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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

For Fiscal Year Ended: January 31, 2004

or

For the transition period from              to             

Commission File Number: 1-13113

SAKS INCORPORATED

(Exact Name of Registrant as Specified in Its Charter)

Registrant’s telephone number, including area code: (205) 940-4000

Securities Registered Pursuant to Section 12 (b) of the Act:

Securities Registered Pursuant to Section 12 (g) of the Act: None

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

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

Indicate by check mark whether registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).      Yes  x    No  ¨

The aggregate market value of the voting stock held by non-affiliates of the Registrant as of August 2, 2003 was approximately $1,435,387,724.

As of April 13, 2004, the number of shares of the Registrant’s Common Stock outstanding was 142,604,590.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Saks Incorporated Proxy Statement for the Annual Shareholders’ Meeting to be held on June 8, 2004 are incorporated by reference into Part III.

The Exhibit Index is on page E-1 of this report.

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PART I

Item 1. Business.

General

Saks Incorporated and its subsidiaries (together the “Company”) operate two business segments, Saks Department Store Group (“SDSG”) and Saks Fifth Avenue Enterprises (“SFAE”).

SDSG currently operates 241 department stores in 24 states under the following nameplates: Parisian (42 stores), Proffitt’s (26 stores), McRae’s (28 stores), Younkers (50 stores), Herberger’s (40 stores), Carson Pirie Scott (31 stores), Bergner’s (14 stores) and Boston Store (10 stores). SDSG stores are principally anchor stores in leading regional or community malls, and the stores typically offer a broad selection of upper-moderate to better fashion apparel, shoes, accessories, jewelry, cosmetics and decorative home furnishings, as well as furniture in selected locations. SDSG stores are promoted as “the best place to shop in your hometown.” In addition, SDSG operates 22 Club Libby Lu mall-based specialty stores, targeting female customers aged 5-12 years old.

SFAE includes Saks Fifth Avenue (“SFA”) luxury department stores (62 stores in 26 states) and Off 5th Saks Fifth Avenue Outlet (“Off 5th”) (53 stores in 23 states). Saks Fifth Avenue stores are principally free-standing stores in exclusive shopping destinations or anchor stores in upscale regional malls, and the stores typically offer a wide assortment of distinctive luxury fashion apparel, shoes, accessories, jewelry, cosmetics and gifts. Customers may also purchase SFA products by catalog or online at saks.com. Off 5th is intended to be the premier luxury off-price retailer in the United States. Off 5th stores are primarily located in upscale mixed-use and off-price centers and offer luxury apparel, shoes, accessories, cosmetics and decorative home furnishings, targeting the value-conscious customer.

Merchandising, sales promotion, and store operating support functions are conducted in multiple locations. Back office sales support functions for the Company, such as accounting, credit card administration, store planning and information technology, are largely centralized.

A summary of each business segment’s revenue, profitability and total assets for each of the last three years is shown in Note 14 to the Consolidated Financial Statements contained in this report.

Merchandising

In both the SDSG and SFA stores, the Company believes that its commitment to a branded merchandising strategy, enhanced by its merchandise presentation and high level of customer service, makes the Company’s stores a preferred distribution channel for premier brand-name merchandise.

SDSG stores attempt to consistently offer a wide selection of unique and limited distribution merchandise as well as competitively priced national brands. Key brands featured in the Company’s SDSG stores include Liz Claiborne, Susan Bristol, Marisa Christina, Sigrid Olsen, Polo/Ralph Lauren, Tommy Hilfiger, Columbia, Hart Schaffner & Marx, Estee Lauder, Clinique, Lancome, Chanel, Nine West, Enzo, Timberland, Clarks, Waterford, and Bali. In addition to the these brands, Parisian stores may carry brands such as Karen Kane, BCBG, Garfield & Marks, Tahari, Oakley, Robert Talbott, Tommy Bahama, Joseph Abboud, Callaway, Trish McEvoy , Stuart Weitzman, Kate Spade, Via Spiga and Brighton, which are typically carried only at specialty stores. SDSG differentiates its offerings from its competitors through exclusive merchandise from its core vendors, assortments from unique and emerging suppliers, and proprietary brands.

SFA stores carry luxury merchandise from both core vendors and new and emerging designers. SFA has key relationships with the leading American and European fashion houses, including Louis Vuitton, Christian Dior, Giorgio Armani, Chanel, Dolce

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and Gabbana, Salvatore Ferragamo, Gucci, Donna Karan, Calvin Klein, Ralph Lauren, Judith Leiber, Prada, Escada, Carolina Herrera, Oscar de la Renta, St. John, Yves St. Laurent, TOD’S, Ermenegildo Zegna and Max Mara.

The Company has developed a knowledge of each of its trade areas and customer bases for its SDSG, SFA, and Off 5th stores. This knowledge is gained through the Company’s regional merchandising structure in conjunction with store visits by senior management and merchandising personnel and use of on-line merchandise information. The Company strives to tailor each store’s merchandise assortment to the characteristics of its trade areas and customer bases and to the lifestyle needs of its local customers.

Certain departments in the Company’s stores are leased to independent companies in order to provide high quality service and merchandise where specialization, focus, and expertise are critical. The leased departments vary by store to complement the Company’s own merchandising departments. The principal leased department in the SDSG stores is fine jewelry, and the principal leased departments in the SFA stores are furs and certain designer luxury leather goods products. The terms of the lease agreements typically are between one and seven years and require the lessee to pay for fixtures and provide its own employees. Management regularly evaluates the performance of the leased departments and requires compliance with established customer service guidelines.

For the year ended January 31, 2004, the Company’s percentages of owned sales (exclusive of sales generated by leased departments) by major merchandise category were as follows:

Purchasing and Distribution

The Company purchases merchandise from many vendors. Management monitors profitability and sales history with each vendor and believes it has alternative sources available for each category of merchandise it purchases. Management believes it maintains good relationships with its vendors.

The Company has six distribution facilities serving its stores. Refer to “Item 2. Properties” for a listing of these facilities.

Each of the Company’s distribution facilities is linked electronically to the Company’s merchandising staffs through a computerized purchase order management system that facilitates re-order and replenishment of merchandise. The Company utilizes electronic data interchange (“EDI”) technology with the majority of its vendors, which is designed to move merchandise onto the selling floor more quickly and cost-effectively by allowing vendors to deliver floor-ready merchandise to the distribution facilities. High-speed automated conveyor systems are capable of scanning bar coded labels and diverting incoming cartons of merchandise to the

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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.

Information Technology

Company management believes that technological investments are necessary to support its business strategies, and, as a result, the Company is continually upgrading its information systems to improve efficiency and productivity.

The Company’s information systems provide information deemed necessary for management operating decisions, cost reduction programs, and customer service enhancements. Individual data processing systems include point-of-sale and sales reporting, purchase order management, receiving, merchandise planning and control, payroll, human resources, general ledger, credit card administration, and accounts payable systems. Bar code ticketing is used, and scanning is utilized at point-of-sale terminals. Information is made available on-line to merchandising staff and store management on a timely basis.

The use of EDI technology allows the Company to speed the flow of information and merchandise in an attempt to capitalize on emerging sales trends, maximize inventory turnover, and minimize out-of-stock conditions. EDI technology includes an advance shipping notice system (“ASN”). The ASN system identifies discrepancies between merchandise that is ready to be shipped from a supplier’s warehouse and that which was ordered from the supplier. This early identification provides the Company with a window of time to resolve any discrepancies in order to speed merchandise through the distribution facilities and into its stores.

Marketing

For the SDSG stores, advertising campaigns include fashion and image advertising, price promotions, and special events. The Company uses a multi-media marketing approach for the SDSG stores, including newspaper, television, radio, and direct mail. To promote its image as the fashion and style leader in its trade areas, the Company also sponsors local fashion shows and in-store special events highlighting the Company’s key brands and offerings.

For the SFA stores, the Company’s marketing principally emphasizes the latest fashion trends in luxury merchandise and primarily utilizes direct mail advertising, supplemented with national magazine and local radio advertising. To promote its image as the primary source of luxury goods in its trade areas, SFA sponsors fashion shows and in-store special events highlighting the designers represented in the SFA stores. SFA also participates in “cause-related” marketing. This includes special in-store events and related national advertising designed to drive store traffic, while raising funds for charitable causes and organizations such as women’s cancer research.

In-house advertising and sales promotion staffs, in conjunction with outside advertising agencies, produce the Company’s advertising for both SDSG and SFAE.

For both SDSG and SFA, the Company utilizes data captured through the use of proprietary credit cards to develop advertising and promotional events targeted at specific customers who have purchasing patterns for certain brands, departments, and store locations.

Proprietary Credit Cards

Prior to April 15, 2003, National Bank of the Great Lakes (“NBGL”), the Company’s wholly owned credit card bank subsidiary, issued all proprietary credit cards to the Company’s customers and made all credit card

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loans. On April 15, 2003, Household Bank (SB), N.A. (“Household”), an affiliate of Household International, acquired the Company’s proprietary credit card business, consisting of the proprietary credit card accounts owned by NBGL and the Company’s ownership interest in the assets of the Saks Credit Card Master Trust, which previously owned and securitized the accounts receivable generated by the proprietary credit card accounts.

As part of the transaction, for a term of ten years and pursuant to a program agreement, Household will establish and own proprietary credit card accounts for customers of the Company’s operating subsidiaries, retain the benefits and risks associated with the ownership of the accounts, receive the finance charge income and incur the bad debts associated with those accounts. During the ten-year term, pursuant to a servicing agreement, the Company will continue to provide key customer service functions, including new account opening, transaction authorization, billing adjustments and customer inquiries, and will receive compensation from Household for the provision of these services.

Historically, proprietary credit card holders have shopped more frequently with the Company and purchased more merchandise than customers who pay with cash or third-party credit cards. The Company also makes frequent use of the names and addresses of the proprietary credit card holders in its direct marketing efforts.

The Company seeks to expand the number and use of the proprietary credit cards by, among other things, providing incentives to sales associates to open new credit accounts, which generally can be opened while a customer is visiting one of the Company’s stores. Customers who open accounts are frequently entitled to discounts on initial and subsequent purchases. Proprietary credit card customers are sometimes offered private shopping nights, direct mail catalogs, special discounts, and advance notice of sale events. The Company has created various loyalty programs that reward customers for frequency and volume of proprietary charge card usage.

There are approximately 5.0 million proprietary credit accounts that have been active within the prior twelve months, and approximately 44% of the Company’s 2003 sales were transacted on the proprietary credit cards.

The Company liquidated NBGL on December 31, 2003. The proprietary credit card programs are subject to government regulations, including consumer protection laws that impose restrictions on the making and collection of consumer loans and on other aspects of credit card operations. There can be no assurance that the existing laws and regulations will not be amended or that new laws or regulations will not be adopted, in a manner that could adversely affect the proprietary credit card program operated by Household for the Company or the Company’s credit card servicing operations.

Trademarks and Service Marks

The Company owns many registered trademarks and service marks, including, but not limited to, “Saks Fifth Avenue,” “SFA,” “S5A,” “The Fifth Avenue Club,” and “Off 5th,” along with its various other store names and its private brands. Management believes its trademarks and service marks are important and that the loss of certain of its trademarks or trade names, particularly the store nameplates, could have a material adverse effect on the Company. Many of the Company’s trademarks and service marks 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. The Company is not aware of any claims of infringement or other challenges to its right to register or use its marks in the United States that would have a material adverse effect on its consolidated financial position, results of operations, or liquidity.

From time to time, the Company also licenses the trademarks of designers and celebrities so as to be able to offer differentiated product in its stores. Examples of such licenses include those for the trademarks Jane Seymour, Laura Ashley and Ruff Hewn, each of which the Company has the exclusive right to use in certain merchandise categories.

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Reliance on Fifth Avenue Store

The Company’s Saks Fifth Avenue store located on Fifth Avenue in New York City accounted for approximately 7% of total Company owned sales and approximately 18% of SFAE’s owned sales in 2003 and plays a significant role in creating awareness for the Saks Fifth Avenue brand name.

Customer Service

The Company believes that good customer service contributes to increased store visits and purchases by its customers.

SDSG stores are intended to be customer-friendly and easy to shop. SDSG stores generally offer two types of service. A higher degree of personalized service is typically offered in several areas of the stores including cosmetics, shoes, women’s better sportswear, women’s special size sportswear, men’s tailored clothing, men’s better sportswear, intimate apparel, china, and furniture. These departments frequently offer clienteling programs and dedicated checkout facilities and are staffed by associates with significant product training. Convenience oriented service is generally offered in the remaining areas of the stores. These areas frequently feature centralized customer service centers and are staffed with knowledgeable sales associates intending to deliver efficient transactions.

The Company has implemented service features in certain SDSG stores in order to make them more convenient to shop. Some of these features include:

At Saks Fifth Avenue, the Company’s goal is to deliver an inviting, customer-focused luxury shopping experience. Compensation for sales associates is, in part, based upon customer satisfaction measures and productivity. Sales associates undergo extensive service, selling, and product knowledge training and are encouraged to maintain frequent, personal contact with their customers. Sales associates are instructed to keep detailed customer records, send personalized thank-you notes, and routinely communicate with customers to advise them of new merchandise offerings and special promotions. Stores generally have a “ServiceFirst” desk, which is a centralized point of contact for service offerings including personal shopping, merchandise returns, coat check, alterations, credit services, and electronic gift card purchases. Stores also typically provide comfortable seating areas and refreshments throughout the store.

At both SDSG and SFAE, good customer service is encouraged through the development and monitoring of sales/productivity goals and through specific award and recognition programs. Service levels are monitored, measured, and analyzed through an independent research organization.

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Seasonality

The Company’s business, like that of many retailers, is subject to seasonal influences, with a significant portion of its sales and net income realized during the second half of the fiscal year, which includes the holiday selling season. Generally, more than 30% of the Company’s sales and over 75% of its net income are generated during the fourth fiscal quarter.

Competition

The retail business is highly competitive. The Company’s stores compete with several national and regional department stores, specialty apparel stores, designer boutiques, outlet stores, discount stores, general and mass merchandisers, and mail-order and electronic commerce retailers, some of which have greater financial and other resources than those of the Company. Management believes that its knowledge of its trade areas and customer base, combined with providing a high level of customer service and a broad selection of quality fashion merchandise at appropriate prices in good store locations, provides the opportunity for a competitive advantage.

Associates

As of April 1, 2004, the Company employed approximately 52,000 associates, of which approximately 43% were employed on a part-time basis. The Company hires additional temporary associates and increases the hours of part-time employees during seasonal peak selling periods. Less than one percent of the Company’s associates are covered by collective bargaining agreements. The Company considers its relations with its associates to be good.

Website Access to Information

The Company provides access free of charge through the Company’s website, www.saksincorporated.com, to the Company’s annual report on Form 10-K, quarterly reports on From 10-Q, current reports on Form 8-K and all amendments to those reports as soon as reasonably practicable after the reports are electronically filed with or furnished to the Securities and Exchange Commission. In addition, the Company’s Board of Directors has adopted Corporate Governance Guidelines, a Code of Business Conduct and Ethics and written charters for its Audit, Human Resources and Corporate Governance Committees, copies of which are available on the Company’s website or in print to any shareholder who requests them.

Item 1A. Executive Officers of the Registrant.

The name, age, and position held with the Company for each of the executive officers of the Company are set forth below.

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R. Brad Martin has served as a Director since 1984 and became Chairman of the Board in February 1987 and Chief Executive Officer in July 1989.

Stephen I. Sadove joined the Company in January 2002 as Vice Chairman and assumed the additional responsibility of Chief Operating Officer in March 2004. Mr. Sadove served as Senior Vice President of Bristol-Myers Squibb and President of Bristol-Myers Squibb Worldwide Beauty Care from 1996 until January 2002. From 1991 until 1996, Mr. Sadove held various other executive positions with Bristol-Myers Squibb. From 1975 until 1991, Mr. Sadove held various positions of increasing responsibility with General Foods USA.

James A. Coggin was named President and Chief Administrative Officer of Saks Incorporated in November 1998. Mr. Coggin served as President and Chief Operating Officer of the Company from March 1995 to November 1998 and served as Executive Vice President and Chief Administrative Officer of the Company from March 1994 to March 1995. From 1971 to March 1994, Mr. Coggin served in various management and executive positions with McRae’s, Inc.

George L. Jones joined the Company in March 2001 as President and Chief Executive Officer of Saks Department Store Group. Mr. Jones served as President of Worldwide Licensing and Studio Stores for Warner Brothers from 1994 until February 2001. Prior to that, he held various executive positions with Target.

Douglas E. Coltharp joined the Company in November 1996 as Executive Vice President and Chief Financial Officer. From 1987 to November 1996, Mr. Coltharp was employed by Bank of America, where he held a variety of positions including the post of Senior Vice President of Corporate Finance.

Charles J. Hansen was promoted to Executive Vice President and General Counsel of the Company in September 2003. He served as Senior Vice President and Deputy General Counsel for the Company from February 1998 to August 2003, and prior to that he served in various legal capacities with Carson Pirie Scott & Co. and its predecessors, including the post of Vice President, General Counsel, and Secretary. Prior to that, he was an attorney with Baxter International, Inc. and Shearman & Sterling.

Donald E. Wright was promoted to Executive Vice President and Chief Accounting Officer in February 2001. Prior to that, he served as Senior Vice President of Finance and Chief Accounting Officer since joining the Company in April 1997. Prior to joining the Company, Mr. Wright was a Partner with Coopers & Lybrand LLP (the predecessor firm to PricewaterhouseCoopers LLP).

Julia A. Bentley has served as Senior Vice President of Investor Relations and Communications and Secretary of the Company since September 1997. Ms. Bentley joined the Company in 1987 and has held various financial positions, including Chief Financial Officer. Prior to joining the Company, she was an audit manager with an international accounting firm.

Item 2. Properties.

The Company currently operates six principal distribution facilities as follows:

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The Company’s principal administrative offices are as follows:

The following table sets forth information about the Company’s stores as of April 1, 2004. The majority of the Company’s stores are leased. Store leases generally require the Company to pay a fixed minimum rent and a variable amount based on a percentage of annual sales at that location. Generally, the Company is responsible under its store leases for a portion of mall promotion and common area maintenance expenses and for certain utility, property tax, and insurance expenses. Typically, the Company contributes to common mall maintenance and is responsible for property tax and insurance expenses at its owned locations. Generally, store leases have primary terms ranging from 20 to 30 years and include renewal options ranging from 5 to 20 years. Off 5th leases typically have shorter terms.

In addition to the stores listed above, SDSG also operates 22 Club Libby Lu specialty stores as of April 1, 2004. These stores are leased and are typically one to two thousand square feet of space in regional malls.

Item 3. Legal Proceedings.

The Company is involved in several legal proceedings arising from its normal business activities and has accruals for losses where appropriate. Management believes that none of these legal proceedings will have an ongoing material adverse effect on the Company’s consolidated financial position, results of operations, or liquidity. Also, the Company has voluntarily entered into a consent order with the U.S. Office of the Comptroller of the Currency (the “OCC”). The consent order requires, among other things, that the Company implement and monitor policies and procedures to ensure compliance with the provisions of the Bank Secrecy Act and the related regulations of the OCC, including without limitation the requirements to maintain policies and procedures designed to comply with the recordkeeping and reporting requirements of the Bank Secrecy Act and to timely file Currency

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Transaction Reports and Suspicious Activity Reports with respect to certain currency payments taken on NBGL’s credit card accounts and on credit card accounts for which the Company or its subsidiaries act as servicer.

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

None.

PART II

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

The Company’s common stock trades on the New York Stock Exchange (“NYSE”) under the symbol SKS. As of April 1, 2004, there were approximately 2,400 shareholders of record. The prices in the table below represent the high and low sales prices for the stock as reported by the NYSE.

The Company did not declare any dividends to common shareholders for the fiscal years ended January 31, 2004 or February 1, 2003. On March 15, 2004, the Company declared a special one-time cash dividend of $2.00 per share of our common stock payable on May 17, 2004 to holders of record on April 30, 2004. The dividend payout is expected to total approximately $284 million. Future dividends, if any, will be determined by the Company’s board of directors in light of circumstances then existing, including the Company’s earnings, its financial requirements, and general business conditions.

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Item 6. Selected Financial Data.

The selected financial data set forth below should be read in conjunction with the Consolidated Financial Statements and notes thereto and the other information contained elsewhere in this report.

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

Management’s Discussion and Analysis (“MD&A”) is intended to provide an analytical view of the business from management’s perspective of operating the business and is considered to have four major components:

MD&A should be read in conjunction with the consolidated financial statements and related notes thereto contained elsewhere in this report.

MANAGEMENT’S OVERVIEW

Saks Incorporated (together with its subsidiaries, the “Company”) is a U.S. retailer operating traditional and luxury department stores in 39 states. The Company operates its business through two principal business segments: the Saks Department Store Group (“SDSG”) and Saks Fifth Avenue Enterprises (“SFAE”). The Company’s merchandise offerings primarily consist of apparel, shoes, cosmetics and accessories, and to a lesser extent, gifts and home items. The Company offers national branded merchandise complemented by differentiated product through exclusive merchandise from core vendors, assortments from unique and emerging suppliers, and proprietary brands. When aided by enhanced merchandise presentation and a high level of customer service, the Company considers its merchandising strategies to provide the customer a preferred distribution channel for its merchandise.

The Company seeks to create value to its shareholders through improving returns on its invested capital. The Company attempts to generate top-line growth while improving merchandising margins and developing a cost-effective operations structure to increase returns. Integral to this objective are enhancing vendor relations, purchasing efficiencies, and differentiated product to maximize merchandise margins; using operating cash flows to repurchase debt and equity or to reinvest in capital projects or other areas of the business; continuously seeking opportunities to rationalize the Company’s cost structure; and actively managing the real estate portfolio by routinely evaluating underproductive stores and potential growth opportunities.

The retail industry is subject to domestic and international economic trends. Changes in consumer confidence and fluctuations in financial markets can influence cyclical trends, particularly in the luxury sector, and can also cause secular trends in certain traditional department store trade areas. Additionally, a number of the Company’s stores are in tourist markets, including the flagship Saks Fifth Avenue New York store.

The retail environment remains challenging, although the Company enjoyed an improving economy in the latter half of 2003. The uncertainty of economic conditions continues to make the forecasting of near-term results difficult, but the Company believes that prevailing trends and conditions indicate that the Company will achieve earnings growth in 2004 over 2003 levels. This improvement is expected to include moderate consolidated comparable store sales growth and continued improvement in the gross margin rate, while further reducing interest expense. These objectives will have to be accomplished in the face of increased depreciation from recent capital investments and selling, general and administrative expenses that are expected to rise at approximately the same level as sales, partially attributed to a first quarter decline in the proprietary credit card contribution as the Company reaches the first anniversary of the April 15, 2003 sale of its proprietary credit card accounts receivable.

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Diluted earnings increased to $0.58 per share in 2003 from $0.48 per share in 2002. This was largely driven by a 1.6% comparable store sales increase and improved merchandise margins. Much of this improvement occurred during the fourth fiscal quarter.

While earnings per share increased in 2003, the Company had a decline in operating income from 2002 levels. This decline was largely driven by an increase in selling, general and administrative expenses largely resulting from reduced proprietary credit card contribution, which offset the improved sales and related margin. The Company was able to reduce its interest expense by nearly $15 million primarily from lower average debt balances, and recognized an $11 million tax benefit following the resolution of federal tax examinations. These items offset the decline in operating income allowing for the improvement in earnings per share.

The Company took several actions during 2003 intended to further improve its financial position and strengthen its balance sheet. Specifically, the Company:

The Company ended 2003 with $366 million of cash. On March 15, 2004, the Company announced a special one-time cash dividend of $2.00 per share to its holders of common stock. The dividend is expected to total approximately $284 million and will be payable on May 17, 2004 to holders of record as of April 30, 2004.

The Company also made key investments in strategic systems improvements during 2003. It completed the conversion of each of its operating divisions to a common technology platform in 2003 with advanced inventory management tools, designed to provide more sophisticated inventory planning and by-store inventory allocation. The Company also began the company-wide installation of enhanced point-of-sale systems, intended for advanced clienteling and customer relationship management capabilities.

The Company created a new corporate Chief Operating Officer position, announced certain leadership changes at SFAE, and reorganized leadership at its Parisian operating division. The Company also completed the consolidation of its Younkers home office into those of Carson Pirie Scott at the beginning of 2003.

The Company believes that an understanding of its reported financial condition and results of operations is not complete without considering the effect of all other components of MD&A included herein.

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RESULTS OF OPERATIONS

The following table sets forth, for the periods indicated, selected items from the Company’s consolidated statements of income, expressed as percentages of net sales (numbers may not total due to rounding):

FISCAL YEAR ENDED JANUARY 31, 2004 (“2003”) COMPARED TO FISCAL YEAR ENDED FEBRUARY 1, 2003 (“2002”)

DISCUSSION OF OPERATING INCOME

The following table shows the changes in operating income from 2002 to 2003:

The two most significant factors affecting operating income in 2003 were a comparable store sales increase and the April 15, 2003 sale of the Company’s proprietary credit card accounts receivable portfolio.

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A comparable store sales increase of 0.4% at SDSG contributed to a $44.9 million improvement in sales and margin. An increase of $25.6 million in operating expenses at SDSG reflected the increase in selling payroll and advertising expenses to support this sales increase. The net effect of new and closed stores contributed $4.9 million of operating income at SDSG.

A comparable store sales increase of 3.4% at SFAE contributed to a $51.8 million improvement in sales and margin. An increase of $27.4 million in operating expenses at SFAE reflected the increase in selling payroll and advertising expenses to support this sales increase. The net effect of new and closed stores contributed $5.9 million of operating income at SFAE.

While the sale of the credit card portfolio eliminated securitization liabilities and generated substantial cash proceeds, it also resulted in a significant decline in the net credit contribution of $33.3 million and $17.4 million at SDSG and SFAE, respectively.

Expenses and charges not allocated to the segments decreased by $3.9 million due largely to a decline in losses from long-lived assets of $11.4 million and a decline in integration and reorganization charges of $2.4 million. These improvements were offset by a $9.9 million increase in corporate operating expenses, primarily due to increases in professional fees, the expensing of stock options and increases in general management expenses.

NET SALES

The following table shows relevant sales information by segment for 2003 compared to 2002:

The majority of the sales increase was due to a consolidated comparable store sales increase of 1.6%. The increase in comparable store sales was primarily attributable to an overall improvement in the economy, primarily during the second half of the year, and principally in the luxury sector. In addition to the comparable store sales increase, sales generated from new stores added $98.8 million and were offset by a decline in sales of $53.2 million from the sale or closure of underproductive stores.

Comparable store sales are calculated on a rolling 13-month basis. Thus, to be included in the comparison, a store must be open for 13 months. The additional month is used to transition the first month impact of a new store opening. Correspondingly, closed stores are removed from the comparable store sales comparison when they begin liquidating merchandise. Expanded, remodeled, converted and re-branded stores are included in the comparable store sales comparison, except for the periods in which they are closed for remodeling and renovation.

GROSS MARGIN

Gross margin increased $96.7 million, or 0.8% of sales, in 2003 from 2002. Approximately $76.8 million of the improvement was the effect of the comparable store sales increase and a reduction in markdown activity. An additional $39.4 million of gross margin contribution related to new stores, partially offset by the loss of approximately $19.5 million in gross margin from the sale or closure of stores.

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Gross margin as a percentage of net sales was 37.9% in 2003 compared to 37.1% in 2002. The increase in gross margin rate in 2003 was primarily attributable to the decline in year-over-year markdowns. Amounts received from vendors as partial reimbursement for markdowns in 2003 were proportionate to the amounts realized in 2002 and did not materially alter the year-over-year improvement in gross margin as a percentage of net sales.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES

Selling, general and administrative expenses (“SG&A”) increased $122.4 million, or 9.0%, in 2003 over 2002, due largely to the $50.7 million reduction in net credit contribution and an increase in operating expenses of $52.8 million related to higher selling and store payroll, media and other expenses needed to support the increase in sales. The net effect of new and closed stores added $6.3 million of additional expenses to SG&A, along with a $5.0 million increase in insurance and retirement expenses and $7.6 million of incremental reorganization charges associated with management changes at SFAE.

Amounts received from vendors in conjunction with compensation programs and cooperative advertising were consistent with the related gross compensation and cooperative advertising expenditures and therefore had no impact on SG&A expense, in dollars or as a percentage of net sales.

SG&A as a percentage of net sales increased to 24.4% in 2003 from 22.9% in 2002. The rate increase reflected the decline in net credit contribution on the increase in net sales and the incremental investment in selling and store payroll and media expenses in an effort to stimulate sales.

OTHER OPERATING EXPENSES

Other operating expenses in 2003 decreased by $1.2 million from 2002 as increased property tax refunds and reduced rents were partially offset by increased depreciation associated with recent capital investments. Other operating expenses as a percentage of net sales were 9.5% in 2003 compared to 9.8% in 2002, reflecting the ability to leverage increased occupancy costs with an increase in comparable store sales.

INTEGRATION CHARGES

The Company incurred certain costs to integrate and combine its operations to further enhance the efficiency of back office functions and processes. These charges are primarily comprised of severance benefits, relocation and systems conversion costs. The 2002 charges of $10.0 million related to the consolidation of the Younkers home office operations into those of Carson Pirie Scott (“Carson’s”). The 2003 activity reflects the net effect of minor revisions to estimates associated with the 2002 charges.

LOSSES FROM LONG-LIVED ASSETS

Losses from long-lived assets in 2003 of $8.2 million consisted of the impairment or closure of underproductive stores, the write-off of software and other asset dispositions. Losses from long-lived assets in 2002 of $19.5 million were comprised of the impairment or closure of underproductive stores totaling $15.6 million and $3.9 million of property write-downs associated with the Younkers consolidation.

INTEREST EXPENSE

Interest expense declined to $109.7 million in 2003 from $124.1 million in 2002 and, as a percentage of net sales, decreased to 1.8% in 2003 from 2.1% in 2002. The improvement was primarily the result of a reduction in

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year-over-year average debt levels, a reduction in interest rates resulting from swap agreements and incremental interest income of approximately $3 million associated with invested proceeds from the sale of the Company’s receivables portfolio. To the extent the Company utilizes operating cash flows or proceeds from the sale of the Company’s receivables portfolio to repurchase debt and without regard to changes in interest rates, interest expense could be reduced on a prospective basis.

GAIN (LOSS) ON EXTINGUISHMENT OF DEBT

The loss on extinguishment of debt in 2003 of $10.5 million resulted largely from a premium paid on the current year exchange offer of 2008 senior notes. The gain on extinguishment of debt in 2002 related primarily to the recognition of gains related to the prior termination of a related interest rate swap agreement that resulted from the repurchase of senior notes.

OTHER INCOME (EXPENSE), NET

In 2003, the Company realized a gain from the sale of its proprietary credit card portfolio of approximately $5 million and realized a loss from an equity investment in FAO, Inc. of approximately $5 million.

INCOME TAXES

For 2003 and 2002, the effective income tax rate differs from the federal statutory tax rate due to state income taxes, the effect of concluding tax examinations and non-deductible goodwill amortization. The decline in the effective income tax rate in 2003 was attributable to the 2003 recognition of an $11.1 million tax benefit resulting from the conclusion of federal tax examinations, partially offset by additional reserves needed for state-related tax filing positions. Management anticipates that income tax rates in future years will approximate the 2003 rate of 36.5%.

CUMULATIVE EFFECT OF A CHANGE IN ACCOUNTING PRINCIPLE

The 2002 cumulative effect of a change in accounting principle was the result of the adoption of SFAS No. 142, “Goodwill and Other Intangible Assets,” in which the Company recorded a non-cash charge of $45.6 million for the write-off of non-deductible SFAE goodwill.

FISCAL YEAR ENDED FEBRUARY 1, 2003 (“2002”) COMPARED TO FISCAL YEAR ENDED FEBRUARY 2, 2002 (“2001”)

DISCUSSION OF OPERATING INCOME

The following table shows the changes in operating income from 2001 to 2002:

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The improvement in operating income in 2002 resulted primarily from an increase in operating contribution at SFAE, in addition to fewer reorganization charges, store closings and other expense reduction initiatives. This improvement occurred in spite of a comparable store sales decline at both segments, which led to a decline in operating income at SDSG, and an increase in integration charges resulting from the Younkers consolidation.

Although comparable store sales at SFAE declined 1.1%, significantly lower levels of merchandise allowed for a significant reduction in markdowns and contributed to a $60.3 million improvement in gross margin. SFAE also reduced operating expenses by $63.9 million, a large portion of which reflected the year-over-year expense reductions from the reorganization of Saks Direct (SFAE’s catalog and e-commerce operations).

The decrease in operating income at SDSG was primarily due to a 1.6% decrease in comparable store sales, which contributed to a $12.5 million reduction in gross margin. Increased operating expenses of $23.4 million (including increased insurance and retirement expenses of $10.6 million and increased store selling payroll of $9.3 million) were partially offset by decreased amortization expense of $10.2 million.

Expenses and charges not allocated to the segments decreased principally due to the absence of 2001 charges of $35 million associated with the reorganization of Saks Direct. An additional $9 million reduction in other items not allocated were primarily the result of fewer store closings and other expense reduction efforts. These expense reductions were offset by $14 million of integration charges in 2002 resulting from the Younkers consolidation, which consisted primarily of property write-downs and employee severance costs.

NET SALES

The following table shows relevant sales information by segment for 2002 compared to 2001:

The decline in comparable store sales at both segments was primarily attributable to a poor fourth quarter 2002 Christmas selling season as a result of the then continued geopolitical and economic uncertainty. In addition to the comparable store sales decrease, year-over-year sales were approximately $58 million less due to the sale or closure of underproductive stores and approximately $80 million less due to the cessation of SFAE’s catalog operations. These decreases were partially offset by sales generated from new store additions of $62.5 million.

GROSS MARGIN

Gross margin increased $63.2 million, or 2.0% of sales, in 2002 over 2001. Approximately $67 million of the improvement was in comparable stores and was the result of fewer year-over-year markdowns, particularly at SFAE. Approximately $23 million of margin contribution related to new stores. These increases were partially offset by the loss of approximately $10 million in margin from the reorganization of the Saks Direct operations and the loss of $16.5 million in margin from the sale or closure of stores.

Gross margin as a percentage of net sales was 37.1% in 2002 compared to 35.1% in 2001. The increase in gross margin rate in 2002 was attributable to the decline in year-over-year markdowns taken to clear inventory,

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principally at SFAE. The 2001 markdowns were due to the weakness in the luxury sector, particularly following September 11^th, in addition to markdowns associated with the reorganization of Saks Direct and store closings. Amounts received from vendors as partial reimbursement for excessive markdowns in 2002 were proportionate to the amounts realized in 2001 and did not materially alter the year-over-year improvement in gross margin as a percentage of net sales.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES

SG&A decreased $56.4 million, or 4.0%, in 2002 over 2001, due primarily to a reduction of approximately $40 million in operating expenses related to the reorganization of the Saks Direct business. Additionally, comparable store expense reductions of approximately $2 million were achieved in spite of an $11.9 million increase in insurance and retirement expenses. There was also a year-over-year decline of $12.7 million in severance costs and other items, principally related to fewer reorganization and other expense reduction initiatives.

Amounts received from vendors in conjunction with compensation programs and cooperative advertising were consistent with the related gross compensation and cooperative advertising expenditures and therefore had essentially no impact on SG&A expense, in dollars or as a percentage of net sales.

SG&A as a percentage of net sales decreased to 22.9% in 2002 from 23.2% in 2001. The rate decrease reflected the effect of targeted expense reduction initiatives in excess of the decline in sales.

OTHER OPERATING EXPENSES

Other operating expenses in 2002 decreased slightly from 2001 as the discontinuation of $12.7 million of goodwill amortization was partially offset by $8.2 million of expense increases, principally related to increased depreciation and rental expenses associated with the remodel and expansion of comparable stores and infrastructure capital spending.

Other operating expenses as a percentage of net sales were 9.8% in 2002 compared to 9.6% in 2001. The increase was primarily due to the inability to (1) leverage increased depreciation and rental expenses during a period of comparable store sales decline and (2) reduce non-store rent and depreciation commensurate with the loss of sales associated with disposed stores and the discontinued catalog operations.

INTEGRATION CHARGES

The Company incurred certain costs to integrate and combine its operations to further enhance the efficiency of back office functions and processes. These charges are primarily comprised of severance benefits, relocation and systems conversion costs. The 2002 charges of $10.0 million related to the consolidation of Younkers into Carson’s. The 2001 charges of $1.5 million related to costs incurred to complete the consolidation of three SDSG southern distribution centers.

LOSSES FROM LONG-LIVED ASSETS

Losses from long-lived assets in 2002 of $19.5 million were comprised of the impairment or closure of underproductive stores totaling $15.6 million and $3.9 million of property write-downs associated with the Younkers consolidation. Losses from long-lived assets of $32.6 million in 2001 consisted of the write-off of goodwill and property and equipment related to Saks Direct of $22.6 million and the impairment or closure of underproductive stores of $10.0 million.

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INTEREST EXPENSE

Interest expense declined to $124.1 million in 2002 from $131.0 million in 2001 and, as a percentage of net sales, decreased to 2.1% in 2002 from 2.2% in 2001. The decrease was due principally to lower average borrowing rates on floating rate debt and lower average debt levels.

GAIN ON EXTINGUISHMENT OF DEBT

The gain on extinguishment of debt in 2002 related primarily to the recognition of gains related to the prior termination of a related interest rate swap agreement that resulted from the repurchase of senior notes. The 2001 gain was primarily the result of the repurchase of senior notes at a discount to the carrying value.

INCOME TAXES

For 2002 and 2001, the effective income tax rate differs from the federal statutory tax rate due to state income taxes and non-deductible goodwill amortization. The decline in the effective income tax rate was attributable to the discontinuation of non-deductible goodwill amortization and the favorable conclusion to a number of state tax examinations, partially offset by increasing the valuation allowance against deferred income tax assets.

CUMULATIVE EFFECT OF A CHANGE IN ACCOUNTING PRINCIPLE

The cumulative effect of a change in accounting principle is the result of the 2002 adoption of SFAS No. 142, “Goodwill and Other Intangible Assets,” in which the Company recorded a non-cash charge of $45.6 million for the write-off of non-deductible SFAE goodwill.

LIQUIDITY AND CAPITAL RESOURCES

CASH FLOW

The primary needs for cash are to acquire or construct new stores, renovate and expand existing stores, provide working capital for new and existing stores and service debt. The Company anticipates that cash generated from operating activities and borrowings under its revolving credit agreement will be sufficient to meet its financial commitments and provide opportunities for future growth.

Cash provided by operating activities was $465.6 million in 2003, $276.3 million in 2002 and $374.0 million in 2001. Cash provided by operating activities principally represents income before depreciation and amortization charges and losses from long-lived assets and also includes changes in working capital. The increase in 2003 from 2002 was primarily due to increased net income and proceeds from the sale of the Company’s credit card accounts, reduced by an increase in invested working capital. The decrease in 2002 from 2001 was primarily due to an increase in invested working capital, resulting from depressed 2001 inventory levels and the use of operating cash to fund pensions.

Cash provided by (used in) investing activities was $(179.1) million in 2003, $(139.9) million in 2002 and $85.6 million in 2001. Cash used in investing activities principally consists of construction of new stores and renovation and expansion of existing stores and investments in support areas (e.g., technology, distribution centers, e-business infrastructure). The increase in “net cash used” in 2003 was largely attributable to an increase in capital spending related to new stores and various merchandising improvements in existing stores. The “net cash provided” in 2001 was largely attributable to $308.0 million of proceeds ($275.5 million after the repurchase of sold receivables) from the sale of nine SDSG stores in early 2001. Additionally, there was a $77.5 million decrease in capital spending from 2001 to 2002 related to fewer new stores, remodels and expansions.

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Cash used in financing activities was $(130.2) million in 2003, $(25.9) million in 2002 and $(425.1) million in 2001. The increase in 2003 from 2002 was primarily attributable to the use of operating cash flows and cash received from the sale of the proprietary credit card portfolio to pay down debt and repurchase common stock. The decrease in 2002 from 2001 was primarily attributable to the use of operating cash flows and cash received from the sale of the nine SDSG stores to pay down debt in 2001.

CASH BALANCES AND LIQUIDITY

On November 26, 2003, the Company amended its revolving credit agreement scheduled to mature in November 2006 by increasing the committed amount from $700 million to $800 million and extending the maturity date to February 2009. The amended facility continues to be secured by the Company’s merchandise inventories and will be used for working capital and general corporate purposes.

The Company’s primary sources of short-term liquidity are comprised of cash on hand and availability under its $800 million revolving credit facility. At January 31, 2004 and February 1, 2003, the Company maintained cash and cash equivalent balances of $365.8 million and $209.6 million, respectively. Exclusive of approximately $30 million of store operating cash, cash was invested in various money market and short-term bond funds. At January 31, 2004, the Company had $250 million invested in a single short-term bond fund. At January 31, 2004, invested cash included proceeds from operating cash flows and the unexpended portion of the cash proceeds received from the sale of the Company’s proprietary credit card portfolio.

At January 31, 2004, the Company’s utilization of its capacity under its $800 million revolving credit facility consisted of $120.1 million in unfunded letters of credit, leaving unutilized availability under the facility of $679.9 million. The Company had no advances on its revolving credit facility during 2003 other than the utilization for unfunded letters of credit. The amount of cash on hand and borrowings under the facility are influenced by a number of factors, including sales, inventory levels, vendor terms, the level of capital expenditures, cash requirements related to financing instruments, and the Company’s tax payment obligations, among others. Prior to April 2003, the amount of cash on hand and borrowings under the revolving credit facility was also influenced by the amount of retained accounts receivable and availability under the proprietary credit card receivable securitization program.

Subsequent to year-end, on March 15, 2004, the Company’s Board of Directors declared a special one-time cash dividend to shareholders of $2.00 per common share. The dividend is payable on May 17, 2004 to shareholders of record as of April 30, 2004. The dividend payout is expected to total approximately $284 million based on the approximately 142 million shares currently outstanding. Management anticipates using cash on hand to fund the dividend payment.

CAPITAL STRUCTURE

At January 31, 2004, the Company’s capital and financing structure was comprised of a revolving credit agreement, senior unsecured notes, capital and operating leases and real estate mortgage financing. At January 31, 2004, the Company’s long-term debt totaled $1,125.6 million which, when combined with $151.9 million of current maturities, represented 35.5% of its capitalization, down from 37.0% at February 1, 2003. The Company continuously evaluates its debt-to-capitalization in light of economic trends; business trends; levels of interest rates; and terms, conditions and availability of capital in the capital markets.

At January 31, 2004, the Company maintained an $800 million senior revolving credit facility maturing in 2009, which is secured by eligible inventory. Borrowings are limited to a prescribed percentage of eligible inventories. There are no debt ratings-based provisions in the facility. The facility includes a fixed-charge

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coverage ratio requirement of 1 to 1 that the Company is subject to only if availability under the facility becomes less than $100 million. The facility contains default provisions that are typical for this type of financing, including a provision that would trigger a default of the facility if a default were to occur in another debt instrument resulting in the acceleration of principal of more than $20 million in that other instrument.

The Company had $1,132.6 million of unsecured notes outstanding as of January 31, 2004, comprised of seven separate series having maturities ranging from 2004 to 2019. The terms of each senior note call for all principal to be repaid at maturity. The senior notes have substantially identical terms except for the maturity dates and the interest coupons payable to investors. Each senior note contains limitations on the amount of secured indebtedness the Company may incur. Senior notes aggregating $72.3 million and $70.4 million will mature in July and December 2004, respectively. The Company believes it has sufficient cash on hand, availability under its revolving credit facility and access to various capital markets to repay these notes at maturity.

During 2003, the Company exchanged $208.1 million in new notes and approximately $88.5 million in cash for $261.2 million of its 8.25% notes due in 2008. This exchange offer resulted in a $53.1 million reduction in senior notes and a loss on debt extinguishment of $10.5 million in the fourth quarter, primarily related to the premium paid on the 2008 notes. During 2002, the Company used cash from operations to repurchase $24.3 million in senior notes.

On March 23, 2004, the Company issued $230 million of convertible senior notes that will bear interest of 2.0% and will mature in 2024. The provisions of the convertible notes allow the holder to convert the notes to shares of the Company’s common stock at a conversion rate of 47.221 shares per one thousand dollars in principal amount of notes. The most significant terms and conditions include: the Company can settle a conversion with shares and cash (limited to the principal); the holder may put the debt back to the Company in 2014 or 2019; the holder cannot convert until the Company’s share price exceeds the conversion price by 20% for a certain trading period; the Company can call the debt after year seven; the conversion rate is subject to a dilution adjustment; and the holder can convert upon a significant credit rating decline and upon a call. The Company used $25 million of the proceeds from the issuances to enter into a convertible note hedge and written call options on its common stock to limit the exposure to dilution from the conversion of the notes by increasing the effective conversion premium. The Company plans to use the remaining proceeds from the offering to repurchase a portion of its higher interest rate debt and for general corporate purposes.

At January 31, 2004 the Company had $136 million in capitalized leases covering various properties and pieces of equipment. The terms of the capitalized leases provide the lessor with a security interest in the asset being leased and require the Company to make periodic lease payments, aggregating between $5 million and $7 million per year.

CONTRACTUAL OBLIGATIONS AND OFF-BALANCE SHEET ARRANGEMENTS

The contractual cash obligations at January 31, 2004 associated with the Company’s capital and financing structure, as well as other contractual obligations, are illustrated in the following table:

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The Company’s purchase obligations principally consist of purchase orders for merchandise, store construction contract commitments, maintenance contracts and services agreements and amounts due under employment agreements. Amounts committed under open purchase orders for merchandise inventory represent approximately $700 million of the purchase obligations within one year, a substantial portion of which are cancelable without penalty prior to a date that precedes the vendor’s scheduled shipment date.

Other cash obligations that have been excluded from the contractual obligations table include contingent rent payments, amounts that might become payable under change-in-control provisions of employment agreements, common area maintenance costs, interest costs associated with debt obligations, non-pension retirement obligations (less than $50 million, due principally after five years) and pension funding obligations. The Company voluntarily contributed $70 million to its pension plans in January 2004 to reduce the underfunding and expects no further contributions in 2004 and minimal funding requirements in 2005 and 2006. Benefit payments to plan participants from the Company’s pension plan trusts are estimated to approximate $32 million annually.

The Company has not entered into any off-balance sheet arrangements which would be reasonably likely to have a current or future material effect, such as obligations under certain guarantees or contracts; retained or contingent interests in assets transferred to an unconsolidated entity or similar arrangements; obligations under certain derivative arrangements; and obligations under material variable interests.

CREDIT CARDS

Prior to April 2003, the Company’s proprietary credit cards were issued by National Bank of the Great Lakes (“NBGL”), a wholly owned subsidiary of the Company. Receivables generated from the sale of merchandise on these credit cards were sold by NBGL to another wholly owned subsidiary which, in turn, transferred, conveyed and assigned all its rights and interests in the receivables to a trust. The Company was responsible for administering the credit card program, including the collection and application of funds. Certificates representing undivided beneficial interests in the pool of receivables held in the trust were issued to third-party investors. Proceeds were remitted by the trust to the Company as consideration for its conveyance of receivables to the trust. The Company retained an interest in the trust that was subordinate to the rights of third-party investors to cash flows from receivables and repayment. The amount of receivables representing certificates sold to third-party investors was accounted for as having been sold, and the subordinated interest in the trust was recorded as an asset under Retained Interest in Accounts Receivable on the Company’s consolidated balance sheet.

On April 15, 2003, the Company sold its proprietary credit card portfolio, consisting of the proprietary credit card accounts owned by NBGL and the Company’s ownership interest in the assets of the trust, to Household Bank (SB), N.A. (“Household”), a third-party financial institution.

In connection with the sale, the Company received an amount in cash equal to (1) the sum of 100% of the outstanding accounts receivable balances, a premium and the value of investments held in securitization accounts, minus (2) the outstanding principal balance, together with unpaid accrued interest, of specified certificates held by public investors, which certificates were assumed by Household at the closing. The Company used a portion of the cash received at closing to repay amounts due under the trust certificates and related obligations held at the time of the closing by bank-sponsored commercial paper conduit investors, which certificates and obligations were not assumed by the financial institution. After deducting these repayment amounts and transaction expenses and after satisfying related payables, the Company’s net cash proceeds from the transaction were approximately $300 million. After allocating the cash proceeds to the sold accounts, the retained interest in the securitized receivables, and an ongoing program agreement, the Company realized a gain of approximately $5 million. The cash proceeds allocated to the ongoing program agreement were deferred and will be reflected as a reimbursement of continuing credit card related expenses over the life of the agreement.

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As part of the transaction, for a term of ten years and pursuant to a program agreement, Household will establish and own proprietary credit card accounts for customers of the Company’s operating subsidiaries, retain the benefits and risks associated with the ownership of the accounts, receive the finance charge income and incur the bad debts associated with those accounts. During the ten-year term, pursuant to a servicing agreement, the Company will continue to provide key customer service functions, including new account opening, transaction authorization, billing adjustments and customer inquiries, and will receive compensation from Household for these services.

At the end of the ten-year term, the agreement can be renewed for successive two-year terms. At the end of the agreement, the Company has the right to repurchase, at fair value, all of the accounts and outstanding accounts receivable, negotiate a new agreement with Household or begin issuing private label credit cards itself or through others. The agreement allows the Company to terminate the agreement early following the incurrence of certain events, the most significant of which would be Household’s failure to pay owed amounts, Household’s bankruptcy, a change in control or a material adverse change in Household’s ability to perform under the agreement. The agreement also allows Household to terminate the agreement if the Company fails to pay owed amounts or enters liquidation. Should either the Company or Household choose to terminate the agreement early, the Company has the right, but not the requirement, to repurchase the accounts and outstanding accounts receivable. The Company is contingently liable to pay monies to Household in the event of an early termination or a significant disposition of stores. The contingent payment is based upon a declining portion of an amount established at the beginning of the ten-year agreement and on a prorated portion of significant store closings. If the agreement had been terminated early at January 31, 2004, the maximum contingent payment would have been approximately $130 million. Management believes the risk of incurring a contingent payment is remote.

The Company utilized a portion of the net proceeds from the Household transaction, together with operating cash flows to repurchase common stock and senior notes in 2003.

CAPITAL NEEDS

The Company estimates capital expenditures for 2004 will approximate $225 to $250 million, primarily for the construction of new stores opening in 2004, initial construction work on stores expected to open in 2005, store expansions and renovations, enhancements to management information systems and replacement capital expenditures.

The Company anticipates that working capital requirements related to new and existing stores and capital expenditures will be funded through cash provided by operations and the revolving credit agreement. Maximum availability under the revolving credit agreement is $800 million. There is no debt rating trigger. During periods in which availability under the agreement exceeds $100 million, the Company is not subject to financial covenants. If availability under the agreement were to decrease to less than $100 million, the Company would be subject to a minimum fixed charge coverage ratio of 1 to 1. During 2003, weighted average borrowings and letters of credit issued under this credit agreement were $144.0 million. The highest amount of borrowings and letters of credit outstanding under the agreement during 2003 was $163.7 million. The Company expects to generate adequate cash flows from operating activities combined with borrowings under its revolving credit agreement in order to sustain its current levels of operations.

The most significant requirement for new or replacement financing in 2004 is the maturity of the 2004 notes aggregating $142.6 million ($72.3 million in July and $70.3 million in December). The Company believes that it will have sufficient cash on hand or availability under its revolving credit agreement to fund this maturity.

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CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The Company’s critical accounting policies and estimates are discussed in the notes to the consolidated financial statements. Certain judgments and estimates utilized in implementing these accounting policies are likewise discussed in each of the notes to the consolidated financial statements. The following discussion aggregates the judgments and uncertainties affecting the application of these policies and estimates and the likelihood that materially different amounts would be reported under varying conditions and assumptions.

REVENUE RECOGNITION

Sales and the related gross margin are recorded at the time our customers provide a satisfactory form of payment and take ownership of the merchandise. There are minimal accounting judgments and uncertainties affecting the application of this policy. The Company estimates the amount of goods that will be returned for a refund and reduces sales and gross margin by that amount. However, given that approximately 15% of merchandise sold is later returned and that the vast majority of merchandise returns are affected within a matter of days of the selling transaction, the risk of the Company realizing a materially different amount for sales and gross margin than reported in the consolidated financial statements is minimal.

COST OF SALES AND INVENTORY VALUATION (excluding depreciation and amortization)

The Company’s inventory is stated at the lower of LIFO cost or market using the retail method. Under the retail method, the valuation of inventories at cost and the resulting gross margins are determined by applying a calculated cost-to-retail ratio to the retail value of inventories. The cost of the inventory reflected on the consolidated balance sheet is decreased with a charge to cost of sales contemporaneous with the lowering of the retail value of the inventory on the sales floor through the use of markdowns. Hence, earnings are negatively impacted as the merchandise is being devalued with markdowns prior to the sale of the merchandise. The areas requiring significant management judgment include (1) setting the original retail value for the merchandise held for sale, (2) recognizing merchandise for which the customer’s perception of value has declined and appropriately marking the retail value of the merchandise down to the perceived value, and (3) estimating the shrinkage that has occurred through theft during the period between physical inventory counts. These judgments and estimates, coupled with the averaging processes within the retail method, can, under certain circumstances, produce varying financial results. Factors that can lead to different financial results include setting original retail values for merchandise held for sale at too high a level, failure to identify a decline in perceived value of inventories and process the appropriate retail value markdowns and overly optimistic or overly conservative shrinkage estimates. The Company believes it has the appropriate merchandise valuation and pricing controls in place to minimize the risk that its inventory values would be materially under or overvalued.

PROPRIETARY CREDIT CARDS

Prior to April 15, 2003

The carrying value of the Company’s retained interest in credit card receivables required a substantial amount of management judgment and estimates. At the time credit card receivables were sold to third-party investors through the securitization program, generally accepted accounting principles required that the Company recognize a gain or loss equal to the excess of the estimated fair value of the consideration to be received from the individual interest sold over the cost of the receivables sold. As the receivables were collected, the estimated gains and losses were reconciled to the actual gains and losses. Given that the Company generated credit card receivables of approximately $3 billion per year and average outstanding sold receivables were generally $1.0 billion to $1.2 billion, a substantial majority of the annual estimated credit gains and losses had been reconciled to actual gains and losses. Only that portion of the gains and losses attributable to the outstanding securitized

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portfolio at year end remained subject to estimating risk. At February 1, 2003, the net gain recognized within the Retained Interest in Accounts Receivable asset was $48.2 million.

Determining the fair value of the consideration to be received from the individual interest sold included estimates of the following amounts associated with the sold portfolio: (1) the gross finance charge income to be generated by the portfolio which required estimates of payment rates, (2) the coupon interest rate due to the third-party investors, (3) bad debts, (4) cost of servicing the portfolio, and (5) assumed cash flow discount rates. The notes to the consolidated financial statements reflect the critical estimates and assumptions utilized. Items that were considered in making judgments and preparing estimates and factors that can lead to variations in the consolidated financial results were as follows:

The most sensitive assumptions in calculating the gain on sold receivables were the credit card customers’ payment rate, the estimate for bad debts and the assumed cash flow discount rates.

The following table represents the Company’s assumptions in measuring the fair value of retained interests in accounts receivable in 2002 and 2001:

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Subsequent to April 15, 2003

Following the sale of the Company’s proprietary credit card business, the Company no longer maintains a retained interest in the credit card receivables. There are minimal accounting judgments and uncertainties affecting the accounting for the credit card program compensation, credit card servicing compensation and servicing expenses. Initial proceeds allocated to the program and servicing agreement are being amortized into income ratably over the lives of the agreement. Ongoing income associated with honoring the credit cards under the program agreement, promoting the credit cards and servicing the credit cards is recognized monthly contemporaneous with providing these services.

SELF-INSURANCE RESERVES

The Company self-insures a substantial portion of the exposure for costs related primarily to employee medical, workers’ compensation and general liability. Expenses are recorded based on estimates for reported and incurred but not reported claims considering a number of factors, including historical claims experience, severity factors, litigation costs, inflation and other assumptions. Although the Company does not expect the amount it will ultimately pay to differ significantly from estimates, self-insurance reserves could be affected if future claims experience differs significantly from the historical trends and assumptions.

DEPRECIATION AND RECOVERABILITY OF CAPITAL ASSETS

Over one-half of the Company’s assets at January 31, 2004 are represented by investments in property, equipment and goodwill. Determining appropriate depreciable lives and reasonable assumptions for use in evaluating the carrying value of capital assets requires judgments and estimates.

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INCOME AND OTHER TAXES

The majority of the Company’s deferred tax assets at January 31, 2004 consist of federal net operating loss carryforwards that will expire between 2005 and 2018. At January 31, 2004, the Company believes that it will be profitable during the periods 2004 through 2018, allowing it to sufficiently utilize the carrying value of the benefit of the federal net operating loss carryforwards. To the extent management’s estimates of future taxable income by jurisdiction is greater than or less than management’s current estimates, future increases or decreases in the benefit of net operating loss carryforwards could occur.

The Company is routinely under audit by federal, state or local authorities in the areas of income taxes and the remittance of sales and use taxes. These audits include questioning the timing and amount of deductions, the allocation of income among various tax jurisdictions and compliance with federal, state and local tax laws. In evaluating the exposure associated with various tax filing positions, the Company often accrues charges for probable exposures. During 2003, the Company concluded a federal income tax examination for the 1998 and 1999 tax years on terms favorable to previously accrued exposures associated with those tax years. Therefore, the Company decreased the amount previously accrued for probable exposures. Additionally, the Company reevaluated its exposures to state-related tax filing positions and determined the need to provide for additional reserves. The net effect of this federal and state reserve adjustment resulted in an income tax benefit of $11.1 million. At January 31, 2004, the Company believes it has appropriately accrued for probable exposures. To the extent the Company was to prevail in matters for which accruals have been established or be required to pay amounts in excess of reserves, the Company’s effective tax rate in a given financial statement period may be materially impacted. At January 31, 2004, two of the Company’s five open tax years were undergoing examination by the Internal Revenue Service.

PENSION PLANS

Pension expense is based on information provided by outside actuarial firms that use assumptions to estimate the total benefits ultimately payable to associates and allocates this cost to service periods. The actuarial assumptions used to calculate pension costs are reviewed annually. The pension plans are valued annually on November 1st. The projected unit credit method is utilized in recognizing the pension liabilities.

Pension assumptions are based upon management’s best estimates, after consulting with outside investment advisors and actuaries, as of the annual measurement date.

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INFLATION AND DEFLATION

Inflation and deflation affect the costs incurred by the Company in its purchase of merchandise and in certain components of its SG&A expenses. The Company attempts to offset the effects of inflation, which has occurred in recent years in SG&A, through price increases and control of expenses, although the Company’s ability to increase prices is limited by competitive factors in its markets. The Company attempts to offset the effects of merchandise deflation, which has occurred in recent years, through control of expenses.

SEASONALITY

The Company’s business, like that of most retailers, is subject to seasonal influences, with a significant portion of net sales and net income realized during the second half of the fiscal year, which includes the holiday selling season. In light of these patterns, SG&A expenses are typically higher as a percentage of net sales during the first three fiscal quarters of each year, and working capital needs are greater in the last two fiscal quarters of each year. The increases in working capital needs during the fall season have typically been financed with cash flow from operations and borrowings under the Company’s revolving credit agreement. Generally, more than 30% of the Company’s net sales and more than 75% of net income are generated during the fourth fiscal quarter.

NEW ACCOUNTING PRONOUNCEMENTS

In December 2002, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure, an amendment of FASB Statement

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No. 123.” Beginning in 2003, all newly issued employee stock option grants are being expensed based on the fair value of the options granted, consistent with the “prospective method.” The adoption of this standard did not have a significant effect on the Company’s financial position or results of operations.

In December 2003, the FASB issued FIN 46, “Consolidation of Variable Interest Entities.” FIN 46 focuses on financial reporting for entities over which control is achieved through means other than voting rights. The Company adopted this new standard in 2003. The Company does not expect that the standard will have a material effect on the Company’s financial position or its results of operations.

The FASB’s Emerging Issues Task Force (“EITF”) Issue No. 02-16, “Accounting By a Customer (Including a Reseller) for Cash Consideration Received from a Vendor,” addressed the accounting treatment for vendor allowances and co-operative advertising programs and became effective in 2003. The Company’s accounting policy for consideration received from a vendor is consistent with the EITF’s consensus opinion.

In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities,” to amend and clarify financial accounting and reporting for derivative instruments and hedging activities. This standard did not have a significant effect on the Company’s financial position or results of operations.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity,” to establish standards on how to classify and measure certain financial instruments with characteristics of both liabilities and equity. This standard became effective during 2003, and it did not have a significant effect on the Company’s financial position or results of operations.

In December 2003, the FASB revised standards associated with disclosures about pensions and other postretirement benefits. This standard became effective at the end of fiscal year 2003 and the Company provided the revised disclosures.

In January 2004, the FASB issued a position on accounting and disclosure requirements related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003. The Company has elected to defer accounting for the effects of this Act. Authoritative guidance remains pending, and although the effects of this Act on the Company’s plan remain unknown until regulations are developed, the adoption of future guidance is not expected to have a material effect on the Company’s financial position or its results of operations.

RELATED PARTY TRANSACTIONS

The Company engaged the services of a law firm, one of whose principals includes a family member of an executive officer. Fees paid to this firm were at market rates and aggregated approximately $0.1 million and $0.1 million in 2003 and 2002, respectively. The Company loaned amounts aggregating approximately $1 million to executive officers prior to June 2002 as a component of the Company’s compensation programs. At January 31, 2004, there was one loan outstanding to an executive officer for $0.4 million. The Company does not believe these services, fees and loans are material to the consolidated financial position or results from operations.

FORWARD-LOOKING INFORMATION

Certain information presented in this report addresses future results or expectations and is considered “forward-looking” information within the definition of the Federal securities laws. Forward-looking statements can be identified through the use of words such as “may,” “will,” “intend,” “plan,” “project,” “expect,” “anticipate,” “should,” “would,” “believe,” “estimate,” “contemplate,” “possible,” “attempts,” “seeks” and

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“point.” The forward-looking information is premised on many factors, some of which are contained below. Actual consolidated results might differ materially from projected forward-looking information if there are any material changes in management’s assumptions.

The forward-looking information and statements are based on a series of projections and estimates that involve risks and uncertainties. These risks and uncertainties include such factors as: the level of consumer spending for apparel and other merchandise carried by the Company and its ability to respond quickly to consumer trends; adequate and stable sources of merchandise; the competitive pricing environment within the department and specialty store industries as well as other retail channels; favorable customer response to planned changes in customer service formats; the effectiveness of planned advertising, marketing and promotional campaigns; favorable customer response to increased relationship marketing efforts and proprietary credit card loyalty programs; effective expense control; effective continued operations of credit card servicing operations; and changes in interest rates. For additional information regarding these and other risk factors, please refer to Exhibit 99.1 filed as part of this report and incorporated by reference herein.

Management undertakes no obligation to correct or update any forward-looking statements, whether as a result of new information, future events or otherwise. Persons are advised, however, to consult any further disclosures management makes on related subjects in its reports with the Securities and Exchange Commission and in its press releases.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk.

The Company’s exposure to market risk primarily arises from changes in interest rates and the U.S. equity and bond markets. The effects of changes in interest rates on earnings generally have been small relative to other factors that also affect earnings, such as sales and operating margins. The Company seeks to manage exposure to adverse interest rate changes through its normal operating and financing activities, and if appropriate, through the use of derivative financial instruments. Such derivative instruments can be used as part of an overall risk management program in order to manage the costs and risks associated with various financial exposures. The Company does not enter into derivative instruments for trading purposes, as clearly defined in its risk management policies. The Company is exposed to interest rate risk primarily through its borrowings, and derivative financial instrument activities, which are described in Notes 2 and 7 to the Consolidated Financial Statements appearing elsewhere in this report.

At January 31, 2004, the Company had interest rate swap agreements with notional amounts of $150 million and $100 million, which swapped coupon rates of 8.25% and 7.50%, respectively for floating rates. The fair value of these swaps at January 31, 2004 was a loss of $2.1 million. The Company previously cancelled interest rate swap agreements resulting in net gains. The net gains on the cancellation of swap agreements are being amortized as a component of interest expense through 2008. At January 31, 2004, $4.6 million of these net gains remained unamortized.

The Company entered into an accelerated stock buy-back agreement in 2003. The agreement settles in May 2004 and the Company expects it will pay the maximum of approximately $5 million, which will serve to reduce shareholders’ equity.

Based on the Company’s market risk sensitive instruments (including variable rate debt and derivative financial instruments) outstanding at January 31, 2004, the Company has determined that there was no material market risk exposure to the Company’s consolidated financial position, results of operations, or cash flows as of such date.

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The Company’s assumptions in measuring the retained interests in accounts receivable as of and for the period ended February 1, 2003 and the sensitivity of the fair value to immediate 10% and 20% adverse changes in those assumptions are as follows: