .74 $ .59 $ 1.94 $ 1.33 - ----------------------------------------------------------------------------------------------------- <CAPTION> Diluted EPS - -------------------------------------------------------------------------------------------------- Three Months Six Months Twelve Months Ended Ended Ended - -------------------------------------------------------------------------------------------------- AUG 1, Aug 2, AUG 1, Aug 2, AUG 1, Aug 2, 1998 1997 1998 1997 1998 1997 - -------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> Net earnings* $ 172 $ 141 $ 332 $ 267 $ 867 $ 598 Less: ESOP net earnings adjustment (3) (4) (6) (7) (12) (13) - -------------------------------------------------------------------------------------------------- Adjusted net earnings* $ 169 $ 137 $ 326 $ 260 $ 855 $ 585 - -------------------------------------------------------------------------------------------------- Weighted average common shares outstanding 439.6 435.7 439.1 435.3 438.0 434.6 Performance shares 0.9 1.5 0.9 1.5 1.0 1.4 Stock options 6.0 4.1 5.8 3.7 4.9 2.3 Assumed conversion of ESOP preferred shares 21.1 22.5 21.3 22.6 21.7 23.0 - -------------------------------------------------------------------------------------------------- Total common equivalent shares outstanding 467.6 463.8 467.1 463.1 465.6 461.3 - -------------------------------------------------------------------------------------------------- Earnings Per Share* $ .36 $ .29 $ .70 $ .56 $ 1.84 $ 1.27 - -------------------------------------------------------------------------------------------------- </TABLE> *Before extraordinary charges 4
LONG-TERM DEBT On June 4, 1998 we issued $200 million of long-term debt maturing in June 2010, puttable in June 2000. In addition, we sold to a third party the right to call and remarket these securities in June 2000 to their final maturity. On July 21, 1998 we issued $200 million of long-term debt with a coupon rate of 6.65%, maturing in August 2028. ACQUISITIONS In the first quarter of 1998, we acquired The Associated Merchandising Corporation, an international sourcing company for our three operating divisions and other retailers, and Rivertown Trading Company, a direct marketing firm. Both subsidiaries are included in the consolidated financial statements. Their revenues and operating results are included in "Corporate and other" and were immaterial in the second quarter and first half of 1998. SEGMENT DISCLOSURES (millions of dollars) Revenues by segment were as follows: <TABLE> <CAPTION> Three Months Ended Six Months Ended ------------------ ------------------ AUGUST 1, August 2, AUGUST 1, August 2, 1998 1997 1998 1997 -------- -------- -------- -------- <S> <C> <C> <C> <C> Target $ 5,294 $ 4,663 $ 10,101 $ 8,917 Mervyn's 935 945 1,825 1,891 DSD 732 685 1,458 1,374 Corporate and other 95 - 140 - -------- -------- -------- -------- Total revenues $ 7,056 $ 6,293 $ 13,524 $ 12,182 -------- -------- -------- -------- -------- -------- -------- -------- </TABLE> Pre-tax segment profit and reconciliation to pre-tax earnings were as follows: <TABLE> <CAPTION> Three Months Ended Six Months Ended ------------------ ------------------ AUGUST 1, August 2, AUGUST 1, August 2, 1998 1997 1998 1997 -------- -------- -------- -------- <S> <C> <C> <C> <C> Target $ 337 $ 274 $ 639 $ 526 Mervyn's 40 58 83 108 DSD 45 33 86 68 -------- -------- -------- -------- Total Pre-tax Segment Profit 422 365 808 702 Securitization adjustments: Interest equivalent (12) (7) (24) (13) SFAS 125 gain - 7 - 13 Interest expense (101) (107) (197) (214) Corporate and other (25) (25) (38) (47) -------- -------- -------- -------- Earnings before income taxes and extraordinary charge $ 284 $ 233 $ 549 $ 441 -------- -------- -------- -------- -------- -------- -------- -------- </TABLE> 5
DERIVATIVES In June 1998, the Financial Accounting Standards Board issued Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities", which is required to be adopted for fiscal years beginning after June 15, 1999. The adoption of this new statement is expected to have an immaterial effect on our earnings and financial position. SUBSEQUENT EVENTS On August 12, 1998, Dayton Hudson Receivables Corporation (DHRC), a special-purpose subsidiary, sold to the public $400 million of securitized receivables. This issue of asset-backed securities has an expected maturity of five years and a stated rate of 5.90%. Proceeds from the sale were used for general corporate purposes, including funding the growth of receivables. In conjunction with this transaction, DHRC retained a $123 million issue of subordinated Class B asset-backed securities, which is classified in Retained Securitized Receivables. As required by Statement of Financial Accounting Standards (SFAS) No. 125, the sale transaction resulted in a pre-tax gain of $35 million, $.05 per share. Later in the third quarter, this gain will be offset by a $38 million pre-tax charge, $.05 per share, related to the maturity of our 1995 securitization. The net impact will result in a reduction of third quarter finance charge revenues and pre-tax earnings of approximately $3 million. We have historically deducted for income tax purposes the inventory shortage expense accrued for book purposes in a manner consistent with industry practice. With respect to our 1983 Federal income tax return, the Internal Revenue Service (IRS) challenged the practice of deducting accrued shortage not verified with a year-end physical inventory. In second quarter of 1997, the United States Tax Court (Tax Court) returned a judgment on this issue in favor of the IRS. We appealed the decision to the United States Court of Appeals for the Eighth Circuit (Appeals Court) and on August 14, 1998, the Appeals Court reversed the Tax Court decision. Final resolution of this matter for 1983 through 1996 now depends on further action, if any, by the IRS. 6
MANAGEMENT'S DISCUSSION AND ANALYSIS OF OPERATIONS AND FINANCIAL CONDITION SECOND QUARTER 1998 ANALYSIS OF OPERATIONS The improvement in second quarter and first half net earnings was due to strong sales and profit performance at Target and DSD. Second quarter and first half 1997 net earnings included extraordinary charges related to the early extinguishment of debt. Second quarter and first half 1998 and 1997 net earnings were as follows: <TABLE> <CAPTION> Earnings Diluted Earnings Per Share ------------------------------------ ------------------------------------ Three Months Six Months Three Months Six Months Ended Ended Ended Ended ---------------- ---------------- ---------------- ---------------- AUG 1, Aug 2, AUG 1, Aug 2, AUG 1, Aug 2, AUG 1, Aug 2, 1998 1997 1998 1997 1998 1997 1998 1997 ------ ------ ------ ------ ------ ------ ------ ------ <S> <C> <C> <C> <C> <C> <C> <C> <C> Net earnings before unusual items $ 172 $ 137 $ 332 $ 260 $ .36 $ .28 $ .70 $ .54 Securitization gain, net of tax (pre-tax $7 and $13 million) - 4 - 7 - .01 - .02 ---------------------------------------------------------------------------- Net earnings before extraordinary charge 172 141 332 267 .36 .29 .70 .56 Extraordinary charge, net of tax - (11) (2) (32) - (.02) (.01) (.07) ---------------------------------------------------------------------------- Net earnings $ 172 $ 130 $ 330 $ 235 $ .36 $ .27 $ .69 $ .49 ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- </TABLE> REVENUES AND COMPARABLE-STORE SALES Total revenues for the quarter increased 12.1 percent to $7,056 million compared with $6,293 million for the same period a year ago. Total revenues for the first half increased 11.0 percent to $13,524 million compared with $12,182 million for the same period a year ago. Total comparable-store sales (sales from stores open longer than one year) increased 5.2 percent for both periods. Year-over-year changes in revenues and comparable-store sales by business segment were as follows: <TABLE> <CAPTION> Three Months Six Months Percentage Change Percentage Change ----------------------- ----------------------- Comparable- Comparable- Revenues Store Sales Revenues Store Sales -------- ----------- -------- ----------- <S> <C> <C> <C> <C> Target 13.5% 6.2% 13.3% 6.1% Mervyn's (1.0) (1.1) (3.5) (0.4) DSD 6.8 7.4 6.1 7.1 -------- ----------- -------- ----------- Total 12.1% 5.2% 11.0% 5.2% -------- ----------- -------- ----------- -------- ----------- -------- ----------- </TABLE> Target's revenue results reflect strong new and comparable-store sales growth. Mervyn's revenues and comparable-store sales declined mainly due to lower than expected sales in its West Coast stores. DSD's revenue results reflect strong comparable-store sales growth. 7
PRE-TAX SEGMENT PROFIT Pre-tax segment profit is first-in, first-out (FIFO) earnings from operations before securitization effects, interest, corporate and other, and unusual items. Our second quarter pre-tax segment profit increased 15 percent to $422 million compared with $365 million for the same period a year ago. Pre-tax segment profit in the first half increased 15 percent to $808 million compared with $702 million for the same period a year ago. Year-over-year pre-tax segment profit growth was as follows: <TABLE> <CAPTION> Three Months Six Months Percentage Change Percentage Change ----------------- ----------------- <S> <C> <C> Target 23% 21% Mervyn's (32) (23) DSD 40 27 -------- -------- Total Pre-tax Segment Profit 15% 15% -------- -------- -------- -------- </TABLE> TARGET'S second quarter and first half pre-tax profit increased 23 and 21 percent, respectively, over the same periods last year, reflecting comparable-store sales growth of 6.2 and 6.1 percent, respectively. During the second quarter and first half, the gross margin rate improved primarily due to lower markdowns and lower inventory shortage. The operating expense rate during the second quarter remained essentially unchanged from last year, reflecting improved store productivity offset by higher wage rates. For the first half, the operating expense rate was favorable to last year due to productivity improvements, partially offset by higher wage rates. We expect mid single-digit comparable-store sales growth at Target in the second half of this year, and a pre-tax profit margin essentially even with 1997. These results would reflect a pre-tax profit increase of 11 to 15 percent during the second half of the year. MERVYN'S second quarter and first half pre-tax profit decreased 32 and 23 percent, respectively, from the same periods last year, reflecting comparable-store sales declines of 1.1 and 0.4 percent, respectively. The gross margin rate declined during the second quarter and first half due to higher markdowns. The operating expense rate declined in both periods due to modestly higher costs on a lower sales base. By the fourth quarter, we expect Mervyn's to reverse the year-to-date trend of year-over-year decreases in pre-tax profit. DSD'S second quarter and first half pre-tax profit increased 40 and 27 percent, respectively, from the same periods last year, reflecting comparable-store sales growth of 7.4 and 7.1 percent, respectively. The gross margin rate improvement in the second quarter and first half was primarily due to improved markdowns. During the second quarter, the operating expense rate was essentially unchanged from the prior year due to strong sales leveraging offset by planned higher marketing expenses. The operating expense rate year-to-date is favorable to last year primarily due to strong sales leveraging. We expect low single-digit comparable-store sales growth at DSD in the second half of this year and a modest increase in the pre-tax profit margin. These results would reflect a more modest increase in DSD's pre-tax profit than the 27 percent growth in the first half. 8
OTHER PERFORMANCE FACTORS Our proprietary guest credit programs strategically support our core retail operations and are an integral component of each business segment. Therefore, credit contribution is reflected in each business segment's pre-tax profit. Net of all expenses, including bad debt expense, pre-tax contribution from guest credit increased over the prior year, for both the quarter and six month period, principally due to continued growth of the Target guest card. We expect to continue to grow guest credit's contribution in 1998 by acquiring new accounts, increasing participation in our guest loyalty programs and controlling bad debt expense. The last-in first-out (LIFO) provision, included in cost of retail sales, was zero in the second quarter and first half for both 1998 and 1997. The cumulative LIFO provision was $92 million at August 1, 1998 and January 31, 1998, and $86 million at August 2, 1997. "Interest equivalent", as shown in our pre-tax earnings reconciliation on page 5, represents payments to holders of our sold securitized receivables and is included in our Consolidated Results of Operations as a reduction of finance charge revenues and bad debt expense. We expect interest equivalent of approximately $12 million per quarter for the remainder of this year. For analytical purposes, management includes the interest equivalent in interest expense. Combined interest expense and interest equivalent decreased $1 million in the second quarter and $6 million in the first half of 1998 compared to the same periods last year due to a lower average portfolio interest rate. Combined interest expense and interest equivalent decreased $4 million in the second quarter and $6 million in the first half of 1997 compared to the same periods in 1996 primarily due to lower average funded balances. For the balance of 1998, combined interest expense and interest equivalent is expected to be similar to, or slightly above, 1997 as somewhat higher average funded balances are partially offset by continued portfolio rate favorability. The estimated annual effective income tax rate was 39.5 percent in the second quarter and first half for both 1998 and 1997. YEAR 2000 We began mitigating the risks associated with the Year 2000 date conversion in 1993. In 1997 we established a corporate-wide, comprehensive plan of action designed to achieve an uninterrupted transition into the year 2000. This project includes three major elements: 1) information technology (IT) systems, 2) non-IT, or embedded technology, systems and 3) relationships with our key business partners. The project is divided into five phases: awareness, assessment, renovation, validation and implementation. We have essentially completed the awareness and assessment phases for all three elements, and are currently at different points in the renovation, validation and implementation phases for each of the elements. We are using both internal and external resources to implement our plan. 9
For our IT systems, we have assessed both existing and newly implemented hardware and applications (software and operating systems), and have substantially finalized the development of plans to address all assessed risks. Approximately 80 percent of our hardware is year 2000 compliant, and the remainder is currently in the renovation phase. Approximately 65 percent of our applications are compliant, with 35 percent in the renovation phase. We anticipate completion of the validation, or testing, phase for our software by early/mid 1999, and we intend to extensively test our key operating systems, through simulation of the year 2000, in late 1998 and early/mid 1999. Our year 2000 readiness in this area has been significantly enhanced by our recent, substantial common systems development initiatives through which we have invested heavily in IT over the past two years. We began addressing non-IT systems, or embedded technology/infrastructure, risks at our stores, distribution centers and headquarters facilities early in our initiative. Approximately 80 percent of our non-IT systems are compliant and the remainder are currently in the renovation phase. Validation and implementation are approximately 70 percent complete and we anticipate substantial completion by early 1999. We have identified our key business partners and will work closely with them to assess their readiness and mitigate the risk to us if they are not prepared for the year 2000. We will install the year 2000 compliant version of Electronic Data Interchange (EDI) software by late 1998, and expect to finalize testing of EDI and other electronic transmissions with key business partners by mid/late 1999. In planning for the most reasonably likely worst case scenarios, we have addressed all three major elements in our project. We believe our IT systems will be ready for the year 2000, but we may experience isolated incidences of non-compliance. We plan to allocate internal resources and retain dedicated consultants and vendor representatives to be ready to take action if these events occur. Our contingency plans for non-IT systems are currently in process, and we are simultaneously putting the required resources in place to carry out those plans for key non-IT systems, such as those within our stores. We are contacting critical business partners to assess their readiness and will develop appropriate contingency plans by mid 1999. Although we value our established relationships with key vendors, substitute products for most of the goods we sell in our stores may be obtained from other vendors. If certain vendors are unable to deliver product on a timely basis, due to their own year 2000 issues, we anticipate there will be others who will be able to deliver similar goods. We also recognize the risks to us if other key suppliers in utilities, communications, transportation, banking and government are not ready for the year 2000, and are beginning to develop contingency plans to minimize the potential adverse impacts of these risks. In 1998 we have expensed $8 million related to year 2000 readiness. Prior to 1998, we expensed approximately $5 million. We estimate another $35 to $40 million will be expensed as incurred to complete the year 2000 readiness program, with most of the spending occurring over the next 12 months. In addition, this program has accelerated the timing of approximately $30 million of planned capital expenditures. All expenditures related to our year 2000 readiness initiative will be funded by cash flow from operations and will not impact our other operating or investment plans. 10
ANALYSIS OF FINANCIAL CONDITION Our financial condition remains strong. We continue to fund the growth in our business through a combination of retained earnings, debt and sold securitized receivables. The ratio of debt to total capitalization attributable to our retail operations was 49 percent at the end of second quarter 1998, compared with 52 percent a year ago and 45 percent at year end. Due to the seasonality of our business, quarterly comparisons will fluctuate, but we expect our debt ratio to continue to be below last year for the balance of 1998. At August 1, 1998, working capital was $1,490 million, essentially equal to a year ago. Retained securitized receivables decreased 17 percent from second quarter last year, reflecting $400 million of securitized receivables sold in third quarter 1997. Compared with last year, merchandise inventories increased $334 million, or 10 percent, as a result of new store growth at Target, partially offset by effective inventory control at all divisions. The inventory growth was more than fully funded by a $453 million, or 19 percent, increase in accounts payable. Capital expenditures for the first six months of 1998 were $793 million, compared with $637 million for the same period a year ago; 83 percent of the current year expenditures were made by Target, 10 percent by Mervyn's and 7 percent by DSD. STORE DATA During the quarter, we opened 21 net new Target stores and closed one DSD store. At August 1, 1998, Target operated 828 stores in 40 states, Mervyn's operated 269 stores in 14 states and DSD operated 64 stores in eight states. Retail square footage was as follows: <TABLE> <CAPTION> (In thousands, reflects total square feet, AUGUST 1, January 31, August 2, less office, warehouse and vacant space) 1998 1998 1997 - ----------------------------------------------------------------------------- <S> <C> <C> <C> Target 91,445 87,158 83,393 Mervyn's 21,810 21,810 22,345 DSD 13,935 14,090 14,222 - ----------------------------------------------------------------------------- Total Retail Square Footage 127,190 123,058 119,960 - ----------------------------------------------------------------------------- - ----------------------------------------------------------------------------- </TABLE> 11
FORWARD-LOOKING STATEMENTS The preceding Management's Discussion and Analysis contains forward-looking statements regarding the Company's performance, liquidity and the adequacy of its capital resources. Those statements are based on management's current assumptions and expectations and are subject to certain risks and uncertainties that could cause actual results to differ materially from those projected. As a result, the Company cautions that the forward-looking statements are qualified by the risks of increased competition, shifting consumer demand, changing consumer credit markets and general economic conditions, hiring and retaining effective team members, sourcing merchandise from domestic and international vendors, preparing for the impact of year 2000, and other risks and uncertainties. As a result, while management believes that there is a reasonable basis for the forward-looking statements, undue reliance should not be placed on those statements. Readers are encouraged to review Exhibit (99) attached hereto which contains additional important factors that may cause actual results to differ materially from those predicted in the forward-looking statements. 12
PART II. OTHER INFORMATION ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K a) Exhibits (2). Not applicable (4). Instruments defining the rights of security holders, including indentures. Registrant agrees to furnish the Commission on request copies of instruments with respect to long-term debt. (11). Not applicable (12). Statements re Computations of Ratios (15). Not applicable (18). Not applicable (19). Not applicable (22). Not applicable (23). Not applicable (24). Not applicable (27). Financial Data Schedule (99). Cautionary Statements b) Reports on Form 8-K: Form 8-K dated June 4, 1998 furnishing the form of the Bonds related to a public offering of $200,000,000 aggregate principal amount of Puttable Reset Securities due June 15, 2010. 13
SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. DAYTON HUDSON CORPORATION Registrant Date: September 11, 1998 By /s/ Douglas A. Scovanner -------------------------------- Douglas A. Scovanner Senior Vice President and Chief Financial Officer Date: September 11, 1998 By /s/ J.A. Bogdan -------------------------------- JoAnn Bogdan Controller and Chief Accounting Officer 14
EXHIBIT INDEX (12). Statements re Computations of Ratios (27). Financial Data Schedule (99). Cautionary Statements 15