2006 FORM 10-K

 

 

 

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-K

 

ANNUAL REPORT PURSUANT TO SECTION 13 or 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

 

 

2801 East Market Street

York, Pennsylvania 17402

(717) 757-7660

www.bonton.com

 

 

 

 

 

 

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

Common Stock, $.01 par value

 

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

None

 

     Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o     No þ

 

     Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o     No þ

 

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

 

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

 

     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer o Accelerated filer þ Non-accelerated filer o

 

     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o     No þ

 

     As of the last business day of the registrant’s most recently completed second fiscal quarter, the aggregate market value of the voting and non-voting stock held by non-affiliates of the registrant was approximately $245.7 million, based upon the closing price of $24.78 per share.*

 

     As of April 2, 2007, there were 14,475,196 shares of Common Stock, $.01 par value, and 2,951,490 shares of Class A Common Stock, $.01 par value, outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

     Portions of the definitive proxy statement for the 2007 Annual Meeting of Shareholders (the “Proxy Statement”) are incorporated by reference in Part III to the extent described in Part III.

 

 

 

 

 

 

References to the “Company,” “we,” “us,” and “our” refer to The Bon-Ton Stores, Inc. and its subsidiaries. References to “Carson’s” are to the Northern Department Store Group acquired by the Company from Saks Incorporated (“Saks”) effective March 5, 2006. References to “Elder-Beerman” denote The Elder-Beerman Stores Corp. and its subsidiaries, which were acquired by the Company in October 2003. References to “Bon-Ton” refer to the Company’s stores operating under the Bon-Ton and Elder-Beerman nameplates. References to “Parisian” refer to the stores acquired from Belk, Inc. effective October 29, 2006.

 

PART I

 

 

Overview

 

The Company was founded in 1898 and is one of the largest regional department store operators in terms of sales in the United States, offering a broad assortment of brand-name fashion apparel and accessories for women, men and children as well as cosmetics, home furnishings and other goods. We currently operate 279 stores in mid-size and metropolitan markets in 23 Northeastern, Midwestern and upper Great Plains states under the Bon-Ton, Bergner’s, Boston Store, Carson Pirie Scott, Elder-Beerman, Herberger’s and Younkers nameplates and, under the Parisian nameplate, stores in the Detroit, Michigan area, encompassing a total of approximately 26 million square feet. Our management believes that we enjoy the #1 or #2 market position among traditional department stores in most of the markets in which we operate.

 

Industry Overview

 

We compete in the department store segment of the U.S. retail industry. Department stores have historically dominated apparel and accessories retailing, occupying a cornerstone in the U.S. retail landscape for more than 100 years. Over time, department stores have evolved from single unit, family owned, urban locations to regional and national chains serving communities of all sizes. The department store industry continues to evolve in response to ongoing consolidation among merchandise vendors as well as the evolution of competitive retail formats — mass merchandisers, national chain retailers, specialty retailers and online retailers.

 

Merchandise

 

Merchandise Mix

 

Our stores offer a broad assortment of quality, brand-name fashion apparel and accessories for women, men and children, as well as footwear, cosmetics, home furnishings and other goods at opening, moderate and better price points. We offer a distinct core merchandise assortment, including nationally distributed brands at competitive prices and unique product at compelling values through our private brands. We further differentiate our merchandise assortment with exclusive product from nationally distributed brands. The following table illustrates our net sales

by product category for the last three years (2006 includes sales of Carson’s, which the Company acquired from Saks effective March 5, 2006):

 

 

Nationally Distributed Brands

 

Our nationally distributed brand assortment includes many of the most well-known and popular labels in the apparel, accessories, footwear, cosmetics and home furnishings industries such as Calvin Klein, Chanel, Coach, Easy Spirit, Bandolino, Børn, Clarks, Estée Lauder, Jones New York, Liz Claiborne, Anne Klein II, Nautica, Columbia, Nine West, OshKosh, Ralph Lauren and Waterford. We believe these brands enable us to position our stores as headquarters for fashion, offering both newness and wardrobe staples at competitive prices. We believe that we maintain excellent relationships with our merchandise vendors, working collaboratively to select the most compelling assortments for our customers.

 

Private Brands

 

Our exclusive private brands complement our offering of nationally distributed brands and are a key component of our overall merchandising strategy. Our private brand portfolio includes popular brands such as Laura Ashley; Consensus; Cuddle Bear; Pursuits, Ltd.; Living Quarters; Relativity; Ruff Hewn; Statements; Studio Works; Breckenridge; and Karen Neuberger Home. By providing exclusive fashion products at price points that are more attractive than nationally distributed brand alternatives, our private brand program creates value for our customers and increases our brand exclusiveness, competitive differentiation and customer loyalty.

 

Since the acquisition of Carson’s, we have built a significant private brand organization to serve the entire Company. Our private brand program presents the opportunity to increase our overall gross margin by virtue of the more efficient cost structure inherent in the design and sourcing of in-house brands.

 

Vendor Relationships and Sourcing

 

Our highly experienced team of buyers has developed long-standing and strong relationships with many of the leading vendors in the marketplace. Our scale, geographic footprint and market leadership make us an important distribution channel for leading merchandise vendors to reach their target consumers. We believe that our status as a key account to many of our vendors serves to strengthen our ability to negotiate for exclusive merchandise as well as better pricing terms. We monitor and evaluate the sales and profitability performance of each vendor and adjust our purchasing decisions based upon the results of this analysis.

 

Consistent with industry practice, we receive reimbursement allowances from certain of our vendors in support of the merchandise sold to us that was marked down or that did not allow us to achieve certain margins upon sale to our customers. Additionally, we receive advertising allowances and reimbursement of certain payroll expenses from some of our vendors, which primarily represent reimbursements of specific, incremental and identifiable costs incurred to promote and sell the vendors’ merchandise.

 

Marketing and Customer Service

 

We are committed to providing our customers with a satisfying shopping experience by offering trend-right fashions, differentiated product, value and convenience. Critical elements of our customer service approach are:

 

 

Marketing

 

Our strategic marketing initiatives develop and enhance our brand equity and support our position as a leading shopping destination among our target customers. We conduct a multi-faceted marketing program, including newspaper advertisements and inserts, broadcast advertisements, direct mail and in-store events. We use a combination of (i) advertising and sales promotion activities to reach and build brand image and traffic and (ii) customer-specific communications and purchase incentives to drive customer spending and loyalty. Both types of marketing efforts focus primarily on our target customer of women between the ages of 35 and 60 with annual household incomes of $55,000 to $125,000, with the intention of increasing visit frequency and purchases per visit. Additionally, our marketing activities attract a broader audience, including juniors, seniors and men. We seek to attract new customers and to maintain customer loyalty by actively communicating with our customers through the execution of targeted marketing facilitated by sophisticated customer relationship management capabilities.

 

Effective communication includes showcasing our “hometown store” tradition. We are focused on important, cause-related efforts and events to enhance our connection with the communities in which we operate and with the customers we serve. These strategic initiatives garner favorable publicity, drive traffic and generate incremental sales. Additionally, these efforts serve to differentiate us from our competitors.

 

We maintain an active calendar of in-store events to promote our sales efforts. These events include appearances by well-known designers and personalities, trunk shows, fashion shows, cooking demonstrations and cosmetic makeovers from leading makeup artists.

 

Proprietary Credit Card

 

Evidencing our customer satisfaction and loyalty is the high penetration rate of our proprietary credit card programs that are administered by HSBC Bank Nevada, N.A. (“HSBC”). We have over 4.9 million active proprietary credit card holders.

 

Our proprietary credit card loyalty programs are designed to cultivate long-term relationships with our customers. Loyalty programs offer rewards and privileges to all members meeting annual purchase requirements. Our targeted loyalty programs focus on our most active customers,

which we refer to as our “loyalty club customers,” and include marketing features such as coupon pricing without coupons, advanced sales notices and extra savings events.

 

On July 8, 2005, HSBC purchased the Bon-Ton proprietary credit card accounts and the related outstanding balances associated with those accounts (we refer to this transaction as the “Credit Card Sale”). As part of the Credit Card Sale, Bon-Ton entered into a seven-year marketing and servicing agreement with HSBC. Under the terms of the agreement, Bon-Ton entered into an Interim Servicing Agreement (the “ISA”) and a Credit Card Program Agreement (the “CCPA”). Under the terms of the ISA, Bon-Ton continued to service the credit card receivables from July 8, 2005 through October 31, 2005, for which Bon-Ton was compensated. The CCPA sets forth the terms and conditions under which HSBC will issue credit cards to Bon-Ton’s customers. Under the CCPA, Bon-Ton is paid a percentage of net credit sales for credit card sales generated after July 7, 2005. Prior to our acquisition of Carson’s, HSBC had acquired Carson’s proprietary credit card program, and the servicing and marketing agreement we have with HSBC was amended to include the Carson’s proprietary credit card program within the Bon-Ton program.

 

Customer Service

 

We maintain a sales force of knowledgeable and well-trained sales associates who deliver excellent service to our customers. Sales associates are trained in the areas of customer service, selling skills and product knowledge. We employ a two-tiered strategy to achieve effective customer service. In selected areas, we offer one-on-one selling with dedicated associates to assist customers with merchandise selections. Our customers also appreciate the convenience of self-service formats in many departments and efficient service centers to expedite their purchases. Our new associates receive computer-based training for effective, efficient and uniform training. We actively monitor and analyze, through our scheduling program, the service levels in our stores in order to maximize sales associate productivity and store profitability.

 

Integration of Carson’s

 

Effective March 5, 2006, the Company purchased Carson’s, adding approximately 15 million square feet of retail space.

 

We began the process of integrating Carson’s into Bon-Ton, which we anticipate will span two years. The Company’s senior management team, which includes a number of former Carson’s executives, adopted best business practices and defined opportunities for profitable growth. One of our goals was and is to implement strategic initiatives to drive sales growth. We targeted several business categories for incremental sales opportunities, building on the merchandising strengths of Bon-Ton and Carson’s. Moreover, by increasing our importance to vendors as a high-volume purchaser, we are better able to differentiate ourselves from competitors via improved access to exclusive merchandise from nationally distributed brands.

 

We achieved a common merchandise assortment of both nationally distributed and private brands and a common marketing and sales promotion calendar for all of our stores. A significant portion of the Carson’s merchandising staff remained with us, which allowed us to enhance the merchandise offerings at Bon-Ton stores. Additionally, the acquisition of Carson’s included a significant private brand program upon which we built a private brand organization to serve the Company as a whole.

 

Of equal importance is enhancing our systems while maintaining a steady flow of merchandise and appropriate levels of inventory to minimize business disruption and ensure customer satisfaction. During 2006, we successfully integrated the Carson’s and Bon-Ton systems. We will continue to evaluate our technology infrastructure to ensure it is positioned to serve our needs efficiently.

 

Competition

 

The retail industry is highly competitive and fragmented. We face competition for customers from traditional department store operators such as Belk, Inc., Dillard’s, Inc. and Federated Department Stores, Inc.; national chain retailers such as J. C. Penney Company, Inc., Kohl’s Corporation and Sears Holdings Corporation; mass merchandisers such as Target Corporation and Wal-Mart Stores, Inc.; specialty stores and, to a lesser extent, catalogue and online retailers. In addition, we face competition for suitable store locations from other department stores, national chain retailers, mass merchandisers and other large-format retailers. In a number of our markets, we compete for customers with national department store chains which offer a similar mix of branded merchandise as we do. In other markets, we face potential competition from national chains that, to date, have not entered such markets and from national chains that have stores in our markets but currently do not carry similar branded goods. In all markets, we generally compete for customers with stores offering moderately priced goods. Many of our competitors have substantially greater financial and other resources than we do, and many of those competitors have significantly less debt than we do and may thus have greater flexibility to respond to changes in our industry.

 

We believe that we compare favorably with our competitors with respect to quality, depth and breadth of merchandise, prices for comparable quality merchandise, customer service and store environment. We also believe our knowledge of and focus on mid-size markets, developed over our many years of operation, give us an advantage in these markets that cannot be readily duplicated. In markets in which we face traditional department store competition, we believe that we compete effectively.

 

Trademarks

 

We own or license various trademarks, including our store nameplates and private brands. We believe our trademarks and service marks are important and that the loss of certain of our trademarks or trade names, particularly the store nameplates, could have a material adverse effect on us. Many of our trademarks are registered in the United States Patent and Trademark Office. The terms of these registrations are generally ten years, and they are renewable for additional ten-year periods indefinitely so long as the marks are in use at the time of renewal. We are not aware of any claims of infringement or other challenges to our right to register or use our marks in the United States that would have a material adverse effect on our consolidated financial position, results of operations, or liquidity.

 

Information Technology and Systems

 

Systems

 

During 2006, we substantially completed the integration of Carson’s systems to allow the Company to operate in the fourth quarter as one company. Substantially all mainframe, midrange, server computing systems, and central storage systems were replaced with new advanced technologies to support the expanded business and provide the foundation for future growth. Data processing facilities in York, Pennsylvania and Dayton, Ohio were upgraded and equipped with standby diesel generators to provide back-up electrical service. The Company is increasing its technology staff to support and enhance the new systems infrastructure. Work to optimize both business and systems processes will continue into 2007 with continued focus on achieving synergy goals, and we will begin a three-year program to install Bon-Ton’s advanced point-of-sale system in all Carson’s stores.

 

Inventory Management

 

Our merchandising function is centralized, with a staff of buyers and a planning and allocation team that have responsibility for determining the merchandise assortment, quantities to be purchased and allocation of merchandise to each store.

 

The majority of the merchandise we purchase is initially received at one of our four distribution facilities.

 

We primarily operate on a pre-distribution model through which we allocate merchandise on our initial purchase orders to each store. This merchandise is shipped from our vendors to our distribution facilities for delivery to designated stores. We then have the ability to direct replenishment merchandise to the stores that demonstrate the highest customer demand. This reactive distribution technique helps minimize excess inventory and affords us timely and accurate replenishment.

 

Our distribution facilities are electronically monitored by our merchandising staff to facilitate the distribution of goods to our stores. We utilize electronic data interchange (EDI) technology with most vendors, which is designed to move merchandise onto the selling floor quickly and cost-effectively by allowing vendors to deliver floor-ready merchandise to the distribution facilities. In addition, we utilize high-speed automated conveyor systems to scan bar coded labels on incoming cartons of merchandise and direct cartons to the proper processing areas. Many types of merchandise are processed in the receiving area and immediately “cross-docked” to the shipping dock for delivery to the stores. Certain processing areas are staffed with personnel equipped with hand-held radio frequency terminals that can scan a vendor’s bar code and transmit the necessary information to a computer to record merchandise on hand. We utilize third-party carriers to distribute our merchandise to individual stores.

 

The majority of our merchandise is held in our stores. We closely monitor the inventory levels and assortments in our stores to facilitate reorder and replenishment decisions, satisfy customer demand and maximize sales.

 

Seasonality

 

Our business, like that of most retailers, is subject to seasonal fluctuations, with the major portion of sales and income realized during the second half of each year, which includes the back-to-school and holiday seasons. Due to the fixed nature of certain costs, our selling, general and administrative (“SG&A”) expenses are typically higher as a percentage of net sales during the first half of each year. Because of the seasonality of our business, results for any quarter are not necessarily indicative of the results that may be achieved for a full year. In addition, quarterly results of operations depend upon the timing and amount of revenues and costs associated with the opening, closing and remodeling of existing stores.

 

Capital Investments

 

We make capital investments to support our long-term business goals and objectives. We invest capital in new and existing stores, distribution and support facilities and information technology.

 

In 2007, we anticipate total capital expenditures, net of landlord contributions, of approximately $106.0 million. As part of our focus on continually improving our store base, significant capital will be employed for major remodels and expansions, as well as on-going upgrades in other stores. We are focused on maintaining the quality of our stores and, consequently, our brand equity. With respect to our major remodels, we expand only after extensive analysis of our projected returns on capital. We generally experience an increase in both total sales and profitability at stores that undergo a remodel or expansion.

 

In 2007, we plan to open two new stores, expand three stores and renovate and reconfigure several existing stores.

 

We believe capital investments for information technology in our stores, distribution facilities and support functions are necessary to support our business strategies. We are continually

upgrading our information systems to improve efficiency and productivity. Included in the 2007 capital budget are significant expenditures for information technology projects.

 

Associates

 

As of April 2, 2007, we had approximately 33,000 full-time and part-time associates. We employ additional part-time associates during peak selling periods. We believe that our relationship with our associates is good.

 

Available Information

 

Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports, are available without charge on our website, www.bonton.com, as soon as reasonably practicable after they are filed electronically with the Securities and Exchange Commission (“SEC”).

 

We also make available on our website, free of charge, the following documents:

 

 

Executive Officers

 

The following table sets forth certain information regarding our executive officers as of April 2, 2007:

 

 

Mr. Grumbacher has been Executive Chairman of the Board of Directors since February 2005. He served as Chairman of the Board of Directors from August 1991 to February 2005. He was Chief Executive Officer from 1985 to 1995 and from June 2000 to August 2004. From 1977 to 1989 he was President.

 

Mr. Bergren has been President and Chief Executive Officer since August 2004. Mr. Bergren, who joined us in November 2003 as Vice Chairman and served as President and Chief Executive Officer of Elder-Beerman from February 2002 through August 2004, served as Chairman of the Southern Division of Belk, Inc. from 1999 to February 2002, as Partner of the Florida Division of Belk, Inc. from 1992 to 1999, and in senior executive positions at Belk, Inc. from 1985 to 1992.

 

Mr. Buccina was appointed Vice Chairman, President — Merchandising on June 1, 2006. He had been President and Chief Merchandising Officer of Carson’s from April 2006 to June 2006. Prior to that time, he had served as President — Head Merchant of the Northern Department Store Group of Saks (“NDSG”) for more than five years.

 

Mr. Byers was appointed Vice Chairman — Stores, Operations, Private Brand, Planning & Allocation on October 9, 2006. He had been Executive Vice President — Stores and Visual Merchandising from April 2006 to October 2006. Prior to that time, he had served as Executive Vice President of Stores and Visual Merchandising of NDSG since August 2004. He held the post of Senior Vice President / Territory Director of Stores for Kohl’s Corporation between 2000 and August 2004.

 

Mr. Zant was named Vice Chairman — Private Brand and Planning & Allocation on August 1, 2006. He had been Vice Chairman and Chief Merchandising Officer from January 2005 to July 2006. From July 2002 to December 2004, he was Executive Vice President — General Merchandise Manager for Belk, Inc. and from June 2001 to July 2002, he was President of the Central Division of Belk, Inc. Prior to that, Mr. Zant was with the Parisian Division of Saks, serving as Executive Vice President of Merchandising.

 

Mr. Carroll became Executive Vice President — Sales Promotion and Marketing effective April 3, 2006. Prior to that time, he had served as Executive Vice President of Sales Promotion and Marketing of NDSG for more than five years.

 

Mr. Clouser has been Executive Vice President — Human Resources since April 3, 2006. He served as Senior Vice President — Human Resources from February 2005 to April 2006 and Vice President — Employment and Training from April 2004 to February 2005. For more than four years prior to that time, he was Senior Vice President — Human Resources at Elder-Beerman.

 

Mr. Plowman has been Executive Vice President — Finance since April 3, 2006, Chief Financial Officer since May 2005 and Principal Accounting Officer since June 2003. He served as Senior Vice President — Finance from September 2001 to April 2006. Mr. Plowman joined us in 1997 as Divisional Vice President — Controller and from May 1999 to September 2001 he was our Vice President — Controller.

 

Mr. Zamberlan has been Executive Vice President — Stores and Visual since November 2004. Prior to that time, he served as Executive Vice President — Stores for Elder-Beerman for more than five years.

 

 

Cautionary Statements Relating to Forward-Looking Information

 

We have made, in this Annual Report on Form 10-K, forward-looking statements relating to developments, results, conditions or other events we expect or anticipate will occur. These statements may relate to revenues, earnings, store openings, business strategy, market conditions and the competitive environment. The words “believe,” “may,” “will,” “estimate,” “intend,” “expect,” “anticipate,” “plan” and similar expressions as they relate to the Company, or future or conditional verbs, such as “will,” “should,” “would,” “may” and “could,” are intended to identify forward-looking statements. Forward-looking statements are based on management’s then-current views and assumptions and we undertake no obligation to update them. Forward-looking statements are subject to risks and uncertainties and actual results may differ materially from those projected.

 

An investment in our securities carries certain risks. Investors should carefully consider the risks described below and other risks which may be disclosed in our filings with the SEC before investing in our securities.

 

Our substantial debt could adversely affect our financial condition and prevent us from fulfilling our debt obligations.

 

We have a substantial amount of debt. As of April 2, 2007, we had total debt of approximately $1.2 billion. This could have important consequences to our investors. For example, it could:

 

 

Our ability to service our debt depends upon, among other things, our ability to replenish inventory, generate sales and maintain our stores. If we do not generate sufficient cash from our operations to service our debt obligations, we will need to take one or more actions, including refinancing our debt, obtaining additional financing, selling assets, obtaining additional equity capital, or reducing or delaying capital expenditures. We cannot be certain that our earnings will be sufficient to allow us to pay the principal and interest on our debt and meet our other obligations. Debt under our senior secured credit facility bears interest at a floating rate, a portion of which is offset by fixed-rate swap derivatives. Accordingly, changes in prevailing interest rates may affect our ability to meet our debt service obligations. A higher interest rate on our debt would adversely affect our operating results. If we are unable to meet our debt service obligations or if we default in some other manner under our credit facilities, our lenders could elect to declare all borrowings outstanding, together with accumulated and unpaid interest and other fees, immediately due and payable, which would have a material adverse effect on our business, financial condition and results of operations.

 

Our discretion in some matters is limited by the restrictions contained in our senior secured credit facility and mortgage loan facility agreements and in the indenture that governs our senior unsecured notes, and any default on our senior secured credit facility, mortgage loan facility or the indenture that governs the senior unsecured notes could harm our business, profitability and growth prospects.

 

The agreements that govern our senior secured credit facility and mortgage loan facility, and the indenture that governs our senior unsecured notes, contain a number of covenants that limit the discretion of our management with respect to certain business matters and may impair our ability to

respond to changing business and economic conditions. The senior secured credit facility, the mortgage loan facility and the indenture, among other things, restrict our ability to:

 

 

Our senior secured credit facility contains financial covenants that require us to comply with a minimum excess availability requirement. Our ability to borrow funds for any purpose depends on our satisfying this requirement.

 

If we fail to comply with any of the financial covenants or the other restrictions contained in our senior secured credit facility or any future financing agreements, an event of default could occur. An event of default could result in the acceleration of some or all of our debt. If the debt is accelerated, we would not have, and may not be able to obtain, sufficient funds to repay our debt, which could have a material adverse effect on our business, financial condition and results of operations.

 

We may not be able to attract or retain a sufficient number of customers in a highly competitive retail environment, which would have an adverse effect on our business, financial condition and results of operations.

 

We compete with other department stores and many other retailers, including store-based, mail-order and internet retailers. Many of our competitors have significant financial and marketing resources. The principal competitive factors in our business are price, quality and selection of merchandise, reputation, store location, advertising and customer service. We cannot assure you that we will be able to compete successfully against existing or future competitors. Our expansion into new markets served by our competitors and the entry of new competitors into, or expansion of existing competitors in, our markets could have a material adverse effect on our business, financial condition and results of operations.

 

We may not be able to accurately predict customer-based trends and effectively manage our inventory levels, which could reduce our revenues and adversely affect our business, financial condition and results of operations.

 

It is difficult to predict what merchandise consumers will want. A substantial part of our business is dependent on our ability to make correct trend decisions for a wide variety of goods and services. Failure to accurately predict constantly changing consumer tastes, preferences, spending patterns and other lifestyle decisions, particularly given the long lead times for ordering much of our merchandise, could adversely affect our long-term relationships with our customers. Our managers focus on inventory levels and balance these levels with inventory plans and reviews of trends; however, if our inventories become too large, we may have to “mark down” or decrease our sales price, and we may be required to sell a significant amount of unsold inventory at discounted prices or even below cost, which could have a material adverse effect on our business, financial condition and results of operations.

 

We may not be able to obtain adequate capital to support our operations and growth strategies.

 

Our operations and growth strategies require adequate capital, the availability of which depends on our ability to generate cash flow from operations, borrow funds on satisfactory terms and raise funds in the capital markets. We may need seasonal borrowing capacity in addition to the funds available under our senior secured credit facility to fund our working capital requirements. The inability to obtain adequate capital could have a material adverse effect on our business, financial condition and results of operations.

 

Our operating results fluctuate from season to season.

 

Our stores experience seasonal fluctuations in net sales and consequently in operating income, with peak sales occurring during the back-to-school and holiday seasons. Any decrease in net sales or margins during our peak selling periods, decrease in the availability of working capital needed in the months before these periods or reduction in vendor allowances could have a material adverse effect on our business. We usually order merchandise in advance of peak selling periods and sometimes before new fashion trends are confirmed by customer purchases. We must carry a significant amount of inventory, especially before the peak selling periods. If we are not successful in selling our inventory, especially during our peak selling periods, we may be forced to rely on markdowns or promotional sales to dispose of the inventory or we may not be able to sell the inventory at all, which could have a material adverse effect on our business, financial condition and results of operations.

 

Weather conditions could adversely affect our results of operations.

 

Because a significant portion of our business is apparel sales and subject to weather conditions in our markets, our operating results may be unexpectedly and adversely affected by inclement weather. Frequent or unusually heavy snow, ice or rain storms might make it difficult for our customers to travel to our stores and thereby reduce our sales and profitability. Extended periods of unseasonable temperatures in our markets, potentially during our peak seasons, could render a portion of our inventory incompatible with those unseasonable conditions. Reduced sales from extreme or prolonged unseasonable weather conditions could adversely affect our business, financial condition and results of operations.

 

We may pursue strategic acquisitions of businesses which may not be completed or, if completed, may not be successfully integrated into our existing business.

 

We may pursue increased market penetration through strategic acquisitions. If we are unable to successfully complete acquisitions or to effectively integrate acquired businesses, our ability to grow our business or to operate our business effectively could be reduced, and our business, financial condition and operating results could suffer. We also cannot assure you that we will be able to integrate the operations of any future completed strategic acquisitions without encountering difficulty regarding different business strategies with respect to marketing, integration of personnel with disparate business backgrounds and corporate cultures, integration of different point-of-sale systems and other technology and managing relationships with other business partners.

 

The consummation and integration of any future acquisition involve many risks, including the risks of:

 

 

 

Failure to maintain our current key vendor relationships may adversely affect our business, financial condition and results of operations.

 

Our business is dependent to a significant degree upon close relationships with our vendors and our ability to purchase brand name merchandise at competitive prices. The loss of key vendor support could have a material adverse effect on our business, financial condition and results of operations. There can be no assurance that we will be able to acquire brand name merchandise at competitive prices or on competitive terms in the future. For example, certain merchandise that is high profile and in high demand may be allocated by vendors based upon the vendors’ internal criteria, which are beyond our control.

 

An inability to find qualified domestic and international vendors and fluctuations in the exchange rate with countries in which our international vendors are located could adversely affect our business.

 

The products we sell are sourced from a wide variety of domestic and international vendors. Our ability to find qualified vendors and source products in a timely and cost-effective manner, including obtaining vendor allowances in support of our advertising and promotional programs, represents a significant challenge. The availability of products and the ultimate costs of buying and selling these products, including advertising and promotional costs, are not completely within our control and could increase our merchandise and operating costs and adversely affect our business. Additionally, costs and other factors specific to imported merchandise, such as trade restrictions, tariffs, currency exchange rates and transport capacity and costs, are beyond our control and could restrict the availability of imported merchandise or significantly increase the costs of our merchandise sales and adversely affect our business, financial condition and results of operations.

 

The loss of the outside vendor that operates our proprietary credit card programs could have an adverse effect on our operations and financial results.

 

Our proprietary credit card programs are operated, under agreements, by HSBC. Under these agreements, HSBC issues our proprietary credit cards to our customers and we receive a percentage of the net credit sales thereunder. If for any reason HSBC is unable to provide the services comprising our proprietary credit card programs, or our agreements with HSBC are terminated, in either case under circumstances in which we are unable to quickly and adequately contract with a comparable replacement vendor of such services, our customers who have accounts under our proprietary credit card programs will be unable to use their cards, which would likely result in a certain decrease in sales to such customers, a loss of the revenues attributable to the payments from HSBC, and an adverse effect on customer goodwill, any or all of which could have a material adverse effect on our business, financial condition and results of operations.

 

Conditions in, and the United States’ relationship with, the foreign countries where we source our merchandise could adversely affect our business.

 

A majority of our merchandise is manufactured outside of the United States, primarily in India and the Far East. Political instability or other events resulting in the disruption of trade from the countries where our merchandise is manufactured or the imposition of additional regulations relating to, or duties upon, the merchandise we import could cause significant delays or interruptions in the supply of our merchandise or increase our costs, either of which could have a material adverse effect on our business. If we are forced to source merchandise from other countries, those goods may be more expensive or of a different or inferior quality from the merchandise we now sell. If we are

unable to adequately replace the merchandise we currently source with merchandise produced elsewhere, our business, financial condition and results of operations could be adversely affected.

 

Our business could be significantly disrupted if we cannot retain or replace members of our management team.

 

Our success depends to a significant degree upon the continued contributions of our executive officers and other key personnel, both individually and as a group. Our future performance will be substantially dependent on our ability to retain or replace our key personnel and the inability to retain or replace our key personnel could prevent us from executing our business strategy.

 

Labor conditions could adversely affect our results of operations.

 

Our performance is dependent on attracting and retaining a large number of quality sales associates. Many of those sales associates are in entry level or part-time positions with historically high rates of turnover. Our ability to meet our labor needs while controlling costs is subject to external factors such as unemployment levels, prevailing wage rates, minimum wage legislation and changing demographics. Changes that adversely impact our ability to attract and retain quality sales associates could adversely affect our performance.

 

Inflation may adversely affect our business operations in the future.

 

In recent years, we have experienced certain inflationary conditions in our cost base due primarily to (1) changes in foreign currency exchange rates that have reduced the purchasing power of the U.S. dollar and (2) increases in SG&A expenses, particularly with regard to employee benefits. Inflation can harm our margins and profitability if we are unable to increase prices or cut costs enough to offset the effects of inflation in our cost base. If inflation in these or other costs worsens, we cannot assure you that our attempts to offset the effects of inflation through control of expenses, passing cost increases to our customers or any other method will be successful. Any future inflation could adversely affect our business, financial condition and results of operations.

 

If we are unable to effectively market our business or if our advertising campaigns are ineffective, our revenues may decline and our results of operations could be adversely affected.

 

We spend extensively on advertising and marketing. Our business depends on effective marketing to generate customer traffic in our stores. If our advertising and marketing efforts are not effective, our business, financial condition and results of operations could be negatively affected.

 

Failure to successfully maintain and update information technology systems and enhance existing systems may adversely affect our business.

 

To keep pace with changing technology, we must continuously provide for the design and implementation of new information technology systems as well as enhancements of our existing systems. Any failure to adequately maintain and update the information technology systems supporting our sales operations or inventory control could prevent us from processing and delivering merchandise, which could adversely affect our business, financial condition and results of operations.

 

Our stock price has been and may continue to be volatile.

 

The market price of our common stock has been and may continue to be volatile and may be significantly affected by:

 

 

 

In addition, the stock market has recently, and from time to time, experienced significant price and volume fluctuations that have adversely affected the market prices of securities of companies without regard to their operating performances.

 

Tim Grumbacher beneficially owns shares of our capital stock giving him voting control over matters submitted to a vote of the shareholders, and he may take actions that conflict with the interests of our other shareholders and holders of our debt securities.

 

Collectively, as of April 2, 2007, Tim Grumbacher, trusts for the benefit of members of Mr. Grumbacher’s family and The Grumbacher Family Foundation beneficially own shares of our outstanding common stock (which is entitled to one vote per share) and shares of our Class A common stock (which is entitled to ten votes per share) representing, in the aggregate, approximately 63% of the votes eligible to be cast by shareholders in the election of directors and generally. Accordingly, Mr. Grumbacher has the power to control all matters requiring the approval of our shareholders, including the election of directors and the approval of mergers and other significant corporate transactions. The interests of Mr. Grumbacher and certain other stockholders may conflict with the interests of our other shareholders and holders of our debt securities.

 

In addition to Mr. Grumbacher’s voting control, certain provisions of our charter documents and Pennsylvania law could discourage potential acquisition proposals and could deter, delay or prevent a change in control of the Company that our other shareholders consider favorable and could depress the market value of our common stock.

 

Certain provisions of our articles of incorporation and by-laws, as well as provisions of the Pennsylvania Business Corporation Law, could have the effect of deterring takeovers or delaying or preventing changes in control or management of the Company that our shareholders consider favorable and could depress the market value of our common stock.

 

Subchapter F of Chapter 25 of the Pennsylvania Business Corporation Law of 1988, which is applicable to us, may have an anti-takeover effect and may delay, defer or prevent a tender offer or takeover attempt that a shareholder might consider in his or her best interest, including those attempts that might result in a premium over the market price for the Company’s shares. In general, Subchapter F of Chapter 25 of the Pennsylvania Business Corporation Law could delay for five years and impose conditions upon “business combinations” between an “interested shareholder” and us, unless prior approval by our Board of Directors is given. The term “business combination” is defined broadly to include various merger, consolidation, division, exchange or sale transactions, including transactions using our assets for purchase price amortization or refinancing purposes. An “interested shareholder,” in general, would be a beneficial owner of shares entitling that person to cast at least 20% of the votes that all shareholders would be entitled to cast in an election of directors.

 

Item 1B.  Unresolved Staff Comments

 

None.

 

 

We currently operate 279 stores in 23 states, encompassing approximately 26 million square feet. We have, however, announced we will be closing two underperforming stores in May 2007. We own 33 stores, have ground leases on seven stores, and lease 239 stores.

 

We operate under eight nameplates, as follows:

 

 

Our corporate headquarters is located in York, Pennsylvania where our administrative and sales support functions reside. Merchandising and marketing functions are located in Milwaukee, Wisconsin. We own two distribution centers which are located in Rockford, Illinois and Green Bay, Wisconsin, and we lease our other two distribution centers which are located in Allentown, Pennsylvania and Fairborn, Ohio.

 

 

In connection with the acquisition of Carson’s, the Company assumed liability for the following matter but only to the extent it applies to the entities acquired from Saks: On October 25, 2005 the Chapter 7 trustee for the bankruptcy estate of Kleinert’s Inc. filed a complaint against Saks and several of its subsidiaries in the United States Bankruptcy Court for the Southern District of New York. In its initial complaint the plaintiff, as assignee, alleged breach of contract, fraud, and unjust enrichment, among other causes of action, and seeks compensatory and punitive damages due to Saks assessment of alleged improper chargebacks against Kleinert’s Inc. totaling approximately $4.0 million which wrongful acts the plaintiff alleges caused the insolvency and bankruptcy of Kleinert’s Inc. On August 15, 2006 the plaintiff, as assignee, filed an amended complaint in which it asserts the following claims, among others: (1) defendants applied improper chargebacks to the accounts payable of Kleinert’s, which led to the extreme financial distress and Kleinert’s eventual bankruptcy and Kleinert’s incurred liabilities and lost profits of at least $100.0 million and plaintiff requests punitive damages of no less than $50.0 million (conversion claim); (2) from 1998- 2003 defendants charged back an amount not less than $4.0 million to Kleinert’s and these chargebacks improperly benefited the defendants, and plaintiff requests $4.0 million on this claim (unjust enrichment claim); (3) defendants falsely represented that its $4.0 million in chargebacks were proper and Kleinert’s reliance on defendants’ misrepresentations caused Kleinert’s to lose not less than $4.0 million and caused it to file for bankruptcy resulting in liabilities and lost profits of $100.0 million, and plaintiff requests punitive damages of no less than $50.0 million (fraud claim); (4) defendants wrongfully charged back at least $4.0 million and these unwarranted chargebacks assisted Kleinert’s officers and directors in booking fictitious sales revenue and accounts receivable and perpetrating a fraud on Kleinert’s lenders in excess of $25.0 million, and plaintiff requests punitive damages of no less than $50.0 million (fraud claim); (5) defendants used dishonest, improper and unfair means in conducting business with Kleinert’s and interfered with Kleinert’s relationship with its lenders (tortious interference with prospective economic advantage claim); (6) defendants assisted officers of Kleinert’s in breaching their fiduciary duties to Kleinert’s and to its creditors by falsifying borrowing base certificates given to the lenders, and defendants knew that their improper chargeback scheme was assisting these breaches of fiduciary duty by Kleinert’s officers, with respect to which plaintiff requests $100.0 million plus $50.0 million in punitive

damages (aiding and abetting breach of fiduciary duty claim); (7) defendants knew that their improper chargeback scheme was assisting the perpetration of fraud by Kleinert’s officers, and plaintiff requests $100.0 million plus $50.0 million in punitive damages (aiding and abetting fraud claim); and (8) various fraudulent conveyance claims with respect to which plaintiff requests damages of $4.0 million.

 

On December 8, 2005 Adamson Apparel, Inc. filed a purported class action lawsuit against Saks in the United States District Court for the Northern District of Alabama. In its complaint the plaintiff asserts breach of contract claims and alleges that Saks improperly assessed chargebacks, timely payment discounts, and deductions for merchandise returns against members of the plaintiff class. The lawsuit seeks compensatory and incidental damages and restitution. Under the terms of the purchase agreement relating to the acquisition of Carson’s from Saks, the Company may have an obligation to indemnify Saks for any damages incurred by Saks under this lawsuit by Adamson Apparel solely to the extent that such damages relate to the business acquired from Saks.

 

In addition, the Company is party to legal proceedings and claims that arise during the ordinary course of business.

 

In the opinion of management, the ultimate outcome of any such litigation and claims, including the two matters detailed above, will not have a material adverse effect on the Company’s financial position, results of operations or liquidity.

 

 

None.

 

PART II

 

 

Our common stock is traded on The Nasdaq Global Select Stock Market (symbol: BONT). There is no established public trading market for our Class A common stock. The Class A common stock is convertible on a share-for-share basis into common stock at the option of the holder. The following table sets forth the high and low sales price of our common stock for the periods indicated as furnished by Nasdaq:

 

 

On April 2, 2007, we had approximately 198 shareholders of record of common stock and four shareholders of record of Class A common stock.

 

We have paid quarterly cash dividends, each at $0.025 per share, on Class A common stock and common stock beginning April 15, 2004. Pursuant to our senior secured credit facility agreement, entered into on March 6, 2006, any dividends paid may not exceed $4.0 million in any year or $15.0 million during the term of the agreement, which expires March 2011. In addition, pursuant to the indenture that governs our senior unsecured notes, any dividends paid may not exceed $0.24 per share in any year. We declared a quarterly cash dividend of $0.05 per share, payable May 1, 2007 to shareholders of record as of April 16, 2007. Our Board of Directors will consider dividends in subsequent periods as it deems appropriate.

 

STOCK PERFORMANCE GRAPH

 

The following graph compares the yearly percentage change in the cumulative total shareholder return on common stock from February 2, 2002 through February 3, 2007, the cumulative total return on the CRSP Total Return Index for The Nasdaq Stock Market (U.S. Companies) and the Nasdaq Retail Trade Stocks Index during such period. The comparison assumes $100 was invested on February 2, 2002 in the Company’s common stock and in each of the foregoing indices and assumes the reinvestment of any dividends.

 

 

 

 

 

 

Company Overview

 

The Company was founded in 1898 and is one of the largest regional department store operators in terms of sales in the United States, offering a broad assortment of brand-name fashion apparel and accessories for women, men and children as well as cosmetics, home furnishings and other goods. At February 3, 2007, we operated 283 stores in 23 states in the Northeast, Midwest and upper Great Plains under the Bon-Ton, Bergner’s, Boston Store, Carson Pirie Scott, Elder-Beerman, Herberger’s and Younkers nameplates and, under the Parisian nameplate, stores in the Detroit, Michigan area, encompassing a total of approximately 26 million square feet. Our management believes we hold the #1 or #2 market position among traditional department stores in most of the markets in which we operate. The Company had net sales of $3.4 billion in 2006.

 

Effective March 5, 2006, we purchased all of the outstanding securities of two subsidiaries of Saks that were solely related to the business of owning and operating 142 retail department stores. The stores are located in 12 states in the Midwest and upper Great Plains regions and operate under the names Carson Pirie Scott, Younkers, Herberger’s, Boston Store and Bergner’s. Under the terms of the purchase agreement, we paid approximately $1.0 billion in cash for Carson’s. Carson’s stores encompass a total of approximately 15 million square feet in mid-size and metropolitan markets.

 

To finance the acquisition and the payoff of our previous revolving credit facility, we entered into a new revolving credit facility which provides for up to $1.0 billion in borrowings, issued $510.0 million in senior unsecured notes, and entered into a new mortgage loan facility in the aggregate principal amount of $260.0 million.

 

On October 25, 2006, we entered into an asset purchase agreement with Belk, Inc. (“Belk”), pursuant to which we agreed to purchase assets in connection with four department stores, all operated under the Parisian nameplate and the rights to construct a new Parisian store. The purchase price was $22.0 million in cash, subject to certain closing revisions. In addition, we agreed to assume specific liabilities and obligations of Belk and its affiliates with respect to the acquired Parisian stores. The acquisition of Parisian was effective as of October 29, 2006.

 

We achieved significant progress with the integration of Bon-Ton and Carson’s operations in 2006, completing scheduled phases of the systems integration and permitting a single management view of the consolidated operations. In so doing, we substantially reduced our dependency on Saks for transition services support. Our merchant and marketing staff successfully introduced a common merchandise assortment across all locations, including new private brand offerings, and implemented a common marketing/advertising calendar in the second half of 2006. The private brand organization, established in Milwaukee in 2006, became an integral part of our merchandise organization. We established and expanded the Planning and Allocation division to advance inventory productivity.

 

Operational areas integrated in the first quarter of 2007 principally include the remaining aspects of internationally-sourced merchandise purchasing and information systems technical support, effectively eliminating our dependency on Saks for transition services support.

 

We compete in the department store segment of the U.S. retail industry. The department store industry continues to evolve in response to ongoing consolidation among merchandise vendors as well as the evolution of competitive retail formats — mass merchandisers, national chain retailers, specialty retailers and online retailers. Our segment of the retail industry is highly competitive, and we foresee competitive pressures and challenges continuing in the future. As such, we anticipate minimal comparable store sales growth in 2007, with a gross margin rate consistent with 2006 results.

Results of Operations

 

The following table summarizes changes in our selected operating indicators, illustrating the relationship of various income and expense items to net sales for each year presented (components may not add or subtract to totals because of rounding):

 

 

2006 Compared to 2005

 

Net sales:  Net sales for 2006 increased 161% to $3,362.3 million compared to $1,287.2 million in the prior year. Net sales include $2,119.1 million from Carson’s stores for the period March 5, 2006 through February 3, 2007 and Parisian stores for the period October 29, 2006 through February 3, 2007. Bon-Ton comparable store net sales for the fifty-two week period ended January 27, 2007 decreased 2.7% compared to the prior year fifty-two week period. We believe that the comparable store net sales decline was the result of several factors including, among others:

 

 

Carson’s sales are not included in the Company’s reported comparable store sales; therefore, the following is provided for informational purposes only: For the period March 5, 2006 through January 27, 2007, Carson’s comparable store sales increased 4.3%.

 

The best performing merchandise categories in 2006 were Women’s Special Size and Misses Outerwear (both included in Women’s Apparel), Footwear, Home and Children’s Apparel. Sales for Women’s Special Size reflect increased inventory investment. Misses Outerwear sales increased as a

result of expanded offerings of updated branded product and aggressive marketing efforts. Footwear sales increased as customers responded favorably to our new and expanded offerings in branded casual footwear. The performance in the Home area in 2006 reflects approximately $17.5 million of incremental sales due primarily to the liquidation of merchandise we no longer intend to carry. Children’s apparel benefited from narrowed merchandise assortments, increased emphasis on stronger national brands and improved penetration of unique brands. The poorest performing merchandise categories in 2006 were Dresses (included in Women’s Apparel) and Accessories. Sales in Dresses continue to trend downward, and we have reduced our inventory investment in this area. Sales decreases in Accessories reflected a lack of clearance merchandise as compared to the prior year and warm weather in our markets during December 2006.

 

Other income:  Other income, which includes income from revenues received under the CCPA, leased departments and other customer revenues, was $93.5 million, or 2.8% of net sales, in 2006 as compared $20.4, or 1.6% of net sales, in 2005. The increase was due to the addition of the Carson’s operations and, commencing in November 2005, revenues received under the CCPA recorded in other income rather than SG&A.

 

Costs and expenses:  Gross margin dollars in 2006 were $1,243.5 million as compared to $465.0 million in 2005, an increase of $778.5 million. The increase in gross margin dollars reflects the addition of the Carson’s stores and an increased gross margin rate, partially offset by reduced sales volume attributable to the comparable store sales decrease and to the four Bon-Ton stores closed in January 2006. Gross margin as a percentage of sales increased 0.9 percentage point to 37.0% in the current year from 36.1% in the prior year. The increase in the gross margin rate reflects a 1.6 percentage point decrease, at cost, in the net markdown rate, the result of improved sales of regular priced goods and less aggressive discounting in our promotional activity, partially offset by increased distribution costs.

 

SG&A expense in 2006 was $1,056.5 million as compared to $407.1 million in 2005, an increase of $649.3 million. The principle factors in the increase in SG&A expenses were the addition of the Carson’s stores and support costs, including the costs associated with the transition services agreement with Saks, and integration expenses. Integration expenses approximated $15.6 million in 2006. The current year expense rate decreased 0.2 percentage point to 31.4% due to the increased sales volume.

 

Depreciation and amortization expense and amortization of lease-related interests increased $78.8 million, to $106.9 million, in 2006 from $28.1 million in 2005, primarily reflecting the addition of depreciation and amortization associated with the acquired Carson’s operations. In addition, in 2006 we recorded $2.9 million of asset impairment charges related to the reduction in the estimated net realizable value of a store property and a reduction in the value of duplicate information systems software, as compared to $0.9 million of accelerated charges on software associated with our credit operation in 2005.

 

Income from operations:  Income from operations in 2006 was $173.7 million, or 5.2% of net sales, as compared to $50.2 million, or 3.9% of net sales, in 2005.

 

Interest expense, net:  Net interest expense in 2006 was $107.1 million, or 3.2% of net sales, as compared to $12.1 million, or 0.9% of net sales, in 2005. The $95.1 million net increase is principally due to the increased debt required to fund the acquisition of Carson’s. Included in the 2006 expense are charges of $2.3 million for the write-off of fees associated with the Company’s previous credit agreement and $4.5 million for fees associated with a bridge facility required in connection with the financing for the acquisition of Carson’s.

 

Income tax provision:  The income tax provision reflects an effective tax rate of 29.5% in 2006 as compared to 31.8% in 2005. Included in the provision is an income tax benefit adjustment of $4.1 million and approximately $2.2 million in 2006 and 2005, respectively, principally associated with a net reduction in income tax valuation allowances.

 

Net income:  Net income in 2006 was $46.9 million, or 1.4% of net sales, as compared to $26.0 million, or 2.0% of net sales, in 2005.

 

2005 Compared to 2004

 

Net sales:  Net sales were $1,287.2 million in 2005, a decrease of $23.2 million, or 1.8%, as compared to 2004. Comparable store sales decreased 1.6% in 2005. The best performing merchandise categories in 2005 were Women’s Special Size (included in Women’s Apparel), Footwear, Home and Intimate Apparel. Sales for Women’s Special Size reflect increased inventory, additional space in stores and increased advertising exposure. Footwear sales increased as customers responded favorably to our focus on maximizing key casual vendors, store intensifications and increased advertising exposure. The Home sales increase resulted from key item maximization in soft home and new product offerings in hard home. Intimate Apparel sales benefited from a narrowed assortment that ensured size availability. The poorest performing merchandise categories in 2005 were Dresses and Coats (included in Women’s Apparel) and Juniors’ Apparel. Apparel sales in 2005 were hampered by unseasonably cold weather during the spring season and unseasonably warm weather in the third quarter.

 

Other income:  Other income, which includes income from program revenue received under the CCPA, leased departments and other customer revenues, increased $11.2 million in 2005 over 2004 primarily because of the revenue received under the CCPA in the fourth quarter of 2005. After the July 8, 2005 Credit Card Sale, we continued to service the credit card receivables through October 31, 2005; proceeds earned pursuant to the CCPA during this period were recorded within SG&A expense.

 

Costs and expenses:  Gross margin dollars for 2005 decreased $15.0 million, or 3.1%, as compared to 2004, reflecting lower sales volume and a reduced gross margin rate. Gross margin as a percentage of net sales was 36.1% in 2005, a decrease of 0.5 percentage point from 36.6% in 2004. The decrease in gross margin rate reflects a decreased markup rate and higher shrinkage partially offset by a lower markdown rate.

 

SG&A expense for 2005 was $407.1 million, or 31.6% of net sales, compared to $415.9 million, or 31.7% of net sales, in 2004. The decrease reflects reduced integration expenses and store payroll, partially offset by increased advertising expenses.

 

Depreciation and amortization expense and amortization of lease-related interests increased $0.3 million, to $28.1 million, in 2005 from $27.8 million in 2004. In 2005, we recognized approximately $0.9 million of accelerated charges on software associated with our credit operation. In 2004, we recorded asset impairment charges on the long-lived assets of certain stores of $0.9 million and a $0.5 million cumulative charge pursuant to a review of our historical lease accounting.

 

Income from operations:  Income from operations in 2005 was $50.2 million, or 3.9% of net sales, compared to $45.5 million, or 3.5% of net sales, in 2004.

 

Interest expense, net:  Net interest expense in 2005 decreased $1.4 million to $12.1 million, or 0.9% of net sales, from $13.4 million, or 1.0% of net sales, in 2004. Interest expense was positively impacted by a reduction in long-term debt as a result of applying the proceeds from the Credit Card Sale, partially offset by an increase in interest rates.

 

Income tax provision:  The effective income tax rate for 2005 was 31.8% compared to 37.1% for 2004. Included in the provision for 2005 was an income tax benefit adjustment of approximately $2.2 million principally associated with a net reduction of the income tax valuation allowances that were established in connection with the October 2003 purchase of Elder-Beerman.

 

Net income:  Net income in 2005 was $26.0 million, or 2.0% of net sales, compared to $20.2 million, or 1.5% of net sales, in 2004.

Liquidity and Capital Resources

 

The following table summarizes material measures of our liquidity and capital resources:

 

 

 

Prior to March 6, 2006, our primary sources of working capital were cash flows from operations and borrowings under our revolving credit facility. On March 6, 2006, to finance the acquisition of Carson’s and the related payoff of our previous revolving credit facility, we entered into a new revolving credit facility which provides for up to $1.0 billion in borrowings, issued $510.0 million in senior unsecured notes and entered into a new mortgage loan facility in the aggregate principal amount of $260.0 million. Our business follows a seasonal pattern; working capital fluctuates with seasonal variations, reaching its highest level in October or November to fund the purchase of merchandise inventories prior to the holiday season.

 

Increases in working capital, current ratio, debt to total capitalization and unused availability under lines of credit in 2006, as compared to 2005, principally reflect the addition of Carson’s operations and the increase in debt to fund the acquisition. Decreases in working capital, current ratio and debt to total capitalization and the increase in unused lines of credit in 2005, as compared to 2004, are largely due to the sale of the credit card operation in July 2005 and associated debt reduction.

 

Net cash provided by operating activities amounted to $117.7 million in 2006, $153.8 million in 2005 and $28.7 million in 2004. The decrease in net cash provided in 2006 is principally due to the 2005 proceeds from the sale of the credit card operation. The increase in net cash provided by operating activities in 2005 as compared to 2004 primarily reflects net proceeds from the Credit Card Sale and decreases in merchandise inventories and retained interest in trade receivables.

 

Net cash used in investing activities amounted to $1,171.8 million in 2006, $28.7 million in 2005 and $31.4 million in 2004. The increase in cash outflow in 2006 reflects the acquisition costs of Carson’s and the Parisian stores as well as increased capital expenditures for the larger combined company. Capital expenditures in 2005 were $2.3 million lower than in 2004 largely because of reduced spending for systems integration, partially offset by increased spending for store remodels. Additionally, proceeds from the sale of property, fixtures and equipment in 2005 were $2.2 million higher than in 2004.

 

Net cash provided by financing activities amounted to $1,069.1 million in 2006 and $7.8 million in 2004. Net cash used in financing activities amounted to $138.2 million in 2005. 2006 cash inflow reflects the increased borrowings to fund the acquisitions of Carson’s and Parisian stores. The increase in net cash used in 2005 primarily reflects payments made to reduce long-term debt as a result of the Credit Card Sale.

 

Prior to March 6, 2006, our amended and restated revolving credit facility agreement (the “Credit Agreement”) provided a revolving line of credit of $300.0 million. In connection with the acquisition of Carson’s and the related financing arrangements, discussed below, the Credit Agreement was terminated and simultaneously replaced by a new senior secured credit facility

on March 6, 2006. There were no prepayment or early termination premiums or penalties in connection with the termination of the Credit Agreement. All deferred financing costs as of March 6, 2006 associated with the Credit Agreement, which totaled $2.3 million, were expensed immediately upon termination of the Credit Agreement.

 

On March 6, 2006, The Bon-Ton Department Stores, Inc., a wholly owned subsidiary of The Bon-Ton Stores, Inc., and certain of its subsidiaries, Bank of America, N.A. (“Bank of America”) and certain other lenders entered into a Loan and Security Agreement (“New Senior Secured Credit Facility”) which provides for up to $1.0 billion of revolver borrowings. The New Senior Secured Credit Facility includes a last-in, first-out revolving credit facility of up to $900.0 million and a first-in, last-out revolving credit facility of up to $100.0 million, and has a sub-limit of $150.0 million for the issuance of standby and documentary letters of credit. All borrowings under the New Senior Secured Credit Facility are limited by amounts available pursuant to a borrowing base calculation, which is based on percentages of eligible inventory, real estate and fixed assets, with a reduction for applicable reserves. The New Senior Secured Credit Facility is guaranteed by The Bon-Ton Stores, Inc. and certain of its subsidiaries. The New Senior Secured Credit Facility is secured by substantially all the assets of the Company, except for certain mortgaged real property. As part of the New Senior Secured Credit Facility, Bank of America and the other lenders will make available certain swing line loans in an aggregate amount not to exceed $75.0 million outstanding at any one time. Borrowings under the New Senior Secured Credit Facility bear interest at either (i) the prime rate established by Bank of America, from time to time, plus the applicable margin (the “Prime Rate”) or (ii) the LIBOR rate from time to time plus the applicable margin. The applicable margin is determined based upon the excess availability under the New Senior Secured Credit Facility. The swing line loans bear interest at the same rate applicable to last-in, first-out Prime Rate loans. We are required to pay a commitment fee to the lenders for unused commitments at a rate of 0.25% to 0.30% per annum, based upon the unused portion of the total commitment under the New Senior Secured Credit Facility. The New Senior Secured Credit Facility expires March 6, 2011. Financial covenants contained in the New Senior Secured Credit Facility require that the minimum excess availability be greater than $75.0 million at all times. In addition, there are certain restrictions against the incurrence of additional indebtedness, pledge or sale of assets, payment of dividends and distributions, and other similar restrictions. Dividends paid may not exceed $15.0 million over the life of the agreement, or $4.0 million in any single year. Capital expenditures are limited to $125.0 million per year, with a one-year carryover of any prior year unused amount. As of February 3, 2007, the Company had borrowings of $342.3 million, with $341.3 million of borrowing availability (before taking into account the minimum borrowing availability covenant of $75.0 million) and letter-of-credit commitments of $47.9 million.

 

On March 6, 2006, The Bon-Ton Department Stores, Inc. entered into an Indenture (the “Indenture”) with The Bank of New York, as trustee, under which The Bon-Ton Department Stores, Inc. issued $510.0 million aggregate principal amount of its 101/4% Senior Notes due 2014 (the “Notes”). The Notes are guaranteed on a senior unsecured basis by The Bon-Ton Stores, Inc. and certain of its subsidiaries. The Notes mature on March 15, 2014. The Notes may not be redeemed prior to March 15, 2010, except that we may redeem up to 35% of the Notes prior to March 15, 2009 through the proceeds of an equity offering. The interest rate of the Notes is fixed at 101/4% per year. Interest on the Notes is payable on March 15 and September 15 of each year, beginning on September 15, 2006. The Indenture includes covenants that limit the ability of the Company and its restricted subsidiaries to, among other things, incur additional debt, pay dividends and make distributions, make certain investments, enter into certain types of transactions with affiliates, use assets as security in other transactions, and sell certain assets or merge with or into other companies.

 

On March 6, 2006, certain bankruptcy-remote special purpose entities (each an “SPE” and, collectively, the “SPEs”) that are indirect wholly owned subsidiaries of The Bon-Ton Stores, Inc. entered into loan agreements with Bank of America, pursuant to which Bank of America provided a new mortgage loan facility in the aggregate principal amount of $260.0 million (the “New Mortgage

Loan Facility”). The New Mortgage Loan Facility has a term of ten years and is secured by mortgages on twenty-three retail stores and one distribution center owned by the SPEs. Each SPE entered into a lease with each of The Bon-Ton Stores, Inc. subsidiaries operating on such SPE’s properties. A portion of the rental income received under these leases will be used to pay the debt service under the New Mortgage Loan Facility. The New Mortgage Loan Facility requires level monthly payments of principal and interest based on an amortization period of twenty-five years and the balance outstanding at the end of ten years will then become due and payable. The interest rate for the New Mortgage Loan Facility is fixed at 6.2125%. Financial covenants contained in the New Mortgage Loan Facility require that the SPEs maintain certain financial thresholds, as defined in the agreements.

 

We used the net proceeds of the Notes offering and New Mortgage Loan Facility, along with borrowings under the New Senior Secured Credit Facility, to finance the acquisition of Carson’s, refinance our previous revolving credit agreement, and pay related fees and expenses in connection with the acquisition and related financing transactions.

 

Aside from planned capital expenditures, our primary cash requirements will be to service debt and finance working capital increases during peak selling seasons.

 

We paid a quarterly cash dividend of $0.025 per share on shares of Class A common stock and common stock to shareholders on May 1, 2006, August 1, 2006, October 16, 2006 and January 16, 2007 to shareholders of record as of April 15, 2006, July 14, 2006, October 2, 2006, and January 2, 2007, respectively. Additionally, we declared a quarterly cash dividend of $0.05 per share, payable May 1, 2007 to shareholders of record as of April 16, 2007. Our Board of Directors will consider dividends in subsequent periods as it deems appropriate.

 

Capital expenditures for 2006, which do not reflect landlord contributions, totaled $101.0 million. Capital expenditures for 2007, net of landlord contributions, are planned at approximately $106.0 million. Included in these planned amounts are expenditures relating to the opening of two new stores, expansions of three stores and the renovation and reconfiguration of several existing stores.

 

We anticipate that cash flows from operations, supplemented by borrowings under the New Senior Secured Credit Facility, will be sufficient to satisfy operating cash requirements for at least the next twelve months.

 

Cash flows from operations are impacted by consumer confidence, weather in the geographic markets served by the Company, and economic and competitive conditions existing in the retail industry. A downturn in any single factor or a combination of factors could have a material adverse impact upon our ability to generate sufficient cash flows to operate our business.

 

We have not identified any probable circumstances that would likely impair our ability to meet our cash requirements or trigger a default or acceleration of payment of our debt.

Contractual Obligations and Commitments

 

The following tables reflect our contractual obligations and commitments as of February 3, 2007:

 

Contractual Obligations

 

 

 

In addition, we expect to make cash contributions to our supplementary pension plans and the Carson Retiree Health plan in the amount of $1.9 million, $2.4 million, $3.0 million, $1.9 million and $1.6 million in 2007, 2008, 2009, 2010 and 2011, respectively, and $11.5 million in the aggregate for the five years thereafter.

 

We currently do not anticipate making payments to the Carson defined benefit pension plan within the next ten years; however, the impact of The Pension Protection Act of 2006 on this plan’s future funding requirements have not been finalized because certain required assumptions have not yet been made available by the Internal Revenue Service.

 

Note 9 in the Notes to Consolidated Financial Statements provides a more complete description of our benefit plans.

 

Commitments

 

 

Documentary letters of credit are primarily issued to support the importing of merchandise, which includes our private brand goods. Standby letters of credit are primarily issued to support the importing of merchandise and as collateral for obligations related to general liability and workers’ compensation insurance. Surety bonds are primarily for previously incurred and expensed obligations related to workers’ compensation.

 

In the ordinary course of business, we enter into arrangements with vendors to purchase merchandise up to twelve months in advance of expected delivery. These purchase orders do not contain any significant termination payments or other penalties if cancelled.

 

Critical Accounting Policies

 

Our discussion and analysis of financial condition and results of operations are based upon the Consolidated Financial Statements, which have been prepared in accordance with U.S. generally accepted accounting principles. Preparation of these financial statements required us to make estimates and judgments that affected reported amounts of assets and liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities at the date of our financial statements. On an ongoing basis, we evaluate our estimates, including those related to merchandise returns, bad debts, inventories, goodwill, intangible assets, income taxes, financings, contingencies, insurance reserves, and litigation. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

 

Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties, and could potentially lead to materially different results under different assumptions and conditions. We believe our critical accounting policies are as described below. For a discussion of the application of these and other accounting policies, see the Notes to Consolidated Financial Statements.

 

Inventory Valuation

 

Inventories are stated at the lower of cost or market with cost determined by the retail inventory method. Under the retail inventory method, the valuation of inventories at cost and the resulting gross margin is derived by applying a calculated cost-to-retail ratio to the retail value of inventories. The retail inventory method is an averaging method that has been widely used in the retail industry. Use of the retail inventory method will result in valuing inventories at the lower of cost or market if markdowns are taken timely as a reduction of the retail value of inventories.

 

Inherent in the retail inventory method calculation are certain significant management judgments and estimates including, among others, merchandise markups, markdowns and shrinkage, which significantly impact both the ending inventory valuation at cost and the resulting gross margin. These significant estimates, coupled with the fact that the retail inventory method is an averaging process, can, under certain circumstances, result in individual inventory components with cost above related net realizable value. Factors that can lead to this result include applying the retail inventory method to a group of products that is not fairly uniform in terms of its cost, selling price relationship and turnover; or applying the retail inventory method to transactions over a period of time that include different rates of gross profit, such as those relating to seasonal merchandise. In addition, failure to take timely markdowns can result in an overstatement of inventory under the lower of cost or market principle. We believe that the retail inventory method we use provides an inventory valuation that approximates cost and results in carrying inventory in the aggregate at the lower of cost or market.

 

We regularly review inventory quantities on-hand and record an adjustment for excess or old inventory based primarily on an estimated forecast of merchandise demand for the selling season. Demand for merchandise can fluctuate greatly. A significant increase in the demand for merchandise could result in a short-term increase in the cost of inventory purchases while a significant decrease in demand could result in an increase in the amount of excess inventory quantities on-hand. Additionally, estimates of future merchandise demand may prove to be inaccurate, in which case we may have understated or overstated the adjustment required for excess or old inventory. If our inventory is

determined to be overvalued in the future, we would be required to recognize such costs in costs of goods sold and reduce operating income at the time of such determination. Likewise, if inventory is later determined to be undervalued, we may have overstated the costs of goods sold in previous periods and would recognize additional operating income when such inventory is sold. Therefore, although every effort is made to ensure the accuracy of forecasts of future merchandise demand, any significant unanticipated changes in demand or in economic conditions within our markets could have a significant impact on the value of our inventory and reported operating results.

 

Prior to the Carson’s acquisition, we utilized the last-in, first-out (“LIFO”) cost basis for all of our inventories. In connection with the Carson’s acquisition, we evaluated the inventory costing for the acquired inventories and elected the first-in, first-out (“FIFO”) cost basis for the majority of the acquired Carson’s locations. As of February 3, 2007, approximately 30% of our inventories were valued using a FIFO cost basis and approximately 70% of our inventories were valued using a LIFO cost basis. As is currently the case with many companies in the retail industry, our LIFO calculations have yielded inventory increases in recent years due to deflation reflected in price indices used. The LIFO method values merchandise sold at the cost of more recent inventory purchases (which the deflationary indices indicate to be lower), resulting in the general inventory on-hand being carried at the older, higher costs. Given these higher values and the promotional retail environment, we have reduced the carrying value of our LIFO inventories to a net realizable value. These reductions totaled $38.9 million and $23.7 million as of February 3, 2007 and January 28, 2006. Inherent in the valuation of inventories are significant management judgments and estimates regarding future merchandise selling costs and pricing. Should these estimates prove to be inaccurate, we may have overstated or understated our inventory carrying value. In such cases, operating results would ultimately be impacted.

 

Vendor Allowances

 

As is standard industry practice, allowances from merchandise vendors are received as reimbursement for charges incurred on marked-down merchandise. Vendor allowances are generally credited to costs of goods sold, provided the allowance is: (1) collectable, (2) for merchandise either permanently marked down or sold, (3) not predicated on a future purchase, (4) not predicated on a future increase in the purchase price from the vendor, and (5) authorized by internal management. If the aforementioned criteria are not met, the allowances are reflected as an adjustment to the cost of merchandise capitalized in inventory.

 

Additionally, allowances are received from vendors in connection with cooperative advertising programs and for reimbursement of certain payroll expenses. These allowances received from each vendor are reviewed to ensure reimbursements are for specific, incremental and identifiable advertising or payroll costs incurred to sell the vendor’s products. If a vendor reimbursement exceeds the costs incurred, the excess reimbursement is recorded as a reduction of cost purchases from the vendor and reflected as a reduction of costs of merchandise sold when the related merchandise is sold. All other amounts are recognized as a reduction of the related advertising or payroll costs that have been incurred and reflected in SG&A expense.

 

Income Taxes

 

Significant management judgment is required in determining the provision for income taxes, deferred tax assets and liabilities, and the valuation allowance recorded against net deferred tax assets. The process involves summarizing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within the consolidated balance sheet. We must then assess the likelihood that deferred tax assets will be recovered from future taxable income or tax carry-back availability and, to the extent we do not believe recovery of the deferred tax asset is more-likely-than-not, a valuation allowance must be established. To the extent a valuation allowance is established in a period, an expense must be recorded within the income tax provision in the statement of income.

 

Our net deferred tax assets were $94.4 million and $53.6 million at February 3, 2007 and January 28, 2006, respectively. In assessing the realizability of the deferred tax assets, we considered whether it was more-likely-than-not that the deferred tax assets, or a portion thereof, will not be realized. We considered the scheduled reversal of deferred tax liabilities, projected future taxable income, tax planning strategies and limitations pursuant to Section 382 of the Internal Revenue Code. As a result, we concluded that a valuation allowance against a portion of the net deferred tax assets was appropriate. A total valuation allowance of $25.4 million and $43.9 million was recorded at February 3, 2007 and January 28, 2006, respectively. If actual results differ from these estimates or these estimates are adjusted in future periods, the valuation allowance may need to be adjusted, which could materially impact our financial position and results of operations.

 

Long-lived Assets

 

Property, fixtures and equipment are recorded at cost and are depreciated on a straight-line basis over the estimated useful lives of such assets. Changes in our business model or capital strategy can result in the actual useful lives differing from estimates. In cases where we determined that the useful life of property, fixtures and equipment should be shortened, we depreciated the net book value in excess of the salvage value over the revised remaining useful life, thereby increasing depreciation expense. Factors such as changes in the planned use of fixtures or leasehold improvements could also result in shortened useful lives. Our net property, fixtures and equipment amounted to $897.9 million and $167.7 million at February 3, 2007 and January 28, 2006, respectively.

 

Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS No. 144”), requires the Company to test a long-lived asset for recoverability whenever events or changes in circumstances indicate that its carrying value may not be recoverable. Factors that could trigger an impairment review include the following:

 

 

If the undiscounted cash flows associated with the asset are insufficient to support the recorded asset, an impairment loss is recognized for the amount (if any) by which the carrying amount of the asset exceeds the fair value of the asset. Cash flow estimates are based on historical results, adjusted to reflect our best estimate of future market and operating conditions. Estimates of fair value represent our best estimate based on industry trends and reference to market rates and transactions, if available. Should cash flow estimates differ significantly from actual results, an impairment could arise and materially impact our financial position and results of operations. Given the seasonality of operations, impairment is not conclusive, in many cases, until after the holiday period in the fourth quarter is concluded.

 

Newly opened stores may take time to generate positive operating and cash flow results. Factors such as store type, store location, current marketplace awareness of private label brands, local customer demographic data and current fashion trends are all considered in determining the time-frame required for a store to achieve positive financial results. If conditions prove to be substantially different from expectations, the carrying value of new stores’ long-lived assets may ultimately become impaired.

 

We evaluated the recoverability of our long-lived assets in accordance with SFAS No. 144. As a result, in 2006 we recorded $2.9 million of asset impairment charges related to the reduction in the estimated net realizable value of a store property and a reduction in the value of duplicate information systems software resulting from the acquisition of Carson’s. No impairment loss was recorded in 2005 and an impairment loss of $0.9 million was recorded in depreciation and

amortization expense in 2004. Included in the impairment loss in 2004 is $0.3 million related to the write-down of an intangible asset at one store location.

 

Goodwill and Intangible Assets

 

Our goodwill was $27.4 million and $3.0 million at February 3, 2007 and January 28, 2006, respectively. The increase in goodwill reflects the purchase accounting for the acquisition of Carson’s.

 

Net intangible assets totaled $176.7 million and $5.0 million at February 3, 2007 and January 28, 2006, respectively. Our intangible assets are principally comprised of $91.1 million of lease interests that relate to below-market-rate leases and $85.6 million associated with trademarks and customer lists. The lease-related interests and the portion of trademarks subject to amortization are being amortized using a straight-line method. The customer lists are being amortized using a declining-balance method. At February 3, 2007, lease-related interests, customer lists and trademarks had average remaining lives of sixteen years, twelve years and two years, respectively, for amortization purposes. Trademarks of $63.5 million have been deemed as having indefinite lives as part of the purchase accounting for Carson’s.

 

In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”), goodwill and other intangible assets that have indefinite lives are reviewed for impairment at least annually or when events or changes in circumstances indicate the carrying value of these assets might exceed their current fair values. Fair value is determined using a discounted cash flow analysis methodology, which requires certain assumptions and estimates regarding industry economic factors and future profitability of acquired businesses. Our policy is to conduct impairment testing based on our most current business plans, which reflect anticipated changes in the economy and the industry. If actual results prove inconsistent with our assumptions and judgments, we could be exposed to a material impairment charge. For 2006, we completed a review of the carrying value of goodwill, in accordance with SFAS No. 142, and determined that goodwill was not impaired.

 

Insurance Reserve Estimates

 

We use a combination of insurance and self-insurance for a number of risks, including workers’ compensation, general liability and employee-related health care benefits, a portion of which is paid by our associates. We determine the estimates for the liabilities associated with these risks by considering historical claims experience, demographic factors, severity factors and other actuarial assumptions. A change in claims frequency and severity of claims from historical experience as well as changes in state statutes and the mix of states in which we operate could result in a change to the required reserve levels.

 

Purchase Accounting

 

We have accounted for the acquisition of Carson’s in accordance with the provisions of SFAS No. 141, “Business Combinations,” whereby the purchase price paid to effect the acquisition was allocated to the acquired assets and assumed liabilities at their estimated fair value as of the acquisition date. The acquisition of Carson’s was effective as of March 5, 2006. In connection with purchase price allocations, we made estimates of the fair values of our long-lived and intangible assets based upon assumptions related to the future cash flows, discount rates and asset lives utilizing currently available information. We have recorded preliminary purchase accounting adjustments to record the property and equipment and inventory at their estimated fair values, to establish intangible assets for trade names, customer lists and favorable lease interests and to revalue long-term benefit plan obligations, among other things.

 

Future Accounting Changes

 

In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN No. 48”). FIN No. 48 requires applying a more-likely-than-not threshold to the recognition and de-recognition of tax positions. The new guidance will become effective for the Company beginning in the first quarter of 2007. We have not yet determined the impact of FIN No. 48 on our consolidated financial statements.

 

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements, but does not require any new fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. We are in the process of evaluating what effect, if any, adoption of SFAS No. 157 may have on our consolidated financial statements.

 

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS No. 159”). SFAS No. 159 permits companies to measure many financial instruments and certain other assets and liabilities at fair value on an instrument by instrument basis. SFAS No. 159 also establishes presentation and disclosure requirements to facilitate comparisons between companies that select different measurement attributes for similar types of assets and liabilities. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. We are in the process of evaluating what effect, if any, adoption of SFAS No. 159 may have on our financial statements.

 

 

Market Risk and Financial Instruments

 

We are exposed to market risk associated with changes in interest rates. To provide some protection against potential rate increases associated with our variable-rate facilities, we enter into derivative financial transactions in the form of interest rate swaps. The interest rate swaps are used to hedge a portion of the underlying variable-rate facilities. The swaps are qualifying hedges and the interest rate differential is reflected as an adjustment to interest expense over the life of the swaps.

 

At February 3, 2007, we held two “variable-to-fixed” rate swaps with a notional amount of $50.0 million each. The notional amount does not represent amounts exchanged by the parties; rather, it is used as the basis to calculate amounts due and to be received under the rate swap. During 2006 and 2005, we did not enter into or hold derivative financial instruments for trading purposes.

 

The following table provides information about our derivative financial instruments and other financial instruments that are sensitive to changes in interest rates, including debt obligations and the interest rate swaps. For debt obligations, the table presents principal cash flows and related weighted average interest rates by expected maturity dates at February 3, 2007. For the interest rate swaps, the table presents the notional amount and weighted average pay and receive interest rates by

expected maturity date. For additional discussion of our interest rate swaps, see Note 11 in the Notes to Consolidated Financial Statements.

 

 

Seasonality and Inflation

 

Our business, like that of most retailers, is subject to seasonal fluctuations, with the major portion of sales and income realized during the second half of each fiscal year, which includes the back-to-school and holiday seasons. See Note 19 in the Notes to Consolidated Financial Statements for the Company’s quarterly results for 2006 and 2005. Due to the fixed nature of certain costs, SG&A expense is typically higher as a percentage of net sales during the first half of each year.

 

Because of the seasonality of our business, results for any quarter are not necessarily indicative of results that may be achieved for a full year. In addition, quarterly operating results are impacted by the timing and amount of revenues and costs associated with the opening of new stores and the closing and remodeling of existing stores.

 

We do not believe inflation had a material effect on operating results during the past three years. However, there can be no assurance that our business will not be affected by inflationary adjustments in the future.

 

 

Information called for by this item is set forth in the Consolidated Financial Statements and Financial Statement Schedule contained in this report and is incorporated herein by this reference. See index at page F-1.

 

 

None.

 

 

Attached as exhibits to this Form 10-K are certifications of the Company’s Chief Executive Officer and Chief Financial Officer, which are required by Rule 13a-14 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). This “Controls and Procedures” section includes information concerning the controls and controls evaluation referred to in the certifications. This section should be read in conjunction with the certifications for a more complete understanding of the topics presented.

 

Evaluation of Disclosure Controls and Procedures

 

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in reports filed pursuant to the Exchange Act is recorded, processed,

summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. Our management, including our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act) as of the end of the period covered by this report and, based on this evaluation, concluded that our disclosure controls and procedures are effective.

 

Management Report on Internal Control Over Financial Reporting

 

The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting to provide reasonable assurance regarding the reliability of its financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the Company’s assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that the Company’s receipts and expenditures are being made only in accordance with authorizations of management and directors of the Company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of its assets that could have a material effect on the financial statements.

 

Management assessed the Company’s internal control over financial reporting as of February 3, 2007, the end of the 2006 year. Management based its assessment on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Management’s assessment included evaluation of such elements as the design and operating effectiveness of key financial reporting controls, process documentation, accounting policies and the Company’s overall control environment.

 

Based on its assessment, management has concluded that the Company’s internal control over financial reporting was effective as of the end of the fiscal year to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external reporting purposes in accordance with generally accepted accounting principles. The results of management’s assessment were reviewed with the Audit Committee of the Company’s Board of Directors.

 

KPMG LLP audited management’s assessment and independently assessed the effectiveness of the Company’s internal control over financial reporting. KPMG LLP has issued an attestation report concurring with management’s assessment, which is included below.

 

Report of Independent Registered Public Accounting Firm

 

The Board of Directors and Shareholders
The Bon-Ton Stores, Inc.:

 

We have audited management’s assessment, included in the accompanying Management Report on Internal Control over Financial Reporting presented above, that The Bon-Ton Stores, Inc. maintained effective internal control over financial reporting as of February 3, 2007, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Bon-Ton Stores, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

 

A Company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

In our opinion, management’s assessment that The Bon-Ton Stores, Inc. maintained effective internal control over financial reporting as of February 3, 2007, is fairly stated, in all material respects, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, The Bon-Ton Stores, Inc. maintained, in all material respects, effective internal control over financial reporting as of February 3, 2007, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of The Bon-Ton Stores, Inc. and subsidiaries as of February 3, 2007 and January 28, 2006, and the related consolidated statements of income, shareholders’ equity, and cash flows for each of the fiscal years in the three-year period ended February 3, 2007, and the related financial statement schedule, and our report dated April 17, 2007 expressed an unqualified opinion on those consolidated financial statements and the related financial statement schedule.

 

 

Philadelphia, Pennsylvania

April 17, 2007

 

Inherent Limitations on Effectiveness of Controls

 

Our management, including the Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls or internal control over financial reporting will prevent or detect all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. The design of a

control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Further, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements because of error or fraud will not occur or that all control issues and instances of fraud, if any, within our Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of a simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based, in part, on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Projections of any evaluation of controls effectiveness to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures.

 

Changes in Internal Control Over Financial Reporting

 

There were no changes to the Company’s internal control over financial reporting that occurred during the fourteen weeks ended February 3, 2007 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

 

None.

PART III

 

 

As part of our system of corporate governance, our Board of Directors has adopted a Code of Ethical Standards and Business Practices applicable to all directors, officers and associates. This Code is available on our website at www.bonton.com.

 

The information regarding executive officers is included in Part I under the heading “Executive Officers.” The remainder of the information called for by this Item is incorporated by reference to the sections entitled “Election of Directors,” “Section 16(a) Beneficial Ownership Reporting Compliance” and “Corporate Governance and Board of Directors Information” in the Proxy Statement.

 

 

The information called for by this Item is incorporated by reference to the section entitled “Executive Compensation” of the Proxy Statement.

 

 

The information called for by this Item is incorporated by reference to the sections entitled “Security Ownership of Directors and Executive Officers” and “Equity Compensation Plan Information” of the Proxy Statement.

 

 

The information called for by this Item is incorporated by reference to the sections entitled “Related Party Transactions” and “Director Independence” of the Proxy Statement.

 

 

The information called for by this Item is incorporated by reference to the section entitled “Fees Paid to KPMG” of the Proxy Statement.

PART IV

 

 

(a) The following documents are filed as part of this report:

 

1. Consolidated Financial Statements — See the Index to Consolidated Financial Statements and Financial Statement Schedule on page F-1.

 

2. Financial Statement Schedule — See the Index to Consolidated Financial Statements and Financial Statement Schedule on page F-1.

 

(b) The following are exhibits to this Form 10-K and, if incorporated by reference, we have indicated the document previously filed with the SEC in which the exhibit was included.